New Article Alert!
PDFIn recent years, company filings show, INET has spent huge sums of money acquiring websites in an effort to bolster its growth. But the former owners of two of those websites – including one that accounts for a major chunk of INET’s traffic – have accused the company of refusing to fully pay off those strategic deals. Meanwhile, longtime fans of other INET-purchased websites have threatened to leave over rate hikes and reported failures in customer service.
With INET under fire from both its past acquisition targets and its inherited customers, the company could face challenges pursuing its ambitious growth strategy going forward. Moreover, regulatory filings indicate, INET has so far failed to capitalize on the websites it has already bought.
Over the course of the past 10 quarters, critics estimate, INET has spent more than $100 million on acquisitions, earn-out payments and capitalized software expenses. However, INET’s latest annual report reveals, the company has seen its pro forma revenue – which includes both organic and acquisition-related sales – actually fall despite all of the new websites it now owns.
Even so, INET has still managed to report record-breaking results to the market. The company’s stock, down a penny to $10.66 on Friday, currently trades near an all-time high due to that rosy picture of success.
Importantly, however, INET has focused on a particularly accommodating metric when showcasing its numbers for the public. Every quarter, INET loudly broadcasts a figure known as “adjusted EBITDA” (earnings before interest, taxes depreciation and amortization) that’s linked tightly to executive pay. That number, up by double digits on a percentage basis last year, has regularly exceeded Wall Street targets and allowed senior management to pocket handsome bonuses along the way.
Meanwhile, company records show, INET’s revenue – on both an actual and a pro forma basis – actually declined last year. INET’s cash flow from operations came in 10% lighter than its celebrated adjusted EBITDA, critics note, while the company’s overall cash flow (after investments in capital expenditures, software, earn-out payments and other items) wound up in negative territory for that same period.
INET’s numbers would look much worse, critics say, without help from some useful accounting tricks. By underestimating future earn-out payments, they say, INET can magically reduce its overhead expenses and make the company look more profitable than it actually is. INET can then exclude those earn-out bonuses from its income statement when it does pay them (as permitted under new accounting rules), they add, further aiding the company’s reported profits.
INET’s audit and ethics committee, which includes two directors linked to notorious subprime mortgage lenders, has raised some eyebrows as well. Martin Melone, the chairman of that committee, previously chaired a similar committee at Countrywide Financial during an aggressive growth spurt that almost led to the company’s demise. James Ukropina, a second member of INET’s three-person audit committee, served on the board at IndyMac before that company actually collapsed in one of the biggest bank failures ever.
With concerns about INET escalating – while its stock price keeps marching higher – company critics have begun sounding alarms about potential landmines ahead.
“Researching this company on Google (Nasdaq: GOOG) yields a fount of information, mostly bad, about this company’s unethical business practices,” one unhappy customer stated in an INET chat room earlier this year. “I had noticed this stock as one on the rise. However, due to their past track record, it’s probably better to put my money elsewhere.”
The Firing Squad
INET portrays ModelMayhem.com, a website it acquired two years ago, as the most popular online community for models and fashion photographers in the country. (The colorful website, featuring scantily clad models looking for work, counts Michelle “Bombshell” McGee – blamed for busting up Sandra Bullock’s marriage to Jesse James – among its 380,000 members.)
According to a recent lawsuit, filed in April of this year, INET estimated that ModelMayhem averaged about 290 million page views per month – a number equal to 40% of the company’s total monthly page views last quarter – throughout most of 2009. However, the lawsuit says, INET later claimed that up to 75% of those page views were bogus and refused to pay the website’s former owners scheduled earn-out bonuses as a result. INET saved itself up to $800,000 in earn-out payments, a sum equal to roughly 20% of the company’s quarterly earnings, in the process.
But ModelMayhem’s former owners have since filed a lawsuit against INET – claiming fraud, deceit and breach of contract – and are now seeking triple damages from the company.
The former owners of FlyerTalk.com, one of INET’s prime travel sites, filed a similar complaint against the company three months later. INET purchased FlyerTalk in early 2007, the July lawsuit notes, promising millions of dollars in earn-out payments if the website achieved certain milestones.
Although INET paid the scheduled bonuses for 2008, the lawsuit says, the company refused to cover roughly $1.2 million worth of additional payments for 2009. The company also failed to operate the website in good faith, the lawsuit claims, triggering a 460% increase in technical problems and an 800% jump in customer complaints.
INET recently denied the allegations levied in both lawsuits, which have yet to be disclosed in the company’s filings.
“We have consistently paid all earn-outs that we believe are owed under the terms of the purchase agreements,” INET stated in an email to TheStreetSweeper last week. “We believe the pending lawsuits are without merit and will vigorously defend them.”
Regardless, INET added, “their financial impact on the company is quite immaterial.”
But customers of other firms purchased by INET have raised some troubling concerns as well. For example, the BBC reported in July, INET released a new version of vBulletin – now a key source of licensing revenue for the company -- that allowed outsiders easy access to administrative user names and passwords for websites utilizing the program.
“It is very worrying,” one customer told the BBC, “that they are releasing a product which has such a serious flaw.”
Although INET has since addressed the problem, the company remains under attack by unhappy vBulletin customers. Before that glitch even surfaced, in fact, TheLawProfessor.com was already blasting INET for the escalating fees it’s been charging for vBulletin since it gained control of the popular software program a few years ago.
“The yearly product updates that I bought for $30 in 2007, which Internet Brands raised to $40 in 2008 and refused to sell me in 2009, (are) being offered to customers for $50 in 2010,” the legal website stated in July. “Now here is the kicker: If you bought a vBulletin 3 license in late August or September 2009, you found out that you had to pay $130 more to upgrade to vBulletin 4 just one month later.
