We believe Giant Interactive (GA) has defrauded investors and the United States Securities & Exchange Commission will bring charges against Chairman Shi Yuzhu and Giant interactive.
On January 6, 2014, we released our report on Giant Interactive ("GA", "Giant" or the "Company"), available here. On January 7, 2014, Giant Interactive's management team released a response to our beliefs. Not only do we believe Giant's responses were intentionally misleading, but management deliberately evaded some of the more serious concerns from our original report.
Giant reported 87% gross margins & 61% operating margins would make it more profitable/operationally efficient than ANY company in the entire S&P 500, any of its peers and one of the most profitable companies in the world.
"You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." - Former President, Abraham Lincoln
In our report we alerted investors to the Chinese margin miracle that was Giant Interactive. Margins that were so rich, they even walloped their Chinese competition by thousands of basis points. Upon further inspection, Giant's FY12 87% gross margins & 61% operating margins are so good it implies Giant is not only the most profitable tech company in China, but one of the most profitable businesses in the world. So if investors are to believe Giant's filings - that GA is able to operate an R&D intensive business in the hyper-competitive, fragmented gaming markets with very low barriers to entry and pricing power more efficiently than virtual monopolies like Visa Inc. and MasterCard - than either a congratulations or subpoenas are in order.
To provide some context, we compiled a spreadsheet (here) of the entire S&P 500 & Nasdaq detailing each company's operating margins. To our astonishment, not a single company in the S&P 500, Nasdaq or any of Giant's Chinese peers reported operating margins above the reported 61% GA claims. That kind of good.
Astounding, but it gets better.
There is another important "tell" in the numbers that makes Giant stand apart -- way, way apart -- and that is its returns on capital versus other leaders in Chinas competitive gaming category. For the FY12, Giant reported a ROIC, ROE& ROA of 212%, 35% and 26%, respectively. What a company! Any rational investor would assume that Giant Interactive had found the cure to cancer. So, what does this cash cow actually do? Well, Giant operates a very simple business. They are an online gaming company that operates in a hyper-competitive space, with little pricing power and just ~4% market share of the online gaming market. And when we contacted management to ask about their largest customers? Well, that is a company secret.
These concerns are even more material next to the core issue: ZT is an old franchise with declining popularity in China and Giants core business is deteriorating. To further complicate matters, this already crowded market is expected to get even more competitive now that the Chinese government has lifted the 14yr banned sale of game consoles - allowing the 'big three' producers of video game consoles, Sony, Nintendo and Microsoft, to enter the space.
In spite of having spent a mere fraction of what competitors have on R&D, and cutting sales and marketing expense by -14%, Giant miraculously grew sales by 20%, expanded GM's by 100bps and grew operating profit by 24% in FY12.
An investor can then conclude that Giant has no real incremental expense to additional sales, that running a growing business in competitive markets which has seen the company lose market share and its peers margins converge is nearly cost-free. Giant's reported financials makes it a complete outlier in the Chinese gaming market which has literally fallen into an "arms race" to maintain share. GA even operates far more efficiently than internet powerhouses Tencent and Netease (despite its much smaller footprint). Notably, the former has leveraged its scalable social networking platform to become China's leader in the space, while Netease has invested significant R&D on its self-developed titles along with forming strong alliances with leading global game developer Activision Blizzard. Other Chinese leaders like Shanda Games and Changyou haven't fared well amid increased competitive pressures and decelerating revenue growth. For instance, online game revenues for Changyou grew just 7% in Q3, while Shanda's actually fell 11%, with no signs of improvement anytime soon.
So perhaps Giant is this generation's Microsoft (who only saw its Windows monopoly reach peak op. margins of 52% -- 9% below GAs, at the height of the tech bubble), at the cutting edge of technology and operational efficiency, but it's a safe bet that isn't the case.
