CyberDefender Corp ("CYDE") is a fraudulent business with very aggressive accounting and a promotional management team.  While the stock is down 13% in the past 1 month and 30% in the past 3 months, we think it's extremely compelling today because the company ran out of cash earlier this month (see 8-K filed on 12/13/10).  The company was saved by a $5mm revolving credit facility (of which $4.3mm has already been drawn) from GR Match ("GRM", the large direct marketer focused on infomercials), which already owns warrants worth 1/3 of the basic share count and a $5mm convertible.  LTM GRM has earned approximately $21mm of revenue supplying CYDE with infomercials and is therefore providing CYDE with additional funding to keep the hamster wheel spinning.  This credit facility is not cheap as the annualized interest expense is 44% (10% interest rate and 10% repayment fee upon expiration which is no later than 3/31/11).

$4.3mm of the $5.0mm credit facility was immediately used to pay outstanding GRM invoices.  As CYDE is FCF negative (and has no hope of generating positive FCF), it must either find traditional debt financing or issue equity by the end of Q1 2011.  It is not possible for CYDE to find traditional debt financing because a bank will not lend to CYDE as it is generating large losses with no hope of profitability; if CYDE could get traditional debt financing, they would have done this two weeks ago rather than agree to GRM's onerous terms.  Issuing equity will be difficult as it's one thing to fool retail investors (the current shareholder base), but with no past profits and a recent investigative journalist flagging the company as a fraud, institutional investors are unlikely to participate in a secondary offering.

While a small cap, we have borrowed stock at both GS and JPM as short interest is 5.3% of float.

Thesis:

1.       CYDE's valuation is infinite as the company is not profitable on any metric.  Aggressive marketing of its products, which consumer advocacy websites note are a scam, has driven CYDE's recent top line growth. 

2.       The core security product has no value as confirmed by industry experts and there is a wide availability of free alternatives.  If one types "CyberDefender" into Google and allows it to auto-fill, the 2^nd most common search is "CyberDefender scam".

3.       CYDE's push of its commoditized remote PC repair services offering is uneconomic as the gross margin on the product is 30-40% while the marketing expense has historically averaged +70% of revenue.  Therefore, the remote PC repair offering has an EBIT margin of -30% or worse.

4.       Even with aggressive accounting that hid CYDE's true marketing costs and left CYDE with a large warrant overhang (19 million warrants on 27 million shares outstanding), CYDE couldn't generate positive EBIT.  In addition to financing marketing with warrants issued to GRM and others, CYDE also improperly capitalized marketing expenses to hide the full marketing cost.  The company's new auditor, Grant Thornton, is restating past financials, which will reflect far larger historical losses (see 11/23/10 8-K filing highlighting that 2009's EBIT will increase to a loss of $18.6mm from the previously reported loss of $10.1mm).

5.       Given the lack of cash flow, CYDE issued a $5 million convert earlier this year that is now convertible, 30% of the basic shares in warrants, and the company acknowledges that it needs to issue equity.

6.       The economic reality of CYDE's flawed business model is coming to light as: (i) the aggressive marketing has hit a wall; (ii) CYDE can no longer fund its marketing expense with warrants; (iii) the switch to Grant Thornton as auditor has led to financial restatements (new financials not filed yet); and (iv) CYDE has run out of cash and needs to issue equity.

In Q1 2011, CYDE needs to issue a very large amount of equity to repay GRM.  The best-case is a highly dilutive offering.  Our opinion is that there is a good chance CYDE is unable to issue sufficient equity and will default on its credit facility.

Company Background

CYDE has two businesses: Internet security software and live PC support services through its U.S.-based and outsourced international call-centers. 

The company was incorporated as Network Dynamics in 2003 and quickly received complaints regarding its security software (eBlocs.com) and several Internet security professionals labeled the product a fraud.  In 2005, the company changed its name to CyberDefender after it acquired the CyberDefender software application for $200k, but did not materially change the product.

CYDE went public in 2007 through a Form S-2 filing, under which existing shareholders sold shares directly to private investors.  Consequently, no investment bankers have underwritten CYDE's offering and CYDE has never raised public equity capital.  For this reason, we believe no one has paid much attention to the company and its flawed business model. 

Valuation

On an LTM basis CYDE has negative EBITDA, EBIT, and net income.  LTM revenue is $39.4 million.  In less than three years since going public, CYDE has issued 21.6 million options and warrants (vs. 27 million total shares outstanding) at $1.01-$1.92/sh.  Using the treasury method, to be generous, the market cap is $113 million, which implies investors are paying 2.8x sales for an unprofitable company with worthless products and no reasonable prospect of profitability.

