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Should Institutions Jump on the VeriFone Bandwagon?

     Many Public Pension Plans are heavily invested in VeriFone Holdings Inc. (NYSE:PAY) and have, most likely, suffered substantial losses as a result of the December 3, 200Intbasic_47 meltdown of the stock.

      We have been investigating this case and have found the facts to be compelling. On December 3, 2007, VeriFone announced that it would restate its financials at least as far back as the quarter ending January 2007. This restatement wiped out four-fifths (80%) of its pretax profits for the first nine months of 2007.

     Clearly, a restatement alone is not fraud. But, in this case, at least three facts compel us to believe that the restatement is not innocent.  

     First, the insider sales in the month of November were huge. The CEO dumped almost 400,000 shares (about 25% or his family trust holdings)for $18.5 million during the month , with 43,000 shares sold just a week before VeriFone’s stock collapsed $23.20, or 48.3%, to $24.83. Over the course of the year the CEO dumped $76,057,159 shares and purchased none. In November, the CFO exercised options for and sold all of his 18000 shares of Verifone stock. For his sales in the month of November he received $802,814, and for the entire year in question he received $7,246,260 for his sales and made no purchases. Even more compelling is the fact that the insiders have been selling shares almost without exception during the entire period at question.The insiders have been dumping their stock for the past 7 ½ quarters, with no purchases since the beginning of the restated periods. Untitled_2 While it is widely reported that these sales were pursuant to a 10b5-1 sales plan, both the plan of the CEO and CFO were reported by them to have been adopted on December 10, 2006 at the inception of the accounting irregularities.

    Second, the purported accounting errors which are being blamed for the restatement involve the valuation of “in-transit inventory”:

On December 2, 2007, following a review by and on the recommendation of management, the Company concluded that its unaudited interim consolidated financial statements for the three months ended January 31, 2007, the three and six months ended April 30, 2007 and the three and nine months ended July 31, 2007 should no longer be relied upon, principally due to errors in accounting related to the valuation of in-transit inventory and allocation of manufacturing and distribution overhead to inventory, each of which affects the Company’s reported costs of net revenues.

     Inventory is one of those items that a company can easily play with, to boost profits for a quarter or two or, in this case, at three. W. Stephen Albrecht, PhD., of Brigham Young University, has written for the AICPA’s Antifraud and Corporate Responsibility Center:

Inventory frauds have been such a significant problem historically that a few years ago the Wall Street Journal featured a front-page article titled "Inventory Chicanery Tempts More Firms, Fools More Auditors."….

See Albrecht, Identifying Fraudulent Financial Transactions, American Institute of Certified Public Accountants, 2005. http://antifraud.aicpa.org/Resources/Auditors/Tools+and+Aids/Fraudulent+Financial+Transactions.htm?PrinterFriendly=true

Dr. Albrecht has identified at least 15 fraud schemes that can be used to overstate Inventory and/or understate Cost of Goods Sold, all of which have the effect of increasing net income in the current period. This in turn leads to a huge problem for management that does not exist with other financial manipulations¬¬¬---it must be repeated more intensely in the next period to cover it up:

With revenue-related frauds, reported revenues are overstated in the current period and accounts receivable are overstated on the balance sheet. However, there is no compounding effect in the subsequent period. With inventory frauds, however, the "overstated ending inventory" of one period becomes the "overstated beginning inventory" of the next period and causes net income to be understated in the second period. Thus, if a dishonest management wanted to continue the fraud into a second period (most frauds are multiple-period frauds), they would have to perpetrate a fraud of an equivalent magnitude just to offset the overstated beginning inventory, and then commit an additional fraud if they again wanted to overstate inventory to increase net income. The result is larger misstatements and a fraud that is much easier to detect.

Fortunately, most financial statement frauds are perpetrated out of desperation, and dishonest management worries only about how income can be overstated in the current period with no thought of the problems they create for themselves in subsequent periods.

