Earlier today (and as speculated by ValueWalk yesterday), Spruce Point Capital released its short thesis on manufacturing conglomerate Ametek, Inc. (NYSE:AME) claiming that the company manipulates its books in a variety of ways and that the stock has a downside of 30% – 50% (down about 3% at the moment, with plenty of volatility). The report is a monster, nearly 900 pages including all the supporting documents, but the thesis revolves around the way that Ametek has pursued growth through acquisitions.

“Given our concerns about aggressive acquisition and inventory accounting, Ametek’s true EBITDA margin may be 400-600 bps lower than reported. Our opinion is also supported by our review of at least 14 of its operating entities, which suggest EBITDA margins closer to 20 – 21%,” says the Spruce Point report. “If Ametek were valued in line w/ peers at 2x and 10-11x ‘14E revenues and EBITDA, its stock would be worth $27-$36/share, implying 30 – 50% downside from its current share price.”

Acquisitions keep R&D low and intangibles high

The first consequence of Ametek Inc’s (NYSE:AME) acquisition strategy is that goodwill and intangible assets make up 69% of total assets, with ‘customer relationships’ being the fastest growing item in those categories. Ametek also amortizes these relationships over a 19 year period on average, which Spruce Point argues adds 5% to EBITDA and 2.5% to EPS.

The other effect is that Ametek Inc (NYSE:AME) spends less than industry peers on R&D, acquiring what it needs when it picks up other companies instead. Aside from hampering organic growth, this means that Ametek is basically capitalizing other firms’ R&D costs instead of financing its own. Spruce Point argues that this adds another 200bps to its EBITDA margins.

Spruce Point found financial information on foreign subsidiaries that make up about 20% of Ametek’s 2013 revenues and found that they had an EBITDA margin of about 21%, in line with industry trends. For Ametek as a whole to beat its peers on EBITDA margins by 5%, the rest of its operations would have to be truly outstanding.

ametek foreign subsidiary margins 1114 Spruce Point

Spruce Point: Allegations of understating inventory on the balance sheet

The other area that Spruce Point focuses on is how Ametek Inc (NYSE:AME) accounts for its inventory. It relies more heavily on purchase obligations than its peers, and according to Spruce Point also uses more consignments, both of which can keep inventory of the balance sheet. Ametek also switched to FIFO accounting method (which actually brings it in line with its peers), and dropped the ‘lower of cost or market’ provision from the annual statement language in recent years.

ametek purchase obligations 1114 Spruce Point

There was also a whistleblower case brought against Ametek Inc (NYSE:AME) when a former employee claimed that he had been fired for raising concerns about accounting practices that he alleged were intended to understate the true cost of Ametek’s inventory. Ametek India’s auditor has also mentioned concerns about internal controls related to sale of goods, services, and inventory.

Allegations that the Dunkermotoren deal was misrepresented

Ametek Inc (NYSE:AME) CFO John Molinelli retired a few days after the acquisition of Dunkermotoren was announced, but that doesn’t actually seem surprising. If Molinelli (who had been with the company 43 years, 18 as CFO) was planning to retire then holding on until the largest deal in Ametek’s history was completely hammered out makes sense.

Spruce Point also objects to how this deal has been portrayed to investors. Dunkermotoren did become more profitable after Ametek took it over, but revenue fell 3% and the gains came from falling interest expense. This is debatably just a sign that Ametek was streamlining operations and keeping the more profitable parts, but Spruce Point Capital believes that Dunkermotoren sales were actually deteriorating before the deal went through.

Finally, insider ownership has been falling since 2007, from 4.1% to just 2% at the beginning of this year. Insider sales can be a sign that something is seriously wrong, and the seven year decline is worrying.

ametek insider sales 1114 Spruce Point