The last day of February was eventful for NQ Mobile ("NQ", or "the Company"), which reached $22.33, a new high since the company was attacked by Muddy Waters ("MW") about four months ago… only to fall to a low of $17.13 around 3 PM on very heavy volume before staging a partial recovery to $19.41 in the final hour of trading. Below are the series of alerts that Bloomberg flashed to its terminals in the final hour (listed in reverse chronological order):
The end result: a final print of -8.49% on daily volume over 3x the year-to-date average, of which two thirds (7.438 million of ~11.05 million ADS) traded in the final hour. NQ continued trading back up in the after-hours market.
Our checks confirmed that the Company is unaware of any negative news or fundamental reason for this aggressive final hour dip.
We have received so many questions about what is quite obviously a trading error that we decided to publish our thoughts publicly as an efficient way to respond.
I. The Setup
Low Actively Traded Float
Several long-term investment firms have capitalized on the opportunity of MW's failed attempt to discredit NQ by accumulating shares since the attack. Since we filed our 13G post-MW to disclose a greater than 5% position, seven other firms have joined us in filing 13Gs to become top 11 holders with at least 2.1% ownership of floated shares (see Bloomberg "page 1" holder list below).
This table understates institutional ownership significantly because it only shows "page 1" holders (and not the many smaller holders with long-term investment styles who also bought) and excludes significant holders who do not report holdings to the SEC because of the way they have structured their funds.
The most obvious example of such a fund is Atlantis Investment Management, one of the largest investment firms in the Greater China region, which spreads its AUM across many separately managed funds. You might recall that Atlantis became an anchor investor in NQ on July 2, 2013, purchasing approximately 2.5 million ADS through its various funds. Given the fact that Atlantis was spotted on the ground, shortly after our due diligence expedition to China, vetting MW's fallacious claims for themselves, and given the billions of USDs in AUM that Atlantis manages, we are confident that Atlantis too has upped its stake. But even if we only include their previously disclosed 2.5 million shares and exclude the many long-term investors we know hold 200,000 shares or more but do not make it to "page 1", we count about 23 million shares held by firms with long-term intent.
Of note, our estimate of institutional ownership also excludes any shrinkage of float from the Company's own share repurchases pursuant to the $35 million buyback plan initiated last year.
So… of the 31.1 million floated ADS, at least 74% are held by institutions that are not trading their shares, which effectively makes the actively traded float around 8 million.
Some institutions may have sold a few shares recently to lock in some of the greater than 100% rise in NQ shares from the MW lows (shame on them for selling even a few shares at any price with a 1- or 2-handle on it), so we believe our estimate, while conservative, is in the right ball park.
Our point is this: With the 74%+ reduction of actively traded float, NQ has quickly become one of the most dangerous stocks to short on the entire NYSE.
On the other side of the trade, of course, you have the shorts.
Per the latest semi-monthly short interest report from the exchanges (available for free and notorious for not being that accurate), there are 13.396 million shares held short as of 2/14, or 1.7x our estimate of the actively traded float. This data suggests days to cover of around five, a fairly high number that foreshadows real pain for the shorts (and "cham-pain" for the longs).
What's interesting is that the high short interest has held despite other traditionally bearish technical indicators plummeting.
For instance, last December, our prime broker reduced the yield on our substantial NQ holdings loaned out to their stock loan desk to low single digits, noting that there is simply not that much demand for our shares anymore from short sellers. This is in stark contrast to last October and November, when NQ stock lenders (including us) were collecting interest of as high as 60-80% for a brief period.
Markit, a short sale analytics firm to which we subscribe, reports the following trend for NQ's cost of borrow (what short sellers pay their lenders to short NQ), a metric they score 1-10 based on how expensive borrow is (10 is most expensive). Think of borrow cost as being highly correlated to the credibility of MW and the cabal of hedge funds short NQ.
A precipitous drop, wouldn't you say?
And then there's this chart, also from Markit, of long inventory supply, a measure of how many shares are being loaned out by guys like us (getting paid by shorts to watch their positions run up against them… priceless).
