GlassHouse Research’s short report on Omnicell, Inc. (NASDAQ:OMCL).
Initiation of Omnicell with a Target Price of $35.50 (59% downside)
Significant declines in revenue and earnings await Omnicell as the company has obfuscated its financials by prematurely recognizing revenue in prior periods and failing to write-off legacy inventory.
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Q2 hedge fund letters, conference, scoops etc
- Omnicell possesses one of the worst net AR positions we have seen within a public company. Concealed long-term receivables and declining deferred revenues lead us to believe the company prematurely recognized approximately $38.3 million in sales over the LTM. The company may need to restate financials based on the magnitude of these inauspicious trends.
- OMCL grossly mismanaged its inventory and now carries a highly bloated inventory balance that needs to be written off as obsolete. We calculate at minimum, management needs to write-off over $23 million (22.4% of total) of obsolete inventory.
- Anomalous surges in both capitalized expenses and prepaid commissions lead us to believe that the firm has accelerated the capitalization of normal expenses over the LTM. Our analysis points to $38.0 million in additional capitalized expenses that we believe should have been expensed. This represents a tailwind of $0.72 to TTM non-GAAP EPS (30% of non-GAAP EPS).
- The lack of accounting experience among the CFO, audit chairman and audit committee present massive red flags to GlassHouse at a time when accounting gimmicks are highly prevalent at Omnicell.
Key Similarities Between Omnicell and Prior Exposed Companies
GlassHouse juxtaposes both Omnicell and the past transgressions of other fraudulent companies. We believe that many of these accounting gimmicks listed below by prior firms may have been utilized by current Omnicell management.
Omnicell Financials Are Set to Unravel in H2 2019
The past two years in Omnicell’s (OMCL) history have been vital to management’s future growth plans as the company has introduced three major product lines; some that have replaced older legacy models. The XT series (decentralized pharmacy), XR2 (centralized pharmacy), and the IVX Workflow and Cloud product lines have been central to the recent run up in OMCL’s stock price as customers have been upgrading to the newer systems. However, while management is quick to paint a rosy picture of heightened sales and earnings as customers upgrade, our analysis points to something different happening at Omnicell.
Based on comments made by OMCL management, investors are being led to believe that the company’s recent revenue and earnings gains stem primarily from organic sources. This sentiment has been reflected in OMCL’s stock price, which has almost doubled since the beginning of 2018. And while GHR does believe there is some merit to OMCL’s product lines within the healthcare industry, we opine that the company’s current stock price is highly inflated and has been based on faux revenue and earnings over 2018 & 2019.
After going through countless filings, earnings calls and presentations, we believe that OMCL management has been using a variety of accounting gimmicks to turn around a company that previously reported depressed margins and earnings. Based on our extensive experience researching accounting frauds, we take issue with both the quantity and scope of financial engineering used by management over the past two years. Too many accounting anomalies took place on the income statement, balance sheet and within the footnotes for GHR to believe these actions were not purposeful in nature.
When we analyze Omnicell’s accounts receivable (AR), inventory, and capitalized expense diagnostics, we find a company that we believe has been manipulating its accounting for significant gains to the income statement. However, in our experience, the manipulation of all these balance sheet accounts points to future share price degradation in upcoming periods as these issues tend to violently reverse.
Management’s Comments Regarding Receivables Spike Are Not Plausible
Delving into the crux of our thesis when looking at OMCL’s accounts receivable (AR) balances, we believe that management has been recognizing revenue prematurely with respects to their performance obligations. We find this more concerning than a collectability issue, as this type of accounting concern ends up with material revenue shortfalls in future periods. Below, we detail OMCL’s unfavorable AR trends and how we believe this will impact revenue and earnings going forward:
- In the latest period, current AR grew by 6.7% YOY to $203.5 million. As a result, Omnicell’s days-sales-outstanding (DSO)1 levels stood at 90 days and 88 days of 3M DSO and 12M DSO, respectively at Q1 2019. This represented an increase of 7.6% YOY from Q1 2018 (12M DSO). We view the current levels of 90 days to be extremely heightened from an absolute level as the firm is now waiting approximately three months to get paid on its products. Furthermore, we point out in the next section that the true DSO value actually lies much higher than 90 days when including long-term AR and factored receivables.
