stox.com Inc - Street Wire
stox takes Accounting 101; Stockgroup risks death ride
stox.com Inc URL
Shares issued 8,547,860 Jun 29 close $3.15
Thu 29 Jun 2000 Street Wire
Also (OTCBB:SWEB)
THE FINANCIAL EXPERTS AT WORK
by Stockwatch Business Reporter
Two Vancouver-based financial Web sites -- the Bloomberg-killing stox.com
Inc. and Stockgroup.com Holdings Inc., which bills itself as indispensable
research tool for small-cap investors -- are both struggling with share
prices at or near their 52-week lows. The companies are the creators of
their own misfortunes and their recent share-price headaches to varying
degrees stem from how they treated revenues in their financial statements.
In the case of stox, the company attempted to dish out misleading revenues
in order to keep its story going and investors happy, while big-spending
Stockgroup's troubles stem from an attempt to bolster its balance sheet in
order to secure a much-needed $3-million (U.S.) financing. It is a
stock-market monstrosity commonly referred to as "death spiral" financing
that can result in an astounding share dilution that will mean a gutted
share price, shareholder panic and, soon after, the handing over of control
to outsiders.
Both stox and Stockgroup risk investor incredulity that the managements of
companies that dispense financial information and advice on-line either
cannot grasp the basics of accounting, or failed to recognize a type of
financing that is well known as financial suicide.
Earlier this month, Patrick Lavin, stox's chief financial officer and
director, was obliged to restate, severely downward, the company's revenue
for the three months ending Jan. 31. What had been first-quarter revenue of
$1,162,660 was restated on June 6 to a nearly non-existent, but more
realistic, $2,660. Mr. Lavin attributed the restatement not to regulatory
supervision or a stock exchange's requirements, but to leading-edge
developments in the world of accounting and how they pertain to stox's
"product development and Web hosting arrangements."
Mr. Lavin, in a stroke of mystifying double-speak, said the company planned
to defer and recognize this "software licence revenue" from two contracts
earlier this year over the terms of the contracts. Knowledgeable
accountants scratched their heads. As a result of its admission, stox has
joined the rest of the more respectable accounting world in reporting
revenue when it is revenue, and not when it is cash, stock certificates, or
more likely, the promise of cash. In any event, investors can expect
further reductions in revenue the company had expected to recognize in the
second quarter, Mr. Lavin added.
The contracts in question were with an unnamed San Francisco brokerage firm
and OTC Bulletin Board travel Web site inTRAVELnet.com Inc., which was in
the process of moving out of suburban Richmond and into stox's building
near Vancouver harbour when the deal was announced.
The transaction involves the sale by stox of something that stox refers to
repeatedly in disclosures as its "proprietary platform." Even though stox
has never explained its platform jargon, investors are led to believe the
platform provides the technical basis of its "Bloomberg Killer" system,
which is available to subscribers for $29 (U.S.) monthly and up.
inTRAVELnet, a Dan Clozza, Michael Darcy and Tara Davies play, is creating
what it touts as the final word in Web sites for timeshare resorts.
(inTRAVELnet posted a loss for the year ending Dec. 31, 1999, of
$6.2-million on revenue of $2.71-million.)
stox's restating of its quarterly revenue this week came 47 days after an
article highlighted the company's accounting procedures regarding the
reporting of what is described as revenue from inTRAVELnet. As indicated by
the company's sagging price in the leadup to its admission of playing games
with its revenue, investors may be left wondering about the promotional
hoopla surrounding a number of other deals in the United States. With so
many deals and such puny revenue, many wonder what other surprises are in
store for the on-line junior.
stox has plenty of dot-com company in having difficulty with revenue
recognition. While accountants have tweaked and twitched their
profit-and-loss figures for as long as there have been accountants, it has
only been recently that regulators, led by the Securities and Exchange
Commission, have made such an issue out of inflated revenue. One Vancouver
accountant calls revenue recognition the "hottest issue" at the SEC. The
bulk of the SEC's admonishments and enforcement actions have been directed
at tech firms. Part of the reason is that they tend to trade not on
earnings, but on revenue, and the temptation to inflate revenue becomes too
great for many company officials to resist.
