Kerrisdale Capital: ServiceNow Share Count Mistake Fuel Overvaluation – Page 2 – ValueWalk Premium

Kerrisdale Capital: ServiceNow Share Count Mistake Fuel Overvaluation

correct figure) to arrive at its mistaken market cap, which they make sure to provide in both dollars and Euros.



Susquehanna follows the example of several other firms that really like that 136.8 million share count figure.



Notice that Stephens specifically characterizes its share count as “fully diluted”. Not only does Stephens attach itself to the inaccurate 136.8 million figure, but by including the words “fully diluted,” it precludes any explanation for its error other than gross oversight.



Janney, not bucking consensus, uses the faulty 136.8 million figure as well.


The preceding reports were prepared before the release of NOW's 10-Q3 2013 on November 4th. Yes this does not excuse the oversight of the option pool. As of the 10-Q2, NOW still had 136.8 million common shares, 27.5 million options with an average strike price of $7.16, and 3.9 million RSUs. At a $52.96 share price, this would equate to 164.5 fully diluted million shares, still nowhere near the figures cited in the brokerage reports.

Furthermore, the justification that options are “anti-dilutive” given NOW's ongoing net income losses is ridiculous. Option grants are not free, nor does the conversion right disappear, just because a business isn't profitable.


We also want to be clear that there are a handful of firms that do list the correct share count for ServiceNow. In contrast with all the erroneous tables above, here is JMP Securities, for example, whose analysts actually did their math properly and account for the upcoming new shares:


Bravo JMP! For correctly calculating something as basic as shares outstanding!


It is important to note that investment banking analysts normally are capable of determining the correct number of shares outstanding in a company's stock. It's perplexing that the majority of the Street won't or can't get the number right here. It truly is unusual to see so many firms be this wrong about something this basic and remain mistaken for such a long period of time. By contrast, check out the below November 19th, 2013 price target upgrade from Citigroup's Yaron Werber:


Werber digs far enough into the weeds to calculate that a previously dilutive convertible note/warrant package is being retired prematurely, and as such, the consensus view of the outstanding share count is too high. Not only had the Street (correctly) factored in a previously announced potential dilutive overhang, but now an analyst realized the overhang will have been cleared and in turn adjusted the price target accordingly. This is the sort of analysis we expect from professional investment analysts, which makes the grossly misleading ServiceNow coverage all the more disappointing.


Why are the Analysts so Wrong?


The bigger question may indeed be why analysts are unable or unwilling to factor in 27 million shares, or $1.55bn worth of capitalization, of way-in-the-money soon-to-be common stock. Previously, you could have ascribed the error to mere sloppiness. Perhaps everyone was pulling their numbers from Yahoo Finance or otherwise not digging into the SEC filings enough to pull out the real number of outstanding shares.


But since we launched our coverage on ServiceNow more than a year ago and highlighted the fact that the majority of analysts were using grossly inaccurate share counts, it seems harder to attribute the misstatement to mere sloppiness at this late date. A simple oversight like that, once pointed out, is easy to correct.


In theory, there is a so-called “Chinese wall” between the parts of investment banks that analyze companies and the parts of investment banks that earn fees from companies by providing them services such as IPO and secondary underwriting advisory. In practice, however, it is often questionable whether or not there is much separation between the research and banking arms of

financial firms.


Take, for example, the recent Evoke Pharma IPO (EVOK). Aegis Capital was the sole bookrunner for the Evoke IPO, no doubt earning a healthy fee for its services. Earlier this month, following the IPO, Aegis' biotech analyst launched coverage for Evoke, then trading at $8, with a jaw-dropping $60 price target. Needless to say, a 650% upside target raises eyebrows, and the more conspiratorially-minded person might draw a connection between Aegis' ambitious price target and Aegis' earning of Evoke's IPO fees. Any company considering Aegis' IPO services in the future will likely recall Aegis' most favorable research opinions for IPOs it has recently underwritten. If you were seeking to define the phrases “perverse incentive” or “moral hazard” in a business textbook, this sort of example would come to mind.

Historically, the “wall” between investment research and banking has often resembled clear cellophane as opposed to anything reliably separating the two divisions. During the last tech boom, CEOs were openly telling analysts to raise their investment ratings before they'd consider doing banking business with the analyst's firm. For example, Bernie Ebbers, former CEO of MCI WorldCom, was asked if he'd do a banking deal with Merrill Lynch. Ebbers replied, “No. We have to have a better rating before Merrill Lynch would do the investment banking.” This doling out of banking fees based on investment research ratings was common practice, as former telecoms analyst Dan Reingold, in his book, recounted: “Bernie [Ebbers] wasn't one to mince words. He simply said aloud what others thought to themselves.”


Later on during the cycle, Jack Grubman, Soloman Smith Barney's former rock star telecom analyst, was asked by Soloman's president to “take a fresh look” at his long-standing negative opinion on AT&T. Grubman soon upgraded AT&T shares. Seemingly as a result, Soloman reaped lucrative fees from a deal involving a large AT&T wireless subsidiary spin-off. Grubman, for doing his part to generate banking business, was able to leverage his upgrade to get his employer to donate $1 million to the 92nd Street Y so that Grubman could get his children accepted into an exclusive Manhattan nursery school.


After examples like this, it's no wonder that market participants began to have doubts about the independence of Wall Street research. Former New York Attorney General Eliot Spitzer confirmed people's worst fears when his investigation hit the mother lode of wrongdoing


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