The power of the filter

Yes, I’ve been quiet of late. My apologies. But I’ll note I did call this “fits and starts” for a reason. There could be 10 posts in the next few days. Or not.

To be honest, it’s been a weird few weeks. A friend is going through the loss of a child, a 16-year-old lost in a one-vehicle accident. At the risk of sounding completely self-absorbed, this has come right as kiddo started driving on her own. There’s been a lot to process. I have no profound thoughts to share on this topic. Just, please, appreciate every day.

Meanwhile, the world continues to spin around us. I’m jumping back on the horse to share this humorous but educational statement from the Securities and Exchange Commission charging an electric vehicle SPAC with overstating its business. There’s a lot to unpack here, and unfortunately none of it is as rare as it should be. But even in gilded age of excess this particular case deserves to be framed and hung on some museum of grift.

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A couple of quick definitions. SPAC stands for special-purpose acquisition company, a tried-and-true shell company format that became extremely popular as a way to go public in the last few years. Typically, when a private company goes public it just sells shares to the public. But in the SPAC a sponsor floats a shell company, a company with no business, raising money by selling shares to the public, and then goes out and finds a private company to merge with and take public.

There are a few reasons to do this. In theory it could be cheaper than an IPO road show and regulatory bakeoff. But the biggest reason is it makes half-done business plans much easier to sell to the market. (Oversimplifying here) In a traditional IPO, companies are supposed to lay out where things stand and how it has gone, but can’t do much to hype the future or talk about what is to come. So, it helps to already have a functioning business with real sales and all of that boring stuff.

The rules on mergers are much more relaxed, and allow for all sorts of forward-looking statements. Since a SPAC is basically an IPO disguised as a merger, companies can go public following the rules of mergers and telling the story of what is to come. If you are a company that has not just done much, or needs to do a lot from here just to accomplish anything, the SPAC could be a better choice.

And companies took advantage of this, with all sorts of wild stories about what they could one day do. And not much warning about what percentage of those stories were best described as daydreams.

The SEC, in filing charges, is trying to say there are limits to the stupidity. The target is XL Fleet, a company that came to market as the designer of electric and hybrid powertrains for commercial and municipal vehicles.

At the time it went public. XL Fleet said it expected amazing revenue growth. $75 million in 2021, growing to $281 million in 2022, and then $648 million this year. Actual results fell considerably short: $15 million in 2021, growing to $23 million in 2022, and on a run rate to generate $80 million this year.

Without getting all mathy, 80 is a lot less than 648.

Those projections, according to the SEC, were made based on a sales and customer service management software package, not based on accounting software. Salespeople are the most optimistic on Earth. If they weren’t, they wouldn’t tie their compensation to how many sales they bring in. Don’t project future revenue on what salespeople believe they will be able to bring in.

It is probably also worth mentioning that XL Fleet has since changed its name to Spruce Power. And the company, according to its website, now provides “subscription-based services that make it easy for homeowners to benefit from rooftop solar power and battery storage.”

The newly christened Spruce Power paid an $11 million civil penalty to close the SEC case.

A few thoughts here:

1. Going from $15M to $80M (assuming they get there this year) in three years is actually pretty amazing growth. That’s 100%-plus compound annualized growth!!! Now obviously it is small numbers and I would guess not all that sustainable but for those who might be inclined to overhype or bend rules I would at least advise you to consider not doing so if the truth is not really that bad. (Not saying this company did any of those things.)

2. Most great innovation came from daydreaming. From hoping to create a world that would be great if it happens but, in all probability, will not happen. It is a truth that lends itself well to fraud (not saying there is any fraud here), but also lends itself poorly to the public markets. Which is a shame because access to cash is a key part of how you make the dreams come true. Hence, the SPAC structure.

3. Less generously, never buy IPOs. Let the rules work. Be it a SPAC or a traditional one or some other hybrid. Let it simmer. It is impossible to eliminate fraud, and there will always be flameouts. But again no one is saying there was fraud here. Fraud is hard to catch, but honest daydreamers ruled by hope over common sense are at least reined in by the public market structure.

Think of the first year of being public as a filtering process. It is a time when regulation forces companies to separate out some of the hope from reality.

Our system is far from perfect, and the SEC is extremely far from perfect. But as rulebooks go we have a decent one, and even in a world of adjusted earnings and crazy metrics we by in large do a good job keeping all but the most conniving players in bounds.

You don’t have to like the referee. But be grateful they are on the job.

Disclaimer: Fits and Starts DOES NOT provide financial advice. All content is for informational purposes only. Stocks mentioned are as reference only, and a mention should not be interpreted as a buy or sell recommendation. The author is not a registered advisor or a broker/dealer. Comments about companies are purely his (uninformed) opinions. DO YOUR OWN HOMEWORK. The information contained within is not and should not be construed as investment advice, and does not purport to be. The red zone has always been for loading and unloading of passengers. There’s never stopping in a white zone.

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