Spruce Point Issues “Strong Sell” Investment Opinion On The Ultimate Software Group (Nasdaq: ULTI) – Sees 20% – 45% Downside Potential
Spruce Point Capital Management is pleased to announce it has released the contents of a unique short idea involving The Ultimate Software Group, Inc. (Nasdaq: ULTI), a $5+ billion dollar human resource software company where we see $110 – $146 per share, or approximately 20% to 45% downside. We have conducted an extensive forensic financial and accounting review, and have obtained unique company contracts released through Freedom of Information (FOIA) requests. Our evidence and primary research suggests intense competition (which the management completely denies), heavy price discounting, and deteriorating margins at ULTI. In our opinion, ULTI is using very aggressive cost capitalization strategies related to software development and sales commissions to bolster its earnings. In addition, in our view its excessive stock compensation schemes are a real cost to shareholders that are being obscured as “financing” activities, and should be viewed as operating cash flows. In contrast to ULTI’s portrayal of a stable business with pricing power and producing >20% operating margins, we believe its operating margins are in persistent decline and less than 5%. ULTI’s tax policies are equally as aggressive; we observe its Net Operating Losses are rising rapidly, while shareholder dilution grows 4% p.a. despite share repurchases. These are not typical signs of a healthy growing company.
Our report also heavily scrutinizes Ultimate’s corporate governance and Board structure, which in our opinion, is entrenched and not properly supervising management or its undisclosed outside business interests and intra-family relationships. ULTI’s audit committee has been in place for nearly 20 years, and its audit chairman served as Board Chairman and audit committee member at Lason Inc, a company that filed for bankruptcy and had its executives charged with fraud and sentenced to prison! ULTI has significant ties to its auditor, and we worry that its abnormally low audit-fees and abnormally high “audit-related” costs suggest a lapse of true auditor independence. ULTI’s CFO, who also holds the role of treasurer and chief accounting officer, worked at ULTI’s auditor and should separate his combined duties for best corporate practice.
As a result, we have a “Strong Sell” opinion detailed extensively in our presentation.
Executive Summary
Spruce Point Believes The Ultimate Software Group Is A “Strong Sell” For The Following Reasons:
- Ultimate Software Group Short Thesis Has Many Parallels With Caesartone, Our Top Short Call From 2015-2016
- ULTI’s Management Is In Denial About Changes In Its Competitive Landscape; In Our View, They’re Being Squeezed From Both The High And Low End
- Recurring Revenue Model and 20% P.A. Sales Growth Is Not Adding Up Based On ULTI’s Statements, And Our Analysis
- Investors Are Not Adequately Discounting The Loss of Up To 10% of Revenues Tied To The NetSuite “Alliance”
- ULTI’s >20% Non-GAAP Operating Margins Are A Significant Outlier To Peers And Should Be Viewed Skeptically
- Newly Revealed, Publicly Available ULTI Contracts Support Our Concern of Price Discounting and Margin Compression
- ULTI’s Meteoric Earnings Outperformance Attributable To Hyper Aggressive Tax and Financial Accounting. Based On Our Adjustments, ULTI’s True Operating Margins Are In Rapid Decline And Under 5%
- Ultimate Software Group Has Amongst The Worst Governance Spruce Point Has Ever Seen: Its Audit Committee Has Been In Place Nearly 20 Years and Its Audit Chairman Held The Same Role At Lason. Lason Went Bankrupt, Its Executives Were Convicted of Fraud
- Spruce Point Has Unearthed New Evidence of Undisclosed Outside Business Interests By Management And Potential Conflicts of Interest That Should Cause Concern For Investors
- The Ties Between ULTI and Its Auditor Run Deep, Investors Need To Pay Close Attention And Assess How Truly Independent Is ULTI From Its Auditor
- Spruce Point Sees Approximately 20% – 45% Downside When The Ultimate Bubble Bursts
Spruce Point Sees Many Parallels Between Ultimate and Caesarstone
Background On Our Interest In Ultimate Software And Why We Believe Investors Should Carefully Scrutinize Its Business
Our interest in Ultimate Software (“ULTI” or “the Company”) was initially peaked when a little-known firm called Soapbox Research published a skeptical report highlighting aggressive software development cost capitalization, potential revenue exaggeration, bloated stock compensation expense, and corporate governance concerns. Spruce Point has conducted its own independent analysis of these claims, and has uncovered many additional fundamental, accounting and tax-related concerns that significantly strengthen the bear case.
Ultimate Software Group’s Short Thesis Has Many Parallels With Caesartone, Our Top Short Call From 2015-2016
One of our most successful shorts in the past few years was Caesarstone (“CSTE”), an Israeli quartz countertop manufacturer. We noted that its margins were suspiciously higher than its peers, and raised concerns about the potential for cost capitalization related to its U.S. plant expansion. We also worried about the governance structure, and influence of the Kibbutz (a communal / family-like structure). To support our short thesis, we conducted deep fundamental analysis and received the Company’s quartz supply contract (through a Freedom of Information request) to illustrate why we believed its margins were unsustainable. The parallels between Caesarstone and Ultimate Software are striking:
- Corporate Structure: While not exactly a kibbutz, Ultimate Software Group heavily promotes itself as a great place to work where employees are like family. Family relationships run deep at ULTI. It’s CEO and COO are brothers, and its CTO is the CEO’s son-in-law. In addition, evidence suggests its Chief People Officer appears to have an undisclosed familial relationship with the CEO (they hold property together and have business entities in common). Spruce Point believes caution is warranted by investors when familial relationships and business intersect.
