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Summary

-NQ Mobile hoards its cash and chronically underinvests in computers and employees relative to roughly 100 peer software companies.
-Until NQ Mobile raised capital again, they were on track to be one of four instances out of 496 I studied where a company's cash position changed less than 1% over a two-year period. This is suggestive of round tripping.
-Two of the three companies that have done this are Asiainfo Linkage, whose former CFO and Chairman sit on NQ Mobile's board, and Sohu, under CFO, Derek Palaschuk, and Audit Committee member, Thomas Gurnee. These two would again team up at Longtop Financial Technologies in the same roles before it was delisted.
-Asiainfo Link is the billing software provider of all three Chinese mobile carriers and others in Southeast Asia. These are two geographies that are the main source of NQ Mobile's revenue and where Omar Khan has made clearly publicly that he is not involved in.
-NQ Mobile's first two acquisitions (Feiliu and Nationsky) involved the only two sectors that have specific prohibitions or policies regarding variable interest entities (VIEs). It is my belief that they did this to intentionally erode the already dubious enforceability of their VIE agreement in China.
-If their VIE agreement cannot be enforced, the founders are legally entitled to all of NQ Mobile's assets, including the $300 million in the company bank account. This explains why they hoard cash and pay for everything with stock; raised the bond in spite of years of operating expense; and why Muddy Waters was wrong about the cash not existing.

So much about the world has changed since baseball began to be played professionally in the 1870s. Globalization, the introduction of the electric light, and the end of segregation have each contributed to make the world and baseball significantly different today from then, and yet when one compares baseball statistics over the last century, you would hardly see the impact of these events.

Take batting averages, for example. In 1875, the league wide batting average was .254, which is exactly what it was in 1918, 1970, 1988, and very nearly in 2012 (.255) and 2013 (.253) too. The same is true with pitchers' earned run averages (ERAs). The 3.87 ERA pitchers league wide averaged in 2013 is not very different from the 3.66 average in 1872, for example.

While all the changes over the last century have certainly made baseball different, the numbers tell us that the balance between pitching and hitting has never really changed much. In fact, the numbers tell us that in the grand scheme of things, all of these changes have been of little consequence to the larger force that has and always will drive the game, which is competition. As long as the rules of the game do not change a lot, which they haven't in a very significant way, then the competitive balance stays the same and so do the statistics.

The statistics of software companies past and present are actually a lot like baseball ones. Despite dramatic changes in computing power over the past two decades, there has always been an obvious balance between the revenue a software company generates, the number of people they employ and the value of the computer equipment on their balance sheets. The force creating this balance is likely the same as in baseball - competition. Even though computing power has improved dramatically, the rules in the software business have not changed, and competition forces companies across time and geography to continually invest in computers and people to generate their revenue. If they do not, then a competitor certainly will.

To show this, I researched about 75 companies that like NQ Mobile are considered "software application" providers by Yahoo Finance. I also included data on all of these companies over a five-year period from 2008 to 2012, so you can get a complete picture. On top of these software applications companies, I also did research on a number of other public companies that I think are relevant to the discussion, including some from the past like the internet security company McAfee, high growth stories like Netscape, Amazon (NASDAQ:AMZN), and Microsoft (NASDAQ:MSFT) in the 1990s, and roughly 20 publicly traded Chinese software and internet firms. All together there is data on nearly 100 companies from roughly 700 years.

As I will show, NQ Mobile's (NYSE:NQ) relationship to revenue, computer equipment, and its employees are very different than the 100 companies I studied, including ones from two decades ago. Before we get started on the data, I want to explain why the data is so fundamental to understanding how it signals that NQ Mobile is likely dramatically exaggerating its revenue.

How Revenue & Runs Are Generated

In 2013, the Boston Red Sox lead the major leagues in on-base percentage. Did you know who scored the most runs in the majors in 2013? It was the Boston Red Sox. That's because in baseball, you generally must first get on base before you can score a run.

In business, in order to generate revenue, you must first make an investment. Every business is different in the types of investments they make, but the basic relationship is the same. Something the company is investing in is driving their revenue, and you can see it clearly on a company's financial statements if you do just a little bit more legwork.

