Spruce Point Believes Kornit Digital Ltd (KRNT) Is A “Strong Sell”Guest Post
Spruce Point Capital Management is pleased to issue a “Strong Sell” opinion on Kornit Digital Ltd (NASDAQ:KRNT).
Not Our First Time Exposing A Printing Solution Company With Accounting Problems
On April 20, 2013 Spruce Point’s founder, in association with Prescience Point, outlined its concerns with InnerWorkings (Nasdaq: INWK), a company touting its proprietary “technology” solutions in the printing solutions and management industry. We outlined how management focused investors on revenue growth, but struggled to generate cash flow. We will explore how Kornit focuses investors on its 20%+ revenue growth, but has historically struggled to generate cash flow.
Spruce Point Believes Kornit Digital (KRNT) Is A “Strong Sell” With 75% -85% Downside Risk
Spruce Point believes Kornit Digital (“the Company” or KRNT) saw 2018 revenues, and particularly cash flow, driven entirely by Amazon’s expansion of its Merch program, which are likely to taper based on a slow-down of program growth, and would leave a gaping hole in Kornit’s aggressive revenue growth strategy. Forensic evidence from warrants granted to Amazon suggests that 105% of 2018 operating cash flow came from Amazon gross payments, and a cessation of new orders and rebate incentives coming due will depress future results. In addition, we believe Amazon is expanding into Japan, and that Kornit is not well positioned to win. Investors’ faith in Kornit’s financial results needs to be evaluated relative to its CFO having been the CFO at MRV Communications, which suspended reliance on its financials related to an option-backdating scandal. With shares up 55% YTD and trading near all-time highs at a substantial premium to digital printing peers, Kornit has 75% –85% downside risk ($4.50 -$9.30/ sh)
Unsustainable Recent Performance Driven By Hyped Amazon Deal:
- Kornit’s revenues to Amazon were 17% in 2018, and grew substantially after Amazon faced environmental permitting delays in 2017. The sales to Amazon are primarily linked to printers supplied to its Merch by Amazon program, which allows merchants todesign and sell printed shirts and sweaters, while outsourcing production and logistics to Amazon
- Caution: Based on shipping records and weight tonnage, we can estimate unit printer shipments. We believe Kornit has discounted list prices to Amazon up to 50%. We also cannot accurately back into Kornit’s 2018 reported revenues, and have extreme concerns about the potential for revenue recognition issues
- While the program enjoyed early success, Spruce Point believes US program growth has plateaued, and has hard evidence that printer orders delivered to Amazon in the US have dramatically slowed YTD 2019. Furthermore, we believe Kornit will lose Amazon’s next leg of expansion of the Merch program to Japan:
- There are numerous alternative competitive print-on-demand solutions to Amazon’s program now on the market
- Amazon has twice changed royalty payouts to merchants, causing a backlash of customer resent
- Google trends for Merch by Amazon show stagnation and recent decline in late 2018
- Amazon stopped disclosing its Merch program and fashion ambitions in its recent annual investor letter
- Extreme Warning: Our industry channel checks and market sources have confirmed that Merch’s program growth is headed next to Japan, exactly where Kornit’s fiercest competitors, Brother, Ricoh and Seiko are located, and where Kornit has the weakest geographic presence, and just lost its Asia/Pacific President. We believe at best, Kornit’s margins will decline as it competes with the inveterate competitors not wanting to lose, and at worst it will lose this expansion opportunity
- We find no evidence that Kornit is hiring labor in Japan, has opened an office in Japan, and has 1 current employee
- Kornit’s printers result in T-shirts that smell like vinegar, which we believe has upset Amazon and its customers. Based on our research, we believe Amazon would terminate its partnership if it could find a higher quality printing partner
Kornit’s Issue of Warrants and Rebates To Amazon Are Highly Suspicious:
- Selling digital printers is akin to selling a commodity product in a hyper competitive industry. In order to entice Amazon, Kornit issued it cashless warrants (a weak form that requires no capital commitment by Amazon) for its stock, which should be viewed as price discounts and are netted against sales.
- Based on the warrant vesting formula, we can determine that total payments by Amazon to Kornit in 2018 were 105% of total 2018 operating cash flow. This suggests underlying organic cash flow decline from its remaining business.
- In addition to warrants (and price discounts to list price), Amazon also gets price rebates, and Kornit is not adequately disclosing the rebate terms in the contract or in the 20-F. This amounts to an effective “triple incentive” to win Amazon
- Based on our research, we believe the rebates will kick-in up to a year afterwards, causing short-term inflation in Kornit’s cash flow, and will be a drag on Kornit’s operating cash flow in 2019.
- Kornit uses the non-standard Monte Carlo analysis to value the warrants, instead of the more common Black-Scholes method, allowing it wider discretion to value the warrants. It claims it cannot issue warrant expense guidance. Warrants areeffectively options, and plenty of public companies issue guidance on stock compensation expense.
- Kornit avoided including warrants in its diluted share count calculation, despite the fact 1.1m are vested and exercisable, withan approximately market value of $16m. Kornit’s diluted EPS is lower than it appears.
- Warning: There’s a discrepancy between reported Amazon revenues in Kornit’s filings. In addition, because it appears Kornit received more cash than revenues booked from Amazon, deferred revenues should have increased more than reported.
