After surging to recent highs above $30 at the close of the first quarter, C3.ai (NYSE:AI) has dropped due to serious accounting allegations from an investment firm short the stock. Naturally, the stock plunged on the alleged accounting issues, though no ‘smoking guy’ exists. My investment thesis is more Bullish on the stock following the big dip in C3.ai after reaching an overvalued position prior to the short letter.
The case for being bullish on C3.ai was never based on the strong business model and excellent execution of the business. After all, the enterprise AI software business just reported a January quarter where revenues fell nearly 5%.
The bullish case is based on a shift in the business model towards consumption with a return to revenues growth in a hot area like AI. C3.ai guided to FQ4’23 revenues returning to growth with a target of $71 million following the $67 million in the prior quarter.
The stock had run too far recently hitting a high of $34, but the switch to a consumption business model only made us bullish due to the stock being beaten down and the potential in the generative AI software segment. The dip from these accounting questions might provide another opportunity to buy the stock.
Kerrisdale Capital Management made some serious allegations regarding the accounting of C3.ai. So much so, the investment firm sent a letter to Deloitte & Touche LLP demanding the audit firm either report the claimed accounting irregularities via the upcoming FY23 audit or resign.
The basis of the accounting allegations are questions regarding the reporting of subscription revenue and related party disclosures and financials related to the Baker Hughes (BKR) deal. The letter to the auditor highlights these issues:
- The highly conspicuous growth in unbilled receivables to levels we’ve never before seen in software companies.
- Opaque, confusing and highly concerning disclosures and financials related to the company’s related party and very large customer, Baker Hughes.
- Efforts to inflate gross profit margins by reclassifying costs of revenue as research and development expenses.
- Classification of significant revenue as subscription revenue that in actuality is services- or consulting-oriented revenue.
- Significant turnover in chief financial officers, and the appointment of successively less qualified CFOs over time.
None of these issues are ‘smoking gun’ allegations. Taken together, the issues due bring up questions as to why the enterprise AI software company has had to replace so many CFOs in such a short period of time. Though, the replacement of CFOs isn’t a clear case of misdealings and the auditing firm of Deloitte should’ve provided extra scrutiny on so many CFO changes when undertaking the FY22 audit. Honestly though, one would have to assume the constant replacement of financial executives might reveal any accounting irregularities. Having a CFO remaining in place for an extended period of time would help keep the company out of the spotlight of auditors.
The biggest question is definitely the ballooning receivables balances. For the FQ3’23 earnings report, C3.ai reported the outstanding A/R balance surged to $143.7 million, up from $80.3 million when FY22 ended just back in April, 2022.
The A/R balance surged in FQ3 by $49.1 million from the $94.6 million level reported for FQ2’23 ending in October. The majority of the growing A/R balance is related to revenues from the Baker Hughes contract.
Along with the FQ3 earnings report, C3.ai announced an expanded strategic partnership leading to an additional booking of $32.5 million. The main comment regarding the expanded Baker Hughes deal was an increase in the frequency of the payments due from the oil services company.
The primary reason for the high A/R balance is the $82.1 million related to Baker Hughes due primarily to $79.6 million in unbilled receivables. In total, unbilled receivables were $87.9 at the end of January.
The recent 10-Q doesn’t appear to explain why such large amounts of revenues are unbilled. Not to mention, the company failed to explain the updated Baker Hughes payment terms, other than this generic statement by the new CFO on the FQ3’23 earnings call:
Actually, one of the really exciting seas part of this extended agreement is that we accelerated the payment schedules. So we’re actually collecting cash faster from Baker Hughes.
Unfortunately, the conversations never reconciled how these payment terms impacted the outstanding A/R balance and whether the expanded agreement with Baker Hughes would help resolve the outstanding balances.
The other primary allegation is that C3.ai is more involved in consulting services than a software subscription business. Kerrisdale Capital doesn’t make a very good case for the consulting business focus being accurate other than a leap as to why recent quarterly results have been weak.
