NQ Mobile (NYSE:NQ) and Longtop Financial Technologies share quite a lot in common. Both were listed on the New York Stock Exchange after going through a traditional IPO process, not a reverse merger like most delisted Chinese stocks. Each also had one of the Big Four as their auditor. In Longtop Financial Technologies' case, their auditor was Deloitte Touche, while NQ Mobile's auditor is PricewaterhouseCooper. Both Longtop Financial Technologies and NQ Mobile had secondary and convertible bond offerings underwritten by Morgan Stanley (NYSE:MS) and Deutsche Bank AG (NYSE:DB) after their IPOs. Further, once they were accused of fraud, some sell-side analysts quickly defended each company. On October 28, 2013, Macquarie argued that "weakness represented a rare opportunity" for investors to buy shares of NQ Mobile. Similarly, a mere two weeks before trading of Longtop Financial Technologies' shares was halted, Carol Wang of Morgan Stanley wrote: "We believe market misconceptions provide a good entry point for long-term investors."
Perhaps the most important quality they share, however, is the fact both NQ Mobile and Longtop Financial Technologies are software companies, not forestry companies (Sino-Forest), outdoor advertising firms (Chinese MediaExpress and Focus Media), or other targets of short-sellers. This is important because software companies tend to share distinctive traits, and one might expect that if NQ Mobile is in fact a fraud, it would share similar characteristics with Longtop Financial Technologies.
What we can learn from Longtop Financial
I have spent a significant amount of time comparing NQ Mobile's financial statements to other Chinese software companies' as well as to Longtop Financial's. In doing this, I found three key ways NQ Mobile's financials strongly resemble Longtop Financial Technologies', but are very different from legitimate Chinese software companies. I have also identified one key difference between NQ Mobile's financials and Longtop Financial Technologies' and what this difference tells us about the nature of the fraud that is possibly being perpetrated.
(1) Fast-growing software companies with proprietary technology have high capital expenditures buying computer equipment, network infrastructure, servers, and the like. NQ Mobile does not and neither did Longtop Financial Technologies.
Despite growing 125% year over year, NQ Mobile spent a mere $2.3 million on capital expenditures in 2012 for servers and equipment to service their 100 million monthly active users. Similarly, Longtop Financial Technologies grew 60% year over year in 2010 and yet by my estimates spent just $3 million on capital expenditures related to equipment. Qihoo 360 Technology (NYSE:QIHU), which happens to be a Chinese mobile internet security company like NQ Mobile, made nearly 60 times the capital expenditures of NQ Mobile in 2012, despite having just four times the number of users.
|Revenue growth rate (y/y)||59.40%||125%||96%||9.60%||25%||53.50%|
Maybe NQ Mobile made a lot of capital expenditures in the past? Nope. NQ Mobile shows just $2.3 million in gross computer and electronics equipment on their balance sheet. For reference, Qihoo 360 Technology shows 40 times as much computer equipment on their balance sheet. Not surprisingly, Longtop Financial Technologies also had very little computer equipment showing on its balance sheet relative to other software companies, and both NQ Mobile and Longtop Financial Technologies show gross computer equipment amounting to roughly $3,000 - $3,700 per employee. The software companies in China I studied, on the other hand, are showing between $18,000 and $38,000 per employee. As you can see, despite the fact that NQ Mobile is supposedly adding tens of millions of users each quarter, there is no evidence of them actually scaling their technology infrastructure. This was a point that could have tipped off more investors that Longtop Financial Technologies was a fraud as well.
|Gross computer equipment||$13,022||$2,335||$81,023||$174,132||$179,188||$798,200|
|Gross computer equipment per employee||$3,058.24||$3,730.03||$25,575.44||$27,208.13||$18,509.24||
(2) Fast-growing software companies that are iterating and developing new technologies spend a lot on engineers (the research and product development lines on their income statement) not executives (general and administration). NQ Mobile, however, devotes nearly four times as much operating expense to administration than to research and product development.
|% of operating expense||Longtop||NQ||Qihoo||Sina||Sohu||Baidu|
|Selling & marketing||0.24||0.27||0.23||0.49||0.46||0.38|
|General & administration||0.16||0.58||0.14||0.14||0.16||0.14|
|Research & development||0.09||0.08||0.31||0.19||0.19||0.24|
Qihoo 360 Technology, for example, basically did the exact opposite in 2012, devoting four times as much operating expense to research and product development than to administration. Interestingly, Longtop Financial Technologies spent roughly 61% of its operating expense on software research development in 2010.
In order to understand why Longtop Financial Technologies resembles a legitimate software company in this case while NQ does not, we must first understand the nature of the alleged fraud. In Longtop Financial Technologies' case, we know they cooperated with (1) the local bank branch that falsified bank statements to their auditors and (2) the human resources company that Longtop Financial Technologies supposedly hired staff from but that their executives actually controlled. This being the case, it makes sense that Longtop Financial Technologies would be able to fake its payroll records and bank statements in order to make their expenses appear more like legitimate software companies.
In NQ Mobile's case, they allegedly control the payment processor, Yidatong, and therefore, can control the revenue that appears on their bank statements, but not the expenses like Longtop Financial Technologies. Also unlike Longtop Financial Technologies, they are not cooperating with a human resources company and therefore, would not be able to falsify their payroll records to auditors. Consequently, it makes sense that NQ Mobile shows just one-fourth of the relative product and research development expense of Qihoo 360 Technology while Longtop Financial Technologies does not.
