Internet Brands is a publicly listed company that acquires smaller web properties and hopes to grow their cash flow. It is one of the most fascinating companies for myself as I am hoping over the next few years to emulate the buying cheap part of their model but then actually improve the small sites once they are acquired.
There was an interesting article from TheStreetSweeper on the firm that is largely negative and INET was down nearly 10% yesterday primarily on the back of it.
The article highlights three concerns about the company:
1. Bonuses of management are tied to ‘Adjusted EBITDA’ and there looks like a systematic underestimating of future earn out payments, which positively affect ‘Adjusted EBITDA’.
2. The audit committee has a lot of guys who used to work in subprime mortgages and the CFO used to work at World Poker Tour, which experienced a dramatic rise and then fall.
3. Even though the company has spent $100m on acquisitions, their revenue has barely moved from five years ago.
Of the three points, only the first really warrants attention. Past failures in subprime mortgages and televised poker tournaments are certainly not pluses but the talk is simply innuendo. On the third point, that’s more a misunderstanding of the company’s roots, which started as an auto lead generator called CarsDirect.com. That business has completely crumbled in recent times, they changed strategy and diversified, and their acquisitions have offset the revenue gains.
A systematic underestimating of earn out payments is of great concern however, and an offshoot of the underestimating – not paying earn them at all – is also being alleged.
Two acquisitions, FlyerTalk, a power traveler community, and ModelMayhem, a model directory, have initiated lawsuits against the company. FlyerTalk claims that Internet Brands didn’t pay the $1.2m 2009 component of their earn out agreement and “also failed to operate the website in good faith, triggering a 460% increase in technical problems and an 800% jump in customer complaints.”
ModelMayhem alleges Internet Brands didn’t pay $800k in earn out payments but Internet Brands says that ModelMayhem fraudulently inflated their traffic.
The allegations are concerning but the more troubling fact is in the systematic underestimating of future earn out payments:
“INET certainly underestimated earn-out payments earlier this year. In its first-quarter report, filed in early May, INET stated that it had paid $500,000 in earn-outs during the first three months of 2010 and predicted that it would pay only $1 million more over the remainder of the year. By the time the second quarter came to an end just eight weeks later, however, INET had already paid another $2.4 million in earn-outs instead. Although INET predicts that it will spend a much smaller sum of $700,000 on earn-outs during the second half of the year, a figure that obviously excludes the bonuses still being sought by ModelMayhem and FlyerTalk, the company could wind up issuing lowball projections once again.”
“If INET expects a reduction in earn-out obligations (as it apparently did with ModelMayhem and FlyerTalk), experts say, the company can trim its overhead expenses for the quarter when it reaches that decision. If INET then later pays out more than it originally projected, they say, the company will exclude that payment from its income statement — escaping any hit to its profitability — and simply post a reduction to cash flow instead”
The reason they can is because of a new accounting guideline known as “ASC 805”.
Outside of the fate of Internet Brands, at their core is a powerful strategy that I think will be proven to be a great one but the fuzzier the numbers get, the more easily that will get lost.