Bud Fox: Why do you need to wreck this company?
Gordon Gekko: Because it's WRECKABLE, all right.
-Wall Street, 1987
Let me preface this post by stating I have no position either way in NQ Mobile (NQ). My interest here is that of a neutral observer who has been sucked into this controversy simply because a couple of people on my distribution list happen to be long the stock, and have gotten me to take a look at it. Here are my thoughts:
I tried to approach this as an objective individual, so I decided to go back through the last 3 NQ Conference Calls before even reading the Muddy Water's report in full. The big takeaway from listening to these calls is I had a very hard time quickly understanding just exactly what it is that NQ actually does. No big deal until you consider the fact that I have been following all kinds of tech stocks in every niche conceivable all the way back to the late 90s. This is a red flag for me. Now, after some time I figured it out, but grasping just what its competitive edge is and how it books revenue is still rather murky for me. That aside, the bigger concern for me listening to the calls was the lingo and tone of management. I have gotten very good at assessing promoters and basically management teams that are quite adept at adopting the relevant lingo for selling a story.
Take these quotes for example:
"We are a mobile Internet platform company today. We're one of the world's leading user acquisition engines." NQ, Dr Henry Lin
"We are building the company for the next 100 years." NQ, Omar Khan
Mobile platform, 100-year visions, user acquisition engine, and anything else you can think of to associate yourself with what is hot in the market is a standard red flag for me. And tone wise to be clear, I don't trust these guys. (I'm not a polygraph, but I have listened to enough calls over the years to know what to worry about). Which brings me to the MW-related conference call, and the subsequent Omar Khan appearances on Bloomberg. As far as the CC, I found Omar Khan's inability or reluctance to answer questions regarding customers as very telling. Basically, he either doesn't know the business well or does know and is choosing not to go on record. In either case, the conclusions to be drawn are not good. I also felt this type of evasiveness carried over onto his Bloomberg interviews as he continually seemed to skirt providing a very direct response to specific questions, despite categorically denying all allegations.
So, before even getting into the Muddy Waters allegations, I can point blank tell you that I would never be long this company. The company strikes me as fast adopters of what it believes the equity market will reward versus the type of people who slowly and gradually want to build a high-quality business. Rich in hype and poor in substance is the way I describe this. But at the end of the day, there is no denying that this can be very rewarding for shareholders who hop on board at the right time. Problem is you need to know when to get off because management that works this way is making moves to extract value in a window of 12 months and even less at times versus the '100 years' they are talking about.
Muddy Waters' Allegations
I have read this 81 page report twice, and I have over the years read most everything MW has put out. I also have had a few email exchanges with Carson Block in a previous role as a Strategist/Prop trader. I will say I found him to be quite a straight-forward guy who prides himself on doing his homework, and who enjoys the challenge of going after 'suspect' business models in China. That being said, if I had to handicap this, the odds of uncovering two massive billion dollar plus frauds in the span of a few years are ridiculously low. My initial inclination was that he had found a very 'weak foundation' business run by reckless though not necessarily fraudulent people. However, at this juncture, it would appear that is all that matters. Here are my quick thoughts on a few of the issues raised by MW...
Level II Cash- This was the first and potentially most serious allegation. It caused a storm, and now seems to be resolved in NQ's favor. My view, which I shared with two different people who seemed to be relieved that the cash existed, is this is a major red flag. NQ trying to compare themselves to BIDU and SINA is in my humble opinion simply laughable. Neither of them hold 100% of cash as level 2, and they are about as rock solid as it gets in the public China tech space. NQ is pitching itself as a 'rapidly evolving growth story in the mobile world', and thus should be as risk averse as possible when it comes to its cash. Add in the DSO issue as far as collecting revenue from carriers, and you would think working capital wise, these guys would want to leave themselves a significant cushion. Is the fact that it can prove it has liquidity a good thing? Or should you be instead asking yourself how did I end up in a company whose liquidity/cash management could so easily be called into question? My take is that no matter what happens (transfers are all well and good, but I still am not satisfied with the fact that they simply have not told us what they were holding) this is another clear sign of a reckless management team. Maybe they are in some exotic high paying interest instrument. Maybe someone got a nice commission to park all their cash in something which they know isn't as liquid as they need it to be. Or maybe they simply are greedy and want a higher yielding instrument because they have little regard for risk and how to build a solid foundation. Whatever the answer, MW managed to sniff something out that should worry any long investor. And if this is not a fraud, they just did all longs a favor by forcing this management team to become more prudent. You should be thanking them! Meanwhile, the underwriters of the convert and analysts recommending this stock seem to have completely overlooked this.
Ghost Offices- Yidatong's hard to find offices are much like the conference calls I listened to. Not exactly conclusive evidence of anything, but clearly another sign of a 'weak foundation' business. It appears it has an office somewhere, but that it prefers it remains low key. Read into that what you will, but 100-year enterprises should not have this issue.
Yidatong and Xu Rong- While the explanations would seem to suffice, you have to be a fool to completely dismiss this. Xu Rong going from an employee to 75% owner of NQ's most important customer is straight up bizarre. Did she win the lotto? Going from employee to Angel/Entrepreneur overnight needs some explanation. Furthermore, there is not a lawyer on the planet who could not make a related party's case stick here. Again nothing conclusive, but more evidence of a 'weak foundation'.
