stock ticker: ARTC

Last week Arthrocare announced its quarterly results.  They led with a PR touting surprisingly high year over year growth numbers.  Notably, the announcement was in the form of an 8-K – only including the numbers the company wanted investors to see.  All the financial details provided by a 10-Q, such as divisional breakout of revenues, cash flow, receivables aging, etc. are still AWOL

Even within the bounds of the company’s carefully orchestrated quarterly release, there was one item that stood out like a sore thumb.  Beyond the sequential decrease in revenue on the recently touted spine business (down 500k), was the cold fact that the rate of growth in receivables outstripped that of revenues by almost 300%.  This should have been the first red flag to investors that something was not kosher in the world of Arthrocare.

Channel Stuffing?

While management is spending their time avoiding depositions and dodging subpoenas, it appears to Citron that there are ominous signs that someone at Arthrocare has been busy stuffing a channel. 

In the recent earnings release, investors took notice of the claimed 25% growth in sports medicine sales, but they failed to notice that sequentially it only increased 4%.  The actual big jump in sports medicine took place in Q4 of 07, when sports medicine went up 100% on an annual basis.  This is a highly competitive sector with many competitors, none of which are able to show more than single digit growth.

On May 1, 2008 Arthrocare announced the acquisition of Ortoconcept of Scandinavia.  How does one say Discocare in Danish?  While we are still waiting for the financials of Discocare, which were promised to investors but never delivered, Citron Research is proud to present the financials of Ortoconcept.

Does this sound like a company who has had its channel stuffed?  Let us keep one thing in mind, as it appears in the company’s website, they distribute only products for Arthrocare Sports Medicine.
http://www.ortoconcept.com/uk_sportsmedicin.htm

All of these numbers were obtained by Dun and Bradstreet Denmark.  This is the company’s disclosure to D&B.  The following numbers represent the change in 2006-2007 (We are left to imagine what 2008 looks like)

Ortoconcept (PDF)

• Sales grew slightly more than 2% while inventories ballooned over 340%. 
• Accounts Receivable were up by 5% but Accounts Payable grew over 120%
• Total Liabilities grew over 110%
• Inventory was over 3 years of sales for an industry whose product cycles are 6-9 months.

Citron first lifted the veil on Discocare, which is now the subject of an intensifying civil litigation onslaught.  Then DRS seemed to creep out of the corners of Sanford, Florida.  No we introduce Ortoconcept…..we are certain to see more cockroaches in this house.

As if it wasn’t bad enough

On May 1, 2008 Arthrocare’s huge competitor Smith & Nephew saw its stock drop 12% on lowered earnings based upon “unacceptable business practices of an acquired company in Switzerland”.

http://www.marketwatch.com/news/story/smith-nephew-down-after/story.aspx?guid=%7B386E23CC%2D8EB6%2D4895%2DA53A%2DEAB4312FC236%7D&siteid=yhoof

Considering Arthrocare has the nefarious DRS and Discocare divisions that are diverting money to doctors on a quarterly basis, it seems unlikely that any other medical device maker would want to put their head in the mouth of this lion.

In David Einhorn’s new book Fooling Some of the People All of the Time, he writes, “Warren Buffett once told me about the difficulty of shorting the stocks of companies run by crooks, because they’ll fight dirty to save themselves.   The crook’s life depends on it… ” Buffet said.  While I am not calling Mr. Baker an outright crook, his consistent dishonesty to Wall St. cannot be ignored

In upcoming reports, Citron will explain the “rebate” “carve-out” kick back schemes that Arthrocare is employing in their sports medicine division.  So complete is Arthrocare’s deception that even knowledgeable investment analysts and investors are finding it difficult to ascertain the true operating condition of this company.

stock ticker: ARTC

As Arthrocare (NASDAQ:ARTC) prepares for its earnings report and conference call on Monday, investors should be preparing as well:  preparing to hold management accountable to stop denying the important issues that threaten the company, as reflected in current legal proceedings that seek to unmask their business model.  With an upside down balance sheet in an industry that has become a hotbed for regulation from the Department of Justice, it appears to Citron that the problems at Arthrocare have just begun.

If you can’t read between these lines than it is time to get some glasses.

CEO Michael Baker has consistently stated that any problems with the spine business are merely a figment of the short-sellers’ imaginations, and the spine business is the engine driving the company’s earnings growth.  In a startling new case brought in Broward County, Florida, we see the defense turn a routine auto negligence case into a direct assault on Arthrocare’s business model.  While the plaintiff (in this case, the “injured” in the auto accident) was ready for trial, the attorneys, acting for the defense (insurance companies), changed the whole scope of the case.

Please Have a read and make your own determination:

New Problems for Arthrocare (PDF)

Note:  This is a completely separate case than the one previously published on Citron Research.