“The past three years have been punishing,” the website continues. “And refusing me the ability to upgrade my software – without any prior notice or opportunity – reeks of a similar odor as consumer fraud.”
‘Governance Train Wreck’
The chairman of INET’s audit and ethics committee is no stranger to criticism.
Before joining the board at INET, records show, Melone launched a five-year stint as a director at Countrywide – where he also served on the audit and ethics committee – that ended with disaster for investors. By Melone’s fourth year on the job, a past article by Reuters reveals, Countrywide and its entire board faced legal complaints for allegedly engaging in securities fraud ahead of the mortgage giant’s rapid decline. The following year, Chief Executive magazine portrayed Countrywide as a possible “governance train wreck” the very month that Melone vacated his boardroom post.
“If the board’s number-one job is risk management,” one expert told the magazine in June of 2008, “it’s fair to say they’ve failed miserably.”
Coincidentally, Internet records reveal, another member of INET’s audit and ethics committee spent five years as a director at a doomed mortgage company as well. Ukropina began serving on IndyMac’s board in early 2001 and remained there through an explosive growth spurt that would cost the company dearly down the road. Although Ukropina resigned from IndyMac’s board to “pursue other interests” – including a new post as a director at INET – two years before the company officially collapsed, records show, government regulators had by then already uncovered dozens of serious problems at the giant mortgage firm.
In a scathing February 2009 review, the Office of Inspector General identified a slew of issues that surfaced – many of them demanding board-level attention – during the same years that Ukropina served as a director at the company. Those problems included (among others) the following: faulty appraisals dating back to 2001; troubled loans dating back to 2002; and worrisome reserves dating back many years as well.
Ultimately, the OIG concluded that regulators “should have taken enforcement action against IndyMac as early as 2005.” When departing from IndyMac the following year, however, Ukropina indicated that he was leaving behind a healthy company with a promising future ahead.
“Through the hard work and commitment of the company’s exceptional management team … IndyMac has become one of the nation’s most successful mortgage providers and a leading thrift,” Ukropina stated in 2006. “I am proud to have served IndyMac during a time of such advancement and look forward to even greater success for this company.”
Instead, federal regulators seized control of IndyMac two years later. The company, crippled by years of risky lending, has since gone down in history for recording one of the largest bank failures ever.
Meanwhile, both Melone and Ukropina have escaped from those mortgage-related disasters relatively unscathed. They continued to serve as INET directors throughout the financial meltdown and, according to regulatory filings, currently rank as the most highly compensated independent directors on the company’s entire board.
When asked about the qualifications of its audit committee members, INET simply referred TheStreetSweeper to its regulatory filings for details.
Behind the Numbers
INET’s finance chief, Scott Friedman, has past ties to a troubled company as well. Before assuming his current post at INET, Friedman spent four years working in the finance department – the last two years as CFO – at World Poker Tours.
In 2005 (Friedman’s second year at the company), Poker News Daily observed, WPT saw its stock shoot to a record high above $25 a share. By 2008, however, WPT had fallen into penny stock territory. Friedman resigned from WPT in August of that year, just two weeks after the company fielded a delisting notice from the Nasdaq due to its sub-$1 share price, and took over as CFO of INET one day later.
Since then, critics say, INET has spent enormous sums buying up websites – and, in effect, future revenue -- while embracing favorable accounting rules that help minimize expenses associated with those deals. Specifically, they say, INET has capitalized on a new accounting guideline known as “ASC 805” that allows the company to reduce projected earn-out costs and boost its reported profitability in the process.
“ASC 805 requires the company to record the present value of the most probable earn-outs for all future years at the time of acquisition as an addition to goodwill,” INET explains in its regulatory filings. “Subsequent changes to the earn-out estimates will be recorded as expense or income in the statement of operations in the period of change.”
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.
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.
By under-reserving -- and potentially under-paying -- for earn-out bonuses in the meantime, critics say, INET can report stronger profit numbers to Wall Street.
Those numbers, particularly adjusted EBITDA, clearly matter. According to regulatory filings, INET ranks adjusted EBITDA figures at the top of a list of metrics considered when determining executive pay. With INET’s adjusted EBITDA climbing a respectable 14% in 2009, beating Wall Street estimates, CEO Robert Brisco managed to double his total compensation package to more than $2 million last year. While other executives took home smaller payouts for the year, they still picked up 100% of their target bonuses as well.
Meanwhile, INET has consistently matched or even beaten Wall Street expectations over the course of the past year. In two of the last four quarters, however, INET has relied on acquisition-related adjustments to deliver those results.
During the fourth quarter of 2009, for example, INET leaned on pricey subscriptions for its new vBulletin software -- which replaced the lower maintenance fees favored by TheLawProfessor.com and other longtime customers – to bolster its reported numbers. More recently, in the second quarter of 2010, INET went on to recognize a 2-cent gain related to its vBulletin business that provided most of its upside.
Nevertheless, critics say, INET investors continue to place unwarranted faith in the company’s numbers. For its part, regulatory filings show, even INET itself has warned that acquisitions can complicate its results while continuing to move forward with its aggressive shopping spree.
“Our acquisitions may make it difficult to evaluate our financial performance,” INET stated in its latest annual report. Regardless, “acquisitions of vertically focused websites have been – and will continue to be – a material component of the expansion of our consumer Internet business.”
* Note: No member of TheStreetSweeper’s staff or advisory board has ever taken a financial position in INET or received any compensation from others who have positions in the stock. As editor of the site, Melissa Davis will never take a position in any of the stocks that she covers. To contact Ms. Davis, the author of this story, please send an email to editor@thestreetsweeper.org.
