Auditors Didn't Find Fraud At NQ Mobile, But A Restatement Isn't Ruled Out

Jun. 6.14 | About: NQ Mobile (NQ)

Summary

NQ issued a press release stating no fraud was found by an independent audit team.

The scope of the investigation does not explicitly state that revenue recognition was addressed.

There is still risk to the story, and possibly a restatement.

NQ Mobile's (NYSE:NQ) independent investigation team didn't find fraud in its due diligence, but the scope of the audit didn't mention revenue recognition, a key point Muddy Waters brought up in its 72-page initiation report published in October 2013. In the coming weeks, after the 20-F is filed, we should have more detail. In the interim, the implication of NQ being exonerated could cause the short squeeze of a lifetime. Shares of NQ had lost 75% of their market value as of May 29. Even with that dramatic fall, short interest remained high at over 50% of the float on May 15.

Investors won't know the sustainable direction of the stock until the 20-F is filed, which will contain the auditors confirmation of NQ's accounting practices. Should investors buy the shares on faith after a press release or wait to see the auditor statement and profits?

Not Finding Fraud Doesn't Mean a Problem Doesn't Exist

Wednesday morning, NQ mobile issued a press release stating that "The Investigation Team did not find evidence that the Company's revenues were inconsistent with public disclosures." This is only point two of an eight-point description of issues the auditors did not find. At first glance this press release seems to indicate that all of the fraud implications are behind the company. On the other hand, other companies have made bold statements and after hearing that Palm, Inc.'s customers don't have return rights and that Portal Software's customer base is not entirely CLECs, I'd rather wait for a confirmation from the auditors.

Scope Doesn't Seem to Address Revenue Recognition

My concern lies in the detailed description of the "scope of the investigation" section in the press release. It states that auditors reviewed cash transactions, financial records, databases, business partners, acquisition purchase contracts, and electronic communications from the management team. However, nowhere does it say it reviewed the company's core revenue recognition practices.

Four Possible Outcomes for the Company

  1. The company could receive an unqualified opinion from the auditors, which would certify that the accounting practices are valid. If the 20-F is filed with a an unqualified opinion, it would refute the claims made by Muddy Waters in its research reports. This is the best possible scenario for shareholders. If the company receives anything other than an Unqualified Opinion, it could put pressure on the stock.
  2. The company could receive an unqualified opinion from the auditors but be forced to restate prior-year results. This would be a negative but could wipe the slate clean for the company. If the outlook is consistent, the stock price could rise.
  3. The 20-F could include a qualified, disclaimer or adverse auditors opinion. This is a rare thing to see in a public document and could indicate weak accounting policies. Usually, companies fix the processes then publish he document with an unqualified report. If the Audit Report is not Unqualified, Institutional investors would keep away from the name taking away much of the support for the share price, despite the significant pullback.
  4. What if nothing happens? The 20-F could be further delayed leaving investors in limbo as shorts struggle with a risk reward that is not in their favor. The company could lose 100% of its market value from here but if the issues are worked through, the upside could dramatically outweigh the downside. The 52-week high was $25.90 per share making the reward/risk more than 1.5:1, unattractive if you have a profitable short position.

Wait Until You See Audited Numbers

Even though the stock has jumped 35% in one day, chasing it for an investment could be a mistake. Until audited financials for the company can be used as a basis for a price target, investing today would be gambling. We don't know if the company will be forced to restate prior results and an unfavorable Auditors Opinion could cause a dramatic drop in the share price.

I think there are better places to invest. However, there are three things you can do if you feel the need to commit capital here:

  1. I would not take a naked long position here. If you buy the stock buy a married put just in case; if the Auditors Opinion is clean, the upside will more than offset the cost of the put.
  2. The other option is to buy calls, this should be resolved by the end of the next quarter.
  3. You could also just wait until we have enough information to make an informed decision after the 20-F is filed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.