For example, restaurant chains such as Chipotle (NYSE:CMG) tend to invest in acquiring more real estate in order to generate greater revenue. As you can see below, despite quadrupling their sales from 2008 to 2012, the revenue Chipotle reported moved in tandem with the value of their property leases on their annual reports. Clearly Chipotle grew its revenue by signing more leases to add more locations to be closer to more hungry people. Pretty simple, right?

The investment could also be in employees, which was the case for Groupon (NASDAQ:GRPN). By 2011, Groupon had more than 200 times the revenue they did in 2008, but this did not just happen out because the idea of a daily deal was so great. Groupon had to invest in people by hiring sales personnel to reach a greater number of small businesses, tech personnel to scale their infrastructure, and more copywriters to write about their ever-increasing number of deals. As you can see, the slope of Groupon's revenue and employees are quite similar, and if you took the extra step and calculated it, you would see Groupon's revenue per employee held steadily between $100,000 and $200,000 from 2008 to 2012, despite growing from 37 to nearly 12,000 employees in four years. Clearly, it was people behind the scenes driving and supporting this tremendous revenue growth.

Google (NASDAQ:GOOG), on the other hand, focused on growing through engineering by constantly improving their search engine, buying servers that could crawl more web pages, and building tools to help advertisers self-service their accounts. As you can see below, even while they grew their revenue 23 fold, Google always generated roughly five to six times the revenue as the value of its computer equipment. Google's computer equipment was clearly an important investment sustaining their revenue growth.

What the same company invests in can even change over time. Take Netflix (NASDAQ:NFLX) for example. As the pioneer in DVD-delivery service, Netflix's revenue more than quadrupled between 2003 and 2010, and yet Netflix's revenue per employee held steadily between $400,000 and $500,000 during this entire time. Clearly, as Netflix gained more subscribers, they needed more warehouse personnel to keep up with the ever-increasing number of DVDs they needed to be delivered.

Then suddenly their revenue per employee tripled between 2010 and 2012. How did Netflix support all this revenue growth without hiring additional employees?

Between 2010 and 2012, as consumers began rapidly adopting tablets and digital media players, Netflix wisely changed its business model, evolving into an on-demand streaming media company. Their whole method of delivering content to their customers changed, and they suddenly needed far fewer warehouse personnel and more software engineers. Netflix's investment of capital never actually went away. It just shifted. As you can see below, even though they host their streaming service through Amazon Web Services, Netflix's computer equipment per employee nearly tripled during this time.

Finally, even software monopolies from the 1990s had to follow this fundamental rule. Here is Microsoft's revenue and its computer equipment from 1985, the year they IPO'd, and then from to 1992 to 1999, the year after the Department of Justice filed a lawsuit against them under the Sherman Anti-Trust Act (I could not locate annual reports for the other years). As you can see, despite putting Apple on its deathbed and using its tremendous advantage with Windows to distribute Internet Explorer to kill Netscape, Microsoft always had to invest $1 in computer equipment to generate roughly $8 to $14 in revenue.

The point is that across all types of businesses over all generations, the way companies grow is by making repeatable investments of their cash that either generates or supports revenue growth for the company. I do not care if the company has a well-recognized brand, unique patented technology, network effects from having billions of users, massive scale, or control of the best distribution channel (Microsoft in the 1990s had all of these by the way): every real business is making investments to generate and support their revenue.

For all of the 100 software companies I studied, it is plain to see that this repeatable investment for most is in people and computers. For every extra dollar of revenue a software company earns, there are extra computers or employees that are either generating or supporting it.

NQ Mobile, as you might have guessed, shows no such relationship. In fact, NQ Mobile shows no investment of its capital in anything whatsoever. Not in employees, not in computers, not in marketing, nothing.

As far as their financial statements are concerned, there is nothing driving or supporting their revenue. It just appears.

NQ Mobile's Revenue per Employee and Computer & Why No One Hits .400

Much like how a .400 batting average has been a limit for hitters in baseball for the past 70 years, there appears to be natural constraints to how much revenue a software company can generate without making requisite investments in equipment and people to keep pace.

