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Tuesday, June 10, 2008

Quality Systems (QSII) earnings lacking quality

QSII reported $51.2mm in revenues. The street was modeling a mean of $53.4mm. The shortfall came entirely from the systems division, maintenance was essentially in-line. The tax rate came in at 36% -- the street was looking for 40%. That pushed EPS a penny above the consensus -- if they'd used a 40% rate they'd have reported 38 cents, below analyst consensus of 40 cents. There's no guidance. At all.

Accounts receivable jumped to 136 days. They have some gobbledy-gook explanation of it -- that if you back out the deferred revenue tied to the accounts receivable increase yoou'll get to 85 days. This certainly seems dubious. The company attributes the increase in receivables to their relationship with Siemens. Possible. It could also be questionable revenue recognition practices.

Management was asked about employee compensation on the call -- how they arrive at their targets (which they missed last year). Here's what they had to say:

I think it's fair to say that thematically the areas of focus have been top line and bottom line for revenue and earnings per share growth, and at least historically there's been input in terms of where the management team feels like the business is going to go or where it's going to be, and that gets mixed in with some of the board and comp committee thoughts and ideas in terms of what they would like to see and somewhere within those sets of numbers, M&A from those sets of numbers, the plan for the year, that's how it's worked historically.

I think compensation tied to "revenue and earnings per share growth" creates an incentive to jack those at the expense of balance sheet metrics... and that's what I believe I see. I could certainly be incorrect but I continue to see the balance sheet get weaker and management reveals less and less information as time goes on.

This company was first brought to my attention because of the balance sheet weakness, which continues to deteriorate. The CFO was investigated for insider trading, a case the SEC has subsequently dropped. A 16% shareholder has filed a 13D/A suggesting management runs a shadow board of affiliated parties that doesn't report to the board of directors. He suggests the shadow board is making decisions on things like acquisitions without board approval. There are a number of red flags here and I don't see anything to make me rethink my theory that quality of earnings here is poor.

In case you haven't figured it out by now, I'm short the stock.

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