"This company develops programs to help its clients market their products through mobile devices and social media. The Company's revenues have grown from $61 million in 2008 to $107 million in 2011 and reported 2011 EPS of $0.46. Given the industry the company operates in we presume it could achieve a trailing PE of 25, translating into a near term price target of $11.50."
In short, AQ has a singular focus of being a leading brand e-commerce and digital marketing company that leverages the internet, mobile devices and social media to enhance its clients' brands, price competitiveness and e-commerce performance.
The company completed its IPO in late April 2012, priced at $6.00. The stock also opened at $6.00, or 9 times the fully-taxed 2012 EPS (based on ADS) analyst estimate of $0.66.
We went on to code the stock as a GeoBargain on the Radar and did go long this name for a period of time as we probed deeper into the story. The stock eventually attained a high of $11.01 on October 18, 2012. On November 16, 2012 we informed our premium GeoInvesting members that:
"…despite our initial bullish outlook we are now short AQ, the stock was trading at around $7.20 at the time of this alert. What looks like an American company on the surface is actually a company controlled by a few Chinese players…"
We have been curious for some time now about how China-based executives accused of exploiting U.S. investors in the reverse merger market might evolve and become more sophisticated in their deceptive practices, a notion posed by GeoInvesting in past reports and research notes.
Unfortunately, during the due diligence process we have uncovered red flags associating AQ with China-based company issues that we can't ignore and hypothesize played a part in AQ's weak IPO debut.
Initial selling pressure will likely come from a current shareholder, Datai Bay, a Cayman Island entity and subsidiary of Khazanah, a Malaysian company owned by the Minister of Finance in Malaysia. AQ was purchased by a Hong Kong-based investment group (2020 Equity Partners Limited) in 2008, a transaction that was funded by Datai Bay through a convertible bond. Datai Bay has made it no secret that it intends to sell its 5 million ADS (American Depository Shares) or 32.5% of AQ's float, starting at the end of the related lockup period, which actually already occurred on October 27, 2012.
"Datai Bay is party to a Deed in Respect of the Bonds pursuant to which, upon expiration of the lockup period provided for in such Deed, 2020 Equity Partners Limited ("Equity Partners") shall use its best efforts to arrange for the sale of all of the 10 million Ordinary Shares (5 million ADS) held by Datai Bay during a selling period defined in the Deed."
We are assuming that Datai Bay has yet to sell the majority of its holdings. As of the end of the lockup period on Oct. 27, 2012, AQ has only traded a total of 1,343,662 shares (as of close on 12/3/2012).
(Note that two ordinary shares equate to one ADS)
Additional elephants in the room include:
- Weak IPO debut given strong history of growth
- Intimate ties to AQ's Chairman/CEO, George Lu, who is the ex-CEO of Exceed (EDS), a company that has been accused of misrepresenting its business to investors in both the U.S. and Hong Kong.
- In addition to funds initially invested in two JVs (with China ties) that were established pre-IPO, 36% of AQ's IPO proceeds are slated to further fund these JVs, not to fund AQ's cores business. We will show that both of these JVs are losing money and seem misaligned with shareholder interests.
- The IPO proceeds were transferred to Hong Kong, rather than remaining in the USA, where the key business operates.
- In 2008, the operating subsidiary of AQ, Acquity Group LLC, was purchased by a Hong Kong based investment group led by George Lu (2020 Equity Partners Ltd.), 4 years before its IPO. Post 2008, AQ's management team has been in Hong Kong, while the operating team has been in Chicago IL. While we have no particular problem with Chinese executives owning shares of a U.S. company, when we consider that certain members of the post-IPO Board, who can control the activities of AQ, have been associated with U.S. listed Chinese companies accused of fraudulent behavior in the past, we became skeptical. This is concerning given the numerous allegations and proven acts of misrepresentation that have occurred with U.S. listed Chinese stocks since 2009. Our concern is exacerbated when we consider that:
- AQ headquarters are in Chicago,
- Almost all of its clients are in the U.S.,
- IPO proceeds left U.S. shores, and
- It has invested in two losing JVs.
As far as we can tell, after four years of being under the realm of the Hong Kong based management team, little if any operations have been conducted from China and/or Hong Kong. We are curious how the management team in Hong Kong can understand and/or manage AQ's key business in the United States.
Red Flag One: Poor IPO Debut
Our expectations of a better IPO reception that would have valued AQ at a P/E greater than 9 were fueled by the following:
- The company undoubtedly operates in a sexy industry.