Consider the following:

  • Only Sohu (NASDAQ:SOHU) from 2001 to 2005, under Chief Financial Officer, Derek Palashuk (2001 till 2003) and audit committee member, Thomas Gurnee, has ever had its revenue per computer grow four-fold in a five-year period.1 In fact, only a handful have ever grown their revenue per computer by more than 100% over five years. In case you didn't know, Derek Palashuk and Thomas Gurnee would team up years later in similar roles at Longtop Financial Technologies, a company that was delisted for lying about its revenue.

From 2008 to 2012 NQ Mobile grew its revenue per computer four fold, and based on NQ Mobile's revenue forecast and capital expenditure for the first three quarters of 2013, I estimate that NQ Mobile is on track to grow its revenue per computer more than six fold from 2009 to 2013.

  • Only Facebook (NASDAQ:FB) from 2008 to 2010 and eLong (NASDAQ:LONG) from 2005 to 2007 (under CFO Derek Palashuk and Audit Committee member, Thomas Gurnee, of course) have managed to grow their revenue per employee by more than 27% for three consecutive years.2

NQ Mobile is on track to do this for four years with 185% (2009-2010), 124% (2009-2010), 39% (2011-2012), and 32% (2012-2013 estimated) revenue per employee growth.

Looking at the statistics, across all kinds of software companies there is an obvious natural competitive constraint that prevents companies from growing leaps and bounds without making additional investments in people and equipment.

I suspect the same reason why Facebook's revenue per employee began to decline in 2012 after its explosive 350% growth from 2007 to 2011 is the same reason why no one has hit .400 since Ted Williams in 1941. In competitive systems such as baseball and software, it gets harder for outliers like Ted Williams and Facebook to get hits and earn revenue over time, not easier. In the case of baseball, this tendency is why 30 players batted above .400 before 1930, but today you see the greatest hitters with batting averages around .350. In the case of software, it is why you always see companies being forced to make equal or greater investments in people and equipment to support growth in their revenue over time.

All of this is true except for NQ Mobile, of course. They have grown their revenue per employee by 817% over the past five years, doubling the growth rate of Microsoft from 1985 to 1998. This was a time when Microsoft had so much operating leverage in their business model they were ordered by the EU and Justice Department to separate their Windows division from the rest of the company, or the business equivalent of the NCAA banning dunking in 1967 to stop Lew Alcindor (ran out of baseball analogies).

Out of all the software applications companies I studied, none generated more revenue per computer than NQ Mobile in 2012 (excluding special cases such as companies that have about 50% or more of their sales from hardware). NQ Mobile is getting even more ridiculous in 2013. Even if we exclude their hardware sales, which admittedly has different economics but make up only 15% of their sales, by my estimates they are still on pace to generate about 20% more in revenue per computer than any other software company did in 2012.

In effect, NQ Mobile is lying about its revenue, or it has discovered the greatest business model ever - one that requires no capital investment, no assumption of risk, not even the headache of having to deal with additional employees, and yet revenue will continue to grow endlessly on a course so predictable that you can forecast it many years in advance (as CEO Henry Lin has done with his "200 million, 500 million, 1 billion" strategy).

Exceptions to the Rules & "Field of Dreams"

Have you ever seen the baseball classic with Kevin Costner, "Field of Dreams"? If you haven't, I'm sure you've at least heard someone mention the line whispered throughout to the main character. "If you build it, they will come." Not only was this a famous line from that movie, but it was also a popular business philosophy during the Dot-Com bubble in the late 1990s.

One of the most famous companies from this era was Webvan. They actually spent $1 billion building out a nationwide warehouse infrastructure for their grocery delivery business before they generated a single dollar of revenue and validated their business concept with consumers. They literally assumed "if they built it, customers would come." Sounds silly today, but a lot of companies flush with cash back then followed similar logic. It did not work out well for Webvan or many other companies.

One company that did survive this unusual time in spite of following the "if you build it they will come" mentality was Netflix. The reason why I bring this up is because Netflix from 1998 to 2002 is one of the only companies I could find that exceeded NQ Mobile's growth in revenue per employee and revenue per computer.