Worthless Products/Promotional Management

CYDE's main product is a computer registry cleaner.  These are given away for free by companies such as AVG, CCleaner, Comodo, Argente, and EasyCleaner.  However, CYDE's management compares its product to larger security firms, such as Symantec ("SYMC") and McAfee ("MFE").  One of our LPs is an executive at SYMC and when we called to discuss CYDE he was embarrassed to say that he had never heard of this "competitor" and would need to call us back.  After looking into CYDE and its products he called back and noted that CYDE's product is worthless and would provide almost no protection for a user.  Further, CYDE has put virtually no resources into their product.  The company has 30 engineers and it appears that less than 20 program (SYMC has nearly 9,000 engineers and more than 500 are solely focused on developing core anti-malware technology).  CYDE has one approved patent while SYMC has more than 900 patents.  CYDE has spent $3 million on LTM R&D while SYMC has spent $800 million over the same period.

To reiterate the point that management compares themselves to much larger peers, at the April 6^th, 2010 Security Research Associates Spring Growth Stock Conference (transcript is available through Bloomberg) Chairman and CEO Gary Guseinov compared his product to the security protection of Kaspersky anti-virus in order to make the argument that CYDE products are similar to those of SYMC and MFE, and not comparable to smaller firm's products.  As you can read in the transcript, the CEO discounted smaller competitors, such as Kaspersky, claiming a small European company will not come to the U.S. and will not make a significant impact.  We are running Kaspersky on our computers right now and live in the U.S.  In fact, we just renewed our Kaspersky license to confirm we weren't confused.  In addition, if you purchase a laptop from Best Buy, Kaspersky is one of the three options offered as security software.  CyberDefender is not.  The best-case explanation for Chairman/CEO Guseinov's comments is he's confused on the competitive environment. 

Separately, as noted by Dave Powell, the Spyware Prevention Guy (a useful blog), CYDE cannot compete with the "real" contenders in the security software industry - ESET, Kaspersky, Symantec, McAfee, Trend-Micro, Zone Alarm, AVG, Computer Associates, etc - as CYDE does not have their products independently certified for product compliance and performance by an accredited 3^rd party company.  Dave notes that while CYDE boasts of receiving many awards dating back to 2006, "none" of these awards are from the big-3 certification companies - ICSA Labs, VB100, or AV Comparatives.  He further notes that it appears that the awards were for the popularity of their product which is based on the number of downloads, which can be attributed to their aggressive television and radio advertising, and not the actual quality or effectiveness of their products: (http://spywarepreventionguy.com/mycleanpc-review/).

So if the product has no value, how does CYDE sell it? 

CYDE advertises aggressively to consumers online with websites such as mycleanpc.com.  The consumer runs a free test that "conveniently" finds ~300 issues with their computer and scares/scams a consumer into buying CyberDefender.  The following links show that it's a fraud:

http://techie-buzz.com/scams/is-cyberdefender-a-scam.html

http://www.starreviews.com/cyberdefender.aspx

http://www.ripoffreport.com/computer-help-desk/cyberdefender-corpor/cyberdefender-corporation-42-276c2.htm.

CYDE also provides on-line tech support targeting households and small businesses.  For $249, a customer can contact CyberDefender where a call-center assistant helps them on-line.  If the customer's PC issues are severe, the call-center assistant remotes into their PC to try and fix the problem.  This service is offered by several companies as highlighted by a simple Google search for "remote pc repair."  In addition, Best Buy's Geek Squad is arguably one of the most successful home electronics repair organizations with 24,000 "agents" and estimates of $1+ billion in revenue.  Geek Squad has its own on-line remote repair services and it's extremely unlikely that CYDE can compete with a branded, industry giant.  According to the Geek Squad website you can receive similar on-line virus and spyware removal for $149, although you will not receive 365/24/7 support.  However, in speaking with CYDE's CFO about the company's accounting, he noted that CYDE values the one-time support component at $179 and the remaining $70 of the $249 contract is the value of the 365/24/7 support.  We doubt that CYDE's product is worth $30 more than that of Geek-Squad.

CYDE's Growth Spurt

CYDE's sales have increased exponentially due to: (i) CYDE's March 2009 expanded marketing agreement with GR Match ("GRM") under which CYDE advertises its products on television and radio; and (ii) CYDE's shift to services revenue from software revenue.

