This is a free preview of Porter & Co.’s Distressed Investing. In the full issue, analyst Marty Fridson details a high-performance computer server company that mainly through its own questionable behavior has found itself in deep distress. To get the full issue, click here.
Through Total Fault Of Its Own… But Still Its Value Will Rise
From its origin (customizing motherboards),
This firm advanced to hardware fabrication,
And now to AI – in other words,
Building on its data center operation.
– Martin Fridson
Company head of sales Yih-Shyan had a fiendishly clever – but not necessarily legal – idea…
The scent of hot solder and cooling metal permeated the air in the California company’s high-tech warehouse – a familiar, metallic perfume that Yih-Shyan, also a co-founder of this energy-components business, had inhaled for decades.
As head of sales, Yih-Shyan felt immense pressure – the company was struggling to keep up with the insatiable global hunger for machines loaded with Nvidia’s powerful GPUs that were powering the artificial intelligence (“AI”) buildout.
Yih-Shyan was a relentless closer. He knew the client base and he knew speed was everything in this boom. Every week that passed was billions of dollars lost to a competitor. The problem wasn’t selling the product – it was shipping it, and doing it in a way that satisfied the labyrinthine paperwork, especially the new, stricter U.S. export controls aimed at keeping cutting-edge AI technology away from China.
Auditing had become a nightmare. Every component and every stop on its travels had to be meticulously accounted for. But Yih-Shyan didn’t have time to be meticulous. He had a $2.5 billion commitment to deliver servers packed with the most advanced Nvidia chips, and he wasn't about to let bureaucracy stand in his way.
His solution was elegantly simple, and utterly criminal. It involved two sets of shipping labels.
When an order was ready for a destination that would raise red flags with U.S. customs or internal auditors – say, a customer in mainland China – the server racks would first be boxed up and tagged with an intermediary destination: a trusted, benign partner country like Taiwan or Malaysia, or sometimes even a domestic U.S. address. This fake paperwork, listing a safe, compliant destination, was the set that auditors and official filing systems would see and approve.
Once the compliant paperwork was filed and the boxes were safely past the initial U.S. checkpoints, the trucks carrying the servers would pull into a secondary, less-scrutinized facility. There, in a flurry of activity known only to a trusted few, the trucks would be quickly unloaded, the "safe" labels peeled off, and the real labels – naming the actual, restricted-destination client – would be affixed. The trucks would then be re-manifested and shipped out, completing the sale. It was a sleight-of-hand all orchestrated to bypass laws Yih-Shyan saw as inconvenient obstacles to market share.
Over several quarters, this illicit method moved an estimated $2.5 billion worth of high-performance servers, satisfying huge clients and driving the company’s spectacular revenue growth. Yih-Shyan saw himself as a hero, a risk-taker securing the company's future.
But the scheme was fundamentally a violation of the U.S. Export Control Reform Act (“ECRA”) – the law that governs the sale and shipment of sensitive U.S. technology abroad, particularly to destinations deemed a national security risk. By creating fraudulent documents to disguise the true destination of the servers, Yih-Shyan and his co-conspirators were violating federal law. They were willfully lying to U.S. authorities and effectively allowing restricted AI technology to fall into the hands of non-approved entities.
For the company, the consequences of getting caught were devastating. The immediate fallout could include:
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Reputational Damage Blue-chip customers would take their business elsewhere, fearing that their own operations could be tainted by the legal troubles
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Litigation Shareholders filing class-action lawsuits would lead to financial pain
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Management Distraction The CEO and other senior staff would be forced to divert significant resources and attention from running the core business to managing a high-stakes legal defense
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Corporate Culture The brazenness of the scheme reinforced existing concerns about the corporate governance and control environment – key employees would leave such a tainted firm
That’s the situation with the high-tech components firm we are reporting on in this issue.
Big Revenue Gains And Big Problems
There are usually three flavors of distress in a company…
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In most cases, a company has too much debt and weak operating results for an extended period causing their bond and stock prices to decline.
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Sometimes the problem is that a company is growing too fast and it runs out of cash or borrowing capacity as it scales up
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There are also times when the problems are management related – causing the market to get nervous and shy away from both its bonds and stock
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