Ben Axler
May 07, 2019
"Hedge fund manager specializing in forensic financial research"

Why Kornit Digital Looks Poised To Lose Amazon's Asia Business, And Why Shares Have Up To 85% Downside Risk

High Level Summary

  • Kornit Digital's shares are +55% YTD, but investors haven't realized sales to its two biggest customers (32% of sales), Cimpress (CMPR), owner of Vistaprint, and Amazon, are under pressure.
  • We believe production quality issues have caused Amazon likely to exclude Kornit from its Asian expansion plans, putting it at great risk of missing lofty 20%+ revenue targets.
  • With shipping data records and looking closely at rebates, we believe Kornit will have a big cash flow contraction in 2019, and will lap large Amazon orders from Q3'18.
  • We have concerns about Kornit's warrant accounting, which the SEC already questioned. Kornit's CFO was the CFO at MRV Communciations, which restated financials in an option backdating scandal, and saw its stock delisted to the Pink sheets
  • Kornit is trading at its avg sell-side target of $28/sh, and has a lofty multiple of 5x sales and 47x P/E. Investors should brace for disappointment and expect 75-85% downside risk.

Report Entitled "Teed Up And Printing Rebates"

Spruce Point is pleased to issue a unique investment research report on Kornit Digital Ltd. ("Kornit," "KRNT," or "the Company"), an Israeli manufacturer of digital printing solutions for the textile and garment industry. KRNT faces 75-85% downside risk to approximately $4.50 to $9.30 per share due to underappreciated risks associated with its Merch By Amazon (AMZN) relationship, highly questionable earnings quality highlighted by myriad accounting irregularities, and a valuation out of line with industry norms and the Company’s own true growth prospects. 

Numerous Signs Of Challenges Ahead :

Kornit’s stock has more than doubled through the last twelve months, and up 55% YTD,  on the back of strong 2018 results and management projections of sustained 20% annual sales growth. To much fanfare, Kornit signed an agreement with Amazon in January 2017 to sell digital printers to support the Merch by Amazon program. By mid-2017, Merch by Amazon would become Kornit’s largest customer, but only after overcoming delays triggered by environmental permitting issues. Despite a strong start to the Merch initiative – which, analysts believe, gives Kornit a long growth runway – we believe US growth for the platform is now slowing as disgruntled merchants push back against repeated royalty cuts, alternative print-on-demand options proliferate, and as Amazon itself hedges its discussion of its fashion-related initiatives in its 10-K.

Our market research indicates that Amazon – which, per industry participants, has had a mixed experience with Kornit to date, largely due to a long-standing ink odor problem – would likely be interested in switching printing partners if a comparable replacement could be sourced. Our research has also uncovered that Amazon intends to expand Merch into Japan. Facing formidable local Japanese competitors, Kornit will at best exit this competition with low-margin business – but, at worst, will lose the business and give Amazon an opportunity to evaluate alternative printing partners. Kornit’s Asia business has underdelivered historically, and we see no signs that it possesses, or is ramping up, the infrastructure necessary to support Merch in Japan. We believe that a potential loss in Japan for Kornit poses a material an underappreciated risk to future growth. Furthermore, Kornit onscures in its SEC filings that Cimpress (Nasdaq: CMPR), owner of Vistaprint, is its second largest customer. Vistaprint’s business is under pressure, having recently admitted business challenges earlier this year, and replaced its CEO. This is another underappreciated risk to Kornit’s growth story.

Warrants, Rebates, And Price Discounts Raise Earnings, Cash Flow And Accounting Concerns:

In order to win the highly-coveted Merch by Amazon business, Kornit provided Amazon with rebates, warrants, and, by our estimates, price discounts up to 50%. This triple-whammy of customer incentives greatly reduces the quality of earnings tied to Amazon – yet, as sales to other customers stagnate (including Cimpress, its second-largest customer), Amazon represents a growing share of Kornit’s revenue and cash flow. In fact, we estimate over 100% of FY18 cash flow was derived from gross payments from Amazon in connection with warrants issued. Accounting and disclosure issues surrounding these rebates and warrants – in particular, indications of possible warrant backdating – are cause for concern, particularly given the CFO’s history with the MRV Communications (Nasdaq: MRVC) option backdating scandal, and the fact that reported Amazon sales cannot be reconciled with shipping data. Given the widely-ignored risks associated with the Amazon business, the fact that Company results may be temporarily inflated by improper accounting, and recent turnover in both the CEO and CTO position, we believe that Kornit’s popular growth narrative carries far more downside risks than the market appreciates.

Already Priced For Perfection:

Kornit’s current valuation, already at the sell side’s lofty price average target of $28/sh, is at an all-time high and significantly above its long-term average multiples. It is also completely out of line with valuations of other low-tech computer and digital printing printer peers (HP (HPQ ) , Ricoh (RICOF), Seiko (SEKEF), Electronics For Imaging (EFII)) currently ranging from 4x to 9x those of competitors. We believe that investors underestimate the risk that Merch by Amazon’s global expansion excludes Kornit, and fail to appreciate that last year’s cash flow expansion is projected to compress from rebates and fewer Amazon orders. If Kornit received a more appropriate multiple closer to those of printing and computer equipment peers, and our concerns about Amazon come to fruition, Kornit shares could decline to $4.50 – $9.30 per share, for 75% – 85% downside from current levels.

Disclaimer

This research note and our presentation expresses our research opinions. You should assume that as of the publication date of any presentation, report or letter, Spruce Point Capital Management LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our subscribers and clients has a short position in all stocks (and are long/short combinations of puts and calls on the stock) covered herein, including without limitation Kornit Digital Ltd. (“KRNT”), and therefore stand to realize significant gains in the event that the price of its stock declines. Following publication of any presentation, report or letter, we intend to continue transacting in the securities covered therein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation. All expressions of opinion are subject to change without notice, and Spruce Point Capital Management does not undertake to updatethis report or any information contained herein. Spruce Point Capital Management, subscribers and/or consultants shall have no obligation to inform any investor or viewer of this report about their historical, current, and future trading activities.

This research note and our presentation expresses our research opinions, which we have based upon interpretation of certain facts and observations, all of which are based upon publicly available information, and all of which are set out in this research presentation. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible lossor gain. Any information contained in this report may include forward looking statements, expectations, pro forma analyses, estimates, and projections. You should assume these types of statements, expectations, pro forma analyses, estimates, and projections may turn out to be incorrect for reasons beyond Spruce Point Capital Management LLC’s control. This is not investment or accounting advice nor should it be construed as such. Use of Spruce Point Capital Management LLC’s research is at your own risk. You should do your own research and due diligence, with assistance from professional financial, legal and tax experts, before making any investment decision with respect to securities covered herein. All figures assumed to be in US Dollars, unless specified otherwise.

To the best of our ability and belief, as of the date hereof, all information contained herein is accurate and reliable and does not omit to state material facts necessary to make the statements herein not misleading, and all information has been obtained from public sources we believe to be accurate and reliable, and who are not insiders or connected persons of the stock covered herein or who may otherwise owe any fiduciary duty or duty of confidentiality to the issuer, or to any other person or entity that was breached by the transmission of information to Spruce Point Capital Management LLC. However, Spruce Point Capital Management LLC recognizes that there may be non-public information in the possession of KRNT or other insiders of KRNT that has not been publicly disclosed by KRNT. Therefore, such information contained herein is presented “as is,” without warranty of any kind –whether express or implied. Spruce Point Capital Management LLC makes no other representations, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. You should assume all statements made are our opinions, unless sourced as facts where practical.

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