This report is the second part of a series of refutations to Muddy Waters' ("MW") most recent hit job on NQ Mobile ("NQ", or the "Company") that we plan to publish in order to provide investors a balanced view. The first part can be read here. The third part, which addresses the issue of users (market share), will be released shortly.
As a reminder, our focus is to debunk the core elements of the short thesis, which are summarized below:
- NQ had no cash at the time of its convertible note issue because it reclassified all its cash and equivalents to level 2 in their 2012 20-F filing (We address this in Part 1)
- NQ's payment service provider, Tianjing Yidatong ("YDT"), is a wholly owned off-balance sheet shell used to roundtrip cash and manufacture revenue because YDT's SAIC financials don't tie exactly with NQ's financials when a litany of curious assumptions are taken as true
- NQ can't possibly have the domestic market share it claims because some surveys MW did lead to a different conclusion
- NQ's security software is actually spyware that insecurely sends personal information to the Chinese government. NQ's enterprise, gaming, and advertising businesses, not to speak of its recent innovations such as the popular Music Radar search app and the recently unveiled NQ Live platform, are frauds too (mainly by association, we suppose).
Today, we will address the second of these fallacious allegations.
As we explained, MW has found shorting in an era when the obvious frauds that used reverse mergers no longer abound to be quite discrediting, as this article points out. The author rightfully questions MW's due diligence practices:
"Muddy Waters is in a difficult place now… The situation is made more difficult because Carson Block refuses to go back to China to conduct due diligence because of safety concerns."
No wonder, then, that MW waved the white flag on China shortly thereafter and moved on, again unsuccessfully, to Singapore and even the good old US of A to find targets (OLAM and AMT) before coming back to Chinese ADRs.
Neither willing nor able to conduct proper due diligence on the ground, it appears that MW, even while doing due diligence remotely (oxymoron?), has yet to master the art of Web search. After the retraction of the TV smear campaign to which MW's hit job links, CCTV (China's largest national TV network) aired a highly pro-NQ exposé that MW insinuates does not exist. Alas, it does exist. (NQ is characterized as China's global leader in mobile security with a deep technology and research background. Co-CEO Henry Lin and third parties including independent research firm employees are interviewed.)
Since SAIC filings must be requested in person, another possibility is that MW actually does little to no research directly and instead relies on conspirators with access to China for its due diligence.
Either way, whoever did the financial analysis on YDT managed to one-up the MW balance sheet analysis discussed in Part 1, which we consider quite a feat.
Before exposing the various problems in that analysis, another primer is in order.
I. A Brief Review of Accounting in China
Contrary to popular belief, there is much more similarity today between Chinese and US accounting than there is dissimilarity. The accounting practices and the actual financial statements themselves are about 90% the same since the Chinese government revamped accounting standards to achieve more compliance to the International Financial Reporting Standards (IFRS) a few years ago.
The main differences are political in nature, i.e. administration, disclosure laws, filing requirements, etc.
The MoF, the SAT, and the SAIC
There are three key government bodies relevant to Chinese accounting:
- Ministry of Finance (MoF): the national executive agency that oversees the national budget and administers national economic policy. The MoF is the sole authority that sets accounting standards
- State Administration of Taxation (SAT): a body of over a dozen departments responsible for taxation at the national and regional levels. Think of the SAT as China's tax bureau
- State Administration for Industry and Commerce (SAIC): China's business registration and licensing authority
For accounting purposes, only the MoF (which sets the law and compulsory standards) and the SAT (which enforces tax law) really matter. Dealings between China's more than 50 million registered companies and either of these two state bodies are private, with any records such as financial statements, tax filings, and other similar correspondence sealed and unavailable to anyone but the state, the company in question, and any affiliated third party.
Chinese businesses must file highly accurate audited financials with the SAT every year to pay taxes. This process is not too different from how US companies pay taxes every year. The financials that are submitted are always reviewed and scrutinized to ensure compliance and accuracy. These filings are private and not ever available to the public after submission.