The biggest impact naturally is that C3.ai would have far less leverage in the business. A consulting business with 40% gross margins versus the current subscription services business with 70% gross margins would possibly alter the value of the stock assigned by the public markets. Kerrisdale Capital isn’t making any claims of misstatements on the level of reported costs, just rather a shift in the correct reporting bucket from cost of services to R&D.
These alleged accounting issues led to the connection that an accounting issue clearly being perpetrated due to the changeover in the CFO office. Kerrisdale Capital provided the following table on the 4 different CFOs since 2019.
Clearly, this much turnover in the finance department is far from ideal. Though, accounting irregularities would be far easier to perpetuate with one CFO in charge. All of the shuffling in executives would only make the exposure of accounting issues much easier.
No doubt, Kerrisdale Capital makes a great case that each new CFO is younger and less experienced with public accounting than the prior executive. This point definitely doesn’t prove any mis-dealings, and in my view it’s most likely outcome that CEO Tom Siebel is simply challenging to work with; he’s 70-years old and has lengthy experience.
Mr. Siebel could just be unwilling to listen to CFOs causing them to find different jobs. Mark Levine was hired as the CFO of private Tanium back in 2021 in a sign these executives have plenty of other job options.
Heading into trading on Tuesday, the stock was getting extended with the huge rally at the end of the quarter. My previous research had highlighted how C3.ai reported a trough quarter for FQ3’23 with the company guiding to a solid return to sales growth in the current year-end quarter.
The whole concept of moving to the enterprise AI software consumption model from the prior license model would appear contrary to the accounting irregularities concept. Any company engaged in a high-level attempts to mislead investors wouldn’t likely need to change the business model and go through the pain of the stock collapsing below $10 due to weak quarterly results.
What is evident from the Kerrisdale Capital letter to Deloitte & Touche LLP is that the investment firm was feeling pain from a short position in C3.ai with the stock rise. Otherwise, the firm wouldn’t have sent the letter to the auditors the day after the stock hit a recent high.
As highlighted in our December research note to buy C3.ai below $13, our bullish call had pointed out the following price targets that were already eclipsed:
- 6x EV/FY24 revenues of $340M = $26
- 8x EV/FY24 revenue of $340M = $32
The stock soared past these price targets hitting $34.68 on the day prior to this follow-on short call. For our part, we highlighted the stretched valuation alerting subscribers to the Out Fox The Street Investing Group via chat to use this rally to look for an exit point.
The stock fell 26% off the news on April 4 to trade back at $25 and is falling again on April 5. C3.ai has been a good buy at this $22 level prior and absent any of the accounting allegations sticking, the stock is a buy again.
C3.ai responded to the allegations suggesting the financials are accurate per U.S. GAAP as audited by Deloitte. A C3.ai spokesperson made the following statement to Seeking Alpha:
Without comment on the legality of stock manipulation nor the innuendo replete in the letter, we will note that their allegation that C3 AI’s financial disclosures regarding Baker Hughes are somehow incorrect manifests a fundamental misunderstanding of US GAAP accounting practices and principles.
The accounting disclosures and financial statement referenced in the letter have been reviewed by our independent audit firm for which we have an unqualified opinion; and are complete and correct.
The major disappointed about the statement is that the company could’ve used the opportunity to better explain the unbilled revenue totals and updated payment terms related to the Baker Hughes deal. A prime reason to abandon the bullish thesis are signs the accounting irregularity claims prove accurate. A secondary red flag would be the A/R balances ballooning further and C3.ai not better addressing the resolution and timing of Baker Hughes payments to clear the outstanding balances.
The key investor takeaway is that Kerrisdale Capital Management is making some serious accounting allegations regarding the financials of C3.ai. A lot of the questions are attempts to connect dots that may not necessarily lead to actual accounting problems.
The stock is a compelling buy near support around $22 where the EV/S multiple is back closer to 5x forward revenue targets. Though, investors need to understand the extra risk as C3.ai would have significant downside risk on any of these accounting allegations turning out to be true.