SMALL CAP, BIG SPEND
Stockgroup is a big-spending financial site, boasting around 100 employees
and five offices in the United States and Canada. A sixth office, in Texas,
is planned. The company ran a television advertising campaign in the U.S.
to boost the loud launch of its smallcapcentre Web site in early October,
1999, based on the "5 to 200" theme. The advertising pitch, which could
still be found in print ads as recently as this May, is built along the
jingle, "Sex is good, but finding a stock at 5 that goes to 200 is even
better." 5 to 200 is also the name of Stockgroup's weekly Webcast, hosted
by its much-touted editor-in-chief David Andelman, a journalist in New
York. The implication is that financial expertise oozes from the company's
every pore.
Some of its advertising expenses were covered by the September, 1999,
"private placement" in Stockgroup by Hollinger International unit Southam
Inc. In the deal, Southam acquired a 2.5-per-cent interest in Stockgroup by
buying 200,000 shares at a hefty $6 for a total $1.2-million. Stockgroup
issued the shares in exchange for advertising in Southam publications in
Canada.
Like stox, Stockgroup also appears to have difficulty with Accounting 101.
With a price dipping below a dollar on the OTC Bulletin Board, it does not
look as though Stockgroup is a 5-to-200 find for investors who bought as
high as $9 a month after its March, 1999, listing. (All figures are in U.S.
dollars unless noted otherwise.)
Beginning with the year-end figures for Dec. 31, 1999, Stockgroup began
reporting according to U.S. generally accepted accounting principles
(GAAP). For the three months ending March 31, 2000, Stockgroup lost
$1,356,015 on revenue of $1,241,207. The quarterly results indicate a
relatively strong surge in revenue compared with all of 1999, when revenue
was $1.92-million. For the year ending Dec. 31, Stockgroup posted revenue
of $1,920,052 and a loss of $4,242,533.
Stockgroup's $1,241,207 revenue for the quarter ending March 31 comprised
$174,539 from "advertising and media services," $169,415 from "Website
design and development," $394,122 from "Website maintenance and marketing"
and $503,131 from "enterprise financial Website development."
In notes to the financial statements, Stockgroup provides an explanation of
how it recognizes revenue for three of its four categories of revenue. The
category that was not explained was "enterprise financial Website
development." Like a page out of the stox book of promotion, this category
is the sale of the company's proprietary "platform." In a Form SB-2
registration statement filed with the SEC on May 25, Stockgroup describes
this business process as "developing opportunities for the sale of its
expertise in the development of enterprise financial Web site platforms."
It is a classification of revenue not seen before Dec. 31, 1999.
The company boasted in the document that it had "recently commenced
initiatives based on the sale of its technology platform and services to
other corporations who offer financial websites on the Internet."
Stockgroup is working on two such deals, one in Singapore and one in Texas.
The Singapore deal, signed on Jan. 18, is with Asia Exchange Information
Service Pte. Ltd., or AsiaXIS. The site was launched on June 28. According
to the SEC disclosure, Stockgroup will develop an enterprise financial Web
site for AsiaXIS in return for approximately $1.5-million for what it calls
the "initial site."
The agreement also provides for AsiaXIS to develop 13 additional sites
throughout Asia, Australia and New Zealand. Stockgroup "will be paid a
licensing fee for its technology, a development fee for building and
customizing each additional financial enterprise site, ongoing maintenance
and support fees and royalties for each of the markets that AsiaXIS
enters."
In the second deal, in Texas, Stockgroup was contracted to build the
eStockAnalyst.com (www.estockanalyst.com) Web site. eStockAnalyst charges
subscribers $24.95 for 90 days, which is about the same as that charged by
Stockgroup for its annual smallcapcentre introductory offer of $99. Even
though the site is up and running, Stockgroup has released practically no
information about this project in the form of press releases or SEC filings
-- only a passing reference to it in the registration statement's
management discussion and analysis.
In an interview, Stockgroup president Les Landes says that the entry
indicating revenue of $503,131, comprised cash from both the Texas and
Singapore deals. Asked why Stockgroup did not explain how this cash was
recognized in the registration statement, Mr. Landes says the revenue was
cash in hand for work performed, so there was no need to treat it as
recognized revenue. Asked if the $503,131 entry in the unaudited quarterly
was recognized revenue, Mr. Landes replied: "We have some good business
practices, we have a good auditor in Ernst & Young and we only recognize
revenue as it is received. That is all cash in hand for work that has been
completed. There is no trade or anything else in that. It's cash for work
completed."
"WRONG ANSWER"
A Vancouver accountant with no ties to Stockgroup but who is familiar with
U.S. GAAP, says even though cash may have been received for work completed,
that is not enough justification to deem the $503,131 as revenue. "If he's
simply saying, 'That's the cash we got,' then that's the wrong answer," the
accountant contends, "because that is not the basis on which you calculate
revenue." He adds that while he does not have enough information to judge
whether or not the quarterly statement is misleading or incorrect in any
way, he stresses that "cash does not equate to revenue, period. The golden
rule in accounting is that ... cash and revenue do not necessarily mean the
same thing for any interim or individual period. Getting the cash doesn't
trigger the recognition of revenue."
The accountant explains that cash may only be recognized as revenue after a
number of specific criteria have been satisfied.
The rules on revenue recognition are not new and the SEC in December, 1999,
clarified its existing rules and interpretations in a lengthy and highly
publicized document, SEC Staff Accounting Bulletin No. 101 -- Revenue
Recognition in Financial Statements. It says that "revenues should not be
recognized until they are realized or realizable and earned," and by
earned, the SEC means whether a company's own costs to earn that revenue
have been calculated and recorded. In the absence of an entry under
"management's discussion and analysis" about how the revenue for the
Singapore and Texas deals have been dealt with, the accountant says it is
almost impossible to say whether Stockgroup has satisfied the SEC's edicts.
(The absence of such notation does not inspire the accountant with
confidence, however.)
Perhaps tellingly, the accountant says that for these kinds of service
contracts -- that is, contracts for the provision of services -- good
accounting practices dictate that companies such as Stockgroup, which lack
experience in providing such services, should adopt the
"completed-contract" method of revenue recognition. This method dictates
that they hold off recognizing revenue until the job is fully completed and
paid for; only the more experienced companies are in a position to
confidently track their costs and revenues over the life of the contract.
An example of the tracking method is when a company believes that providing
services in a $250,000 contract will cost it $200,000 to provide those
services. In this method, for every dollar of cost, the company realizes
$1.25 of revenue, and that is the way it shows on the balance sheet.
THE DEBENTURE FROM HELL
The company's May 25 registration statement was filed in connection with
the $3-million financing from Minnetonka, Minn., fund manager Deephaven
Capital Management LLC and Zurich-based Amro International SA. (Figures are
in U.S. dollars unless otherwise indicated.)
With 98 employees, Stockgroup is spending at least $4-million a year in
salaries alone. Then there are the offices, in Calgary, San Francisco and
Toronto, the planned Texas office, plus space in New York's trendy Silicon
Alley and an entire floor of office space in a AAA building in Vancouver
which serves as its headquarters. No cramped dot-com space in an former
warehouse for this company. Its cash position as of Dec. 31, 1999, was
$1.65-million. Stockgroup says that with the $3-million provided in the
April financing, the company will have enough cash to last until April,
2001.
The financing, also known as a death spiral financing, involves the sale of
$3-million in 8 per cent convertible notes, and five-year callable
warrants, to both Deephaven and Amro International, with Deephaven taking a
majority position in the financing. (Amro International should not be
confused with ABN AMRO Bank NV, the Dutch-based banking giant.) In the
deal, at the lenders' option, Stockgroup's notes can be converted any time
after July 31, 2000. While the interest may be paid in the form of cash or
shares at Stockgroup's option, the lenders have the right to put back to
Stockgroup "up to 25 per cent of the unconverted amount of the notes during
any 30-day period after July 31," the company says in its SB-2.