The cause for this distortion was very different than NQ Mobile, of course. Unlike NQ Mobile, which shows very little investment of its capital whatsoever, Netflix grossly overinvested in employees and equipment like other Dot-Coms of that era, such as Webvan and Pets.com. So as they grew their revenue, they did not have to continue investing in computers and employees, since they already had too much.

Netflix (1998)

NQ Mobile (2008)

Computer equipment per employee

$21,652

$1,415

Revenue per computer

$1.34

$11.28

Operating expense per employee

$243,000

$22,870

Revenue per employee

$17,000

$15,000

In the end, what we can learn from this Netflix example is you can chronically overinvest in your business. It is a risky strategy, but it is possible that "if you build it, they will come." What is clear is you cannot chronically underinvest in your business like NQ Mobile. If you chronically underinvest, you're either dead or you're a fraud.

Growth models for businesses

Classic examples

Raise capital --> Invest capital while growing company

Basically every company

Raise capital --> Invest capital --> Grow company into your investments

Netflix, VeriSign (late '90s)

Raise capital --> Invest capital --> Fail to grow company into your investments

Pets.com, Webvan (late '90s)

Raise capital --> Do not invest capital -->Raise more capital

NQ Mobile, Longtop Financial Technologies

NQ Mobile - the Barry Bonds of Software Application Companies

Looking at the list of about 75 software application companies and their computer equipment per employee relative to NQ Mobile, Asiainfo Linkage (NASDAQ:ASIA), and Longtop Financial Technologies' is a lot like comparing Barry Bonds, Sammy Sosa and Mark McGwire's home runs by age to other power hitters'. All look very much like each other, but very different from their peers.

NQ Mobile and Longtop Financial Technologies not only show the lowest computer equipment per employee out of all these companies, but their $3,000 per employee is about 40% less than even the lowest range of all software companies. Asiainfo Linkage shows 50% of the computer equipment of even NQ Mobile. Asiainfo Linkage, if you did not know, is the company whose chairman, James Ding, and former CFO, Ying Han, sit on NQ Mobile's Board of Directors.

Companies that offer security software like NQ Mobile, such as AVG Technologies (NYSE:AVG), Qihoo (NYSE:QIHU), and McAfee (before it was acquired by Intel (NASDAQ:INTC)) showed at a minimum 2.5 times the computer equipment per employee than NQ Mobile does today even when they were much smaller, private companies that relied on third-party data centers.

As far as I can tell, companies that have less than $10,000 in computer equipment per employee either report significant hosting costs under their costs of revenue [Bazaarvoice (NASDAQ:BV)]; are more marketing driven than tech-driven [Rosetta Stone (NYSE:RST)]; show significant expenses to support a large sales team that do not require more equipment than a laptop [Bazaarvoice and Cvent, Inc. (NYSE:CVT)]; or have other specialized equipment showing on their balance sheets [airplane equipment for KEYW Holdings (NASDAQ:KEYW) and aerial photography equipment for AutoNavi Holdings (NASDAQ:AMAP)]. Keep in mind that NQ Mobile shows none of these things in their financial statements and still shows roughly 40% of the computer equipment per employee of the nearest company in 2012 (excluding Asiainfo Linkage).

I don't know how much more clear this can be, but the statistics from this large of a sample size paint a pretty clear picture: people making and maintaining software applications today need significantly more computer equipment than $3,000 per person. It's kind of like how major league ball players don't hit 70 home runs in a season, and 35-year-olds absolutely don't unless they are cheating. There's no rule saying they cannot, but when you look at statistics it sure seems like there is.

Computer equipment / employee

Type of software company

Inflection point

Corrective action taken

Classic examples

$15,000 and up

Invests in computers

Not applicable

None needed

Basically every company

$6,000 to $12,000

Sales & marketing driven

Realizing customers will choose the best product

Invests in computers

Rosetta Stone / Lifelock

$5,000 to $10,000

Pays third-party hosting companies

Realizing third-party hosting is expensive, being able to predict load

Invests in computers

Marketo

$1,500 to $3,000

Does none of the above

Having enough cash to operate for 3 years without any new sales

Raises more capital

NQ Mobile, Longtop Financial Technology

Rounders & Round Tripping - How the Game is Played

Most baseball historians trace the roots of our national pastime back to the favorite game of British school children, rounders. Like baseball, rounders is played with a wooden stick and a leather ball, and the premise is also the same: in order to score the batter must complete a full circuit of the bases without being called out.

