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Shares of NQ Mobile (NQ) have plummeted following a report by Muddy Waters saying the company is a massive fraud and worthless. As expected the company is coming out and trying to counter all the claims. However investors should remain extremely wary of NQ. This is because many fraudulent Chinese companies in the past, whose shares are now worthless, have done the same when being accused of fraud. In fact it appears NQ is using many of the same tactics as Sino-Forest, a fraudulent forest plantation operator in China which was also exposed by Muddy Waters. In addition we discovered some Chinese news articles that greatly question the legitimacy of NQ which we will share at the end.

Deny all claims, provide "evidence"

When Sino-Forest was initially hit with fraud claims, they released a statement on June 6, 2011 claiming that all accusations are false. Sino-Forest also released "a summary schedule of cash and cash equivalent and short term deposits along with a detailed listing with copies of its bank statements confirming the cash held within the Company as at that date" on the company's website that day.

Similarly NQ had a press release on October 24, 2013 saying all "allegations and accusations" are "false and inaccurate" and provided a "Table of Major Term Deposits" allegedly as evidence to show their current cash position is real and where their accounts were. However based on what happened in Sino-Forest's case and others, this is worthless as evidence. Even if NQ is to provide copies of individual bank statements like they claim they will, those can easily be doctored and may not be worth the paper they are printed on either.

Furthermore if you can recall from the case of Longtop Financial, sometimes even having independent auditors and other credible outside parties verify cash balances in Chinese bank accounts still might not be enough to prove that the cash is actually real. Longtop Financial was a Chinese software company that ended up being exposed as another fraud and their shares worthless. As it turns out they had inside help from their banks in creating fake accounts which showed cash balances that didn't even exist. This is what fooled their auditor, analysts, and even some high level executives at the company.

NQ's cash explanation seems questionable

In NQ's case, one of the major points against them is regarding how their entire cash position is being classified as level 2 assets. As a quick explanation, cash sitting in a checking or savings account should always be classified as a level 1 asset. Level 2 assets are assets which don't have an actively traded market and have to be valued from a mark to market basis, comparing them to similar assets that are actively traded. So when cash is being classified as a level 2 asset, it isn't really cash. Generally it is cash invested into some form of a non-traded short-term security. NQ claims that their cash is in term deposits.

While there's nothing wrong with having excess money invested in term deposits, it would seem strange that this includes every single penny for NQ. The company was questioned about this in the conference call they held on October 25, 2013 to defend themselves. A caller asked them since all their cash is in term deposits, how would the company have any working capital for normal daily business operations? Initially their explanation was that while all the cash was being classified as level 2 assets, in reality some of that cash was actually level 1. NQ also claimed in addition their business generates a lot of free cash flow so they have enough working capital readily available. But seeing how DSO (Days Sales Outstanding) is an astronomical 145 days for NQ as they reported in their Q2 2013 earnings release, that would appear to be highly unlikely.

However when pressed again a few more times by different individuals on their cash position on the call, later NQ seems to change their story a bit and claimed that while all the cash is in term deposits they can easily move the money out within one day if needed since term deposits work differently in China.

Another possible cause for concern from the call is that when asked questions about their cash, the company would often first need a translation from unidentified Mandarin speakers in the background before answering. It would seem that the English speaking executives on the call may not really have a complete grasp regarding the company's cash position. This would happen to include their recently appointed new CFO KB Teo, who does speak English fluently (with a slight accent).

Form a special independent committee

Back when they were initially accused of fraud, one of the first things Sino-Forest did was form an independent committee to investigate the claims by Muddy Waters in order to disprove them. NQ have done the same currently as they announced the formation of their own independent special committee.

Sino-Forest's independent committee even went as far as releasing reports saying that all the Muddy Waters claims against them were false. However from the final outcome we now know that Sino-Forest was in fact fraudulent and therefore many of the findings in the reports from their independent committee were either inaccurate or lies.

The issue with special independent committees is that they are almost always just comprised of independent (non-executive) members of the board. In NQ Mobile's case, 4 of their current 5 independent directors are heading their special committee. Sometimes with Chinese companies, many of the independent directors are actually close friends, family friends, previous business associates, or relatives of friends with those running the company. Therefore they may not really be "independent".

It is perfectly possible that the independent directors of a company are completely unaware of any fraud even if it is occurring. However we do not know if the board members heading the committee are really on the outside shareholder's side and will really expose the truth if fraud is discovered. Or are they really on management's side and will help cover up any fraudulent activities.