This means, primarily, that the company must hold back 25 per cent of the
unconverted amount of the notes at any given time, unless it has blind
trust in the good intentions of its financiers. Starting on July 31,
Deephaven-Amro have the right to demand that much back during any 30-day
period. Should Stockgroup not pay back the lenders within 10 days of
receipt of the "put" notice, all hell breaks loose: the conversion rate of
the note changes to the lesser of (a), the initial conversion price ($3.72)
and (b), 88 per cent of the five lowest closing prices of Stockgroup share
price during the 30 trading days prior to the date of conversion.
The net effect of this may be corporate devastation for Stockgroup. If
Stockgroup cannot pay back the cash as demanded by Deephaven-Amro, the
company will then be forced to issue to the lenders $3-million worth of
shares at ever cheaper prices. Ignoring little details such as interest
accrued, and the 88 per cent discount to the five lowest close prices, at
$1, the company would have to issue three million shares, or at 50 cents,
six million shares. Following this picture, the implication for Stockgroup,
its principals and its current shareholders, is a horror show. The lenders,
should they want control of the company, are motivated to receive as many
shares for their $3-million as they can engineer, and what better way to
engineer themselves control than to pound the poor victim down to a penny.
There, they would receive 300 million shares, rather than the paltry 30
million they would get if they only pounded Stockgroup's shares down to a
dime.
During this hypothetical exercise the position of Stockgroup's investors
who held the 8,195,000 shares prior to this financing, remains static. Once
the dust has cleared, the new controlling shareholders can consolidate the
shares one for one hundred, or whatever pleases them, and carry on with
business if they like its prospects or sell the company for what it will
fetch. Either way, Mr. Landes, company founder Marcus New, and the other
directors would be history.
Not surprisingly, Stockgroup's shares have been on a steady decline since
the financing deal with Deephaven and Amro was signed on April 3, at
$2-7/8. While a number of factors have played a role in the continued
decline of Stockgroup shares from their intraday high of $9 on April 14,
1999, systematic shorting on the part of the lenders is a distinct
likelihood given the history of these kinds of financings, and its
inclusion in the recent prospectus.
In an interview, Mr. Landes indicated that Stockgroup was gratified by the
show of support given to the company by Deephaven, a subsidiary of major
financial outfit Knight/Trimark Group of Jersey City, N.J. "We were very
interested in getting them involved and they were very interested in doing
it, and that was a way of doing it and it was an attractive method for us,"
said Mr. Landes. He added that having Deephaven "show confidence" in
Stockgroup was particularly gratifying given the timing of the deal. By
April 3, the tech boom was beginning to show its age and financings were
not easy to secure. "We're very, very happy to get those guys, have them
show confidence in us," Mr. Landes said.
Although such financings are not common, the financial press (but probably
not stox and Stockgroup) have reported on death-spiral financings often
enough. In May, 1999, The Salt Lake City Tribune detailed the fall of Fonix
Corp., what it called one of Utah's most spectacular business failures. The
perpetual money-losing developer of voice-recognition technology, faced
with investors reluctant to keep bankrolling its expensive operations (it
lost $43.1-million in 1998) got into what is known as a death-spiral or
death-ride financing. As a result, the number of its shares soared from
43.7 million at the end of 1997, to 70.1 million by April 9, 1999.
CORPORATE HARA-KIRI
Companies engaging in this kind of financing also tie their hands for any
kind of alternative financing arrangement. It is considered a suicide
measure, and virtually no sane financiers will offer further financing to
companies involved in such deals because of the high likelihood of lower
prices and severe dilution around the corner.
Another company that made the trip down death-spiral lane was Nasdaq-listed
Alberta oil and gas company Odyssey Petroleum Corp., formerly Brimm Energy
Corp. It did a Regulation S financing with Kessler Asher International LP,
an indirect subsidiary of Arbitrade Holdings LLC, of which Deephaven is a
direct subsidiary. In the end, the previous shareholders lost control to
United Kingdom-based Melrose Resources PLC, which wound up with just under
79 per cent of the company's shares for a fraction of their previous value.
Odyssey had several development and exploration concessions in Egypt.