GRM is a subsidiary of Guthy-Renker, one of the largest direct marketing services companies focusing on infomercials, radio, and television ads.  CYDE has partnered with GRM since 2008 and driven CYDE's significant sales growth through television and radio ads.  Initially GRM's boost was minimal, but in March 2009 the agreement changed to give GRM up to 8 million warrants of CYDE at $1.25.  CYDE had found a way to receive financing for their marketing costs where GRM would receive one warrant for every $2.00 worth of media time advanced.  Per the agreement, GRM also invoiced CYDE each month for the amount of media costs advanced, after which CYDE had 45 days to repay the amount advanced plus 2.5% (22% annualized). 

As of October 28, 2010, GRM had earned all of the 8 million warrants.  CYDE effectively moved a cost off its financials creating a nasty cycle, especially for a company running into capital constraints.  The GRM agreement was set to formally end in June 2011, however at the rate CYDE was spending to advertise in order to further drive sales, GRM earned the remaining warrants a few weeks into the fourth quarter.  A revised October 28, 2010 agreement with GRM specifies that CYDE must pay GRM $75,000 per month in lieu of warrants (as CYDE will not grant anymore warrants to GRM) as a fee, while the other conditions remain.  This means that CYDE pays $900,000 per year plus an effective annual interest rate of 22% in order to receive 45 day financing on its marketing costs.

CYDE Runs Out of Cash

In an 8K filed December 13, 2010, CYDE reported that they had to take a $5 million line of credit with GRM only five weeks after not being able to use warrants to finance their marketing expenditures.  The 8K notes that the initial drawdown on the line of credit was $4.3 million, "which is the total amount of invoices owing by {CYDE} to GRM pursuant to the Media Services Agreement as of December 3, 2010."  Even more telling is that the line of credit calls for CYDE to issue equity or refinance by March 31, 2011 to pay off the amount in full (language below).  This was not a line of credit, but rather a lifeline extended to the company as it couldn't pay its bills.  The line of credit has a 10% annual interest rate as well as a 10% repayment fee (conveniently left out of CYDE's press release praising the line of credit, but easily found in the actual 8K), resulting in an effective interest rate of 44%.

"The initial principal amount of the Credit Facility is $4,287,660.05, which is the total amount of invoices owing by the Company to GRM pursuant to the Media Services Agreement as of December 3, 2010, and will be repaid in accordance with the terms of the Loan Documents.   Advances made by GRM under the Credit Facility will not exceed $500,000 per week during the term of the Credit Facility and will not exceed a maximum total amount of $5,000,000 unless otherwise agreed to by GRM.  All outstanding principal and accrued but unpaid interest under the Credit Facility is due and payable in full on the earlier of either March 31, 2011 or the closing of the Company's sale and issuance of any debt or equity securities of the Company in an aggregate amount exceeding $10,000,000 (the "Revolving Credit Expiration Date")."  

Capitalized Marketing Expenses

CYDE has one historical quarter of positive EBIT: Q409 when CYDE started capitalizing direct-response marketing costs as they transitioned advertising from primarily Internet to television and radio.  CYDE capitalized $2.3 million in advertising expenses in Q409.  Given the unproven life span of customers (if not the overwhelming evidence they're burning consumers so they will not renew) this is not appropriate and it's important to note that no other security software firm capitalizes marketing expenses.  Adding cash advertising expense back to the income statement completely wipes out CYDE's $407k in EBIT.  Investors will soon see CYDE's true marketing expenses as Grant Thornton has forced CYDE to restate its financials for capitalized marketing expenses (new financial statements not out yet).  

Inflated Gross Margins

Historical gross margins are artificially inflated.  As a result of CYDE's revenue share agreement with a partner providing outsourced call-center services, CYDE was able to capitalize its call-center expenses and amortize them over the life of its products, which is typically one year.  However, when CYDE started bringing the call-center operations in-house in Q409, the company had to start expensing call-center expenses when incurred and gross margins declined as a result.  Historical gross margins of 77-79% did not accurately reflect CYDE's true margins, eliminating the possibility that CYDE reverts to prior margin levels as estimated by some on the street. 

Earlier in the write-up, we noted that the remote PC repair services have a 30-40% gross margin, which is not provided by the company, but calculated below.  Today 63% of sales are from services and 22% of sales are from software.  The CEO told me that they have 95% gross margins on their software and that services margins were 60-70%.  Assuming that ancillary services and renewals have 90% margins (consistent with sell-side estimate), then the Q310 gross margin should be 75%, consistent with historical margins.  However, the company's Q310 consolidated gross margin of 54% implies a much lower margin in services than the CEO claims.  For example, assuming all other margins are fixed and solving for services margins based on historical sales mix, the numbers speak for themselves. 

