A Bitcoin Stock Play That's Scarier Than Bitcoin

NEW YORK ( TheStreet) -- Bitcoin may be speculative, but WPCS International ( WPCS), a tiny company near Philadelphia touted as " the first and only stock for investing in the Bitcoin sector," looks like an even riskier bet.

That's because the decision by WPCS to acquire a Bitcoin software startup called BTX Trader looks at best like a desperate move to save a struggling company that until last month was principally focused on businesses such as installing telecommunications cables in hospitals and municipal government offices.

At worst, it looks like a cynical ploy by a pair of hedge funds to take advantage of the Bitcoin frenzy to create some excitement around the stock so the funds could get out from under a troubled loan.

Iroquois and Hudson Bay Pull the Strings

The hedge funds, which according to WPCS interim CEO Sebastian Giordano were led by Iroquois Capital and Hudson Bay Capital, acquired $4 million in convertible bonds on Dec. 5, 2012. Convertible bonds start out their life as bonds, but can be converted to equity at a pre-determined price. The bonds were themselves an act of near-desperation, as WPCS saw revenues decline from a peak of $107 million in 2009 to $42 million in 2013. Costs on certain projects spiraled out of control and the company struggled under an increasing debt burden. Its core electrical contracting business was a "tired story," concedes one person close to the company who asked not to be identified.

Convertible bonds are rarely the first option for companies seeking financing because they erode equity value. Understanding how these particular bonds work isn't an easy task. The initial agreement is difficult enough, containing language like this.

The Notes will be initially convertible into shares of Common Stock at a conversion price of $0.3768 per share (the "Conversion Price"). The Conversion Price will be adjusted to 85% of the average of the closing bid prices for the five consecutive trading dates immediately prior to the following adjustment dates: (1) the earlier of the effective date of a registration statement or six months after closing (the "First Adjustment"); (2) the later of the date that is three months after the First Adjustment or one year after closing (the "Second Adjustment"); and (3) on the Stockholder Approval Date.

But then the bonds have been amended a few times, making it even more difficult to figure out what actions holders of the notes are likely to take.

What is clear at the very least is that the bonds gave the note holders near total control over WPCS -- something I suspect wasn't so clear to some longtime investors in the company, and was probably even less apparent to new investors drawn in by the Bitcoin acquisition.

Giordano told me it was those note holders who "could have bankrupted the company," but instead came to him with the BTX Trader acquisition.

And it was those note holders pulling the strings when, following the BTX/Bitcoin announcement, the shares experienced a trading frenzy that made investors feel the way residents of a very small town would probably feel if, say, Justin Bieber bought a house there.

'We Need To End This Call'

Trading volumes, which on most days were comfortably under 50,000 shares, passed 12 million Dec. 18, the first trading day after the announcement. The share price bounced between $1.52 and $3.12, closing at $1.64 for a 48% drop.

During a Dec. 19 conference call, investors rightly conjectured there had been massive new share issuance, but Giordano and CFO Joseph Heater acknowledged they didn't know how many shares were outstanding at the time.

Investors, maybe needless to say, were not happy. They hammered Giordano and Heater with questions on the call, held to discuss second quarter earnings for fiscal year 2014. The event ended rather abruptly, with Heater telling one investor "you've made your point," and saying to Giordano, "we need to end this call."

Investors were especially incredulous that Giordano and Heater didn't know how many shares had been issued.

"Today I don't know if the market cap of the company is $2 million or $200 million," said one. "The stock would essentially be worth $0.01 or could be worth $5."

This second quarter filing released three days earlier was the most up-to-date information investors had available to them at the time. It stated WPCS had 1,558,669 shares outstanding.

Another investor guessed that "when you count them all up, there probably would have been well over 10 million shares converted."

Giordano promised the investor, "it's not over 10 million shares, I can tell you that."

It would be soon enough, however. The next day, WPCS disclosed it had issued 4,153,179 new shares -- nearly quadrupling the float -- to a total of six investors. Eleven days after that, WPCS would reveal it had issued a total of nearly seven million more shares in three separate transactions, bringing the total share count to just over 12 million shares. Again, the number of investors receiving these shares was small: two in the first instance, seven in the second, and two in the third. Late Tuesday this week, WPCS reported it had issued another 1.25 million shares to four investors, bringing the total to 13,303,622. Putting this latest issuance together with information from an earlier filing, WPCS has another $1 million or so worth of convertible notes that could be converted, suggesting the share count could increase by roughly 4 million to 5 million more. That would require additional authorization, however, since according to WPCS's latest 10-Q it is only authorized to issue 14,285,715 common shares.

Giordano told me his ignorance about the share count as the call was taking place wasn't that big a deal.

"We have limited staffing right now," he said. His CFO Joseph Heater "was still gathering all the information, analyzing information, running calculations, again: I don't believe that not having that information at the instant that someone asks the question is a negative."