The only way the short interest can persist while the aforementioned metrics plummet is if the borrow is very actively traded, which means the shorts aren't holding their positions with confidence, but rather, trading them nervously (i.e. covering every so often to manage losses) as their hope that they might be right wanes by the day. Alternatively, or in addition, borrow is likely unstable, which would explain some of these conflicting trends.
Markit, which updates its short interest data daily (as opposed to the semi-monthly updates available for free from the exchanges), has a very different short interest chart than the one we showed above that claims 13.4 million shares held short. Markit shows less than 6 million shares held short as of 2/27.
Whether the real number is 6 million or 14 million or something in between, we'll never know, but what is clear as day is that the shorts have lost confidence, with few holding sizable positions as the stock continues to rise into March, a critical month. By the end of this month, we expect the MW discount to be completely erased as the Board's special committee discloses the results of its investigation, the Company reports its earnings (which we expect will be strong as usual), and the Company resumes its normal investor relations initiatives.
II. The Flash Crash
So we've established that a fraction of the float trades actively and borrow is low to very low and quite unstable as of 2/27.
Now behold the following intraday charts of the Nasdaq index (Bloomberg ticker CCMP), E-mini Nasdaq 100 futures (Bloomberg ticker NQ1 or NQA, CME ticker NQ), QIHU, YY, and NQ (the company, not the futures).
What do they have in common? And which is the single outlier?
As the Nasdaq started to sell off into the close, it gapped down around 3 PM, dragging down the Nasdaq futures, its constituents, and, in particular, high-beta Chinese names such as QIHU and YY. All sold off with a modest but not extraordinary rise in volume, something in the order of 0.5-2.5x increase.
And then there's NQ (the company, not the futures), which sold off so suddenly and severely that the SEC's short sale uptick rule was triggered within seconds and the volatility circuit breaker forced a trading halt of several minutes.
Specifically, between, 3:00 and sometime shortly after 3:10 PM, when tradingw as halted, over 1.5 million shares were sold at a 10% VWAP discount (with a portion of it as low as a 20% discount) to $21.51, the VWAP of shares traded through 3 PM. That's half the average daily volume YTD traded in 11 minutes, with a massive 780,000 shares dumped in under one minute starting from 3:09 to 3:10 PM. (Source of all trading data: Bloomberg.)
After trading resumed, chaos ensued, and when all was said and done, over 7.7 million shares, over two times the average daily volume YTD, were dumped in the last trading hour.
It is quite obvious to us that some unfortunate trader got a verbal beatdown at a minimum from his boss last Friday after intending to short Nasdaq futures but instead fat-fingering a very quick loss.
III. Some Questions
There will undoubtedly be those who think we are wrong, so if we are, then consider the following questions:
- Where did all this supply come from? Almost 8 million shares in under an hour? Nearly a million shares in under a minute? Did several page 1 holders all agree to sell at exactly the same time on the final hour of the last day of the month for the fun of it? Would any of them even sell if MW released another report anyway, especially at just the thought of it, sight unseen, when just weeks ago they bought boatloads of shares in spite of MW? Did hundreds of retail investors and fast money suddenly decide to team up at 3 PM to begin the dump on no news that would lead to the entire actively traded float being sold off on the final trading hour of February? If it wasn't institutions long NQ and very unlikely retail, then who was it? Why does Bloomberg show that more than 27% of the volume was traded by a single broker that has been almost completely inactive in NQ the preceding days and prior weeks? Almost an entire average trading day worth of volume was suddenly executed on Friday by this new broker, and the brokers that are known to have the largest share of the retail volume only accounted for less than one third of the activity.
- Is it just sheer coincidence that whoever sold the initial volume that triggered the flash crash just happened to time the trade exactly with the gap down in the Nasdaq index? Is that trader psychic?
- Whether selling long or short, who consciously puts a trade on this way? Who randomly dumps over 20% of the average daily volume in under 60 seconds with no regard for price? What happened around 3:09 PM is just impossibly idiotic. How can this not have been a mistake? At a minimum, one would expect use of any of the many algorithms that prevent this kind of price impact. Even someone trying to manipulate price would not trade this way.