As stated by the attorney to the court

“The defendant needs to conduct discovery to, among other things, determine whether the discograms, assuming they were performed, were intentionally performed merely to “maximize” the bills under same sort of business model in general, or the Discocare Model in particular.”

We also read claims in the case about:

1. Exorbitant Medical Bills for Arthrocare Products
2. Arthrocare’s targeting of personal injury attorneys as a source of business
3. The malpractice of physicians in alignment with the coaching of Arthrocare
4. Upcoding to defraud the insurance companies

There is nothing more conclusive that Citron can say that cannot be read in the document linked below.  What makes this case so damning compared to other cases we have seen is:

1. The attending physician is Dr. Jeffery Kugler, who has become Arthrocare’s “poster child” of how to be a successful spine surgeon.  Dr Kugler has even written the “study” that Arthrocare distributes to spine physicians to justify performing and coding PDD’s as open surgeries.
2. The insurance companies have taken the initiative to change the focus of the investigations from auto negligence to the grand scheme as orchestrated by Arthrocare
3. The soap-operatic scenario of an assortment of parties, supposedly unrelated, hiding behind a single attorney in a collective attempt to avoid subpoena service sounds more like an episode of Sopranos than a strategy appropriate to a publicly traded corporation.
4. Someone needs to begin to get serious about risk assessment with regard to Arthrocare’s liabilities in the face of a potential civil RICO case against the “Discocare model”.

The Previous Case Involving Arthrocare

Two months ago, Citron showed how Baker was served with a subpoena from State Farm that was quite damning.  The subpoena went right to the heart of the “Discocare Model” as it manifests at Arthrocare.  Yet, the company shrugged it off as if it was “normal course of business”.  Citron failed to point out that it was not just CEO Baker and David Applegate (head of spine division) who were subpoenaed, but rather there were nine total subpoenas served on Arthrocare.  The insurance company wanted to take depositions on

1. Arthrocare Corp- person with the most knowledge of CPT coding of the Plasma Disc Decompression, Nucleoplast or any spinal disc surgery utilizing Arthrocare devices.
2. Person with the most knowledge of the amounts charged by Arthrocare for Arthrocare Spinewands from January 2003 through present and how such amounts were determined
3. Person with the most knowledge of any documents, job advertisements, or listing published relating to Regional Business Development Manager….
4. Person with the most knowledge of any suggestions, recommendation or examples of physician or facility charges for the Plasma Disc Decompression
5. Person with the most knowledge of all information and posting to the Arthrocare Website from January 2003, through present.

http://www.citronresearch.com/wp-content/uploads/2008/02/arthrocare-subpeona.pdf

These are all in addition to the previously shown subpoena to Michael Baker

Do these questions sound like “normal course of business” ???

Class Action Lawsuit

Most recently investors have witnessed a slew of class actions against Arthrocare.  We all know that class action attorneys can be vultures, but we can sometimes find indications of real issues within their lawsuits.  Even setting aside the “Discocare model”, the sizable insider sales, and the already questionable “bill and hold” transactions, these class actions offer a glimpse into the questionable sports medicine reimbursement business of Arthrocare, which comprises the majority of their revenue.  Here are a few of the points that Citron found to be most interesting.

1. The company did not report revenue properly under SAB 104 because while they were guaranteeing devices to doctors (a medical no-no), they were recording revenue as if it was generated on a “non-recourse” basis.
2. Arthorcare may have arranged transactions to obtain certain results from related parties (Device Reimbursement Solutions)

http://www.csgrr.com/cases/arthrocare/complaint.pdf

A Canary in the Mine?

The job of a short-seller / investigative blogger is a process that involves time and effort.  So in order to prove this point, we are going to have to give away one of our secrets.  A recent search of job applicants on Monster.com showed us something interesting:  an Arthrocare internal auditor is looking for a new job.  Note this is not merely a salesperson or just an administrative staff person; this is a specialist who deals with Sarbanes-Oxley compliance.  In order to protect the person’s privacy, we have redacted their name and phone #, but here is what it says.  The employee left Arthrocare just last month.

Citron notes that while he might have left his job for a multitude of reasons, having your internal auditor leave without having another job already lined up is normally not a good sign.

Conclusion

Denial is wearing perilously thin as a damage control strategy at Arthrocare.  Its balance sheet is already a casualty of management that has chosen to circle the wagons rather than face the harsh reality that is closing in on its options.

Cautious investing to all.

stock ticker: EMKR

“And we would have gotten away with it, if it wasn’t for you meddling kids!”

Famous Scooby Doo line

Citron has observed with keen interest developments at Emcore since our first report March 18th and follow-up March 25th.  There are a few significant events, all of which point to a ménage trios of convenience between Emcore, Green and Gold Energy and the head cheerleader analyst at Jefferies & Co.