Round tripping is a lot like rounders, except it is a favorite game of business executives instead of school children and is played with three bases, not four. The three bases are:

  1. Home - the company's bank account
  2. First base - fake expenses (cooperating vendors / acquisitions)
  3. Second base - fake revenue (cooperating payment processors or customers)

Just like baseball and rounders, the goal of the game is to get the runner [cash] home. You do this by creating fake invoices or acquisitions from companies that are actually cooperating with you, which you pay. These cooperating vendors then send the money you paid them to your payment processor, who in turn, deposits the same money back into your bank account as revenue. The more times you can do this, the more you appear legitimate, the longer the game goes on, and the more you can steal from unsuspecting shareholders by doing things like convertible bond offers and eventually selling your stake in the company.

Since the money that appears to be revenue is actually the company's own cash, one may expect the round tripper's cash position will not increase much of the cash that is paid for "expenses" is what ultimately reappears as "revenue."

Not surprisingly, until NQ Mobile raised money from the convertible bond and Atlantis, they were on track to be one of four instances out of 496 where the cash position of a company I studied had changed less than 1% over a two-year period. Keep in mind this is a company whose revenue is on track to more than quadruple since 2011.

Two of the three companies to nearly achieve this feat are Sohu from 2003 to 2005 under CFO Derek Palaschuk (2003) and Audit Committee Chairman, Thomas Gurnee (2003 to 2005), and Asiainfo Linkage from 2003 to 2005, when NQ Mobile's audit committee chairman was Asiainfo Linkage's Chief Financial Officer and James Ding was its chairman.

Asiainfo Linkage is also the operations and billing software provider of all three Chinese carriers, as well as others throughout Southeast Asia, which one gathers are NQ Mobile's main revenue sources.

Furthermore, China and Southeast Asia are two areas that Omar Khan has publicly distanced himself from when asked about his role with the company. Here is his exact quote from the conference call on October 25 after the Muddy Waters allegations: "I look after the international business from a go-to-market perspective, and that comprises of markets like North America, Latin America, Western Europe, Korea, Japan and others; while Henry looks after many of the -- obviously, our largest single market, which is Greater China, and some of the markets that have similar business dynamics."

So basically Omar Khan looks after the Asian countries where the carriers do not use Asiainfo Linkage products and Henry Lin looks after the ones that do. That makes sense. If and when it is accepted that NQ Mobile is a hoax, can anyone guess what Omar Khan's explanation will be to avoid any legal responsibility for this?

Keeping Score in Round Tripping

In the first section, we were able to conclude that NQ Mobile is likely to be inflating its revenue by comparing their computer equipment, employees, and revenue to peer companies. In the last section, by better understanding how round tripping works and comparing NQ Mobile's cash position to peer companies, we have located one possible mechanism behind their revenue inflation. In this section, we will learn how to keep score in the game of round tripping, and I will show you how I was able to predict NQ Mobile's cash position within 93% of their actual cash balance while pretending their revenue did not exist.

The Basics

Keeping score in round tripping involves attempting to arrive at the cash position of the company by: (1) ignoring things that you suspect are fraudulent, which is in this case both the revenue and the expenses of the company; (2) adjusting for expenses and revenue that you think are likely to be real, such as expenses the company has to pay in order to maintain the façade that it is legitimate; and (3) adjusting for expenses that have no impact on the cash position of the company, such as depreciation and stock-based compensation.

In the case of Chinese companies owned by foreigners through a variable interest entity (VIE) structure, there needs to be a special category of cash generation that should be counted as well. That special category of "revenue" for the company is related to stock sales of collaborators, which can be from both acquisitions and employee option plans. As I will show below, the VIE structure of NQ Mobile makes it such as that NQ Mobile's cash in China is literally the founders'.