- Looking at the long-term trend of DSO values, we see an inauspicious pattern of longer and longer receivables cycles at OMCL. Dating back to 2013, we see that the company consistently reported DSO values within historical and peer group ranges from 50 to 60 days. However, since this time, DSO values have been on a consistent rise with very limited or inconsistent explanations given by management as discussed in the next section. To put things into perspective, the current DSO value of 88 days now lies 63% above the 2012 ending balance of only 54 days (see Chart 1, Page 8).
- Turning to ending AR balances, we find similar results when analyzing the firm’s AR-to-sales metrics. Three-month and 12M balances stand well above their five-year averages at 100.5% and 25.2% respectively. Moreover, OMCL’s AR-to-3M sales ratio stands at the fourth highest ratio reported in any period over the past five years.
- Management provides their own calculation of DSO values in every conference call that slightly differs from our calculation; however, the adverse trend still is highly apparent. In the latest period, management discloses a value of 93 days, the second highest value ever reported by OMCL, only to the 97-day value reported in Q1 of last year.
For reference, the last time OMCL reported a DSO near these levels at 95 days in Q2 2015, the firm’s stock price drew down by 33% afterwards in H2 2015. Again, we believe OMCL’s current predicament lies in a much worse place today than in 2015.
Hidden Long-Term Receivables Metrics Exacerbate OMCL’s Dire Situation
Further diving into OMCL’s receivable footnotes, GHR finds more concerning metrics that suggest Omnicell will face material sales headwinds over the next year as it deals with billing issues. In addition to OMCL’s trade receivables which it stores under current assets, the company also stores both long-term sales-type leases and unbilled receivables in “Other Long-Term Assets” on the balance sheet. Readers familiar with our work know we view these long-term receivables as the worst forms of revenue quality out there as they carry the highest risk.
- Illustrating this, we observe that sales-type leases and long-term unbilled AR currently stand at $19.5 million and $11.4 million, respectively, as of 03/31/19. When we add these figures to the current receivables balance, we find that the company is in a much worse position than they are leading on.
- For example, we see that management is patting themselves on the back for reporting a bloated DSO metric of 93 days in the Q1 2019 earnings call. However, when we add these hidden receivables back into our 3M DSO metric, this causes the current value to surge up to 109 days in Q1 2019; this represents the second highest value ever reported by OMCL. Twelve-month DSO also hit an all-time high, increasing by 10% to 106 days in the period (see Chart 1, Page 8).
- GHR finds it to be quite misleading by OMCL management to only report a DSO balance only using trade receivables. In fact, we point out that long-term AR is the riskiest form of receivable balance and it should without-a-doubt be included in their given metric to analysts. For example, if management wanted to conceal a poor DSO metric in any given period, management could subjectively move trade AR into “Other Long-term Assets” on the balance sheet to hide the unwanted receivables.
- Unbilled receivables on a balance sheet specifically mean that the company recognized revenue, but has yet to invoice the client, directly contrasting from CFO Kuipers’ explanations detailed in the next section. GHR also wants to point out that ASC 606 adjustments were not to blame for the rise in receivables either, as the pronouncement only impacted Omnicell’s AR balance by $819,000 on 12/31/17.