Quarterly GM% Mix:                                      Q109      Q209      Q309      Q409      Q110      Q210      Q310
Software                                                                95%       95%         95%        95%        95%       95%        95%
Services                                                                  60%       60%         55%        50%        40%       33%        32%     
Ancillary                                                                  90%       90%         90%        90%        90%       90%        90%       
Renewal                                                                 90%       90%         90%        90%        90%       90%        90%       
Consolidated GM%                                            79%       79%         77%        77%        67%       59%       54%     

Losses Worsening

Gross margin declined due to the move to services from software. Based on our diligence, we believe this was driven by the negative publicity surrounding its product and diminishing returns from advertising (there are only so many suckers and it is hard to get them more than once).

Gross Sales by Category ($ Mil):                                Q109      Q209      Q309      Q409      Q110      Q210      Q310
Software                                                             $2.5          $2.5        $2.7        $4.4        $4.1        $3.5        $4.1     
Services                                                               $2.6         $2.7        $2.9        $3.7        $5.8        $7.0      $11.6
Ancillary                                                               $0.6         $0.6        $0.4        $1.0        $0.9        $0.6        $0.6
Renewal                                                              $0.5         $0.5        $0.7        $0.7        $1.1        $1.4        $2.2     
Total                                                                      $6.2         $6.2        $6.7        $9.8    $11.8     $12.4       $18.5 

Gross Sales % Mix:                                          Q109      Q209      Q309      Q409      Q110      Q210      Q310
Software                                                                40%       40%      40%         45%        35%        28%        22%     
Services                                                                  43%       43%      43%         38%        49%        56%        63%     
Ancillary                                                                  10%         9%         7%         10%          7%          5%          3%  
Renewal                                                                  8%         8%      10%            7%          9%        11%        12%     
Total                                                                      100%     100%     100%     100%    100%     100%     100%   

Beginning in Q110 CYDE ramped up costs to build out an internal call-center as the company switched from an outsourced call-center located in India under a revenue share agreement to a predominately in-house call-center located in Los Angeles, California.  This transition resulted from customer complaints and inefficiencies in the outsourced call-center.  Placing its main call-center at corporate headquarters has increased costs significantly, as operating overseas call-centers cost one-third of what U.S. call-centers cost.  The CEO explains this in the following article: http://www.labusinessjournal.com/news/2010/jul/12/software-maker-calls-growth/.  As CYDE continues to build out its Los Angeles call-center, the company is growing from 275 full-time call-center agents to more than 500 by the end of the year.  This will significantly increase the company's cost structure, weighing on the company's profitability.

Dilution

Exercisable options and warrants represent ~44% (~30% using treasury method, although this capital starved company is very unlikely to employ) of the company's fully diluted share count, significantly diluting shareholders.  Management justified its dilution best in the Q209 10Q as they noted that negative cash from operations, negative working capital, and a large accumulated deficit, combined to raise substantial doubt about their ability to continue as a going-concern.  It was either further dilute shareholders or go bankrupt.

CYDE currently has 27.0 million shares outstanding excluding dilution.  CYDE is not profitable so this dilution is not factored into the company's earnings as it would be anti-dilutive.  If CYDE ever becomes profitable, diluted share count will immediately increase ~80%, from 27.0 million to 48.6 million, cutting earnings materially.  Using the treasury method, diluted share count would increase ~42% to 39.0 million FD shares outstanding.

Dilutive Securities:                             Options                Warrants             Total Dilution        
Total Dilutive Securities                   2,598,761           19,032,575                 21,631,336
Shares Outstanding                        27,034,651           27,034,651                 27,034,651    
Absolute Dilution %                                     10%                          70%                              80%

Total Dilutive Securities                   2,598,761           19,032,575                 21,631,336
Average Price                                              $1.92                     $1.21                               N/M
Current Price                                               $2.90                     $2.90                               N/M
Dilution (Treasury Method)               878,202           11,091,397                 11,969,599                    
Shares Outstanding                        27,034,651           27,034,651                 27,034,651                    
Treasury Method Dilution %                      3%                          41%                              44%

CYDE filed a registration statement on September 1, 2010 with the SEC to sell 9.4 million shares and GRM listed 3.5 million shares for sale in that same registration statement.