Chinese businesses must also register or renew the various regional/provincial and national licenses required to operate legally in China every year. This process occurs at the SAIC, which also requires the submission of financial information. Unlike SAT filings, SAIC filings are available to random third parties (one can pay the necessary fees for access and request the documents). These SAIC filings are the source of financial information that MW uses to find their smoking gun in YDT's financials.
After analyzing the SAIC filings of YDT and NQ (let's call them "apples") and then attempting to draw conclusions based on comparisons to NQ's SEC filings (let's call them "oranges"), MW alleges fraud.
Apparently, the revenue figures for YDT do not match the business taxes that are owed, and the Accounts Payable on YDT's balance sheet do not match the Accounts Receivable on NQ's balance sheet. Fraud!
But there's a problem: The SAIC filings are not official tax statements or audited financial statements. They are not guaranteed to be accurate and are often merely directional indicators of financial performance. Chinese companies submit financials to the SAIC, which does not even review them, simply storing them away, as a formality, as a sign that they are working with the SAT (where the audited and highly accurate financials are submitted and sealed) to pay taxes.
This article by Benjamin Wey, the Chinese CEO of NY Global Group, explains this dynamic in more detail. Of note, after a lengthy explanation as to why, Wey states:
"SAIC filings have no relevance to the credibility of a company's public filings filed with the SEC."
SAIC filings, for investor due diligence purposes, are NOT guaranteed to be accurate nor should they be exactly accurate. At best, they are only directional indicators of financial performance for the small minority who has an intimate understanding of a particular business and its corporate structure (how many subsidiaries it has, how its financials interconnect across the various subs, which of several accounting standards are used, etc.).
Short sellers digging for financial facts in SAIC filings to discredit the company's SEC filings are merely preying on the general ignorance of the US investor community with regard to Chinese accounting practices.
The term "Chinese GAAP" refers to the Chinese accounting standards issued by the Accounting Regulatory Department of the MoF. There are two main GAAP standards:
- Accounting Standards for Business Enterprises (ASBE), which apply to listed companies, state-owned enterprises (SOEs), financial institutions, and companies that surpass employee count or annual revenue thresholds
- Accounting Standards for Small-Sized Business Enterprises (ASSBE), which apply to smaller, unlisted businesses (such as YDT)
Think of the ASBE as Chinese GAAP for mid- and large-caps and listed companies. The ASSBE is Chinese GAAP for SMEs, i.e. the private "small-caps." When people say "Chinese GAAP", they really mean ASBE, which is the Chinese counterpart of International Financial Reporting Standards (IFRS). The ASSBEs are the counterpart of IFRS for SMEs. The ASBE was issued in 2006 and updated in 2011 to ensure conformity to the IFRS changes.
Compared with the IFRS, the ASBEs are very concise, with several wording differences. However, these wording differences do not mean differences in accounting requirements, because achieving full convergence with the IFRSs was one of the main reasons why the ASBEs were issued in the first place.
As a result, there are almost no differences between annual financial statements prepared under Chinese GAAP and those prepared in compliance with Hong Kong Financial Reporting Standards (HKFRS), which is what HK-listed companies use. There are a few more difference between Chinese and US GAAP, but approximately 90% convergence has been achieved since 2006.
Interestingly, as there are no requirements for recording revenue on a gross or net basis in either HK or the US, no such requirement exists in Chinese GAAP (ASBE or ASSBE) either. None.
And since Chinese companies report financials in Chinese GAAP to the SAT (compulsory) and, as previously noted, also the SAIC, though with much less care and detail, they too have no requirement to record revenue on a gross or net basis. None.
To ensure that we were not misinterpreting Chinese GAAP or tax law in any way, we spoke with various local and international accounting firms (including Big 4 partners) and even had contact through one of our broker relationships with the tax bureau itself about the matter. As expected, we were told on all occasions that there was no requirement to report revenue any specific way, much less on a gross basis. None.
The notion does not even pass the sniff test, really. Why would the tax authority, and much less the SAIC to which financials are submitted as a formality, care how revenue is reported? All they care about is how income is reported, since that is how income tax (hence, the name) is calculated and paid.
What's more, the concept of "gross revenue" as a standard input as defined in the US does not even exist in China. Below is the actual income statement template for the ASBE (Chinese GAAP), translated into English line by line (Chinese courtesy of the MoF, translation courtesy of "International Trends in Financial Reporting Under IFRS"):
As you can see, there is no concept of "Gross Revenue" nor is there the concept of "Gross Profit." In Chinese GAAP, you go from Revenue from Operations (net) right to Profit from Operations, a term we do not even use in US GAAP. The non-operating line items we typically see below Gross Profit in US GAAP are pulled up above what Chinese GAAP calls "Profit from Operations."
Only in MW's fantasy world of imaginary accounting -- a world in which Level 2 classification of cash assets is a huge problem that inevitably leads to fraud and SAIC filings are gospel -- does a company need to report revenue specifically on a gross basis.
In the real world, the SAIC filings of millions of companies will show revenue being recorded on a net basis. The great irony is that NQ itself records revenue on a net basis in its SAIC filings, but MW's accounting all-stars failed to note that as they publish irrelevant links that do not even contain the information they are looking to reference, such as this one, which was the footnoted reference to the claim that YDT is required to report revenue on a gross basis.
The real link, brought to you by the Chinese State Administration of Taxation (they might know a thing or two about how to tax their companies) is this link, which contains the following excerpt (translated):
Section 3, Article 14
Postal and Telecommunications Unit and other units work together to provide users with telecommunication services and other postal services received by the Postal and Telecommunications Unit. The revenue is calculated based on the price to be paid to the carrier minus partner revenue sharing.
Requiring Chinese companies to report gross revenue is like requiring them to report gross profit, which does not exist in Chinese GAAP (but must exist in MW GAAP).
II. The Proper (Non-MW GAAP) Way to Interpret YDT's Financials
Pages and pages of seemingly forensic accounting detail obfuscate the inconvenient reality that the foundation for MW's financial analysis is built on two assumptions that are patently false:
- SAIC filings contain accurate financial statements from which investment conclusions can be definitively made
- Chinese accounting standards mandate that YDT record revenue in the financial statements filed with the SAIC on a gross basis
We have established that neither of these are true, but for the sake of intellectual curiosity, let us analyze what happens when (A) SAIC filings are considered as approximations and not definitive records of financial performance and (B) revenue is recorded the proper non-MW GAAP way.
Revenue and Tax
YDT derives approximately 60% of its revenue from NQ. NQ's revenue in 2012 was $91.8 million. NQ's 2012 20-F annual report states that 22.1% of its revenue was processed through YDT. We also know, per interviews with the management team and various analyst reports, that 8% is a good approximation for YDT's fees (net of the 15% revenue share that China Mobile always gets, similar to how Apple takes 30% of all app store revenue). Per MW's hit job report, we know YDT's 2012 revenue is around $2.9 million and the business tax it paid was around $97,000.
Do these numbers add up? Do the above inputs result in business tax payments of around $97,000? Do the above inputs result in YDT revenue derived from servicing NQ of around 60%, as NQ management has claimed in the past?
See for yourself:
Accounts Receivable and Payable
Another interesting observation from the MW accounting all-stars is that NQ's AR from YDT of ~$9.3 million and YDT's AP to NQ of ~$3.7 million point to fraud, because they don't match. How can NQ expect to receive $9.3 million when all YDT will pay is $3.7 million?
A balance sheet is a recording of a moment in time. Unlike the other financial statements that record a time continuum, the balance sheet is a snapshot and is therefore liable to change with the vagaries of the business in question a week or a month or a quarter or even a day later. But let's assume that the balance sheet that MW references is roughly what YDT's balance sheet looks like year-round, give or take.
If we make that assumption, that $3.7 million is roughly the average AP on YDT's balance sheet for the period in question, then we must also assume the same for the corresponding $9.3 million of AR on NQ's balance sheet. That's an AP/AR ratio of 0.4, which, at first blush, might mean… wait for it… fraud?