- And if they did trade this way, how do they feel now that the stock closed down only a little over 8% and was trading up in the after-hours, in spite of the trading fireworks of the final hour? Like a goat, perhaps? Why would that person suddenly stop their attempt and let the stock rebound more than 50% of the initial short-lived drop? Isn't that a great way to lose money quickly? And if someone were to do something like that, wouldn't the attempt be accompanied by some kind of scary rumor or hit of some sort? Why the complete lack of news?
The interesting question is not why the flash crash occurred, but rather, now that it has occurred, what, if anything, might the shorts do to take advantage of renewed investor skittishness as a result of Friday's technical snafu?
While we're asking questions, we might as well tack on a few for the shorts. After all, if anything interesting for the shorts is going to go down, it's very likely going to happen this month.
- By now, everyone has seen the fraud allegations and had four months to review them ad nauseum. Included in "everyone" are NQ's executive team and other members of its global leadership team, NQ's board and its special investigation committee, the SEC, the Chinese government, NQ's auditor PWC, the special committee's financial advisor Deloitte (not the auditors, but rather Deloitte Financial Advisory Services, i.e., the "fraud guys"), the eight institutions who have become "page 1" holders post-MW and have collectively bought three quarters of the float, every single partner of NQ--including the largest carrier in the world (China Mobile), two of the other largest carriers in the world (America Movil, Telkomsel), the largest mobile Internet company in China (Tencent), the largest handset manufacturer in the world (Samsung), one of the largest technology distributors in the world (Ingram Micro), one of the largest carriers in the US (Sprint, owned by another of the largest carriers in the world, Softbank), one of the largest retailers in the US (Target), the largest European gaming company (Ubisoft), Apple (which hosts every single NQ app, including all the supposedly fraudulent games that were taken down)…These are all people who care about their partners and reputations. Why is everyone still firmly in their seats, doing business with NQ as usual? No resignations, contract terminations, lawsuits, delays. Just more business. Why?
- If something is amiss and thereby triggered panicked selling on Friday, why is NQ presenting at MS's annual technology conference, one of the largest technology conferences in the world, on Monday? Isn't that odd? It will be the first technology conference NQ has attended since the MW incident, and it also happens to be hosted by a firm that took a sizable position in NQ recently. Why is NQ all of a sudden attending conferences again, if not to resume business as usual and attract investor interest?
- If something is amiss, why has NQ not filed for an extension to the 20-F filing deadline of 4/30? After all, PWC is certainly going to be interested in what Deloitte has to say, and NQ is going through the enormous added distraction of a self-inflicted financial proctology exam (they didn't have to do anything but chose to go the full audit route with Deloitte's fraud specialists and forensic accountants instead). Isn't it a bullish sign that the 20-F audit appears to be on track?
- Why are Goldman Sachs and Credit Suisse, two of the most reputable and experienced bulge bracket firms, taking Tarena public with CFO Suhai Ji, NQ's former CFO? Given their filing last week, Tarena will likely be the first Chinese IPO of 2014, and we expect the IPO to do well (full disclosure: we intend to get long Tarena).
- How does it feel to be short a company that has publicly acknowledged inbound interest from both strategics and private equity firms alike during the most acquisitive period in the history of the Chinese technology sector? In case you didn't notice, the mobile industry in particular is consolidating quickly, and acquisition targets and recipients of strategic investments are receiving prices that point to enormous upside for NQ (see precedent transaction table below). We believe NQ could sell NationSky alone and generate proceeds that approach the entire market cap of NQ.
NQ shareholders who had the patience and equanimity to deal with the past four months of volatility have much to look forward to. And once March is over, the focus will be back on what really matters: the Company's fundamentals. We look forward to moving the conversation to NQ's fundamentals and away from the inane discussion of the latest rumor or news flash du jour.
Additional disclosure: Refer to additional disclosures here: toroip.com/disclaimer-nq.html