Variable Interest Entities (VIEs)

As most NQ Mobile shareholders probably recall, the bank account where all the company's term deposits are located is owned by Beijing NQ Technology, a company 100% owned by NQ Mobile's three founders. NQ Mobile's shareholders do not own Beijing NQ Technology in a strict legal sense, but rather are entitled to its assets and revenue through contractual agreements. The difference between direct ownership and the type of indirect ownership NQ Mobile's shareholders enjoy is not important unless there is a dispute.

For example, if you are a shareholder in a company and the CEO stole all of your company's cash, the police would be informed, and in turn, they could arrest this individual and return it to its legal owners, the shareholders. In NQ Mobile's case, in order to have the cash returned to you, you would first need to sue Beijing NQ Technology and its owners (the three NQ Mobile founders), and then prove in court that you actually own the assets of Beijing NQ Technology through contractual arrangements you made with the company separately.

In theory, this extra step should be nothing more than a nuisance, but in reality, many legal and accounting experts, such as Paul Gillis at Peking University, doubt that Chinese courts will ever uphold variable interest entity agreements in the first place. In fact, China's Supreme People's Court, the highest judicial body in China, recently ruled on a similar issue. In their ruling, they argued that a contractual agreement was used to circumvent restrictions on foreign investments in China and accordingly the contract was unenforceable under Article 52 of the PRC Contract Law, which provides that contracts are invalid where they "conceal illegal intentions within a lawful form." According Morison & Forester, the law firm that represented Apple against Samsung, "the judgment's wording suggests the key fact underlying the ruling was that the parties intentionally breached mandatory regulatory provisions of the Chinese financial industry" as evidence that the purpose of their VIE was to "conceal illegal intentions."

Based on my research, I believe NQ Mobile's founders have knowingly created similar violations of Chinese regulations to undermine the enforceability of their VIE agreements even further. In fact, I believe NQ Mobile's first three large "acquisitions" involved exactly that.

Domain ownership

Anyone that has read through NQ Mobile's annual report thoroughly is probably surprised when they realize that their largest capital expenditure as a public company in 2011 was paying $1.5 million to license NQ.com. Not only would this make NQ.com one of the 25 most expensive domains ever purchased, but they do not even own the domain, which is required of value-added telecommunications providers in China. According to NQ Mobile's own annual report, "value-added telecommunications services operation license holders or their shareholders must directly own the domain names and trademarks used by such license holders in their daily operations." By licensing their domain, they do not directly own their domain, which they disclosed is required of companies in their industry.

(By the way, NQ.com was the most expensive two-letter domain name other than Facebook-related domains, FB.com and IG.com (Instagram), until I was shocked to learn that someone paid $2.5 million for KK.com a few weeks ago. Of course, I later learn that NQ Mobile's is probably behind this as well since KK is the name of their latest acquisition in Japan, NQ Mobile KK.)

Online gaming

In September 2010, the People's Republic of China's (PRC) General Administration of Press and Publication (GAPP) directly prohibited the use of contractual arrangements by foreigners such as VIEs to indirectly control or participate in online gaming businesses.

The difficulty in enforcing VIE agreements with internet gaming companies was a lesson learned by Taiwan-based GigaMedia when the founder of its Chinese subsidiary, T2CN, refused to honor its VIE agreement and took control of over $32 million in the company's assets. GigaMedia ultimately sued T2CN, but the Shanghai Sub-commission of the China International Economic and Trade Arbitration Commission ruled against them, stating that the purpose of the VIE was "to enable [GigaMedia], which did not have online operation qualifications, to participate in the operation of online games in the PRC and to obtain financial returns therefrom." Morrison & Foerster, recently wrote that the "outcome might well have been different if GigaMedia were operating in a different sector" due to GAPP's policy that specifically prohibited VIEs in online gaming businesses.

National economic security

NQ Mobile touts Nationsky as helping to secure the mobile devices of over 1,250 Chinese enterprises in a number of industries such as energy, which, for example, is one of many sectors that China has specifically deemed of importance to its national economic security. Interestingly, in 2011 the State Council of China published Rules on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors. According to the Rules, foreign investors shall not avoid national security review through any means, including through VIE agreements, when they acquire a company that is deemed to be critical to China's national defense and economic security.