- Warning: Kornit initially tried to exclude the warrant cost from Non-GAAP EPS, an aggressive tactic that the SEC questioned, and made it restate results. In our view, this illustrates how aggressive management is using the warrants.
- Extreme Warning: Kornit’s CFO was the CFO, and named in the option backdating scandal, at MRV Communications (Nasdaq: MRVC), which was delisted to the pink sheets, restated financials and settled a shareholder lawsuit. He omits from his bio that he started his career at Ernst & Young, which served as MRVC’s auditor and as Kornit’s. We observe that Kornit backdated the warrant expense in 2016 –before the Amazon deal was announced in Jan 2017. The backdating amount in Q4’16 has represented the single largest charge since inception, which suggest front-loading of expense recognition and could allow Kornit to inflate future revenues.
Other Concerning Aspects of The Kornit Growth Story
- Kornit’s second biggest customer, Cimpress NV (Nasdaq: CMPR) known for its Vistaprint business, revealed in late Jan 2019 that it is under severe pressure, and going through a management shake-up. Kornit conceals the extent of its exposure to Cimpress.
- Kornit’s long-time CEO abruptly and unexpectedly resigned in the middle of 2018, right after shipments were made to TX and PA, and ahead of the miraculous recovery in its financial performance and stock price explosion. Before leaving, he received a “special bonus” for what amounts to the ordinary role of helping the company raise capital.
- The new CEO has issued wildly optimistic long-term revenue goals of $500m. Kornit focuses investors to revenue over cash flow, which has remained elusive. To illustrate, from 2015-2017 it converted just 1.5% of sales to cash.
- After presenting its long-term vision to investors, Kornit’s earliest and biggest shareholder, sold all of its stock in December2018. The appears to be a vote of no confidence in management’s long-term growth plan
- Kornit is now actively promoting a “game-changing” and “breakthrough” technology for printing on polyester. However, what it didn’t actively say, rather burying it in the 20-F, is that its Chief Technology Officer would resign April 2019.
- Kornit is also having to reformulate its go-to-market strategy and acquired its largest distributor, Hirsch Solutions (Feb 2019), which accounted for 15% of 2018 sales. From our successful experience identifying short ideas (eg. iRobot, Sabre Corp, Caesarstone), distributor acquisitions often foretell signs of strain.
Kornit’s Share Price Offers A Terrible Risk / Reward
- Analysts have bought into Kornit’s long-term growth story, and have meaningfully raised price targets in anticipation that the Company will deliver on its promises of sustained 20%+ p.a. sales growth.
- The current average sell-side analyst price target of $28 per share leaves no upside at the current price.
- Kornit’s current valuation is at an all-time high, and significantly above its long-term average. In addition, when viewed in the context of its competitors’ multiple and other low-technology computer and printer peers, Kornit’s valuation is at an extreme we’ve never seen. Kornit’s average sales, book, and cash flow multiple are 4.4x, 4.0x, 80x vs. current 5.6x, 5.8x, and 182x on our estimates. Digital printing peers trade at 1x, 1.4x, and 9x.
- We believe that investors are underestimating the risk that Amazon’s global expansion exclude Kornit, and that recent revenueand cash flow contribution taper; analysts also haven’t evaluated the risk or quantified the cash flow contribution in 2018.
- If Kornit received a multiple closer to printing and computer equipment peers, and our concerns about Amazon come to fruition, it’s easy to justify a price target of $4.50 –$9.30 or 75% –85% downside risk.
Top Questions For Management
- Why Does Kornit Always Promote Its Revenue Opportunities, And Why Has Kornit Failed To Generate Meaningful Cash Flow?
- Why Did Kornit Offer Price Discounts, Warrants and Rebates To Amazon As Incentives To Work Together? How Material Are The Rebates And Why Does Kornit Claim Hardship In Estimating Them?
- Why Can’t Kornit’s 2018 Amazon Sales Be Reconciled?
- Excluding Amazon Payments In 2018, Did Kornit’s Underlying Cash Flow Decline Organically?
- Why Is Deferred Revenue Not Growing If Kornit Received More In Payments From Amazon, Than Revenues Booked From Amazon In 2018?
- Why Is Kornit Not Expanding Into Japan, When Evidence Shows That Amazon Is Expanding Its Merch Program There Next?
- How Does Kornit Plan To Solve Its Vinegar-Smelling Production Problem, And Does This Jeopardize Its Relationships With Amazon And Other Customers?
- Why Does Kornit Not Discuss Its Relationship With Cimpress, Its Second Largest Customer? Are Cimpress’ Problems Affecting Kornit?
Fact Pattern of Recent Events Cause For Investor Skepticism
With KRNT’s share price up 55% YTD and near all-time highs, Spruce Point finds certain events concerning in the overall context of management touting record results and ‘game changing’ new product innovations, and promoting an Amazon deal where we find concerning revenue recognition and accounting anomalies. Kornit has touted aggressive long-term goals with a new CEO in place, inviting multiple broker upgrades, and allowing the Company’s long-time investment backer to completely exit its shares. Yet, it buried the fact its CTO would resign in April 2019 after announcing the game-changing new product introduction. Furthermore, the acquisition of its material distributor at a time when Amazon is expanding to Asia/Japan, Kornit’s weakest market, is also a red flag we’ve observed from prior successful short ideas.
Read the full report here by Spruce Point Capital Management