- To make matters worse for OMCL, the firm is factoring its receivables, as evident in the footnote below from the 2018 10K. This balance has increased by 39.4% and 16.5% in 2017 and 2018 respectively; far outpacing the recent rise in sales. We believe management may be factoring its receivables at a heightened pace to mask the firm’s already bloated AR balance. The problem with this is that the action is only transitory in nature and cannot stop the eventual rise in AR balance; plus the firm takes a loss on the sale of these receivables, pressuring margins. If we add these values back to AR, we calculate an astonishing DSO balance of 126 days at the end of 2018.2
Sales of Accounts Receivable
The Company records the sale of its accounts receivables as in accordance with accounting guidance for transfers and servicing of financial assets. The Company transferred non-recourse accounts receivable totaling $46.6 million, $40.0 million, and $28.7 million during fiscal years 2018, 2017, and 2016, respectively, which approximated fair value, to leasing companies on a non-recourse basis. Accounts receivable balance included approximately $10.6 million, $0.1 million, and $0.2 million due from third-party leasing companies for transferred non-recourse accounts receivable as of December 31, 2018, December 31, 2017, and December 31, 2016, respectively.
Table 1: OMCL Receivables Metrics ($ in millions)
Chart 1: OMCL Long-Term DSO Trends
Omnicell Management Continues to Move Goalposts and Gives Elucidations that Do Not Hold Water
Dating back to 2014, then CFO Robin Seim stated that he believed the firm’s expected DSO range would lie between 65 and 75 days. Subsequently, when DSOs again began to trend out of line in Q3 2015, the newly appointed CFO Peter Kuipers echoed the same sentiment that OMCL would look to improve on this metric next period.
We generally expect DSO to be in the 65 to 75 days range. We review the collectability of our own receivables regularly and we do not believe the fluctuation of DSO are indicative of a change in our rate of bad debt. – CFO Peter Kuipers
Since Q3 2015, management has stayed fairly silent regarding the persistent rise in DSO and AR values. In fact, we find it quite misleading that management dodged questions regarding the heightened levels of DSO values in the latest quarter. Specifically, CFO Kuipers disclosed in the Q1 2019 earnings call, “OMCL’s DSO value of 93 days were down four days from the first quarter of 2018. The decrease was mostly driven by strong collections.”
GHR finds this highly disingenuous, as it is all Mr. Kuipers decided to say on the subject. We point out that the firm’s 93 days value is the third highest ever reported by the company, but apparently the company is patting themselves on the back for not being as bad as the disastrous levels of Q1 2018. Let’s not forget that the current value now stands 23 days above the firm’s self-reported target range for DSO values.
So, what is going on with OMCL and their receivables? Management is quick to point out that this rise does not stem from a collectability issue and we at GHR tend to agree with them. However, our analysts at GHR actually believe that something more nefarious may be at play here. Dating back to 2014, GHR found eight instances of OMCL management blaming the firm’s ominous DSO balance on “timing of billing.” However, herein lies the problem for Omnicell and their argument that does not hold water to us or any accountant out there. In Q3 2018 for instance, CFO Kuipers explains that recent DSO value of 93 days at the time was due to the following:
Accounts receivable days sales outstanding for the third quarter were 93 days, up 7 days from the second quarter in 2018. The increase is mostly driven by timing of billing during the quarter. Based on our customer agreements, we largely invoice upon shipments. Generally, shipments and related billings in the last month of the quarter become revenue in the following quarter after installation is completed. The month of September 2018 was a record billing month.
Kuipers, who is not licensed as a CPA in the U.S. and carries more of a FP&A work history, does not appear to give a valid explanation as to why the firm’s receivables balance continues to outpace sales period after period in the long term. Here, he states that billings become revenue in the quarter after installation is completed, but in previous statements he claims that they invoice upon shipment.
These two statements conflict with each other and do not explain the recent rise in DSO values; in fact they would explain the opposite. If this statement from Kuipers was true, we would see AR values plummeting relative to sales. What Mr. Kuipers fails to understand is that when the firm’s AR balance (both billed and unbilled AR) continues to rise at an accelerated rate, it suggests that OMCL is recognizing revenue earlier on in the sales cycle compared to previous periods by jamming in sales at the end of the quarter.
In fact, we point out that OMCL also carries unbilled receivables on its balance sheet. This form of AR is revenue that has been recognized in the period, even before the invoice has been sent out to the client! The transaction Mr. Kuipers is describing is more akin to deferred revenues, which would be stored as a current liability (recent deferred revenue trends do not suggest this is occurring in any way).