Auditor Resigns

In the middle of all this dilution, on Dec. 20, WPCS's auditor, CohnReznick, resigned, though the company did not disclose the fact until 5:15 pm on the Friday between Christmas and New Year's. Making a disclosure at a time like that is the equivalent of dumping a body in a ditch far outside of town on a cloudy night.

The filing announcing the CohnReznick resignation includes a statement approved by both companies that WPCS had "no disagreements with [CohnReznick] on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure." While CohnReznick "raised substantial doubt about [WPCS's] ability to continue as a going concern," it had done the same thing in 2012 without seeing the need to resign.

Repeated calls and email messages to CohnReznick executives, including co-CEOs Ken Baggett and Thomas Marino, weren't returned. An administrative assistant to one of the firm's senior executives initially promised to find someone who could address the issue, but in a follow up call she said "It's going to be very awkward how I answer you. I have nothing to tell you at this time and you're just going to have to do what you think is best."

Giordano told me CohnReznick resigned because "they did not have the expertise in the Bitcoin space -- in the virtual currency space -- how Bitcoins are valued -- all the issues relative to that industry -- it was just too new for them."

Won't pretty much every other reputable auditor say the same thing?

Giordano said WPCS will "have a decision very soon," about a new auditor.

"We've spoken to [auditors] that have clients that are in emerging technologies, disruptive technologies, that have clients in the payments space and who are very comfortable dealing in those arenas," he said.

'Sicilian From the Bronx'

If there is anything I like about WPCS, it is Giordano. Despite all the chaos swirling around the company, he did not hide from me, and his answers to my questions, while not exactly reassuring about WPCS's chances for making a steady profit, by and large made sense.

"I'm a Sicilian from the Bronx, I don't get rattled," he said.

Giordano, 56, has worked in the finance department and in upper management at several companies that aren't exactly household names (Nuevo Financial, Drive One). Early in his career he worked for large, troubled companies such as AMF -- now known for bowling alleys, but formerly a manufacturing powerhouse until it ran into trouble in the late 1970s and early 1980s and began selling off various business units.

"I actually learned more in the problems than I did in companies that are successful because many companies that are successful I've found also cover a lot of sins. And they don't really look at problems. They look around them."

Giordano is paid a monthly consulting fee of $10,883 and will receive 30,000 shares (worth just over $51,300 at Wednesday's closing price of $1.71) if a new incentive plan is approved, according to the company's latest quarterly regulatory filing.

Giordano says his father sold insurance door to door for Prudential with Jay Leno's father.

"They were both basically debit agents together going into homes selling $2 policies and weekly policies so he taught me a tremendous amount about finance and business and that type of thing."

Giordano says he and the comedian used to visit each others' houses as children, though because Leno is seven years older, they weren't close. He did, however, connect with Leno on the set of the Tonight Show a few years ago. Attempts to reach Leno were unsuccessful.

BTX's Prospects

If you aren't bothered by the massive share issuance, the powerful hedge funds behind the curtain, the auditor's resignation, or other sundry issues, such as an outsized pay package of former CEO Andrew Hidalgo, (Giordano says he scored a coup in pushing the payments out into the future) you might wonder about BTX Trader's chances of actually making money.

Plans include software that will enable users to see prices for Bitcoin on various exchanges.

The fact that WPCS acquired BTX (which officially came into existence 13 days before the acquisition) out of sheer desperation wouldn't seem to be a positive sign.

Giordano says BTX wasn't the only acquisition WPCS considered, but it was the only Bitcoin acquisition it looked at, and as Giordano himself puts it, "Who was going to be acquired by a company whose Nasdaq listing was jeopardized? No one. Who was going to be acquired by a company that had no cash? No one."

Well, not no one. BTX took the deal because it got capital to start a business, as principals Divya Thakur, 28, and Ilya Subkhankulov, 24, explained to me. The holders of the convertible notes gave them $439,408 worth of convertible notes and $1.185 million in cash "as their initial capital contributions to BTX," according to the filing announcing the deal. In addition, Thakur, who will join WPCS's Board of Directors, will get a one-time signing bonus of $133,333 and an annual base salary of $170,000, while Subkhankulov will receive a $130,000 salary and a $66,667 signing bonus.

The filing describes Thakur and Subkhankulov as having worked at Goldman Sachs (GS), which is more or less true. They both worked at REDI Technologies for roughly two years ending in Dec. 2013. Goldman was a majority shareholder in REDI until July 2013 and retains a "significant minority stake," according to a press release.

If, having brought the BTX acquisition to WPCS, the hedge funds plan to stay in the stock, the company's turnaround prospects would look a bit better.

While hedge funds generally have a reputation for trading constantly in and out of positions, there are certainly exceptions. Iroquois and Hudson Bay, however, are not exceptions. They trade their positions frequently, according to people close to those firms. The firms declined to comment for the record.

Of course, you might also wonder about the future of Bitcoin. Even Subkhankulov admits the virtual currency is "too risky for my blood," and won't buy any. Thakur, on the other hand, owns "a bunch" of Bitcoin, but won't say how much.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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