- The company has been growing revenues at greater than 40% annually since its inception back in 2001.
- Revenues have grown steadily from $51 million in 2009 to $107 million in 2011.
- Adjusted EBITDA grew from $8 million in 2009 to $20 million in 2011.
- For the first nine months of 2012, revenues have grown 41.1% to $107.2 million.
- During conference calls, AQ had stated that it anticipated that it would be able to continue to grow its revenues at an annual clip of 40% (although management did not seem as confident in this goal during its 2012 third quarter conference call as it had in the past).
- EPS fully-taxed estimates (based on ADS) are expected to grow to $0.66 in 2012 vs. $0.46 in 2011 on revenues of $150 million.
- 2013 EPS estimates are expected to reach around $0.88 on revenues of $193 million.
- Long term debt to equity currently stands at only at 6.4%.
- The current ratio currently stands at 6.8.
- In 2009, 2010 and 2011, AQ generated healthy operating cash flows of $7.3 million, $5 million and $4.6 million, respectively.
- The company's customer base consists of Fortune 500 companies.
- The company's revenues consist of substantial recurring revenue streams.
After some digging we think we found our answer to the weak IPO reception and what is currently holding back AQ's shares.
Red Flag Two: Hong Kong based Management Team with serious past accusations of misrepresentation.
AQ Changes Hands
AQ was founded in 2001 in Chicago. In 2008, a subsidiary of 2020 China Holdings Ltd., established in the Cayman Islands and led by George Lu and other individuals with experience in the capital markets, purchased a 70% stake in AQ for USD 49 million. 2020 funded its purchase through the issuance of convertible bonds in the aggregate amount of USD 50.2 million to two financial investors - Datai Bay Investments Ltd. and SHK Asian Opportunities Holdings Ltd. After further digging, a couple of things initially piqued our curiosity:
- Post-2008, AQ formed and funded US$4.7 million for two Joint Ventures with China based firms. These JVs reported a 20% loss ($1 million) as of the end of 2011.
- IPO proceeds were sent to Hong Kong for a "lower capital gain tax", despite the fact that AQ's business is in the USA except for the two joint ventures with minimal operations.
Could this story highlight another angle where China based executives take control of a real U.S. firm to portray a sense of legitimacy while they raise and send funds to China?
Who Really Controls AQ Post-IPO?
The change in ownership resulted in the creation of a Board of Directors consisting of individuals located in Hong Kong. Essentially, even though the operating team remains in Chicago IL, a change of guards occurred, redefining who could control the direction of AQ's operations and flow of cash.
AQ's key business is in the USA and its headquarters are in Chicago, IL. The operating team residing in the U.S is as follows:
|Christopher Dalton||44||President and CEO|
|Matthew Schmeltz||43||Executive Vice President|
|James Newman||50||Executive Vice President|
|Andrew Peebler||37||Executive Vice President|
|Jay Dettling||41||Executive Vice President|
However, AQ's key management team members, including the Chairman/CEO, corporate secretary and all independent directors, reside in Hong Kong:
|G. George Lu*||47||Executive Chairman and Group Chief Executive|
|Adrian Chan*||37||Director and Company Secretary|
|Wing Chung Anders Cheung*||47||Independent Director|
|William John Sharp*||70||Independent Director|
|Donghui Wang*||40||Independent Director|
|Paul Weinewuth||47||Chief Financial Officer|
|Raymond Grady||40||Executive Vice President and Global Head of Sales|
*Hong Kong affiliation
As for AQ's audit committee:
"Our audit committee will be comprised of Mr. Wing Chung Anders Cheung, Mr. William John Sharp and Mr. Donghui Wang."
Paul Weinewuth, the CFO and Raymond Grady, Executive Vice president and Global Head of Sales, reside in Chicago IL as a part of AQ's operating team.
Two of AQ's board members located in Hong Kong have ties to Exceed, a U.S publicly traded Chinese company that was the product of a reverse merger transaction in 2009. Independent director William Sharp was an EDS board member between November 2009 and February 4, 2012. In the EDS reverse merger transaction, George Lu invested in EDS and sold the shell (2020 Chinacap Acquirco Inc.) to EDS. EDS has been widely accused of misrepresenting the nature of its operations to investors in the U.S. and China. The stock trades at around $1.50 just shy of its 52 week low.
