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Natus Medical Inc. (BABY) “Fraudulent Activity” Short: Glasshouse

The following is a new short report on Natus Medical Inc.  (NASDAQ:BABY) stock from Glasshouse Research. The pitch was released to the general public at 10AM EST on 2/06/2018. The firm calls this bet “our highest conviction short ever” See details below and decide for yourself.

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Natus Medical Inc.
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Initiation of Natus Medical Inc.  (NASDAQ:BABY) with a Target Price of $9.80
(70% downside)
Lowered guidance, impairments, write-offs, restatements and fines from the SEC are all on the table as Natus Medical will need to deal with these major accounting concerns in 2019.

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• Concealed obsolete inventory makes Natus inventory situation the worst we have ever seen. We calculate that at minimum, Natus needs to write-off/take losses on approximately $18.0 million (one-fifth of total inventory, or 30% of earnings) in obsolete inventory.
• Natus’ warranty/bad debt reserves and prepaid expenses accounts have all been depleted/manipulated over the last year to artificially increase EPS by $0.33 (or nearly 25% of earnings). This will reverse violently in 2019.
• Based on comment letters found from the SEC, the Commission has been highly critical of Natus’ use of non-GAAP exclusions in the past. We see Natus Medical’s current exclusions as the most aggressive they have ever been.
• CEO Kennedy and CFO Davies left their past companies in ruins with both Intersil and Extreme Network’s stock price falling over 55% each before they bailed as CFO to come to Natus Medical.

Key Similarities Between Natus Medical and Logitech’s Fraudulent Activity
GlassHouse juxtaposes both Natus Medical (BABY) and the past transgressions of the prior fraud Logitech International (2011). Based on our research, we believe Natus is in a much worse accounting position than Logitech ever was in 2011. The end result for Logitech was not a pretty one. Restatements, fines with the SEC, but most importantly the stock price dropped over 70% as a result of management’s malfeasance.

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Concealed Non-Current Inventory Makes BABY’s Inventory Diagnostics One of the Worst GHR has Ever Seen
Let GlassHouse be perfectly clear that after examining Natus Medical’ current inventory metrics, we find the firm’s inventory diagnostics to be one of the worst we have ever seen when analyzing public companies.

When we dig into BABY’s 10K and 10Q filings, the situation only becomes graver as we believe management will need to write-off and take losses on most of their obsolete inventory. Exacerbating the issue, it appears that analysts are completely blind to the highly growing balance of inventory on the company’s balance sheet as inventories have been rarely discussed in recent conference calls. In this regard, we find it peculiar that days-sales-outstanding (DSO) metrics are disclosed by the Natus Medical CFO every period, but we are befuddled to why inventory metrics are rarely discussed.
Diving into Natus’ inventory metrics, GHR finds a plethora of accounting concerns that all point to the fact that BABY is 1) currently stuffing its channel/end user to increase sales and/or 2) refusing to write-down their obsolete inventory in order to keep margins artificially healthy. Due to the company’s recent proxy fight with Voce Capital, we believe that prior CEO Jim Hawkins and now new CEO Jonathan Kennedy possessed high motivation to cosmetically increase sales/margins and may have resorted to these accounting gimmicks in order to do so. While non-GAAP gross margins have recently hovered around the 60% value over the last two years, we believe that this ratio has been highly inflated due to management’s efforts. But again, these games can only be played in the short-term and will violently reverse in future periods.

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Overall, our research has pointed to Natus Medical’s inventory previously being pushed onto hospitals, physician offices, and clinics to the point where they are stuffed with products and are hesitant to procure any more inventory. To make matters worse, it appears that management’s visibility into future buying trends of its clients were highly inaccurate and now the company is stuck with bloated inventory on its shelves and balance sheet; in some cases, the products have been discontinued and have become obsolete.
What does this ultimately mean for Natus Medical with respect to future sustainability of earnings? With only unfavorable options on the table for Natus Medical, we believe our inventory analysis puts a time catalyst of BABY’s share price decline (within one-to-three quarters). Below we detail Natus’ unfavorable recent inventory metrics:

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Conclusion

 

Accounting Red Flags Are Set to Violently Reverse for Natus Medical in 2019
The bull case regarding Natus Medical’ stock price revolves around the following tenants that we believe the sell-side community has misunderstood:
1) Investors believe that Jonathan Kennedy is different from previous CEO Mr. Hawkins and under his leadership, Mr. Kennedy will be able to turn around the company based on his track record.
2) Analysts believe that gross and operating margins have room to expand and the result will propel Natus Medical stock price upwards.
3) Investors believe that the company will now be able to grow the company organically with the focus now coming off acquisitions.
Regarding the above items, we have gone step by step to debunk many of these flawed reasonings for investors. With regards to Mr. Kennedy, Voce Capital sang his praises stating that he “mopped up CEO Hawkins mess” and that he “helped to expand both gross and operating margins”. Based on our analysis, Mr. Kennedy was only able to expand margins by consciously deciding not to write-off what we believe to be legacy and impaired inventories on the balance sheet.
This segues into the second bullet point, the only way that Natus Medical has been able to keep such consistent gross margins near 60% is because Mr. Hawkins and Mr. Kennedy orchestrated accounting games with inventories, receivables, AFDA, prepaids, and their warranty expense. Finally, now that the company will cease its acquisition strategy, we believe that in this current weak demand environment, Natus’ true earnings will continue to report declines and losses with respect to revenues and earnings. All these items, we believe, will cause Natus’ stock price to decline precipitously over the next twelve months. Furthermore, we highly doubt that the sell-side community fully comprehends the magnitude of accounting headwinds (especially Natus’ current inventory situation) that Natus Medical faces over the next year.

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