But if we are to believe the reported financials of this company, then investors and notably the Chairman should be re-investing every single dollar earned in what appears to be one of the most profitable businesses in the world - EVER. Yet, that is not the case. In fact, from FY 2010 to FY 2012, Giant spent $28.2m, $36.6m, and $52.5m for an aggregate of $117.2m. Conversely, Giant has spent $186m on financial investments that the company noted "are purely financial in nature" over the same period. Furthermore, the Chairman continues to aggressively sell shares at fire sale prices and cites "diversifying" his holdings as the reasoning.
Furthermore, according to Giant's SAIC filings within China, in 2011, the principal operating subsidiary reported 44% gross margins. Even considering consolidation issues with domestic company reports, none of the subsidiaries reported a higher margin and many reported lower. So much like a typical Chinese fraud, we believe that Giant reports accurate financial figures to their own government where as they report fabricated financial figures to the U.S government and U.S. investors.
Thus investors must ask themselves, if the margins are misrepresented, then the earnings must be misrepresented -- and if the earnings are overstated -- investors must question the willingness of any private equity firm to make good on its buyout offer.
What the Chairman says vs. What the Chairman Does
Warren Buffett once wrote to his investors:
"If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."
Giant Interactive shareholders - You are the patsy.
In our initial report, we expressed skepticism regarding why Chairman Shi Yuzhu transacted more than 11% of his Giant stake in the last six months alone; notably after his management buyout proposal and at far lower valuations (in June 2013, -62% lower) than his purported buyout price.
In response to our report, management noted that Chairman Shi Yuzhu sold a significant portion of his stake (despite his management buyout offer) in a purported "best in class" 87% gross margin and 61% business as "consistent with Mr. Shi's desire to diversify his personal holdings." A fundamental conflict. Investors should find this response simply implausible and question why the Chairman would propose a management led buyout then choose to diversify his dollars away.
We continue to find the Chairman's selling behavior to be a significant red flag and in stark contrast to any management buyout we've ever seen. Typically, the goal of a management buyout is to strengthen the managers' interest in the success of the company, not encourage the manager to liquidate his shares at artificially inflated prices once a proposal is made.
Investors should note that post buyout the Chairman's ownership could likely be far lower than we initially thought - liquidating to a pro-forma ownership of roughly just 20% of his current stake.
The Chairman has spoken through his actions. Right now, GA is nothing more than a promise ring that rests on the shoulders of leadership's credibility.
Is Shi Yuzhu & Giant Interactive telling the truth, the whole truth, and nothing but the truth?
"When truth is replaced by silence, the silence is a lie." - Yevgeny Yevtushenko
Here is a glaringly simple question, yet one which management willingly overlooked - why did Giant's management feel it was appropriate to invest in "unregistered" shares of Alibaba (if indeed they bought them) through the chairman and independent directors private equity firm, Yunfeng Capital?
Furthermore, if Giant's intention was to be honest and transparent, why was Shi Yuzhu and independent director Jason Jiang's related party affiliation to Yunfeng Capital not disclosed in any of GA's SEC filings, particularly after the SEC raised pointed questions about the business activities of Yunfeng?
Yunfeng's website doesn't support Giant Interactive's explanation
It amazes Ottoman Bay what type of short-term memory investors have. In 2011, Giant Interactive was highly criticized when Giant's chairman used company resources as his personal investment vehicle to buy an insurance company, a business that was completely unrelated to Giant's core gaming business - . Following the debacle longtime CFO Eric He resigned and Giant transferred the investment back to the Chairman. Chairman Shi Yuzhu's investment is a again a violation of investors trust.
Giant responded to Ottoman Bay by misleadingly claiming that "neither Mr. Shi nor Mr. Jiang has ever been involved in Yunfeng Capital's management, decision-making, or governance. Mr. Shi's and Mr. Jiang's interests are strictly passive financial investments in an established private equity fund."
