ShotSpotter: Bracing for A Bear Raid

ShotSpotter (SSTI) first came to my attention three months ago. After reviewing the company’s first earnings as a public company, I became convinced that the company’s gun detection technology and business had enough potential to be worth a speculative investment. I proceeded to accumulate shares at lower prices and at a higher price ahead of the company’s second earnings report on November 7th. After investors and traders greeted those earnings with strong buying interest, I assumed that the market was coming around to recognize the potential that I saw.

Yet, starting the following week, sellers stepped in. I did not worry much at first because the volume was exceptionally light. When sellers finished erasing all the post-earnings gains, I worried a little more. I worried even more as the stock started this week by swiftly selling off to close on its line of support at its 50-day moving average (DMA). On-line, I searched for and speculated about several catalysts; nothing conclusive turned up.

The next day brought the news that suddenly seemed to explain the sudden lack of buying interest: a bearish piece on SSTI with the frightening headline “Short $SSTI: ShotSpotter is worse than you thought.” Without being familiar with the author MOXReports, I was surprised by the surge in trading volume and resulting collapse in the stock. Of course, with the report coming in a holiday-shortened week, determined traders can more easily move the price of a stock with a small float. The 598,000 shares traded is second only to the volume on SSTI’s first day of trading. At its lowest point, SSTI closed the gap up formed on October 2nd with a stomach-churning 12.5% loss. Much to my relief, buyers stepped in to send the stock upward and near a flat close on the day. Sellers returned today (Wednesday, November 22) and closed the stock with a 5.0% loss. So clearly this drama is far from over, and I am bracing myself for a more prolonged bear raid.

Source: FreeStockCharts.com

I thought the most difficult part of holding for the long-term would be the ups and downs of a lumpy revenue stream. As with any speculative IPO, I also warily looked ahead toward what could happen after the company’s lockup expired and opened up the floodgates for insiders to dump shares. I became mildly hopeful that the event would provide liquidity for bigger investors to join the shareholder base. Someone later pointed out to me that the total shares outstanding is likely too small to matter one way or the other. Yet, MOXReports seized upon the lockup expiration of 8M shares as the deadline to prove its charge that SSTI’s IPO is a fraud created to provide long-suffering insiders with a liquidation event for their investment. The report claims that once insiders dump their shares, the fraud will be exposed as the company starts to come clean. MOXReports pegs the company’s eventual value at a rock-bottom range of $2-4.

The report is quite long and provides a lurid account of deceptive business practices. Here is the summary from the report:

• “In over 20 years SSTI has never generated profits or meaningful cash. Recent IPO simply allows VCs to finally exit positions. Dec 4th lockup expiration on 8 million shares
• Reams of independent data and test use confirm that SSTI’s technology simply doesn’t work. Period. Customers repeatedly describe overwhelming failure rate.
• Aggressive tactics by SSTI thwart release of FOIA docs to journalists and researchers. Employee testimony states SSTI provides fabricated data to law enforcement.
• Multiple recent undisclosed contract losses (just ahead of lockup expiration) and inflated 3Q revenue.
• Contracts such as Miami and Baltimore (and others) have been repeatedly announced, then quietly cancelled, re-announced, but then quietly cancelled again.”

I think the MOXReports has points worth considering, but fails to give the company any credit for its achievements. Those achievements keep me in the stock in the expectation that these claims will be resolved to the upside. I even added to my position today in the teeth of the renewed selling.

However, I also have to be practical. Since this report has clearly captured the imaginations and fears of enough sellers, I have to assume the stock could be under pressure until the company specifically and directly addresses the bearish thesis. Until then, the truth will be in the eye of the beholder, and the stock will be vulnerable to a bear raid. If the stock cannot hold the current post-report low or bounce back quickly to it, I will have to consider exiting my position to preserve my remaining profits. I would then watch the drama unfold from the sidelines until the next catalyst for a new entry point. Under no circumstances am I interested in shorting SSTI, but I also have no interest in trying to fight a swell of determined sellers (for an example of my technical trading principle, see “Anatomy of A Bottom: Do Not Argue With Sellers – Celebrate With Buyers“.)

One reason I have to be practical is the very real news that SSTI did not discuss in its earnings call its strategy of offering free service to prevent customer cancellations. For example, the Fall River, MA police department announced that ShotSpotter agreed to provide free service in the wake of the city concluding the results were not worth the cost. This decision apparently occurred at the end of September and was not revealed in the earnings call. While I do not find fault in the strategy since it gives the company time to prove itself, I am a bit concerned the company did not include this info in either earnings report (note I have yet to review the 10Qs). Here is the local news report from Fall River…

Note well that the mayor of Fall River, Jasiel Correia explained that ShotSpotter will be working with the city to improve the system. Also, Police Chief Daniel Racine provided statistics I find encouraging under the circumstances: a rate of 40 to 50% of false alarms. This is far from an “overwhelming failure” as MOXReports would claim. I see this as a system that provides REAL alarms 50 to 60% of the time. I would hope that the system can be further calibrated over time to the specific operational conditions to get better and better. SSTI could easily dispel alarm over these kinds of customer engagements if it explained the business strategy and described the path to continuous improvement. Absent such information, it is relatively easy for anyone to amplify the negatives.

