Should You Fear Related Party Transactions?

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I recently the book “What’s Behind the Numbers?” by John Del Vecchio and Tom Jacobs where they explore the red flags investors should be looking out for in order to avoid huge losses.  One of the red flags they discussed is what’s called Related Party Revenue.  In the book they say that, “When a company derives an increasing portion of its revenue from affiliated entities, the investor should be concerned.”

A related party revenue or transaction is not a red flag in and of itself, but it is a good place to keep an eye on when digging deeper into stock might want to own.  As this revenue increases it could be a sign of troubles to come or at least give you a little more insight into the inner workings of the company. 

Take tiny Rex Energy (NASDAQ: REXX) for example.  Tucked into their recent Form 8-K filed with the SEC the company notes that they,

“We currently have an oral month-to-month agreement with Charlie Brown Air Corp. (“Charlie Brown”), a New York corporation owned by Lance T. Shaner, our Chairman, regarding the use of two airplanes owned by Charlie Brown. Under our agreement with Charlie Brown, we pay a monthly fee for the right to use the airplanes equal to our percentage (based upon the total number of hours of use of the airplanes by us) of the monthly fixed costs for the airplanes, plus a variable per hour flight rate that ranges from $400 to $1,850 per hour. “

Given the nature of their business (oil and gas drilling) and their operations spread across several states it’s reasonable to assume that the company needs access to a plane for their executives to travel at a moment’s notice.  The fact that the plane is owned both their chairman isn’t a red flag either though the “oral month-to-month” agreement does at least raise my eyebrows a bit.  Still, the amount of money changing hands is minimal and hardly a red flag.

In an example where related-party revenue is a bit more substantial we can look at recent Expedia (NASDAQ: EXPE) spin-off Trip Advisor (NASDAQ: TRIP).  In Trip Advisor’s first quarter earnings report they specifically point out that their related party revenues from Expedia totaled $52.6 million in the first quarter, but that it was a decrease of $2.4 million or 4% compared to the prior year’s quarter.  What’s important here is that the related party revenue is nearly 29% of the total so it bears watching.  In subsequent quarters that revenue was $55.7 million and $56.9 million both of where were 6% year-over-year decreases.  Again, no red flags with either company but something investors should at least watch. 

Where we’ve seen these transaction become a problem in the past is in former hot consumer stocks like Krispy Kreme (NYSE: KKD) and Green Mountain (NASDAQ: GMCR).  Both stocks got creamed when they couldn’t keep the revenue growth percolating.  They both appeared to manipulate revenue growth through related party transcations.

In the case of Green Mountain one of the red flags oddly enough had to do with related party transactions relating to an aviation business.  However, the biggest red flag was their relationship with MBlock which provided the company with a large portion of their shipping and inventory management.  While not necessarily a related party the two appeared to be playing inventory games if not worse.  Investors who dug deep enough saw a company that had enough red flags to provide caution and looking into related party transactions might have been a good tip off that a foul brew was percolating at Green Mountain.

Meanwhile, over at Krispy Kreme the company “enjoyed significant profits by requiring franchisees to purchase mix and doughnut-making equipment from the parent's Krispy Kreme Manufacturing and Distribution (KKM&D) division.”  The company was alleged to be, “channel stuffing by franchisees, whose stores reportedly ‘received twice their regular shipments in the final weeks of a quarter so that headquarters could make its numbers.” Krispy Kreme was also dogged by questionable transactions and self-dealing accusations over the buybacks of franchisees, including those operated by company insiders.”  This is a prime example of where keying in on related party transactions could save your portfolio from a trouble. 

Before you invest your hard earned money into a company make sure you dig a little deeper into what’s going on behind the scenes.  While related party transactions are not always a red flag nor are they something to fear.  What they are is something that you should at least be aware of before you put in your buy order. 

latimerburned owns shares of and has an options position in Green Mountain Coffee Roasters. The Motley Fool owns shares of TripAdvisor and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters and short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Green Mountain Coffee Roasters, Krispy Kreme Doughnuts, and TripAdvisor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus