As you boarded your flight that day, perhaps you didn't realize you were in the market for a garden statue that looks like Bigfoot. But, as the plane doors close, you curse the FAA regulation that bans electronic devices from being used during takeoff and landing. How do you entertain yourself for these interminable 30 minutes? The inflight magazine? The emergency safety instructions card? How about the SkyMall magazine? Yes, the SkyMall magazine will do. And that's when you find yourself considering whether you need the The Garden Yeti.

On almost all US flights, you'll find SkyMall magazine in the seat-back pocket in front of you. This magazine is a catalogue filled with whimsical products that are available for sale. None of these products are things you strictly "need". They're not even products that a reasonable person could anticipate wanting until they've seen it -- a baseball bat shaped pepper grinder, a vacuum cleaner to catch flies, an alien butler drink tray, a helmet that promises to regrow your hair using lasers.

Having entertained ourselves by thumbing through the SkyMall catalogue hundreds of times in our lives, but never having purchased anything, we were curious. How does the business of SkyMall work? 

As we were researching the economics of the SkyMall business model, a darker story emerged. SkyMall recently merged with a newly formed company called Xhibit Corp, a company that trumpets itself as a "cloud" marketing software company, but in reality makes its money from dubious sources. With even a small amount of research, this company, Xhibit, raises all sort of red flags.

Has SkyMall, a quintessential piece of Americana, fallen in with a very bad crowd? 

The Economics of SkyMall
Every year, 650 million passengers have the opportunity to peruse through SkyMall on their flight. According to a survey commissioned by the company, over 70% of passengers read SkyMall on every flight.

The company has negotiated deals with most major airlines in the United States to be their exclusive product catalogue partners. This covers 90% of passengers on US flights. Most SkyMall customers are exposed to the products via the in-flight magazine, but they can order the products using the catalogue or through the website, SkyMall.com.

For most of its history, SkyMall has been a private company so its financial information is not well disclosed. However, in 2009 its website generated approximately $80.5 MM in revenue, and it was the 185th largest e-commerce website by revenue, according to the Internet Retailers Top 500 ranking. In interviews, company officials have stated that 60% of the company sales come through the website (the rest through the catalogue) so we can estimate that the company does about $130 million in revenue per year (website + catalogue).

The company was started in 1989 by Robert Worsley. Worsley's original plan was that passengers could use the "Airphone" (a phone that used to be located on the back of most seats) to call SkyMall and when they landed, their purchases would be ready for them to pick up. Customers could buy name brand merchandise from retailers like Land's End, as well as SkyMall-branded products like luggage.

This initial business model was a bit of a disaster. The company had to have warehouses near the airports full with all the products in case someone bought something. When a purchase was made, it would have to be quickly transported to the gate. And it seemed no one really wanted SkyMall branded-luggage. By 1993, the company was losing $6 million per year.

Around this time, the company pivoted to a more capital-efficient model. They wouldn't carry any products, they'd just be a magazine where other companies could advertise. These companies would either pay a flat advertising fee or pay SkyMall a percentage of each transaction. The companies that advertise in SkyMall would be responsible to "drop ship" their products directly to the customer. SkyMall would be an advertising company in the vein of Google or eBay rather than an e-commerce company that held inventory like Amazon.

Today, when you see a product advertised on SkyMall, the company selling the product is paying handsomely for the opportunity. A full page placement in SkyMall costs $129K per issue (3 months) plus a 6% transaction fee. Or, you can opt to pay a 5% transaction, a smaller advertising fee, and an additional profit share with SkyMall. SkyMall sells space by the full page, half page or quarter page. The cheapest option, a quarter page, costs $41K per issue. Below are the monthly rates to buy space in SkyMall (it's required you buy three months at a time).

Taking a percentage of each transaction and an advertising fee has been a durable model for SkyMall. According to company President Christine Aguilera, they get approximately 100 requests a week from prospective companies to have their products featured in SkyMall. In order for this business model to work, SkyMall needs to continue to be carried on nearly every domestic flight to maintain its access to this captive audience of travelers. It's not disclosed how large these fees are, but in 1999 (their last annual report), it was only around 5% of revenues.

Over its corporate history, SkyMall has been owned by various private equity firms who have passed it amongst themselves. Most recently, SkyMall was owned by Najafi Companies, a Phoenix based private equity firm that was best know for buying Network Solutions in 2003 with a $20 MM equity investment, and then later reselling the company for $800 MM in 2007.

And then, on May 17, 2013, a curious event took place that wasn't reported anywhere in the press. SkyMall merged with a company called Xhibit Corp, an entity which looks to be more of a parody of a tech company than a real company at all.

Xhibit Corp: a "Cloud" Company

Last month, SkyMall merged with Xhibit Corp, a recently formed marketing software and digital advertising company that trades on an "over-the-counter" exchange where equity shares of small companies can be bought and sold. As part of the merger, SkyMall owns 40% of the new company and Xhibit owns 60%. Sounds like a merger of almost equals, with the cutting edge tech company getting more ownership and the old economy catologue business getting less, right?

Except here's the problem. Skymall is by all accounts a reasonably successful company with $130 million in annual revenue, a differentiated offering, a well known brand, and at least some happy customers. Xhibit on the other hand, appears to be a company with dubious sources of revenue, a very thin competitive advantage, and more hype than substance.

The Xhibit Corporation went public via a "reverse takeover" of a shell company in 2012. Earlier, in 2011, the individuals behind the company acquired a shell company called NB Manufacturing for $350K, and voila, Xhibit was able to become a publicly traded company. The SEC warns that investors should be wary of putting their money in companies that become public this way because there is essentially no regulation:

Reverse mergers permit private companies, including those located outside the U.S., to access U.S. investors and markets by merging with an existing public shell company. The SEC and U.S. exchanges recently suspended trading in a more than a dozen reverse merger companies, citing a lack of current, accurate information about these firms and their finances...

"Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies," said Lori J. Schock, Director of the SEC's Office of Investor Education and Advocacy. 

When Xhibit merged with Skymall, it's market capitalization was about $300MM. How does a company go from $350K valuation to $300MM in under two years? The answer is that if a security is fairly illiquid, the "price" is more or less arbitrary because people aren't really buying or selling many shares. If only a few shares are trading on the market, the price can be really high, regardless of the fundamentals of the company. If there is substantial "hype" about this company, the price of these very limited shares will be high. But, if the insiders unload most of their stock, the share price would plummet. Maybe Xhbit is worth a lot of money, maybe it's not. There is no way to tell by just looking at the stock price if there isn't a vibrant and liquid market for the security. Below is the Xhibit Corp (XBTC) stock price over the last two years:

But what does the company do exactly? Is Xhibit the kind of company that should be trading at 30X revenue? Here's how Xhibit Corp describes itself:

Xhibit is a cloud based technology development company with its primary historical focus on digital advertising, and a recently expanded focus on online and mobile social media, games and CRM (customer relationship management) solutions.

It hits all the buzzwords, sounds like it should be trading at a huge multiple to revenue since it's some sort of cloud social crm something company. But if you take a look at their website, everything that comes after the words "recently" don't really exist yet. The social games and social media sites (like much anticipated social network, "Twityap") haven't been launched yet. The realtime ad exchange hasn't launched yet. The email marketing CRM solution has "several customers" according to the company's latest annual report. So most of how the company presents itself is vaporware.

However, the company made $9.2 MM in revenue in 2012, with very healthy 52% gross margins. That sounds pretty good, but where does it come from? The answer comes buried deep in it's annual report:

During the first quarter of 2013 a majority of our revenues have been generated by these five employees from the sales of a weight loss product, colon cleanser and green coffee supplement...

As the profit margins for sale of these products is far higher than online marketing of education, home business or other services we have traditionally advertised, we have re-directed our advertising resources to this sector. 

Ah, the answer to how Xhibit makes money. The company made money this year by selling spammy weight loss products. Last year, the company made money by selling online education and home-based business leads, but the profit was much better in nutraceuticals! But alas, this is a high risk game and the company's merchant banks aren't releasing the funds from recent credit card transactions:

None of our merchant banks were willing to immediately release the cash to us after they processed the credit cards used by our consumers to pay for these nutraceutical products. The combination of taking credit card numbers over the internet, selling products subject to more frequent returns, and selling products overseas resulted in a change in the policies of the merchant banks as they were concerned with a greater number chargebacks.

Failure to get the cash from these sales immediately with a potential delay as much as 100 days may result in the failure to meet other obligations on a timely basis, delay research and development or even impact our ability to meet payroll. We plan to raise short term capital to fund these sales.

So, in the best case the iconic SkyMall has merged with a company that makes its money selling spammy weight-loss products but poses as a marketing software company. The worst case could be much worse.

Six months ago (well before the merger with SkyMall), Issac Silberman, a contributor to Seeking Alpha put forth a hypothesis that would explain most the actions by Xhibit and its management team - the company might be a run of the mill "pump and dump" scheme to defraud investors.

According to Silberman, it's really nothing too complicated: become a publicly traded company without SEC scrutiny, hold most shares among insiders so that price is artificially high, hype up the stock with phrases like "cloud",  "real-time" and "social", and then unload the shares to unsuspecting investors. Silberman makes a compelling case that this is why a company of dubious origin is supposedly "trading" at nearly a $300MM valuation like it's the second coming of Salesforce.com. Even Silberman's hyper-critical analysis overlooks that the company makes all its money from selling spammy weight loss products, not from cloud software.

There is almost too much bizarre information about Xhibit and we're barely scratching the surface. To dig deeper, we'd encourage you to read this Seeking Alpha article, look at their corporate site full of vaporware, take a gander through their annual report, or listen for a few minutes to this strange "interview" with the company's founder Chris Richarde. 

When all this information about the sketchy nature of Xhibit Corp is available, why would the owners of SkyMall willingly exchange the shares of their company for shares of Xhibit Corp? Why would an American institution with strong revenue sources merge with what's in the best case a very crappy tech company, and in the worst case, something the SEC should be investigating?

Conclusion
To us, it's a bit sad that SkyMall has fallen in with such a bad crowd. It's also very confusing.

SkyMall, was owned by a private equity firm that by all accounts is sophisticated and knows how to structure deals to its advantage. This leaves three possibilities for why Najafi Companies would merge with Xhibit 1) There is some arcane tax or financial benefit that accrues to them through this kind of merger 2) They understand whatever scheme Xhibit is working on and think it's a good business idea 3) They got tricked into the acquisition.

We'll admit to be completely confounded. The owners of SkyMall are pretty smart so it's unlikely they got tricked or Xhibit's shaky finances weren't uncovered during due diligence. Moreover, if there is some tax benefit to this kind of merger, why not merge with a less sketchy company? It's a mystery to us.

So dear readers and financial sleuths, can you figure out the curious case of the merger between the great SkyMall and the lowly Xhibit Corp? Is there some financial benefit here for the owners of SkyMall, or did they get sold a bill of rotten goods, perhaps as karma for the decades of using their catalogue to sell a bunch of lovable but useless junk?

This article also appeared on the Priceonomics blog, a content partner