    This is the very pattern we see in VeriFone’s restatement. As reported by VeriFone in it’s 8-K filed on December 3, 2007:

[T]he Company’s management currently anticipates that the restatement will result in reductions to previously reported inventories of approximately $7.7 million, $16.5 million and $30.2 million as of January 31, 2007, April 30, 2007 and July 31, 2007, respectively, and reductions to previously reported pre-tax income of approximately $8.9 million, $7.0 million and $13.8 million for the three month periods ended January 31, 2007, April 30, 2007 and July 31, 2007, respectively.

Based on this compounding pattern and Dr. Stephens observations, the inventory overstatements appear intentional.

     Third, the size of the restatement is huge when one considers it has all but wiped out the profits, and conveniently is accountable for 80% or the Company’s profits. Moreover, in the Company’s 8-K of December 3, 2007, it states that it has not finished it’s investigation and has cautioned that more is yet to come.

     In VeriFone’s defense, the SEC has not yet started an investigation, Goldman Sachs is blaming it on “friction” with the Lipman acquisition (but the Company is not) and others are blaming VeriFone’s major customers which may have held tons of VeriFone inventory. The Company, itself, has claimed that the overstatement is the result of double entries in VeriFone’s inventory accounting system. According to one unverified press report which comports with at least one analyst report (we wonder where the 8-K is of this filing or why the conference does not seem to have complied with Reg FD and was made public----do you hear me SEC?):

During a conference call with analysts Monday afternoon, Bergeron explained the company's accounting system was not set up to automatically input the value of inventory moving between VeriFone locations in Singapore; Sacramento, Calif.; and Tel Aviv, Israel, Card Technology’s sister publication CardLine reported. Bergeron told analysts that because the in-transit shipments were not automatically applied to the accounting system, someone had to manually input the numbers. Bergeron said that procedure was correct and required. The error surfaced when someone incorrectly determined that direct shipments also had to be entered manually, he said. The double entry was not found until work began on VeriFone's annual audit. "In short, these errors were characterized by double-booking of overhead in Sacramento," Bergeron said. "We are confident that we have isolated the problems in our systems and in our accounting. We are also confident that this issue did not exist before fiscal year 2007."

Card Technology.com, December 5, 2007. http://www.cardtechnology.com/article.html?id=20071205VUXI34XB.

     Whether there is truly a fraud here will be developed by investigations still in process. But, as the class action lawsuits have been filed and the days are counting down to the last day for an institutional investor to decide whether to take the lead the prosecution of the litigation on behalf of all purchasers of VeriFone stock, is coming up, you do not have the luxury of waiting to see how the facts develop.

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Reader Comments (1)

Reed, you got to love this. Last Tuesday (Aug. 19, 2008) Verifone Holdings held a news conference wherein the management stated that Verifone would meet analyst's projections. This caused the stock price to go up over 30%. However, if one studies the basis of this optimistic outlook at http://ir.verifone.com/phoenix.zhtml?c=187628&p=irol-newsArticle&ID=1188702&highlight= and deciphering the language, one easily concludes that these optimistic projections requires the addition of these following amounts (and other outrageous items) to projected GAAP net earnings:

cost of defending oneself in a legal suit = earnings to stockholders

cost of paying too much for an acquisition = earnings to stockholders

stock grants to the management and employees = earnings to stockholders

wear and tear on equipment = earnings to stockholders

losing patent coverage = earnings to stockholders

and lastly: corporate income taxes = earnings to stockholders

As you might imagine, business news outlets picked up the story without doing their homework. So many "fat cats" are unloading their shares so that the new stockholders will take the fall. It is important to note that after a very delayed restatement of earnings, due to previous accounting errors, Verifone has been and still is operating at a loss.

Question: As an attorney, could you comment if Verifone has found a scheme to deceive investors which is legal? Management is not hiding what they are doing, however their presentation of the strange accounting is way above the small investor's head.
August 23, 2008 | Unregistered CommenterMickey Jones

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