C3.ai (AI -1.71%) stock plunged on Tuesday after it was slammed by short-seller Kerrisdale Capital for the second time in a month.

In a scathing letter to C3.ai auditor Deloitte & Touche, on which the Securities and Exchange Commission (SEC) was copied, Kerrisdale accused the company of multiple accounting irregularities, making the case that C3.ai was inflating its revenue and gross margin in order to appear as if it's a software subscription company, even though it's really a consulting services-oriented business.

As Kerrisdale argues, subscription software businesses tend to trade at much higher multiples than consulting businesses so it's in C3.ai management's interest to inflate the multiple and the valuation because executives are compensated largely with stock and options.

The letter also focuses on the company's complicated relationship with strategic partner Baker Hughes and how it accounts for revenue from the oil services company.

C3.ai stock fell as much as 29% on Tuesday after Kerrisdale released its letter.

People looking at an income statement

Image source: Getty Images.

A question about receivables

Kerrisdale's case centers around the company's abstruse relationship with Baker Hughes and the way it handles its receivables accounting.

Through the first three quarters of its fiscal year, C3.ai's revenue has been relatively flat, even declining in its most recent quarter. However, at the same time, accounts receivable jumped from $80.2 million to $143.7 million, while revenue rose from just $62.4 million to $66.7 million.

AI Revenue (Quarterly) Chart

AI Revenue (Quarterly) data by YCharts

Since accounts receivable represents revenue that has been recorded but not yet collected, it's odd to see receivables growing so much faster than revenue. Normally, you'd expect them to grow at a similar pace, barring any change in billing practices or difficulty in collecting bills.

Additionally, many of those receivables were unbilled. As C3.ai says in its own 10-Q filing, it had $79.6 million in unbilled receivables from Baker Hughes as of Jan. 31, up from $16.5 million three quarters earlier. 

C3.ai makes no explanation for the sizable amount of unbilled receivables, though it does note that Baker Hughes accounted for 45% of its revenue in the most recent quarter, a uniquely high degree of customer concentration for a publicly traded company. 

Because of the ballooning unbilled receivables from its close strategic partner, Kerrisdale concludes that "C3.ai is booking fictional revenue in order to meet consensus analyst estimates and cover up the fact that, in reality, its products are unable to get traction with customers and its business is failing." Essentially, Kerrisdale is saying that it's inventing revenue that it then reports as an unbilled receivable in order to account for it on the balance sheet and cash flow statement.

There's no clear answer to the question of why the company has not invoiced 30% of its reported revenue over the last nine months.

A software or a services business?

Kerrisdale's other main argument is that C3.ai is a consulting business masquerading as a software business in order to earn a higher valuation multiple.

For example, C3.ai reported $55.9 million of related party subscription revenue for the first three quarters of fiscal 2023, but no related cost of revenue, implying that the subscription software business connected to Baker Hughes has a 100% gross margin. 

According to Kerrisdale, the company is doing that to convince the market that it's a software-as-a-service company rather than a services-intensive consulting business. Kerrisdale also observed that research and development expenses exceeded gross profit in the last three quarters, leading it to believe the company is recording cost of revenue as research and development expenses to help its financial numbers look like those of a software business.

What it means for investors

As a stock, C3.ai has had a banner year with shares having tripled at one point this year and up more than 100% year to date even after Tuesday's sell-off.

However, the performance of the business itself remains wanting. Revenue actually declined in the third quarter, falling 4.4% to $66.7 million and the company continues to be highly unprofitable on a generally acceptable accounting principles (GAAP) basis with a loss of $63.1 million in the third quarter and a free-cash-flow loss of $202 million through the first three quarters of the year. 

Kerrisdale is short the stock so it has an interest in the share price is falling, but its arguments are credible, and it doesn't have to be right about everything in order for C3.ai to be forced into restating its books, or worse. Investors should expect a response from C3.ai soon.

Considering the artificial intelligence stock still trades at a lofty price-to-sales valuation of around 12, the stock could have a lot more room to fall especially if Kerrisdale's claims gain traction. 

Keep your eye on upcoming news out on the report, including C3.ai's rebuttal, as these accusations aren't just going to go away on their own.