Consider the following assumptions:
- The average paying security software user pays 5 RMB/month
- When the user pays, a 5 RMB charge will show up on his China Mobile monthly phone bill
- The 5 RMB is split as follows in order of payment: 15% to China Mobile, 8% of the remaining 85% (6.8%) to the payment service provider YDT, and finally 92% of the 85% (78.2%) to NQ, who gets paid last. The revenue share split across the value chain is 15%/6.8%/78.2%
- We know from interviews of Xu Rong, the YDT CEO, that between 80-90% of YDT's payment processing is for domestic users and the rest is international
- We know from interviews of co-CEO Omar Khan that NQ's DSOs are mainly a problem of international collection from emerging markets with underdeveloped (read, slow) payment protocols, and that sometimes these DSOs can hit the high 100s and almost 200
- We know from interviewing various players in the industry that average DSOs to the content provider ("CP", or in this case, NQ) in China are around 100, give or take, when the AR clock starts ticking as soon as a purchase is made
- For the sake of simplicity, let's assume the user buys the subscription on the first of the month. China Mobile will get paid in 30 days when the user pays his monthly bill. As is standard in the SP industry, about 60 days later, China Mobile will pay the SP (YDT). And as MW correctly points out, the contract between NQ and YDT calls for 30-day payment to NQ
As any good analyst would do, let us follow the cash.
We summarized the above assumptions in the table below, which walks through how each player in the value chain sees their AR, AP, and cash from one single 5 RMB purchase balance out every 30 days- first China Mobile, who gets paid in 30 days, then YDT 60 days later, and finally our fraudulent friends at NQ 30 days later. The total cycle depicted is 90-100 days end to end, but in real life, there is likely to be variance of +/- 10 days or so to this illustrative cash cycle. Remember, this is the cash cycle for a single payment from a single user (in reality, thousands of these cycles occur contemporaneously). Navigate left to right, top to bottom, to understand how the cash moves across the value chain.
Following the cash:
- Everyone records AR when the user transacts on Day 1
- CM gets paid its share of revenue first on Day 30. The remainder of the cash turns to AP on the CM balance sheet. Nothing changes for YDT and NQ; both still wait for payment
- On Day 60, CM pays YDT. YDT recognizes its share of revenue and records AP on its balance sheet. Still nothing changes for NQ, awaiting payment.
- Finally, on Day 90, NQ's AR goes away along with YDT's AP as payment is settled end to end.
Here is the punch line: In the long run, at any given point in time, on average, NQ's AR will be 3x greater than YDT's AP, with an AP/AR ratio of ~33%.
While 33% is not exactly 40%, as we noted, multiple factors could explain the difference:
- The balance sheet is a snapshot in time. As many orders are processed contemporaneously, it is likely that there will be some fluctuation in this ratio over time
- Our illustrative model assumed 100% revenue from China Mobile. We know that NQ's relatively high DSOs are largely due to legacy international deals where collection times are slower. In reality, YDT processes at least 10% internationally, likely more, which might lengthen its AP and bring the ratio closer to 40%
- Our illustrative model assumed an ideal world in which every actor behaves as per the contracted times. In reality, there will be slippage now and then, which could add to fluctuations in the ratio
- Importantly, some of the most important data for this analysis comes from an SAIC filing, which, we've noted is not necessarily accurate and likely more of a directional guide than an exact match to, say, an SAT or SEC filing
Fraud (per MW GAAP), or a simple case of cash versus accrual accounting? You decide.
If nothing else, let us at least agree that MW's accounting all-stars were a little "sloppy" once again when claiming that an AR/AP mismatch meant fraud, not to speak of the fact that they completely forgot to consider the overall cash cycle when claiming fraud due to the "impossibly" high DSOs relative to the 30-day NQ/YDT payment terms.
III. Band of Thieves or Birds of a Feather?
Much has been made of the cozy relationship between YDT CEO Rong Xu and members of NQ's team.
The Company addresses most of MW's more pedestrian allegations in this presentation released yesterday, e.g. explanation of "ghost addresses" (used for business registration in regions where operations are not physically required), not finding YDT as an option on 17 prepaid SIM cards (rationale and photographic evidence provided), availability of less costly payment methods (not if you include cost of building billing services), etc. We were satisfied with their responses but encourage readers to draw their own conclusions after reading the presentation.