(3) One warning sign that could have tipped off investors that Longtop Financial Technologies' revenue was bogus was how much they compensated employees through stock, not cash. The same is true with NQ Mobile.
|Longtop 2009||NQ 2012||Qihoo 2012||Sina 2008||Sohu 2001||Baidu 2006|
|Total operating expense||$25,492||$63,757||$248,742||$144,671||$48,846||$42,218|
|Actual operating expense||$50,492||$63,757||$248,742||$144,671||$48,846||$42,218|
|Actual share compensation||$30,600||$24,543||$50,607||$14,300||$63||$6,186|
|Share-based compensation %||0.6060366||0.384945967||0.203451769||0.098844965||0.001289768||0.146525179|
Stock-based compensation is expected to be high for companies that are in their second year as a publicly traded company such as NQ. That said, NQ Mobile still paid 2 to 4 times more in stock-based compensation relative to its operating expense in 2012 than other Chinese software firms during their second year.
Longtop Financial Technologies' case again was different than NQ's in that the Chairman gave away roughly $100 million of stock he owned as "gifts" to his employees from 2007 to 2010, so it was not considered an operating expense on their income statement. However, if these "gifts" were included as stock-based compensation (as they should have been) and spread out evenly over those four years, Longtop would have paid roughly three to six times more in stock compensation in their second year than similar firms. In their third and final year on the New York Stock Exchange, Longtop Financial Technologies paid 45% of their operating expense as stock-based compensation, which again was unusually high. Likewise, NQ Mobile is on track to spend nearly 45% of their operating expense on stock-based compensation in year three as a public company. For reference, Qihoo 360 Technology, which is also in its third year as a publicly-traded company, shows just 16% of operating expense as stock-based compensation year to date.
|Longtop 2010||NQ YTD||QIHU YTD|
|Total operating expense||$89,048||$47,515||$186,414|
|Actual operating expense||$114,048||$47,515||$186,414|
|Actual share compensation||$45,100||$20,526||$29,929|
|Share-based compensation %||0.395447531||0.431989898||0.160551246|
(4) Another warning sign that Longtop Financial Technologies may not have been generating the revenue they claimed was when they did a $100 million secondary offering despite having enough cash, cash equivalents, and receivables in their last annual report to operate for more than three years even if they never generated another dollar in revenue. The same is almost true with NQ Mobile.
|Total cash available||$268,619||$182,511||$406,339||$848,849||$1,097,974||$5,478,784|
|Years could operate without new revenue||3.42||2.76||1.06||2.47||1.75||4.67|
At the beginning of 2013, NQ Mobile had enough cash to stop taking any new business and continue operating for 2 years and 9 months, and yet just 9 months later they opted to raise $150 million through a convertible bond offer. To give you an idea how unusual this is, the only other Chinese software company that could operate on its cash and receivables for as long as NQ Mobile is Baidu (NASDAQ:BIDU). Not only would it be preposterous for Baidu to raise additional capital right now, but they are also visibly overpaying to acquire other tech companies just to use the cash they have, such as when they spent $1.9 billion to acquire 91 Wireless.
In NQ Mobile's case, not only is it strange that a cash-rich company would seek out a convertible bond offering, but it is even stranger that an early stage, high growth company cannot find ways to spend its cash (until you realize they have no capital expenditures and invest minimally in research and product development).
Putting it all together
In sum, if NQ Mobile was in fact a rapidly scaling technology company with hundreds of millions of users, there should be evidence of this fact in its financial statements. Instead, we see very little capital expenditures, computer equipment, and minimal resources being devoted to product development. In light of the fact that NQ Mobile's user base is possibly exaggerated, it would come as no surprise to see NQ Mobile subsidizing a great deal of its operations through stock-based compensation and even raising capital through a convertible bond offer despite having relative capital resources beyond every software company I've studied in China other than Baidu. After all, this is almost the exact same story that played out with Longtop Financial Technologies.
NQ Mobile's management is framing this argument around whether or not the cash on their balance sheet exists, and I am confident it exists because qualified auditors such as PricewaterhouseCooper have learned their lessons from the Longtop Financial Technologies debacle.
The key point in all of this is, unlike Longtop Financial Technologies, NQ Mobile may control its revenue through payment processors, and therefore, unless NQ Mobile's users are validated through an audit of Yidatong, the only value an investor in NQ Mobile can trust is the cash on its balance sheet (less the $166 million it owes its bondholders). Because as far as its financial statements are concerned, NQ Mobile's revenue source looks as likely to be from a Los Pollos Hermanos fast food chain in New Mexico as it does from a software company in China.
Clearly the financial statements say the number of users is exaggerated, as do independent third-parties such as Alexa, the web traffic statistics company, which shows that 20% of all visitors to NQ.com go to the investor relations page, making it the most visited page on NQ Mobile's website other than its homepage. None of this is normal for a company that supposedly has hundreds of millions of users and is growing like gangbusters.
I wish it wasn't true, but the fact remains: nothing makes sense about NQ Mobile. Until it does, it is my belief that NQ Mobile is a resignation away, whether it is an executive or an auditor, from being halted.
(I do wonder whether PriceWaterhouseCooper was already suspicious of NQ Mobile's financials in light of the fact that in 2012 they had the highest auditor costs of any software company in China that I've studied. Given the strong correlation between auditing costs and revenue, it is unusual that NQ Mobile has higher auditing costs even than Baidu, a company nearly 40 times its size.)
Note: Special thanks to John Hempton of Bronte Capital, whose blog posts on the lessons of Longtop Financial Technologies, a Chinese company that was delisted by the SEC in June of 2011, taught me a lot about this subject and ultimately prevented me from making the costly mistake of going long in Mobile. I hope I can be of some service to others as he was to me.
Disclosure: I was long NQ at one point, but am now short after doing more due diligence. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.