Threaten legal action

Sino-Forest initially threatened to sue Muddy Waters when hit with the claims. In their press release they stated: "Given the deeply damaging nature of Muddy Waters' self-interested attack on the Company and its shareholders, the Company is considering its legal remedies against Muddy Waters and its principals. Further, the Company intends to ask the securities regulators in Canada and in other jurisdictions to investigate the trading activities conducted by Muddy Waters."

NQ Mobile seems also to be hinting they may seek legal action against Muddy Waters when stating, "The company intends to take all appropriate legal actions to defend itself against these charges and to protect the interest of shareholders" in their press release.

Saying that the company is considering taking legal action is usually one of the ploys used by Chinese companies when accused of fraud. It helps give the illusion to some that the company may be legitimate since they are willing to defend themselves in court and have nothing to hide. However in reality it doesn't really mean much at all. Many of the Chinese companies that were delisted and whose shares become worthless have threatened legal action initially. Some went as far as filing actual lawsuits and some didn't. But the eventual outcome for the stock was the same.

Defend the company in front of the media

When accused of the fraud, Sino-Forest's former CEO and Chairman Allen Chan would give interviews to various financial media outlets defending his company and claiming all allegations against them were false, such as this interview with The Globe And Mail. This is what NQ Mobile's Co-CEO Omar Khan is starting to do now after the Muddy Waters report. In China, it appears that the Chinese executives of NQ are also defending the company in front of the Chinese media.

For those unfamiliar with NQ Mobile, they have two global offices with one in Beijing and one in Dallas. Omar Khan works from the Dallas office with a small number of employees and is in charge of NQ's operations in the United States and other international markets outside of Asia. Most of NQ's revenue though comes from China and the majority of their employees are in Beijing.

The frauds claims against NQ are based mostly on their operations in China and other Asia regions, which are managed by Chinese executives. Therefore it is questionable if Khan is actually the most qualified executive to be defending the claims against NQ in front of the media in the US. It is also debatable about how much does he really know about NQ's operations that are going on in the China and Asia regions. Those areas aren't under his direct control and he isn't even in China the majority of the time.

Although there is no doubt Khan is the best spokesman for the company in the US. His name is known in the mobile industry and he is an American. The Muddy Waters report does claim that Omer Khan was hired specifically for that reason, as a pitchman to help sell NQ to investors rather than actual products to customers.

As some investors may recall, in the past many fraudulent Chinese companies trading in the US would hire an American CFO or have an American Chairman for the purpose of lending credence to the company being a legitimate operation. Much like how Sino-Forest hired David Horsley as their CFO. In some cases the American executives was aware and complicit with the fraud. Other times they were misled and unaware, or at least they claim to be.

Investors of NQ in the US however now often don't hear or see much from NQ's other Co-CEO, Chairman, and co-founder of the company, Dr. Henry Yu Lin (pictured below). He is largely relegated to just reading prepared remarks in their earnings and other conference calls when it comes to addressing US investors after Khan was added to the company.

Dr. Henry Yu Lin

Chinese news report says NQ fabricated partnership

After the Muddy Waters report news broke out on NQ Mobile and made its way to the Chinese media, I asked a Chinese contact of mine to sift through the Chinese news to see if there were any interesting stories regarding the matter. Most of the online news was just talking about the Muddy Waters report, how the stock fell, and NQ denying the claims. However there was a very interesting and damning one we discovered on money.163.com, NetEase's (NTES) financial website.

The article is in Chinese but non-Chinese readers can use Google Translate or similar online translation websites to get a general sense of what the article saying. We have provided clearer translations of key parts, which are underlined.

The title of the article says that NetQin has allegedly announced fake partnership news. (NetQin is the original name of NQ Mobile and is a more proper English translation for their Chinese name. From here on we will replace NetQin with NQ in translations)

The first paragraph states that in response to the claims from Muddy Waters, NQ stated that their users come from two main channels. They are preloads and network downloads. NQ supposedly has preload agreements with ZTE and other popular smartphone manufacturers.

But when NetEase called ZTE asking about their partnership with NetQin, they responded by saying they have no business relationship with NQ. ZTE claimed that news regarding their partnership with NQ was released solely by NQ without their authorization.

The report goes on to talk about how on September 26, NQ announced preload deals with Huawei, ZTE and Lenovo smartphones (link to referred announcement). However ZTE stated that there were no such business dealings between ZTE and NQ. They have asked NQ repeatedly to delete this news, which now still remains on their website. ZTE is currently in negotiations to have the news taken down.

Another Chinese news report is highly critical of NQ

Another interesting Chinese article we found is one highly questionable of NQ's market share and profitability found on DoNews.com, a Chinese website for tech related news.

The title of the article says that: According to industry experts, NQ does not appear to have any lucrative markets which they can grow under.

