Acquisition Is Bad Medicine for VisionChina Media

Includes: FMCN, VISN
by: Chimin Sang

VisionChina Media (NASDAQ:VISN), a Chinese city bus TV operator, lopped off 38% of its market cap with huge volume on Wednesday after it delivered a poor forecast of 2010 Q1 performance. The company expected to make 22 million USD plus in revenue, compared to The Street consensus of 38.2 million.

The management cited three causes.

1) Pricing increase in the traditional TV channel stole away budgets from advertisers for the spring festival.
2) Revenue loss due to earn-out ends for its acquired distributors.
3) Revenue loss due to integration with DMG, a newly acquired unit.

The reason number one is a one-time effect, which is believable since traditional TV and VisionChina probably share the same budget with advertisers. It is the reason number two and three that scared away the investors.

They all come down to one issue: acquisition. It is a double-edged sword for China's New Media companies. It is acquisition that drove the stock price of Focus Media (NASDAQ:FMCN), an outdoor media operator and leading New Media company, from adjusted $10 in 2005 to $70 in 2007 and then all the way back to $6 in 2008 before it climbed up to $15 as of Wednesday. Now the story is being played again with VisionChina Media as the hero.

Focus Media first employed massive acquisitions to boost its revenue and earnings. In doing so, it typically offers two valuations to the acquired target -- a lower one for the initial acquisition and a higher one if the target crosses a certain performance threshold, typically net income. VisionChina copied the formula of Focus Media.

On the surface, it looks like a perfect solution. The target enjoys the higher valuation if it delivers, and the acquirer is also happy because it is buying with a lower multiple than the Street offers.

However, in practice, we have seen significant execution risks with this approach. The target management has 100% motivation to make the performance threshold to get the earn-out (the difference between the two valuation) and zero motivation after making the earn-out.

For example, Focus Media acquired Framedia, a frame advertising network, in 2005, and Framedia made splendid numbers in the following two years when it needed to make the earn-out. Framedia management sold out all their stocks as soon as they got them. When earn-outs dried out, the whole Framedia management, including the then-appointed CEO, Tan Zhi, had a big showdown with Focus Media and left the company. With the money get made from earn-out, they started a new firm competing against Focus Media in the frame advertising business.

Focus Media also acquired dozens of smaller firms but did not disclose the acquisitions on time because each one of them was not big enough for a mandated disclosure. In the recent reorganizations, Focus Media cut loss on those acquisitions, swapping back the equity interest in exchange for stopping earn-out payments.

In retrospect, nearly all the acquisitions of Focus Media have been dilutive to the investors.

VisionChina's problem is not less severe. In 2008, the company acquired six advertising businesses, which contributed 56.3% of the 2008 revenue. In 2009, this number was 31%, which I believe did not include the revenue from the acquired target after one year integration. Otherwise we would see an expanding existing business and a shrinking acquired business. It is likely that the acquired six businesses contributed more than half the revenue since the acquisitions.

However, these six acquisitions had not been disclosed until April 2009 in the 2009 first quarter earning report, and the revenue contributions were only mentioned when asked by the analysts in the conference call. For these acquisitions, VisionChina paid $150 million in installments, compared to $365 million market cap after Wednesday's drop. Coincidentally, Dina Liu, the former CFO, resigned in April 2009, for personal reasons, of course.

One wrong incentive that those acquired businesses get is that they were motivated to make up revenue, such as early recognition of revenue or related party transaction, if they could not make the earn-out threshold but not far. Once the earn-out was made, they lost motivation to make up the fake revenue, and we observed the revenue falling.

If I am correct in my analysis, about half of the revenue of VisionChina comes from the six acquired agencies. About half of them had all the earn-outs made, and the rest may have existing earn-out bets until end of 2010. This portion of revenue is at risk of contraction.

I don't believe VisionChina itself is directly involved in any wrongdoing. I tend to believe that it was copying an existing formula and only found the problem the hard way. In the most recent DMG acquisition, it was still paying by installments but the deal was no longer a hedged bet but a single valuation deal.

There it bumped into another problem. The true merging of the two companies is much harder than VisionChina expected since the previous acquisitions it has done before were not much beyond merging of financial statements.

So here is the story for VisionChina. This price drop on Wednesday is on one hand a punishment for its previous messy acquisitions and on the other hand a high discount on a murky future.

I made no effort to figure out how much the business is worth, but this business is still valid, and the true value will reveal itself some time in the future when all the dust settles. The biggest money belongs to the brave who jump in before everyone else has a clear picture.

I am not one of the brave.

Author's Disclosure: no positions