Accounting for Riverstone's Problems
Riverstone Networks Inc. (Nasdaq: RSTN) says it isn't yet sure what the Securities and Exchange Commission (SEC) is hunting for, nor why. Riverstone announced last week that the SEC had made some requests for documents and put its investors on notice that the matter could evolve into a formal investigation (see SEC Calls on Riverstone).
"To the best of my knowledge, the SEC did not indicate the basis for their inquiry," says Riverstone spokesman Peter Ruzicka.
Quite a few sources outside the company, though, seem convinced that Riverstone may undergo probing similar to what Enterasys Networks Inc. (NYSE: ETS), another Cabletron spinoff, endured for about a year (see Enterasys Hits New Low, Enterasys Networks: From Riches to Rags, and Enterasys Names New President). More on that later.
In the meantime, is there anything fishy about Riverstone's business? A swim through some of its most recent SEC filings suggests not, but there are a couple of items that could raise a skeptical investor's eyebrows. Let's take a look.
During an 18-month period in 2001 and 2002, Riverstone recognized about $25 million in net revenues from companies in which it held a strategic investment, according to its SEC filings. Meanwhile, the company took a writedown of about $35 million on its strategic investments for the first nine months of its fiscal 2003.
Why the writedowns? Riverstone's SEC filings say its investee companies – and customers – "continued to experience financial declines and therefore might not be able to raise sufficient funding to operate in the next six to twelve months."
Of course, the SEC might not give a rip about Riverstone helping its portfolio (or vice versa), but the disclosure does indicate that some small part of Riverstone's shrinking revenue base is at risk. Interestingly, Riverstone owns less than 20 percent of the investee companies it refers to in its filings, and since its ownership is so small, Ruzicka says, the company is not required to name the at-risk companies.
Many Happy Returns? Another head-scratcher, if we're being picky, is Riverstone's policy of letting international network integrators and value added resellers return portions of their inventory, up to a stated amount, when they place new orders for merchandise. Such an item stands out only because Riverstone counts the sales when they reach the reseller or integrator – it doesn't wait until the gear actually makes its way into a network. That could cause concern if any of Riverstone's partner companies chose to stockpile inventory at specific times in order to help it meet quarterly sales goals.
Of course, no one's accusing Riverstone of channel-stuffing. And Ruzicka says the majority of Riverstone's partners are integrators, which typically don't keep any substantial amount of inventory. But it should be noted that one of Riverstone's resellers – not integrators – accounted for 14 percent of the company's net revenues during the three months that ended November 30, 2002.
Two other customers accounted for 19 percent and 12 percent of Riverstone's net revenues during the same period. While there's nothing especially wrong with that, Riverstone's sales concentration is a concern for investors, because a small customer base increases the company's vulnerability if one of the customers hits a wall.
Now about that Enterasys link. Riverstone should hope that whatever sickness infected its sibling company hasn't rubbed off, as some have suggested. Enterasys settled its suit with the SEC, admitted no wrongdoing, and didn't pay any fines. But during the investigation period, the company moved its headquarters, blew out most of its upper management staff, and restated its financial filings to show losses that were much larger than it first reported.
And, though Enterasys admitted no wrongdoing, that doesn't mean it didn't do anything wrong. In its documents, the SEC found that Enterasys and Aprisma "knowingly and recklessly" engaged in improper accounting practices between March 2000 and December 2001.
Specifically, the SEC says Enterasys and its subsidiary Aprisma improperly recognized revenues for sales "that were subject to return, exchange, or cancellation rights." The SEC also found that Enterasys "entered into several transactions in which they invested cash in... other companies in return for an equity or debt interest and the other company's agreement to purchase their products either directly or indirectly through a third-party reseller."
The SEC also says Enterasys and Aprisma "exchanged products or services with other companies without having a legitimate business purpose for the exchange." The company also had a way of using intermediate shippers to count sales of products that hadn't actually made it to customers, according to SEC documents.
Assessing the Impact
So what's it all mean? Taken on their own, Riverstone's SEC dealings make for some fun armchair quarterbacking, if nothing else. Still, the potential investigation could add to the blackening cloud already hanging over the telecom equipment sector. At the very least, analysts say Riverstone's CEO search might be more difficult with an SEC inquiry going on. "We view this as a severe event," says Erik L. Suppiger, an analyst at Pacific Growth Equities Inc.
Ruzicka, however, says the CEO search won't be dampened. "Riverstone is a worldwide company with an established customer base," he says. "There's a tremendous opportunity for the right leader with the right background to do great things here."
Bottom line: It's hard to tell exactly what the SEC's beef with Riverstone might be. Riverstone itself doesn't seem to know. However, if industry speculators are right and Riverstone is going through a deal similar to Enterasys, last week's announcement could be the tip of a very ugly iceberg.
— Phil Harvey, Senior Editor, Light Reading