4 Red Flags for KIT Digital

At the Fool, we love healthy debate, and KIT Digital (NAS: KITD) is one stock that has proponents and detractors alike among us. On one side of the argument, Sean Sun identified it as a high-growth story, and Rick Aristotle Munarriz described the stock as a steal for less than $10 a share. On the other side, Fool blogger Chad Henage agrees with the shorts, and our CAPS community has given the stock a lowly rating of two stars. In this debate, I'm siding with Chad and the CAPS community, particularly after reviewing the company's 2011 10-K.

My opinion: While software-as-a-service (SaaS) and digital video are certainly growth markets, KIT Digital is not the best way to play that growth story. In fact, KIT Digital is a downright risky proposition, at least based on its most recent 10-K filing, which contained four major red flags. First, the company seems to have trouble reconciling and reporting its actual cash balance. Second, the company violated lender covenants by holding too much cash overseas. Third, the SEC has launched an investigation of the company. And fourth, the company's auditors have identified a material weakness in the company's financial controls. Adding those factors together make it seem as if something fishy is going on at this company. I'd advise Fools to tread with caution.

The disappearance of $2.1 million in cash
Between reporting Q4 results and filing the 2011 10-K, $2.14 million in cash disappeared. For a small company like KIT Digital, $2 million is big, and it indicates a serious lack of financial controls to allow an error like this. On March 15, in a press release to report Q4 2011 results, the company stated, "Cash and cash equivalents at December 31, 2011 totaled $47.8 million." (Emphasis mine.) The next day on a conference call, CFO Robyn Smith said in his prepared remarks: "Cash and cash equivalents as of Dec. 31, 2011, were approximately $48 million." (Emphasis again mine.) Fast0forward to March 30, and the company finally files its 2011 10-K with the SEC. In the filing (on page 41, if you want to play along at home), the company reports "as of December 31, 2011, we had cash and cash equivalents of $45,660." The units are in thousands, so the company reported $45.66 million in cash.

Defaulting on debt covenants
So not only is cash disappearing, but it's also being held overseas in direct violation of lending terms. In the 10-K (again on page 41), the company states, "as of December 31, 2011, we were in default of a debt covenant on all of our secured notes payable which states that we must maintain at least 75% of the dollar value of worldwide cash with one or more banks located in the United States." It goes on to state that KIT Digital has received a temporary waiver from the lender and that it is in "discussions with the lender."

SEC investigation
The SEC has taken notice of the company, and its chairman has been subpoenaed in an official investigation. On page 28 of its 2011 10-K, the company discloses: "Our company and Mr. Isaza Tuzman have been required to produce documents to the SEC under two simultaneous February 24, 2012 subpoenas issued by the SEC. The investigation includes and we believe may focus on June 2010 transactions in company common stock and a related Form 4 filing by Mr. Isaza Tuzman that reported a purchase of 54,645 shares of company common stock, but we cannot be certain of its scope or outcome."

Auditors warn about "material weakness"
KIT digital auditor Grant Thornton has raised red flags over the company's financials. Ultimately, the auditors signed off on the company's financial reports with an "unqualified opinion," but the auditors also noted a "material weakness" in the company's internal controls over financial reporting. Specifically, the auditors noted on page 47 of the 2011 10-K that "the Company does not currently have sufficient accounting personnel with an adequate understanding of US GAAP to timely review and ensure that all transactions were reported in accordance with US GAAP." As a result, "KIT digital and Subsidiaries has not maintained effective internal control over financial reporting as of December 31, 2011." That's not exactly reassuring to investors.

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At the time thisarticle was published Brendan Mathews has a short position in KITD. You can view hisholdings. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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