Specifically, he is suggesting that the client receive shipment of the product and is invoiced, however NO revenue is recorded until installation is completed in the following quarter. Again, OMCL cannot debit (increase) AR unless revenue is being credited. Therefore, under this bizarre scenario Mr. Kuipers is describing, OMCL’s AR balance would actually be going down.
A more likely scenario would be the following at OMCL: the firm has been recognizing revenue at an accelerated rate relative to historical norms at the end of each period (i.e. recognizing revenue prematurely), which would then cause the firm’s AR balance to spike to anomalous levels. Because the clients are being invoiced at a later point in time, they still pay within the 60-day normalized timeframe, again not a collectability issue. However, the problem now lies within taking revenue from future periods to meet current estimates, and we all know how that ends up for companies that try this. Time and time again, management explains how the DSO rise is not attributable to collection/credit concerns. If we are to believe them, the only other explanation is that the company is recognizing revenue prematurely, leading to non-recurring gains to the top-line.
Our thesis is further corroborated by statements made by CEO Randall Lipps when discussing the delayed rollouts of the XT series pharmacy in Q4 2017:
First question, maybe you could give us an update on the implementations. It sounds like there have been a couple sticking points here the last couple of quarters. Obviously, when you’ve got a new platform rollout, such as XT, that’s the software as well as the hardware, you would expect maybe a couple hiccups. But it seems to be these are dragging on a little bit. Maybe if you could provide an update on that front.
Randall A. Lipps, CEO
Well, I think there are a couple of dynamics that are changing, but one of them is the orders are getting very large. And therefore, the implementation pieces are getting very large. And so it’s a little blockier, which is — it’s not a bad thing. But when somebody slows it down, it slows down a larger block of implementations. And the team has gotten better and better every quarter at setting up the installations and moving those forward. And I think that, certainly, for 2018, we have built in a plan that allows for more of these last-minute changes if we get them, just because backlog has backed up even a little more.
So there’s no individual reason why some of these accounts get pushed off. They’re always for different reasons. But it’s just that the size of some of these single installations are at the size that it does impact the revenue.
One question, just in terms of the outlook and then a couple of housekeeping items. So first, we’ve seen 2 quarters in a row where you’ve had this issue with implementations. Understanding that it’s difficult to sort of get the customer to move in the larger implementations, but do you think relative to your guidance for 2018, you’ve factored in some of these issues — do you think you adequately reflected some of these
implementation, if you want call them, challenges that you’ve had the last couple of quarters?
Randall A. Lipps, CEO
Definitely. We’ve shifted both our strategy with our customers, the way we’ve positioned particular Q1 to make sure that — to be conservative in case something happens. I just think — I’m like you. The last 2 quarters, I said, “That’s enough of this.” And so this year’s plan is built on not doing that anymore.
While these delayed implementations fully corroborate our thesis, Mr. Lipps has stated that these implementation concerns have been fixed in later periods. However, in the latest earnings call we continue to see issues pop up:
Randall A. Lipps, CEO
The implementations are always a little bit longer in that sense in that we usually have to do some preparatory work and redesign maybe in a pharmacy to get some of those installs done.
Based on these comments made by management that suggest that installation and implementation of Omnicell’s new products are taking longer than expected, we believe that management may have possessed high motivation to recognize revenue prematurely in order to meet revenue targets. As the evidence suggests, OMCL is not facing a collectability issue from its customers, therefore the only other explanation for the unfavorable receivable trends is management recognizing revenue in advance of meeting its performance obligations. This directly conflicts with CFO Kuipers comments about “timing” and “deferring” revenue on the income statement until the next period.