- Failure To Acknowledge Changes In The Competitive Env’t: We argued that CSTE’s quartz countertop products were rapidly being commoditized and pricing pressures were mounting, but that its executives would dismiss these concerns when pressed by analysts. Ironically, we find that ULTI’s executives repeatedly deny changes in the competitive landscape. Our channel checks suggest that ULTI is experiencing pressure from new entrants with cheaper solutions at the lower end of the market targeting small/medium sized-businesses, and larger competitors up-market with more robust/scalable solutions to meet the needs of larger enterprises. Not surprisingly, ULTI has shuffled its market targeting and market share discussion numerous times in an attempt to reposition itself.
- Revenue Concerns: Investors cheered CSTE’s consistent >20% p.a. revenue growth, but lost track of questioning its sustainability. At ULTI, investors are equally enthralled by its recurring revenue “SaaS” model, which allows analysts to comfortably pencil in 20% p.a. growth without questioning underlying assumptions. We’ve pieced together comments from management and have concerns. First, the PEPM (or price per employee per month) it charges customers is difficult to achieve in reality, otherwise its reported revenues could not possibly be accurate. Secondly, we’ve seen management deflect a discussion of its deferred revenues, a critical financial metric to evaluate a SaaS provider. ULTI recently changed its description of deferred revenue after a highly suspicious surge of deferred revenue in 2015. We also have difficulty reconciling how ULTI is growing its average revenue per customer in the face of evidence of turnover and declining total revenue per employee. Lastly, donations to Ultimate Software Group’s Director Leiter’s foundation are based on a fixed % of ULTI’s total revenues, and are not reconciling to tax filings we evaluated. The discrepancies suggest potential revenue overstatement by up to 5%
- Suspiciously High Margins: We criticized CSTE for having suspiciously high margins >20% for producing a commodity product. Similarly, we note that ULTI’s Non-GAAP operating margins are suspiciously higher than its peers at >20% for a commodity-like software solution. These margins continue to expand in the face of competition with GAAP/Non-GAAP results widening. Similar to our CSTE research process, we also conducted numerous FOIA requests to obtain key ULTI contracts to support our concerns. While ULTI’s management touts its ability to realize pricing of $30.00 PEPM (and increase it to $40.00), recent contract pricing suggests a realized PEPM in the range of $13.00 – $21.00 – clearly indicating heavy price discounts, never disclosed by ULTI’s management.
- Aggressive Accounting Bolstering Financial Results: At CSTE, we failed to understand why the Company believed it necessary to construct a U.S. manufacturing facility, and repeatedly increased its estimates for capital expenditures. In our opinion, its motive appeared to be to use the construction period as a reason to justify the capitalization of costs on its balance sheet, thereby inflating its earnings. At ULTI, we fail to understand why it aggressively capitalizes software development and R&D costs. Investors should be alarmed that ULTI is a fairly mature company with a commodity-like product, will have capitalized nearly $150m of costs by next year, and is now extending its amortization period up to 7 years – beyond any reasonable measure used by its peers. Despite these enormous expenditures, it has recently acquired two small companies with little revenue impact that it claims will add new product functionality. It’s possible the 100bp of margin dilution from the recent Kanjoya deal is just a cover-up to explain why management can’t hit its previous goal of 100bps of margin expansion. Another key accounting concern we believe is flattering ULTI’s margins is its rapidly escalating capitalization of long-term sales commissions. Based on our research, we believe ULTI pays these commission costs mostly upfront, yet its accounting method allows it to amortize costs in future periods (now stretching it up to 3 years). This accounting choice flatters current earnings by delaying expense recognition and spreading these costs over future periods.
- Promotion of Key Strategic Partner: CSTE heavily promoted a deal it signed with IKEA to extend its distribution. Spruce Point criticized the deal noting it sent an inconsistent message to sell CSTE’s “premium” product through a low cost outlet such as IKEA. CSTE has subsequently noted significant disappointment in the IKEA deal. Similarly, ULTI has heavily promoted a “Strategic Alliance” with NetSuite that it says has resulted in significant bookings. Spruce Point believes investors should be cautioned given there is no contractual arrangement in this alliance. Furthermore, Oracle’s recent acquisition of NetSuite could seriously curtail the partnership given that Oracle is a competitor to ULTI. ULTI has said up to 10% of bookings recently came through NetSuite referral channels.
- Insider Enrichment: The IPO of CSTE allowed the Kibbutz to cash out almost $300m, and its CEO exercised options in early 2015 near alltime highs before the growth story started to unravel. Using stock grants and sales to enrich insiders is another tactic used by ULTI. Investors should take note of the outlandish stock compensation scheme sought by management and criticized earlier this year by a Bloomberg article. Spruce Point is concerned that ULTI appears to be using an aggressive tax scheme tied to equity grants to avoid paying taxes. We observe that the delta between ULTI’s GAAP income tax expenses and actual cash taxes paid is rapidly diverging. What’s even more bizarre is that Ultimate Software Group’s Net Operating Losses (“NOLs”) are ballooning which is at odds with a company claiming to make money! Since its IPO, insiders have largely cashed out, and most recently, key executives started new 10b5-1 programs to liquidate shares.
Article by Spruce Point Capital Management
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