Public Letter To Super Micro Computer's Auditors

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Below is the text of the letter we sent to Deloitte, SuperMicro's auditors: 

8/12/2018

Dear Deloitte Engagement Partner,

We recently published a report outlining our opinion concerning various irregularities we observed involving your client, Super Micro Computer Inc. (“SMCI).  The company has not filed its financial statements since announcing an internal investigation by the company’s audit committee last year. Three senior executives, including the longtime CFO, resigned earlier this year. We currently hold a short position in the stock.

We are writing to bring two matters to your attention:

1) SMCI has apparently engaged in an undisclosed related party transaction with a Taiwenese company named Aeon Lighting, which is run by an individual we believe to be the brother (James Liang) of SMCI’s CEO Charles Liang, and

2) Allegations of accounting impropriety were made by former employees in a December 2017 amended complaint filed in a putative class action lawsuit against SMCI (case No. 5:15-CV-04049-EJD, see exhibit 1). The lawsuit was dismissed, in part for lack of standing, and is currently on appeal.

These issues may be material to your audit under AS 2401 (Consideration of Fraud in a Financial Statement Audit) and AS 2405 (Related Parties) and we want to ensure that you are both aware of these matters and have tested them thoroughly.

Aeon Lighting – A Related Party?

Prior to 2012, SMCI invested in Aeon Lighting, according to Aeon’s own company profile (Exhibit 2 at p. 3).  The same document identifies SMCI as an “investor partner” and also identifies Aeon’s CEO as James Liang. Aeon makes references to SMCI’s financial backing and claims it uses SMCI technology in its products and has even issued a press release that states “thanks to a close partnership with Supermicro, the world’s largest server manufacturer, the company was able to develop a range of LED lighting products”.

Based on our research and review of Taiwanese corporate records, we believe Aeon Lighting CEO James Liang (Chien-Kuo 梁見國) is the brother of SMCI CEO Charles Liang (Chien-Hou 梁見後), Steve Liang (Chien-Fa 梁見發, a principal of Ablecom), and Bill Liang (Chien-Ta 梁見達, a principal of CompuWare). Each of these brothers appear to have substantial financial and business overlap with each other. SMCI has disclosed that its largest supplier, Ablecom, is 10.5% owned by SMCI CEO Charles Liang and operated by his brother Steve Liang, who owns 36% of Ablecom. SMCI purchased $671 million in products from Ablecom over the last three reported years, according to the most recent proxy filing filed in January 2017.  The proxy states that Ablecom owns a stake in another related party named CompuWare, which acts as a SMCI distributor. CompuWare’s website states that it also owns numerous branches and “registered distributors” operating under different names located in North America, Asia, and Europe. Furthermore, we note that SMCI, Ablecom, and Aeon Lighting all have addresses on the same street in Taiwan. Numerous other business with names/operations we are unfamiliar with are variously registered to the brothers at these addresses. 

Despite Aeon’s references to SMCI, SMCI did not disclose its own investment in, or business relationship with, Aeon in SMCI’s SEC filings.

We do not know if SMCI disclosed its relationship with Aeon Lighting to you; however, as you are aware, the PCAOB states that:

If the auditor identifies information that indicates that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist, the auditor should perform the procedures necessary to determine whether previously undisclosed relationships or transactions with related parties, in fact, exist. These procedures should extend beyond inquiry of management.

Allegations of Accounting Impropriety

SMCI has a history of delinquent filings and completed a small restatement in 2015 related to warranty expense.  This triggered a stockholder suit (Case 5:15-cv-04049-EJD) and amended complaint (see exhibit 1) filed in December 2017 that included allegations from four former employees that suggest SMCI may have serious accounting problems.  The suit was later dismissed, in part for lack of standing, and is currently on appeal. SMCI CEO Charles Liang's wife, Sara Liang, has been the Chief Accounting Officer and Treasurer of SMCI since 1993.

According to the amended complaint, a former sales manager observed “sales people shifting the dates on purchase orders at the company” (¶ 92) and that SMCI “shipped products without the consent of  customers, and that customers refused shipments” (¶ 92).  Because the products were optimized for particular customers, “when the systems were returned, Super Micro had parts that had to be scrapped.” (¶ 92)

In addition, the amended complaint claims that, “VP of Strategic Accounts [Gloria] Sun shipped products and asked customers to hold the products, knowing that the products were not what the customers wanted and that the products would be returned” (¶ 92) , which appears to describe a bill and hold scheme.  The complaint alleges that management and specifically SMCI’s now-former VP of Worldwide Sales [Phidias Chou] learned about the ship and hold problem and SMCI “took no action and no changes occurred.”  (¶ 92)  Chou was one of the three senior executives that resigned in January.  

 

SMCI has disclosed that over 44% of its sales are to distributors and third-party resellers, and the company’s accounting policy appears to call for the recognition of revenue as soon as products are shipped to distributors and resellers.  Thus, shipments without legitimate purchase orders or shipments with undisclosed rights of return may result in inflated revenue figures.  SMCI’s SEC filings state that distributors have return rights in the first 60-90 days and also “at product obsolescence.”  That right, coupled with the allegations from former employees, should cause Deloitte to investigate whether SMCI has shifted the risk to distributors when SMCI records revenue.

The amended complaint also reflects allegations from former employees who said they observed the company improperly using marketing credits to discount product and compensate distributors. One former employee stated that “the Company’s marketing credits were supposed to be used for co-marketing, but that the company routinely used these credits to provide discounts to customers for current purchases” and “there were “numerous instances where the marketing credits appeared on invoices as a discount.” (¶ 93)   Accounting rules concerning marketing incentives generally require that the incentives be used to market the product, not to reduce costs to distributors – otherwise, the marketing dollars are simply a way to inflate revenue figures.  We are aware that the SEC has previously brought enforcement actions related to improper accounting for distributor rebates/credits. 

According to the complaint, a former employee who was a credit and collections analyst stated that “the volume with respect to accounts receivable was insane” and “the company’s collections department consisted of only four collectors and they were serving approximately 1,400 accounts.” (¶ 89) SMCI’s last 10-K includes a footnote discussing “receivable financing arrangements,” which suggests the company is engaging in factoring activities. It is therefore possible that accounts receivable would otherwise be higher without the factoring arrangement.

The PCAOB lists in AS2401 “Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth” as a risk factor relating to misstatements arising from fraudulent financial reporting.  Therefore, Deloitte may want to investigate the divergence between cash flow and reported profits at SMCI. Although SMCI has reported $694 million in cumulative pre-tax profits over the past 10 years, the business has generated negative $166 million in free cash flow, according to Bloomberg data.  Put another way, SMCI claims it earned $850 million more than the free cash it has actually generated.  That may warrant Deloitte investigating, especially since the balance sheet increasingly consists of accruals for accounts receivable and inventories, which totaled over $1 Billion as of June 2017.   The company’s cash conversion cycle has similarly soared to a record 98 days as of the last reported period, nearly double what it was in 2010. 

We hope this information is useful to your audit and investigation. Please feel free to contact us with any questions.

Sincerely,

Red Owl Research