After losing $5,021,655 in the nine months ending Sept. 30, 1997, Odyssey
on Oct. 7, 1997, issued a $2-million, 8 per cent convertible debenture plus
50,000 warrants for net proceeds of $1.86-million. According to Odyssey's
1998 annual report, the debenture was convertible into common shares at any
time at the holder's option. The conversion price per share of the
debenture was the lower of $3.425 or 82.5 per cent of the average trading
price of the common shares on the last five trading days prior to the
conversion. A quarter of the gross proceeds, or $484,114, was held by the
company as a debenture liability.
The market may have recognized the danger of this type of financing and
reacted accordingly. Odyssey shares opened on Oct. 7, 1997, at $3-11/16 and
closed that day at $2-15/16, albeit on light volume of 15,400 shares. The
slide would continue, however.
Odyssey's president at the time of the financing, David Robinson, recalls
that things were okay for several months, but then "everything just sort of
fell apart and the share price went from about $2 to six cents."
According to Odyssey's August, 1999, management proxy to remove the
company's shares from Nasdaq, on Dec. 30, 1998, Melrose entered into a deal
to acquire 24 million shares at 12.5 cents in four installments.
Simultaneously, with the closing of the first installment, on Feb. 15,
1999, Melrose acquired from "a third party" all of the company's
outstanding 8 per cent convertible debentures due Oct. 1, 2002, and gave
notice of the conversion of the debentures into 15,356,000 shares. In the
end, Melrose wound up with 41,682,123 shares out of a total 52,781,875
shares, or 78.97 per cent.
What would be the literally final direction of the company was made clear
when the convertible was bought out by Melrose, the group that took over
the company, Mr. Robinson says. "I was long gone by then (late-1998) but I
was still a shareholder so I heard what was going on, and when Melrose
first got involved I heard right from the beginning their intention was to
take over the company."
Mr. Robinson says there were other factors in play that contributed to
Odyssey's demise beyond the financing, such as management changes and a
deal falling through in the Ukraine. Such are the problems that beset any
company that is desperate enough to take up an offer of suicide financing,
however. The lesson for Mr. Robinson and, no doubt, others from the old
Odyssey board, is that Regulation S financings are to be avoided. "Since
that time with Odyssey I've been with other companies that have been
offered similar type financings, and these things called equity credit
lines, and I've just said no way because I'm too fearful of what appears to
be happening to Stockgroup," Mr. Robinson says.
Odyssey's journey to dilution hell with Deephaven is, however, instructive
for companies that may be inclined to sign on the dotted line before some
very careful thought. Deephaven's client relations director, Jeffrey
Applebaum, indicates that his company's policy is to not ally itself too
closely with any particular investor (although on the surface the Odyssey
financing might raise an eyebrow or two). "Do our clients give us
discretion? Yes," Mr. Applebaum says. "Do they know what in general the
types of investments we're investing in? Yes. Do they know the specific
issues and do we have them approve them before we make any investments?
There's not one money manager in the world that does that."
Beyond that, Deephaven officials were not keen to discuss the way Deephaven
does business or who it does it for. Asked if he were familiar with
death-spiral financings, Mr. Applebaum said, "I don't know the answer to
that." He ended the interview at that point and invited a reporter to send
future questions in written form.
Bruce Bowie, an investigator who does securities work in British Columbia,
says there are three main reasons why companies such as Stockgroup find
themselves of being pushed over the brink of oblivion by predatory
investors. First is expediency -- "all they can see are the dollar signs,"
of the money offered, he says. Second, they often get bad legal advice
before agreeing to such financings. Third is the inexperience of the
managers at victim companies. "You've got a lot more people who have come
into the market who have absolutely no experience than ever before, these
dot-coms," Mr. Bowie says. "They're just mutts waiting to be exploited by
someone who knows the ins and outs of this."
As for Stockgroup president Mr. Landes, if he understands the full
implications of the current financing, he is not letting on. "No, there's
nothing afoot, nothing afoot whatsoever," Mr. Landes says in response to
the seemingly inexplicable share-price deep-sea dive. "We are feeling
really good about our business. We are feeling very, very good about our
business."
(c) Copyright 2000 Canjex Publishing Ltd. canada-stockwatch.com
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