Chicago provides a great example of how ShotSpotter redeemed itself after an earlier failure. Chicago recently decided to expand its use of ShotSpotter’s gun detection technology. Here is what CBS Chicago wrote in its coverage:

“‘Being a cop for almost 30 years, cops are skeptical, initially, about technology,’ said Police Superintendent Eddie Johnson.

‘So when I saw what that technology could do, there was no question in my mind that we should utilize it and try to see if it would help us with our gun violence reduction,’ said Johnson.

Mayor Rahm Emanuel said it changes the approach from reactive to proactive.

‘It allows us to bring intelligence with intuition. And put the two together,’ said Emanuel.

Johnson said he’s pleased with the reduction in shootings in districts using the new approach.'”

The Chicago expansion does not quite fit the bearish thesis in the MOXReport. Chicago sees potential in the technology and decided to allocate funds from asset forfeitures. Here is what the Sun Times wrote in its coverage:

“Chief police spokesman Anthony Guglielmi said the additional technology is a ‘force multiplier’ that will better allow the department to put cops where they’re needed right away.

He said the department hopes the extra sensors will also help improve community relations in those two police districts because officers will respond more quickly to shootings there.”

The coverage goes on to reveal that Chicago was an earlier customer in 2003 but gave up due to an excessive number of false alarms. Fortunately, SSTI has clearly improved over the years. I suspect changing its business model from hardware to a service model also greatly improved the economics of the system. The city tried again in 2012 and found success with an implementation in its Englewood and Harrison districts. ShotSpotter notifies police of shootings five minutes faster than 911 calls; sometimes no one ever makes a 911 call (MOXReports found other cities where officers observed that 911 calls provided sufficient alerts). SSTI guarantees location within a 25m radius. A police supervisor claimed that s/he has heard of fleeing suspects getting arrested after an alert from ShotSpotter. Sadly, while the system may increase arrest rates, it may not prevent gun crime as this same supervisor claimed that these criminals “just don’t care.”

The police will soon collect data that can be used to develop specific success metrics. Again from the Sun Times:

“…the police department will improve its analysis of ShotSpotter data. The patrol division can use the information to see how often gunshot notifications have led to arrests and where clusters of shootings are happening. Detectives can process bullet casings found at shooting scenes to make connections to other cases.”

Moreover, Chicago will integrate alerts into mobile computer terminals which will also get streaming video from surveillance cameras.

So while cancellations can be discouraging, I am encouraged to see that the company is able to improve its system enough to get another chance.

Rochester, NY provides an interesting (and tragic) case not covered at all by MOXReports. A paper from the USA Today Network asks the question: “Is shot spotter reliable enough? Critics question human equation behind technology.” The main issue here is whether the data produced from ShotSpotter is good enough to be used as evidence in a court trial. Qualifying as evidentiary data is a much higher bar to reach than usage as investigative data. Investigative data leads police to the time and location that can then be used to build a criminal case. If the company clears the bar for evidentiary data, it would open up a new vista of potential business. ShotSpotter could have two pathways to success: 1) an investigative tool that leads to arrests, and/or 2) independent of its use in a real-time investigation, the system could serve audio information just like video surveillance provides eyes on the street.

Earnings

When I read the earnings report, I noted three significant achievements that increased my confidence in the company:

• The company is now debt-free – a sign of financial strength.
• The company is cash flow positive for the second consecutive quarter – a sign of operational health.
• Guidance is strong. From the transcript of the earnings call (emphasis mine): “Our prior guidance was for revenues to range between $21.5 million and $22.5 million. We now expect our revenues for fiscal year 2017 to be approximately $23 million based on our operational momentum and the current pipeline of expected deployments. Twenty-three million dollars would represent approximately 48% growth over 2016…we are confident in our ability to add new customers and expand deployments with our existing customers, such that we are providing preliminary full year revenue guidance for 2018 of between $30 million and $32 million, which, at the midpoint, would represent approximately 35% top line growth from the 2017 revenue guidance figure. This guidance does not include any revenues from Puerto Rico and the U.S. Virgin Islands.

Analyst participation is my main concern from the earnings call. Only one analyst, from ROTH Capital, bothered to ask questions. Spotty coverage increases the difficulty of getting visibility into ShotSpotter’s investment thesis. Note that MOXReports claims that analysts are pumping the stock in preparation for the lock-up expiration. ROTH Capital was the underwriter for SSTI’s IPO.

Parting Thoughts

While I can quibble with positioning, perspective, and interpretation, I cannot do MOXReports full justice. I am not privy to enough information to address and rebut every point. ShotSpotter itself will have to address some of the concerns MOXReports raises, and I hope and expect over time the company will prove itself capable in dispelling the concerns. Until then, I am focused on the technical behavior of the stock to decide whether and how long to hold against whatever bear raid is on the way thanks to these allegations and revelations.

Be careful out there!

Full disclosure: long SSTI