The language of what qualifies as "critical to China's national defense and economic security" is broad, but one factor that has been highlighted was the impact of the acquisition on China's "ability to research and develop key technologies for national security." It could easily be said that Nationsky falls under this criteria given their access to trade secrets of more than one thousand Chinese businesses via the mobile devices they manage, and I highly doubt this acquisition was ever reviewed.

The overarching point is once NQ Mobile IPO'd and deposited the $80 million in their bank account, they chose to only acquire companies in the two industries (gaming and security) that have very specific policies towards the use of VIEs. Their other "acquisition" violated a very specific policy relating to value-added telecommunications companies and VIEs (domain name ownership).

Therefore, if and when the founders decide to ignore their VIE agreements, they structured their company in such a way that it will be easier to argue that the purpose of the VIE agreement was primarily to skirt Chinese laws, which would make it unenforceable and give them clear title to all the assets, including the $300 million in cash under Beijing Technology.

This being the case, one can assume that anything deposited into Beijing NQ Technology is literally the founders' cash under Chinese law, not shareholders'. Not only does this explain NQ Mobile's odd hodgepodge of unrelated businesses, but it also explains why the founders are treating the cash as their own by having low cash operating expenses and paying for everything with stock.

Further, knowing that NQ Mobile's founders control the bank account and many doubt a contract based on a VIE structure will ever be upheld by a Chinese court, there is very little risk in the collaborators depositing cash they gain from stock sales (or loans against restricted stock as collateral) in Beijing NQ Technology's account and much to gain as it makes the company appear more legitimate in the eyes of auditors. Again, the longer the round tripping game goes on, the longer NQ Mobile can defraud investors by doing things like convertible bond offers and eventually selling their stake in the company.

Keeping Score in Round Tripping Summary

Revenue or cash you count

Why

Revenue on cash & investments

Auditor verified cash and investments at the bank; money made on this cash is probably real

Cash from fundraising

We know the IPO and convertible bond happened and was real

Cash from stock sales of collaborators and loans against restricted stock in acquisitions (China only)

Bank in China is controlled by three founders; VIE structure unlikely to stand up if founders refuse to honor agreement; collaborators have much to gain and little to lose by depositing money in this account

Proceeds from stock option purchases of employees

The shares sold are likely verified by the auditor

Expenses you count

Payments to employees

Auditor likely verified payroll and tax payments; employees do not want to owe taxes without actually getting paid; unlikely executives included hundreds of employees on the fraud.

Cash you ignore

Revenue from operations

You suspect this is the company's cash as it comes from third-party payment processors affiliated with the company

Expenses you ignore

Payments to companies

It is much easier to get a small number of companies to cooperate with your fraud; possible to have a small number of related people controlling a large number of companies.

Adjustments you make

Depreciation

This is not an actual cash expense to the company

Stock-based compensation

Same as above

Box Scores from NQ Mobile's First 10 Quarters as a Publicly Traded Company

The point of this exercise is not to predict how exactly the round tripping may be occurring, but rather to determine if there is a directional indication that round tripping is actually happening. You do this by comparing the cash balance you obtain using the assumptions from round tripping with the actual cash balance verified by the auditors. One would suspect that the cash balance you obtain from using the round tripping assumptions would be far off from the company's cash balance if they were in fact legitimate. After all, these assumptions ignore the company's operating revenue completely.

In NQ Mobile's case, however, I was able to come within 93% of the reported cash balance by using these simple assumptions for every quarter that NQ Mobile was a publicly traded company. In fact, the many of the quarters I was not within 97% of their cash position using these assumptions were quarters when NQ Mobile reported receiving a large amount of cash proceeds from the sale of stock options from employees. Not knowing who sold their stock and what their options were priced at, I did not include any cash generation into my model, but it is obvious that there was enough stock sold in that quarter and the immediately prior one to account for the 7% difference between my estimated cash balance and NQ Mobile's reported cash balance.

While I do believe NQ Mobile has real revenue and expenses not accounted for in these assumptions, it appears as though NQ Mobile shows a stronger relationship between the growth in cash on its balance sheet from stock grants or sales occurring by Chinese parties in current and prior quarters than from its own revenue.