The Coalition of the Willing

• Emcore needs Green and Gold Energy because it is the largest “customer” of record for its terrestrial solar products, representing 80% or more of its “backlog” for solar technology.  Emcore desperately needs the appearance of a growing solar business as it needs to raise huge amounts of capital to cover operational losses.
• Green and Gold Energy needs Emcore because it is a tiny, thinly capitalized Australian business trying to create the appearance that it is a major player in the solar business.  Green and Gold uses its purported Emcore purchase order as a credential to establish credibility. Green and Gold’s CEO has a multi-year track record of trying to raise money by selling promises which never come to fruition, including perpetual machine kits and rooftop solar electric devices.  There is little or no public information available on any of Green and Gold’s “licensee” customers.
• Jefferies & Co recently underwrote Emcore’s private placement, and sees a lucrative cash-raise offering coming over the horizon.

Analyze This

Jefferies analyst John Lau needs to issue a big mea culpa to Wall St.

On March 11, he states clearly, “GGE is an important customer to Emcore.”  He goes on to mention either Green and Gold or the Suncube over 12 times in a 3 page report to Wall St. There is no financial model included in the March 11 report.

And then on March 27, only two weeks later (after the Citron report of course) Lau publishes a report that is reminiscent of the glossy “scammy” mailers you might receive on an OTC company.  The  report is full of nice pictures of companies who are not Emcore and do not have business with Emocre…..yet not even one mention of Emcore’s major contract with Green and Gold.  But it gets worse.  In the same report, Lau’s financial model grossly understates Emcore’s losses, paints a picture of its emerging into profitability when there is not a scintilla of evidence that it is about to do so, and thereby completely misrepresents its financial situation.

There are several shocking deficiencies in Lau’s model, include understating operating income, net loss, and SG&A by all close to 100%…this is either an unheard of oversight or someone is really trying to pull a fast one.  Even better, Lau’s projected share count into  2009 is lower than the company’s current share count.  Someone has a lot of explaining to do here.

March 11, Jefferies (PDF)

March 27, Jefferies (PDF)

The Rain in Spain

Emcore and Green and Gold were both scheduled speakers at the much-anticipated CPV conference in Madrid.  Green and Gold’s presentation is laced with preposterous material misrepresentations, and states a client list of companies who have no public presence. Meanwhile, Emcore claims GGE as its largest terrestrial solar photovoltaic customer.  Emcore has done nothing to create accurate disclosure to the US investing public as to actual condition of its solar business or the reliance that can be placed on GGE’s claims.

By appearing in the same venue with Green and Gold, and by having gone on record with a “To Whom it May Concern” letter expressing “support” for GGE, Emcore is in fact aiding and abetting the fraud perpetrated on the market by Green and Gold Energy.

Danzilio Letter (PDF)

Citron notes that “backlog” is the one financial metric about a company’s current business that is not typically audited.  Therefore, it is especially subject to being used in a misleading way.

Therefore, today Citron calls on the SEC to investigate Emcore’s public statements about its solar technology business, and calls on Emcore to go on record to correct its statements with regard to its “backlog” of terrestrial solar orders — and specifically, that percentage of orders which are from customers who can be relied upon to pay for their purchases.

SEC Letter on Emocre (PDF)

Lets Make a Deal

Subsequent to the CPV conference in Spain, Emcore has announced two deals:

1. Buying additional fiber assets from Intel, and
2. A solar deal in China.

As to the former, Citron notes that this follow-on asset purchase requires zero cash, just some freshly minted stock, which Emcore has in good supply.  Citron observes that Intel is not in the habit of giving away attractive, profitable businesses for free.  We believe that as these integration and operational numbers begin to flow through Emcore’s financial statements, the gusher of red ink will intensify.  No doubt Emcore’s quarter will be heralded by headlines of “Record Revenues” … but without sating its ravenous appetite for the public’s investment money, the losses generated by these “record revenues” are simply not sustainable.

As to the latter, Citron notes that aside from the slippery accountable-to-nobody future promises, the stated deal is for 60kW of solar technology.  While no terms are announced, but by extrapolating from previously published numbers about Emcore’s backlog, its possible to compute a value of 60kW at about (……drum roll…..) $18,000. …nothing more than a college science project.

CITRON CALLS UPON EMCORE AND JEFFERIES TO COME CLEAN.

The only way investors can validate a technology as a business is if we see valid orders from customers.  Where are the commercial-sized valid orders from Emcore?  Green and Gold is the only major customer.  Emcore has gone out of its way to perpetrate the fraud by not only writing letters of recommendation for Green and Gold to induce investors, but more importantly by lying to its own investors by stating in press release, “Green and Gold Energy is a world leading CPV system provider.”
http://www.emcore.com/news_events/release?y=2007&news=163

In our next report, we will show how this whole circle of hype is not new for CEO Reuben Richards, but rather he has been promoting fictional backlogs and unfulfilled promises for years.