The Security Product is a Liability- MW hired engineers to test the product, and this was at the end of the day what I was most interested in as far as the veracity of its report. In my humble opinion, calling into question the reliability of NQ's main source of revenue might end up being MW's greatest discovery in this whole saga. Because all other things aside, the company's partners will want to distance themselves from a security product that actually makes your phone less secure (and press reports in China would indicate they are doing exactly that). And that would be a stake in NQ's heart. If MW's made this up, it would be highly libelous and this whole thing would be over in two seconds. Yet, over the weekend we got this, courtesy of Bloomberg....
"In terms of the data it collects and sends back to the vendor, that's not atypical, because antivirus apps need to collect a lot of data to protect the phone," said Thomas Cannon, director of research and development at Oak Park, Illinois-based ViaForensics. "The concern is the security is very poor. You wouldn't expect that in a security application."
This is a 3rd party commissioned report. This is very embarrassing for any major carrier doing pre-installs, and if not refuted soon, a potential death knell for NQ's security business. So, again more information that is not conclusive, but at the same time evidentiary of a very weak foundation business.
Other Red Flags that Jumped Out at Me:
1) Stock Buyback Knee Jerk Move- There is nothing that gets me more confident about shorting a momentum tech stock than a buyback announcement at the first sign of trouble. NQ is not trading at multi-year lows. It is simply back where it was several months ago. It has no business buying back stock, especially if the management team truly believes they are building a '100 year enterprise'. If a company that just stumbled into its business model growth engine for infinity and beyond can think of nothing better to do with its cash than to use it for a stock buyback, I would run and not walk towards the exit.
See, you know who buys back stock at the first sign of trouble in small cap tech land? Promoters looking to cash out quick who know nothing better to do than use a headline move that they expect to quiet skeptics. Simply stating, "we have better uses for our cash at this stage in our life-cycle, and despite the current correction in the stock believe a buyback would simply not be the prudent move to make," would have been more consistent with their purported and loudly stated future vision for the business.
2) NQ is a Value Growth Stock- Nothing scares me more than a growth tech stock that is priced as a value play. If you believe the hype, this thing was dirt cheap at $26 let alone $12. In fact, it always looks dirt cheap. The problem I have with this is I have had countless disaster experiences with cheap growth value screened stocks in tech. They either end up having accounting issues, a customer concentration problem, a weak business model, or some sort of capital structure issues that are about to imminently be solved. Reality is good growth rarely if ever looks cheap, especially on EPS/EV/EBITDA metrics. Stumbling into such a stock via a 'magic formula' often ends up being a forgettable experience.
3) Wedge Partners/NQ- Three people have forwarded me Wedge Partners' rather bullish research on NQ both pre and post MW report. So, I took a look at them just to understand who they are and why they are covering it. And what I discovered after a simple "wedge partners/nq mobile" Google search is that the former CIO WP Asset Mgmt (a Colorado based RIA) and former president of their research department was hired by NQ to head their Capital Markets team in June.
Here is the PR:
"As we stated on our last quarterly conference call, creating shareholder value is one of NQ Mobile's top priorities," said Co-Chief Executive Officer Omar Khan. "The appointment of Mr. Mathison to the role of vice president overseeing all of NQ Mobile's capital market efforts is a pivotal step in fundamentally changing the way we ultimately deliver shareholder returns."
Mr. Mathison will begin in this role effective immediately and will be based in the company's Dallas, Texas headquarters.
"Mr. Mathison is uniquely positioned to help NQ Mobile achieve our vision and strategy to be recognized by the marketplace as one of the leading mobile Internet platform companies globally," said Co-Chief Executive Officer and Founder Dr. Henry Lin.
Prior to joining NQ Mobile, Mr. Mathison acted as Portfolio Manager and CIO of WP Asset Management. He was President of Wedge Partners, a global TMT-focused research firm with extensive reach in Mainland China and Asia. Prior to leading Wedge Partners, Mr. Mathison worked in the equities division of Goldman Sachs in San Francisco.
"I am thrilled to be joining the incredible team at NQ Mobile. The company is firing on all cylinders fundamentally as a mobile Internet platform business on a global scale," said Matt Mathison. "I look forward to helping this tremendous team match the fundamental execution equally with the capital markets and ultimately by delivering superior shareholder returns."
Again, not conclusive of anything, but at the same time quite hard to ignore the potential perceived conflict of interests given everything else that is going on here.
Whether this is a fraud or not remains to be seen, but there are definitely better places to be if you want quality growth stories. I personally am not short because I have had enough bad experiences over the years shorting small cap stocks. I also think that an optimist could attribute a lot of what is going on here to the fact that China is simply like the Wild West at this point. Basically, aesthetics are not a priority, and at times things will look messy. If you want amazing returns, you are going to have to be willing to get your hands a little dirty. But all that aside, if I had uncovered everything MW found, shorting this stock would not have been a difficult decision. And considering the tone of this piece, the only precedent really is Sino Forest, so Carson Block has pretty much staked his entire firm and his reputation on this report. He is basically all in here, which would have me very concerned if I was on the other side of the trade.
As for what to focus on long term, NQ needs to conclusively shoot down the evidence that seems to indicate its security product is a security liability. If it can't do this, no matter what you believe about fraud or not here, MW has effectively wrecked/exposed a key part of its business model. Without clearly dispelling this, the case against NQ will always have teeth.