Highlights from our due diligence into the EDS story revealed:
"EDS had planned to IPO in Hong Kong in June of 2008. After these plans fell through, the company chose to enter the U.S. market through an RTO/SPAC transaction. The RTO/SPAC transaction took place at a terrible valuation; many times lower than the originally proposed valuation of the HK IPO. Goldman Sachs was to be the lead underwriter in the IPO and made an investment in the company that it eventually abandoned prior to the SPAC/RTO. Why did Goldman want out? We believe that the reasons for the negative IPO reception in Hong Kong and for the fact that Goldman wanted out of the investment may have gone much deeper than the opportunistic "weak market condition" excuse provided by EDS. We learned that "rumors" and "allegations" surfaced in the PRC media related to the integrity of the company's accounting. We also discuss a point of view that the Chinese management team of EDS may not have held U.S. shareholder interests in high regard."
What Is the Value Added by the Hong Kong-based Management Team?
AQ's Hong Kong based management team members reside far from the key business and, based upon their biographies in the IPO prospectus, don't appear to have experience in AQ's business. Only Paul Weinewuth and Raymond Grady, who in fact are also part of the operating team of Acquity Group LLC, reside in Chicago, IL to manage the company's real business. AQ's website (www.acquitygroup.com), currently does not mention anything about the Hong Kong management team, but only the operating team of Acquity Group LLC residing in Chicago, IL.
Therefore, it seems to us that the only job for the management team residing in Hong Kong was to take the Chicago Company, Acquity Group LLC, to the capital market, rather than to manage this company and its business. If they are not managing the company why did they send the IPO proceeds to Hong Kong and why are they on the Board?
Show Us the Money
Management told us during an interview on June 5, 2012 that the IPO proceeds were transferred to Hong Kong (for tax planning), rather than remaining in the USA where the key business operates and needs money for further growth. The stated uses of the proceeds are as follows:
- Approximately US$15.4 million to conduct acquisitions and increase its working capital; and
- Approximately US$9.0 million to maintain its existing ownership interests in current joint ventures.
At the very least, why did the company transfer all the IPO proceeds to Hong Kong when it only requires $9 million for its JVs? And what does "maintain" mean? Furthermore, the savings gained from tax planning don't outweigh the loss in potential market value of AQ shares as investors begin to connect the dots.
The Money Pit - The JVs Seem Misaligned With Shareholder Interests
There are a few reasons why we are somewhat skeptical about the direction AQ chose to take with respect to its two joint ventures. Digital Li-Ning is a joint venture relating to branded e-commerce and digital marketing of the Chinese Li-Ning sportswear brand in the U.S. markets (www.li-ning.com ). The K121 joint venture is an e-commerce platform (www.k121.com) to sell different sportswear brands in China.
In 2009, Li-Ning tried to expand its business to Portland, Oregon with showroom, designer and marketing activities. That part of the business lasted barely two years. By 2011, Li Ning's management was having guarded discussions about reducing the company's headcount, pursuing a misguided mission with visions of growing a table tennis league in a back room, rather than continuing to sell sportswear. Thrillist.com posted this entertaining YouTube video to show how the Li-Ning staff tried to help one man improve his game. With the failure in Portland, OR, Li-Ning set up the joint venture with AQ and moved to Chicago for its online operation.
In fact, Li-Ning is facing really serious difficulties. For the first half of 2012, Li-Ning's profit was down 85% from a year earlier with revenue off 10%. Li-Ning also closed nearly one thousand stores in 2012. Because of these issues, the company is:
"Now scaling back its plans for global domination in athletic shoes and apparel, the brand is embarking on a three-year transformation program to win a bigger slice on the home turf and improve profitability." (Source: WSJ Online)
Under such a situation, it is hard to imagine that Li-Ning could inject more money into its campaign in the United States. If this is the case, why would AQ continue to invest money into such a project bound to fail?
The same can be said about the joint venture representing the K121 e-commerce platform, www.k121.com, hosted in China. The difference here is that it is not brand-specific and offers an assortment of sportswear brands. Competitors in this genre include DangDang, 360buy and Newegg, a theme of larger, more established multi-product (not just sportswear) e-commerce platforms slicing deeply into the market-share of their smaller counterparts. The burden lies with K121 to offer a better shopping experience and better prices, which from what we can tell is not happening.