For example, NQ Mobile's cash position surged in the fourth quarter of 2011 when its shares were unlocked and they reported $1.6 million in proceeds from employees exercising stock options. While until that point, much of their cash generation was related to foreign exchange rates and interest earned on their cash. Additionally, NQ Mobile reported a large increase in their cash balance in the third quarter of 2013 after the Atlantis investment and the acquisition of the remaining 45% of equity in Nationsky.

Furthermore, as you can see in my model below, NQ Mobile's cash expense is not very high once stock-based compensation is excluded, and one can easily see why they are so anal about having every dollar in term deposits, as the interest they are earning is substantial and helps to subsidize their operations without depleting their cash reserves.

If I had one bit of praise towards NQ Mobile's management, it is how they differ from most corporate executives and truly treat the company cash as their own.

View the spreadsheet here.

Concluding Remarks & Joe DiMaggio's Hit Streak

Several years ago a group of mathematicians argued that Joe DiMaggio's famous 56 game hit streak was totally random. They argued that like landing on heads 100 times in a row, at some point a baseball player was bound to have a hit streak as long as DiMaggio's, and it was as likely to be DiMaggio as any other player.

Needless to say, this was quickly debunked by better mathematicians that used DiMaggio's past batting statistics to prove a conclusion that anyone with common sense already knew: it was a testament to DiMaggio's tremendous skill that he was the player to get a hit in 56 consecutive games.

Much like how only a fool would think Joe DiMaggio's hit streak was a complete coincidence, only a fool would believe that the following NQ Mobile distinctions are totally random:

  • Chronically low investment of its capital in computers relative to nearly 100 peers
  • Grows revenue per employee and computer faster than almost any company ever
  • Revenue per employee and computer growth resemble companies associated with Derek Plashuck and Thomas Gurnee
  • Uses a payment processor that is owned by its former Director of Marketing
  • One of its Directors is the chairman of the billing software provider of the major carriers in China and Southeast Asia
  • Their audit committee chairman is the former CFO of this billing software provider as well
  • American management are not associated with either China or Southeast Asia
  • One of the least fluctuations in their cash position of any software company on an annual basis, despite being on pace to quadruple their revenue
  • Two of three companies that have done this are associated with Derek Plashuck and Thomas Gurnee and their audit committee chairman
  • A clearer relationship between a growth in their cash balance and stock sales to Chinese parties than to their own revenue
  • Paid more than anyone in history to license, not own, a domain name, while not owning their domain happens to violate a regulatory requirement of their industry in China for foreign owners
  • Acquired a hodgepodge of unrelated businesses, the two largest of which are the only industries that prohibit or have specific policies towards VIE agreements, which happens to be the basis of their entire corporate legal structure in China
  • A legal structure, if ruled unenforceable, entitles the company's founders to all of its assets held in China, such as the $300 million in its bank account
  • One of the most tight-fisted management teams when it comes to using the cash in the company's bank account
  • A Chinese management team that will face no legal repercussions for any of this whatsoever
  • A division of labor such that the American management team will not either

From here you can either listen to common sense and statistics, or you can put your faith in hedge funds that show you colorful pictures and write nice little anecdotes from their travels abroad. I suspect if you do the latter you will learn the same expensive lesson that GM Billy Beane taught big budget front offices ten years ago: you arrive at the truth faster with a nerd and a spreadsheet than from big shots that fly around the world to see if something "passes the eye test."

Wake up people. None of this is a coincidence.

All of the data is here.

1 My assumptions eliminate years where the company's revenue relative to their computer equipment and employees is clearly unsustainable. This being the case, I eliminated years where companies showed more gross computer equipment than revenue. The only other companies that were eliminated were from the Dot-Com Bubble era, which showed dramatic overinvestment in its computer equipment, which I detail, and ones that had dramatic changes to their business over night (i.e. mergers or selling the software portion of their business).

2 The only data eliminated were years where the company's revenue per employee was less than twice the minimum wage of their country ($3,500 per year in China) and ($15,000 per year in the United States).

Source: Research Report: What Baseball Can Teach Us About NQ Mobile