We're happy to answer questions, but a few additional points to make:

1.       As highlighted by StreetSweeper.org in an article written December 2, 2010, CYDE has Board members with questionable backgrounds.  Howard Bain, Chairman of the Audit Committee, served as CFO of two different companies hit with class action lawsuits for allegedly misleading investors.  Separately, another member of the Audit Committee is Ricardo Silas, the former CEO of LQMT who had to resign due to his being the target of a Department of Justice investigation.  For further information on the company, please refer to the article directly at: http://thestreetsweeper.org/undersurveillance.html?i=1406

2.       The SEC has issued at least eight correspondence letters to CYDE since January 2009 relating to various aspects of financial reporting and disclosures at CYDE.  There are several more issues flagged by the SEC in these letters such as the company's revenue recognition policies, lack of reserves for returns and charge-backs, related party transactions, etc.

3.       CYDE has had at least six different investor relations firms since 2008.  The latest firm, The Piacente Group, started covering CYDE in August and is not familiar with the details of the company and its business.  Perhaps they won't be covering the company for long as they begin to understand the true fundamentals.

4.       Internal control deficiencies highlighted in 2007 were recently fixed.  In a letter dated May 10, 2010 sent to the SEC, CYDE notes: "The lack of formal documentation of the company's disclosure controls and procedures has been a deficiency since the company began reporting." In the same letter CYDE notes: "The material weakness in our internal control over financial reporting resulted from our lack of independent directors and an audit committee to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP.  We do not believe that the addition of independent directors and an audit committee would enhance our ability to resolve the reported deficiency..."  That's right, CYDE just made the argument that independent directors and an audit committee would not play a role in effective financial reporting!  While the company has since corrected this deficiency by hiring independent directors and establishing an audit committee in Q210, one can only imagine the potential issues of not having effective internal controls for more than three years.  Note that the CFO is currently re-assessing the effectiveness of internal controls given the recent accounting restatements.

5.       CYDE's former auditor, KMJ Corbin & Co, is an accounting firm we have never heard of.  This is likely due to its small size: 6 partners/directors and 20 staff members.  During our diligence, we noticed that the Public Company Accounting Oversight Board ("PCAOB") investigated KMJ Corbin & Co in 2006 and found deficiencies in 100% of the firm's audits the PCAOB selected for review (for those non-accountants, the PCAOB is a private sector, nonprofit corporation, created by the Sarbanes-Oxley Act of 2002, to oversee auditors).  The PCAOB noted that the deficiencies were of such significance "that it appeared to the inspection team that the Firm did not obtain sufficient competent evidential matter to support its opinion on the issuer's financial statements."  While 2006 was a while ago, it is the latest data available as the PCAOB investigates firms with <100 clients every third year, as is the case with KMJ Corbin & Co.  On top of that, the PCAOB reports are usually on a year lag for smaller firms, so I would not expect a new report on KMJ Corbin & Co until late 2010 at the earliest.  Here is a link to the report: http://pcaobus.org/Inspections/Reports/Documents/2006_Corbin_and_Company.pdf.  On October 8^th, 2010 CYDE dismissed KMJ Corbin & Co as its auditor and on October 11^th, 2010 CYDE announced that they engaged Grant Thornton as its new auditor.  Within weeks Grant Thornton forced CYDE to restate its financial statements and account for the warrants correctly, as well as to expense all advertising costs.  We believe these were the easiest errors to identify and would not be surprised if there were many more accounting items that need to be restated.

Risks

There are two main risks to shorting CYDE.  The first is that this is a fraud and the management team finds a way to perpetuate it - if they can find a way to con people into buying anti-virus software that provides no protection to one's computer, it's possible that they can con investors into buying stock in a secondary offering.  Additionally, while it is likely to push the stock lower, there is an active registration statement for 9.4mm shares and on October 28^th GRM's representative on CYDE's Board of Directors resigned, which we believe was designed to allow GRM to sell warrants and/or stock.  The average strike of the warrants is $1.21/sh - if a few million warrants are exercised, this will generate cash for CYDE without a secondary offering.  Please note that our estimates of dilution are based on the treasury method, but it seems very unlikely that CYDE uses warrant proceeds to buyback stock.  The offset to this is that CYDE is burning $6-7mm/qtr, so for the company to cross its fingers and hope for a large number of warrants to be exercised is not a realistic scenario.

Summary                                                                                                         

CYDE's core registry cleaning product is worthless, the management team promotional, and the company has run out of cash, creating a great short opportunity.  The overhang of an upcoming secondary (if they can) will continue to weigh on the share price. 

As the company has never generated profits and has no hope of future profits, we believe that the equity is worthless (similar to their software).  Being generous and giving management credit for knowing the value of their stock, the midpoint of the options and warrants is $1.56/sh.  Therefore, downside is 46-100% below the current price of $2.90/sh.