Deferred Revenues Suggest Lower Quality of Revenues
When analyzing companies that have a spiking AR balance, we also need to make sure that the firm’s deferred revenue (DR) balance does not offset this rise with a rise of its own. If the firm is pulling in more cash in the form of deferred revenue, this usually alleviates most our concern for the AR increase. However, this is not the case for Omnicell. When we dive into the deferred revenue footnotes, we find a scenario similar to what management explained for their DSO increase above:
Note 9. Deferred Revenues
Short-term deferred revenues of $81.8 million and $78.8 million include deferred revenues from product sales and service contracts, net of deferred cost of sales of $11.1 million and $16.9 million as of December 31, 2018 and December 31, 2017, respectively.
The short-term deferred revenues from product sales relate to delivered and invoiced products, pending installation and acceptance, expected to occur within the next twelve months.
A contract liability is an obligation to transfer goods or services for which we have received consideration, or for which an amount of consideration is due from the customer. Contract liabilities include customer deposits under non-cancelable contracts, and current and non-current deferred revenue balances. Our contract balances are reported in a net contract asset or liability position on a contract-by-contract basis at the end of each reporting period.
However, none of what Mr. Kuipers stated still makes any sense, as deferred revenues have been on a consistent downtrend relative to sales in the last five years. On top of that, we would expect a CFO of a company to know the difference between accounts receivable and deferred revenue, but based on his flawed explanations, we are not so sure at the moment. Below, we detail OMCL’s recent negative deferred revenue trends:
- When analyzing both current and non-current DR balances, we find that DR actually decreased by 3.9% YOY to $100.4 million in Q1 2019. Again, from a quality of revenue standpoint, our analysts would like to see deferred revenues increasing, especially when relative to sales. When unearned revenues increase on the balance sheet, this added cash acts as a “down payment” by the client and virtually guarantees future revenues on the income statement.
- Here we find the opposite impact has been plaguing OMCL. Relative to 3M sales, DR has decreased by 765 bps YOY to 49.6%, representing a five-year seasonal low for the company. This compares unfavorably with the five-year seasonal average of 60.2%. Longer-term metrics report similar discouraging trends with DR falling by 156 bps YOY to 12.4% relative to 12M sales.
- Days-of-deferred revenues (DDR)3 also reported material degradation by falling 10.3% (9.1%) YOY to 43 days (44 days) as referenced on Table 2, Page 14. Both figures represented a new five-year low for the firm. Ouch.
- As stated above, our analysts like to judge net receivables and deferred revenues trends to get a full picture of the firm’s quality of revenues. In most cases, we expect to see companies with a net balance near $0 or negative, as the firm’s deferred balance is above AR. This was the case for Omnicell in the years preceding 2013, suggesting strong quality of revenues.
- In Omnicell’s case, net AR reached its third highest absolute level (only to Q3 & Q4 2018), increasing by 17.4% YOY to $143.0 million. This absolute value stands at an extremely high level for the company, especially when we see that this balance stood at a negative $1.3 million only four years ago.
- As one would expect, relative to quarterly sales, net AR jumped by 391 bps to 70.6%, representing the second highest ratio recorded in any period. Twelve-month net AR-to-sales reported a similar increase of 140 bps to 17.7%. Make no mistake about it, these are absolutely terrible net figures reported by OMCL and very rarely seen to this extent in our experience.
- Overall, the continued increase of receivables coupled with the deterioration of unearned revenue metrics lead us to believe that the quality of OMCL’s recent sales is at extremely low levels. Based on our experience, we expect to see a material drop off of revenues in future periods as a result. This is corroborated by the excerpt above detailing contract liabilities as being “customer deposits under non-cancelable contracts”.
- To quantify the impact that recognizing this revenue earlier relative to historical standards has had on performance, we can reverse engineer OMCL’s net AR balance using the firm’s net DSO value reported in Q1 2018 (47 days). As a result, we calculate that OMCL recognized an astonishing $38.3 million more in revenue (also pure margin gains) over the TTM. This considerable figure also translates to a tailwind of 72-cents in EPS over the last year, or 30.2% of non-GAAP EPS!
Table 2: Deferred Revenue and Net AR Metrics ($ in millions)
Chart 2: Long-Term Net AR & DSO Trends ($ in millions)
See the full report here.