We would be remiss not to touch on two other topics related to YDT: the ~$5 million of interest-free loans provided by NQ to YDT from 2007-2011 and the fact that YDT CEO Rong Xu shares equity ownership of three companies (NQ, H9, and Jingxiu) with NQ co-founder Xu Zhou.
Incubating a Competitive Advantage
The first point to note with regard to the ~$5 million of interest-free loans provided over a 4-5 year period is that it was all paid back several years ago just before the Company's IPO, and therefore, the arrangement was heavily scrutinized in various pre-IPO audits before NQ was listed. Interestingly, the lead banker on the IPO, who we imagine was quite involved in the auditing, is now the new CFO of the Company. Although the shorts surely won't care, perhaps objective readers might find those facts, along with the long list of subsequent successful audits (we listed them in Part 1) as sufficient validation to consider possibilities other than fraud.
One such possibility is that NQ might have felt that having a strong relationship with the most critical third party in its business (the one who settles payments) was a good idea. $5 million is certainly nothing to sneeze at, but disbursed at the average rate of about $1 million per year, those loans would have required serious rapid-fire roundtripping to manufacture meaningful revenue NQ generated over the past few years.
But what if they were actually used as intended, to help ramp a growing business? Given NQ's growth, it is not hard to believe that YDT might have grown nicely too, enough to pay back the loans over a five-year period and establish itself with other customers. Maybe some of the shared infrastructure (email server, office space, etc.) to support YDT through its expansion period helped along the way. After all, an SP is not a capital- or people-intensive business to operate.
The upshot of that scenario would be that NQ paid a very cheap price to establish a strong service history and partnership with its top service provider which provides service at an 8% rate net of China Mobile fees (other SPs charge significantly more, such as Union Mobilepay, ~20%).
Is this scenario really that implausible? At least in the hedge fund industry, it is the norm and practically best practice. The standard fund seeding arrangement involves taking a modest investment from a sponsor, often getting some office space and shared infrastructure, in exchange for preferential and most-favored-nation treatment with service and performance fees once a business is established. The famous Tiger Cubs and too many others to name all got started this way.
Related Party Equity Ownership
We do not understand the huge concern over the fact that former senior colleagues invested together twice. Perhaps our Silicon Valley professional roots bias us to the positive on this dynamic, but what exactly is the problem behind investing together in unrelated businesses and even in each other after working together at a company? Doesn't this happen all the time?
In Silicon Valley, some of the most successful entrepreneurs and investors operate exactly this way, sharing investment opportunities within a circle of colleagues, investing in each other's ventures, and generally supporting each other. Are Peter Thiel, Reid Hoffman and the rest of the Paypal Mafia all frauds too?
There aren't any successful Internet franchise businesses we can think of that don't have at least some history of related party transactions of some sort. Amazon co-founder and SVP Jeff Holden took an investment from his co-founder and CEO Jeff Bezos when he left Amazon (AMZN) to found Pelago, which was subsequently acquired by Groupon. More recently, several Facebook (FB) stakeholders (CTO Adam D'Angelo and VC Marc Andreesen) invested in Instagram, only to have Facebook acquire Instagram shortly thereafter. Was that a fraudulent transaction?
This type of activity is quite prevalent in China's technology sector as well. Baidu (BIDU) invested in soon-to-go-public Qunar (QUNR), a private business in which investors and directors of Baidu had equity stakes. Online travel leader Ctrip.com (CTRP) has invested in multiple businesses in which CTRP's own founders or other executives had personal stakes, e.g. Home Inn (HMIN), China Lodging Group (HTHT), BTG-Jianguo Hotel and Resorts, etc.
It is hard to take seriously any allegations of fraud that are not backed by irrefutable evidence. At least in the case of YDT, if not NQ altogether, not one such piece of hard evidence has surfaced. We certainly do not consider the minimal equity stakes that Xu Zhou has in Rong Xu's businesses to be evidence of anything but mutual respect.
Additional disclosure: Refer here: www.toroip.com/disclaimer-nq.html