At the same time, in 2012, China's major sportswear brands, even including NIKE and Adidas in China, have been suffering from a decline in new orders due to intensified competition and a sagging market amid the economic slowdown. Suffice it to say that this also stands to adversely influence k121's business.
The results speak for themselves. The financial information regarding these two joint ventures is as follows:
|Huaren Kudong Commercial Trading Co., Ltd (K121):|
|Equity method loss recognized||(812,401)||-||-|
|Other comprehensive income||101,920||-||-|
|Investment value at December 31, 2011||2,121,504||-||-|
|Digital Li-Ning Company Limited:|
|Equity method loss recognized||(224,836)||-||-|
|Investment value at December 31, 2011||1,765,164||-||-|
|Total investments in joint venture||3,886,668||-||-|
The total $4.83 million investment in these JVs is now worth $3.86 million and appears to be a very poor investment.
We listened to AQ's 2012 third quarter conference call and noticed that management did not talk about its growth opportunity in China or the role its JVs will play in its growth tract. When asked for more color on the strategic options regarding the JVs, management stated they are "in early stages of process of evaluation."
Given the scope of AQ's operations, we do not understand the reason for AQ to start these two joint ventures. It would make more sense to just sign these two companies as clients and collect recurring subscription fees like they do with their American clients, rather than dump capital into a project that poses unnecessary risk to the company. Instead, AQ has "invested" in two JVs that are losing money and not generating any revenue. Despite the great success that AQ claims to have had with its U.S. clients, "AQ's technologies and solutions" have "produced losses" for these two joint ventures as of the end of 2011.
It appears that at best, the Hong Kong based team used AQ funds to promote risky business ventures in China that seem misaligned with shareholder interests.
On August 1, 2012 we emailed AQ's management team, highlighting our concerns. We noticed that in its 2012 third quarter press release, management made the following statement:
"…we are looking to simplify our corporate structure by exploring strategic options in relation to our joint ventures."
We have no idea what that means, but we suggest that if the company really wants to increase its legitimacy it should transfer its IPO funds out of Hong Kong to another domicile in which investors can take solace, unwind its JVs and remit whatever JV funds are left back to the U.S.
Red flag Three: Datai Bay and other shareholders may be about to sell AQ's shares. Recall that Datai helped fund the acquisition of AQ by 2020 Equity Partners Limited:
"For the consideration of US$20,938,040.85, Datai Bay received 10,631,035 AQ shares (5,315,517 ADS). Datai Bay registered these shares with 13D on May 15, 2012."
Datai has explicitly said from day one that they intended to sell AQ shares once they were able to.
"upon expiration of the lockup period provided for in such Deed, 2020 Equity Partners Limited ("Equity Partners") shall use its best efforts to arrange for the sale of all of the Ordinary Shares held by Datai Bay during a selling period defined in the Deed."
Well, the 180-day lock-up period coinciding with the date referenced in the prospectus for the IPO (April 27, 2012) has come to an end. After Oct. 27, 2012, Datai Bay could sell its shares, which represents around 22.6% of AQ's outstanding shares and 32.5% of its float. Coincidentally, shares have been in a steady decline from $9.87 on October 27, 2012 to its current price of $6.23 (as of 12/3/2012 close).
For those that think Datai Bay is going to hold on to its shares, consider that its cost basis per share is only USD 1.97 (3.93 per ADS). Even at AQ's current price, shares are still about 60% higher than this cost basis, adding a big incentive for the company to sell its AQ shares, especially since the stock is quickly falling.
We are worried about some of the players involved in AQ's story. Currently, it seems that the company's Hong Kong-based management team led by George Lu used a Chicago company to raise money for its Chinese joint ventures and other future possible acquisitions. These two joint ventures are both sportswear B-C e-commerce platforms and represent businesses that are totally different from AQ's direction. Furthermore, we doubt the future of these two platforms as there are many big B-C e-commerce platforms carrying sportswear.
Let's not forget that the money raised in AQ's IPO has been transferred out of the USA and that the Hong Kong management team does not appear to have any experience regarding AQ's U.S. business. This can lead to a possible internal management conflict between the Hong Kong management team and the operating team in Chicago IL regarding AQ's future direction. Aside from the red flags we pose, there is "perception risk" that could shadow AQ for some time - risk that investors may have to price into the stock. If AQ can take steps to quell our concerns we would actually consider going long this name in the future, but in the near term we will view a long investment with trepidation since we think it is just a matter of time until the market puts two and two together and recognizes the red flags we have brought to the table.