We find clear evidence that Chairman Shi Yuzhu and Jason Jiang are NOT just passive financial investors - they are co-founders with significant influence on Yunfeng Capital's decision making and investment process.
- Yunfeng notes its founding LPs expertise and analysis as part of the funds core "strengths and highlights" for investment decisions vs. other domestic funds. This disclosure, directly contradicts managements claims that both Jason Jiang have no input or relationship with Yunfeng aside from being strictly financial investors
- Yunfeng's website here - refers to Shi Yuzhu and Jason Jiang as "co-founders" the company notes "Yunfeng is the result of combining the Chinese first names of Mr. Jack MA (Yun), Chairman of Alibaba, and Mr. David YU (FENG), Founder of Target Media. In addition, there are more than 10 other co-founders, including Mr. Yu Zhu SHI, Chairman of Giant interactive group"
- We have never seen "strictly passive financial investors" promoted all over a private equity firm's website - given their apparent lack of input or influence. Coincidentally, after we released our article, Yunfeng conceded their misdeeds by quickly erasing any evidence of Shi Yuzhu and Jason Jiangs involvement in the fund
How can Shi Yuzhu and Jason Jiang be "strictly passive investors" yet simultaneously provide expertise and analysis on investment decisions?
Yunfeng's link(click to enlarge)
Shortly after our note, Yunfeng's website received a much needed facelift. Yet both parties stand by the their "belief" that they did nothing wrong.
Jan 6, 2014
Jan 7, 2014
Note that of the numerous times Jason Jiang's bio appears in Giant's filings and website, Giant hid both parties' affiliation to Yunfeng funds; this despite Yunfeng's high profile in the China investment community. Keep in mind, Jason Jiang and Shi Yuzhu happily posted their picture and bio all over Yunfeng's website despite management's claims that they are "strictly passive investors"
Giant hasn't been in compliance with NYSE requirements for years
In managements rebuttal to Ottoman Bay the company claimed that Jason Jiang was not a related party and does satisfy NYSE independence requirements and SEC rules despite his clear affiliation and involvement in Yunfeng.
This is a clear contradiction to the company's reported filings that we believe will be hard for any regulator or private equity affiliate to ignore.
In Giant's FY12 filing (as can be seen below),The Company concedes that it hasn't been in compliance with NYSE requirements for years and has no plans to. According to the company's filings, Giant may or may not have a severe lack of corporate governance. This disclosure goes directly to management's credibility and trustworthiness.
"We do not currently voluntarily comply with the requirement that a majority of our board of directors consist of independent directors." - Giant Interactive 2012 20F, pg. 29
Management claims that because they are a "controlled company" that somehow Giant is omitted from NYSE independence requirements and SEC rules. This is simply false. Any US listed company on the NYSE is subject to the corporate governance requirements imposed by the NYSE under Section 303A of the NYSE's Listed Company Manual. This along with the SEC guidelines is in place to protect investors from fraudulent companies. This lack of compliance by Giant should represent a significant red flag to investors.
The cost of hope - that is, the cost of making hope a component of one's investment strategy - is the eternal risk of capital. Some sneak through like Chairman Shi Yuzhu and make a profit before investors can get out. For others, it will come at a significant cost, when Barings completes its prudent due diligence process and finds out the business they were presented with is unlikely to be one of the most profitable and operatially effficient companies in the world.
Investors will ultimately have to take their chances on a binary event - either the going private deal passes regulatory hurdles and savvy investors like Barings doesn't catch on and closes, or it does not, and the stock falls back to mid to low single digits - where it has traded over the past 5 years. There is really no other outcome - no other suitors have shown any interest in buying a business with 61% operating margins at 13x earnings. We find limited upside from here, investors can get better returns by "diversifying their holdings" elsewhere as Chairman Shi Yuhzu has done. We have continued to make repeated attempts to address our concerns with management and investor relations to no avail, furthering our suspicion. Rational investors have an asymmetrical risk/reward profile while longs just have risk.