The Introduction states: NQ was recently being shorted by Muddy Waters. This isn't the first time they are short a Chinese stock but however this time it is different because many people (in China) actually support shorting the company.

In the beginning of the article there is a quote from an IT administrator which roughly translates to: "When I first heard that NQ Mobile Security had 60% market share in China, as an IT administrator I feel very ashamed since I can't believe I've never heard of this company before. And if 360, Tencent, and Kingsoft are licensing NQ's technology (for their mobile security apps), then they would have to pay NQ a fee."

However 360 which is Qihoo (QIHU), Tencent, and Kingsoft does not license their mobile antivirus technology from NQ. They developed their own. The individual quoted is suggesting that the only way NQ can have 60% market share is if the other popular Chinese mobile antivirus companies licensed NQ's technology.

The article would go on to say that the quote mentioned is what many in China's Internet/Mobile industry are likely thinking. The Netqin and NQ brand is almost only found in stock related news while pretty much no one is actually using the company's software. Even in Zhongguancun, the so called Silicon Valley of China, the majority of the people there can't even describe what kind of company NQ Mobile is.

The middle portion of the article is about Muddy Waters and some of their arguments against NQ, which most are probably already familiar with and doesn't need to be retranslated.

The last portion asks: Is there even a profitable market for mobile antivirus right now in China?

It states that currently 360 (Qihoo) and QQ (Tencent) owns around half of the market share for mobile security apps. Based on data from the 91 Wireless and PeaPod (Wandoujia) app stores, NQ apps only make up around 1% of security application downloads.

This situation is very suspicious. Given the two giants (Qihoo and Tecent) have already cornered the market, how can they (NQ Mobile) continue to grow?

If you ask people today if a paid mobile security market actually exists, no one would really believe it does. First of all, there is actually no real need. Even though you may see some occasional news about mobile viruses, the chances of users encountering them is very low. Second, the current mobile payment system is very immature, therefore even if a market exists (for paid mobile security apps), you cannot charge enough users to achieve profitability.

Chinese Netizens comments on NQ is another major concern

I also asked my Chinese contact to see what were the common reactions from Sina Weibo (Chinese version of Twitter), Xueqiu.com (Chinese version of StockTwits or Seeking Alpha), user comments in news articles, and other platforms. The majority of them would seem to be against NQ Mobile.

One of the most frequent types of reactions we found are those that roughly translate to either "Never heard of Netqin/NQ", "This is the first time I've heard of Netqin/NQ", or "I don't know anyone who uses Netqin/NQ". From those responses it would seem the level of brand recognition for NQ is extremely low in China as the Chinese article just mentioned has stated.

The comments we found from those that seem to have heard of NQ were overwhelmingly negative. A lot of comments simply referred to the NQ company or their apps as "garbage" or "junk". A few of the comments also asked "The company/NetQin is still around?". I am guessing this is in reference to the earlier days of the company when they were making mobile antivirus software for the Nokia Symbian OS and didn't have much competition. We also noticed some comments asking why would anyone pay NQ when they can get mobile antivirus from either 360 (Qihoo) or QQ (Tencent) for free.

We did find some comments that would suggest some have actually used NQ apps. However many of them also weren't very positive either. Quite a few users commented on how hard it was to uninstall NQ's app from their phone. Although some of these users have might purchased a phone that had NQ preloaded, never had any intention of using their app, and were just trying to remove it. We also noticed a few complaints on how NQ stated their product was free but they ended up being charged after using it.

The online reaction to NQ's fraud allegations seems to be in stark contrast to those of New Oriental Education (EDU). When accused of fraud most of the online comments confirmed that individuals have heard of New Oriental's schools or seen their schools. Meanwhile those that have actually taken their courses seemed to have different opinions on their service. But most online reactions did confirm that New Oriental does in fact have a real business.

Conclusion

At this point investors would be wise to steer clear of NQ Mobile even as the company is trying to defend themselves. What NQ is doing now to counter the claims has already been done before by known fraudulent Chinese companies in the past. So far NQ is just using the same playbook as Sino-Forest.

There are much better speculative investments out there whose stock doesn't have the same risk level of being halted, delisted, and ending up completely worthless. Those still holding onto the stock might strongly consider getting out now, especially when shares still have value left.

The majority of comments from online users in China on NQ Mobile are not supportive of the company being legitimate at all. Meanwhile if more negative news reports come out from the Chinese media helping confirm that NQ is suspicious or appears to be conducting fraudulent activities, the stock still has much further to fall.

Source: NQ Mobile Using Sino-Forest Tactics To Delay The Inevitable?