Montage's stated set top box revenue is not consistent with its reputation as a very minor player; other brands dominate Montage by 10:1 to 35:1 among suppliers and finished goods.
Montage produces the majority of chips in a 5 million chip per month black market; China's government recently ordered them to "stop illegal production and sales activities immediately".
Excluding illegal chips, Montage trades at roughly 10x revenue. Neither PDSTI nor anyone else is likely to buy MONT at this price. Any of numerous catalysts could drop MONT precipitously.
In our article on Montage Technology (NASDAQ:MONT) dated March 20, 2014 (Montage Technology: The SoC You Can't See), we noted that Montage claimed that its standard definition satellite set top box chip revenue was equal or greater than that of ALi Corp, in spite of the fact that ALi's chips seemed to be outselling Montage's by a factor of roughly 10 to 1, according to distributor data. This phenomenon was not isolated to ALi, nor was it isolated to distributors. Subsequent data show that among low-end set-top boxes available for sale on Alibaba, three chip brands, ALi, MStar, and Sunplus, are each featured in more than 30 times as many set-top boxes as Montage chips are. The vast majority of Montage's revenue is invisible to the market.
We assumed that the most likely reason that so much of Montage's revenue did not show up anywhere in the supply chain is that Montage was inventing the revenue. We kept hearing rumors of a competing hypothesis--that Montage was getting the vast majority of its revenue from selling illegal chips--but we discounted those rumors as proof was lacking. The Chinese government has now provided such proof. On April 29, the Science and Technology Division in the State Administration of Press, Publication, Radio, Film and Television of the People's Republic of China (SARFT), issued a notice requiring Montage to stop production and sales of its explicitly banned direct-broadcast satellite chips. These chips allow users to view satellite television without paying for it. According to the order, "Montage Technology gravely violates the state's provisions, disrupts the order of the programming broadcasting, and impairs the interests of the people. We order Montage Technology to stop illegal production and sales activities immediately, to conduct self-examination and rectification immediately." In an article about the notice, published in the Chinese-language industry publication Communications World Network (CWW), CWW notes that Montage is providing the majority of the chips used in a 5 million unit per month black market.
Montage has a proud history of concealing the truth from investors, and this time is no different. The symmetry is satisfying; when it came public, Montage failed to tell investors that it created and controlled a one-man shop "distributor" in Hong Kong, LQW, accounting for more than 70% of the company's revenue. Now, the Chinese government has ordered Montage to stop manufacturing the chips, which are almost certainly the sole reason for LQW's existence, and Montage has again failed to notify shareholders; no press release, no 8-K, no anything at all.
We believe that Montage Technology, currently trading above $20.00, with only 6% of the float held short, is arguably the best short position in the entire listed U.S. market today. The stock recently bounced after another embattled Chinese company also accused of inventing 70% of its revenue, NQ Mobile (NYSE:NQ), announced the mostly benign results of its own internal review. While Shanghai Pudong Science and Technology Investment Co. (PDSTI) made a non-binding $21.50 takeover offer for Montage months ago, and since that time, various rumors of a "competitive process" have been stoked by the company and its affiliates, most recently in a publication for merger-arb investors called The Deal, we are fairly certain that no credible second buyer has come forth. Montage, excluding revenues from illegal chips, likely trades at roughly ten times forward revenues, and has negative operating margins. Montage's only "good" business segment, memory buffers, is still quite small, and well-positioned competitors in the memory buffer space, Integrated Device Technology (NASDAQ:IDTI) and Inphi (NYSE:IPHI), trade at only 3.0x enterprise value to revenue and 2.5x EV/rev, respectively.
Montage longs "win" at this point only if PDSTI is fully committed to throwing away the money of Shanghai to buy a company which exists mainly to make illegal products. Even in that case, longs only win $1.50. The recent speculation that PDSTI may need to up its bid based on strong financial results to come is absurd. By simply aggressively enforcing the ban that SARFT has issued, China can make Montage unprofitable overnight, and PDSTI could subsequently acquire the company at any single digit price of its choosing. Does it really make sense that PDSTI will "pay up" so that large U.S. shareholders like Capital Group, Gilder Gagnon & Howe, Wellington, and various merger-arb funds can reap a large reward on the backs of the people of Shanghai? Montage "shorts" win if the U.S. Securities and Exchange Commission does its job, if Montage's auditors do their job (or even simply resign), if MIT professor Dr. Charles Sodini (one of MONT's independent directors, and a member of the audit committee) does his job, or simply if PDSTI does the right thing for the people of Shanghai and withdraws its offer. Any of these events would likely knock more than 50% off of MONT's share price in a day. Unless PDSTI is brazenly corrupt, we believe that day will come before October.
(Appendix: our complete English translation of the CWW article follows.)
CWW (April 30th, 2014) According to sources, on April 29, the Science and Technology Division in the State Administration of Press, Publication, Radio, Film and Television of the People's Republic of China (SARFT), issued a notice requiring the Shanghai Montage Microelectronics Technology Co., Ltd. (hereinafter, Montage Technology) to stop production and sales of its explicitly banned direct-broadcast satellite channel chips. This is the third time that the agency has given Montage Technology such notice.
As reported, the direct-broadcast satellite chips manufactured and sold by Montage Technology have never been approved by administrative authority, and they have been wandering in the regulatory gray zone. This notice issued by SARFT clarified Montage Technology's violation and irregularities.
Last September, Montage Technology was listed on NASDAQ, however, its journey has been quite tough since then. This February, a report released by a U.S. based investment research firm, Gravity Research Group, indicates that, the largest dealer for Montage Technology is actually a shell corporation; its main purpose is to produce the company's financial performance. Later on, Montage Technology suffered a class action lawsuit in the United States due to "financial fraud" allegation. The company also got a delisting warning by NASDAQ because of its delay to submit annual reports while conducting an internal investigation of the financial allegations. This notice, issued by SARFT on April 29th, will cause unpredictabilities when Shanghai Pudong Science and Technology Investment Co.. (PDSTI) tries to impose an initial non-binding privatization offer to Montage Technology.
The notice issued by SARFT, which requires Montage Technology to stop illegal production and sale of the direct-broadcast satellite channel chips, casts a shadow for the company's privatization process.
Four years of moratorium chip production without obtaining the legal qualification
As reported, the first generation satellite broadcast standards have many technical limitations; Due to the fact that the program content did not take any encryption, due to the fact that the user can install the receiver without any restrictions, and due to the fact that it is very difficult to supervise and monitor the satellite receivers' production, sale and installation process to ensure broadcasting safety, the first generation satellite broadcast standards have been abolished. The second-generation and third-generation receiver standards adopt encryption technology in both program content itself and its transmission, therefore it makes content broadcasting and receiving very controllable and manageable, and then completely eliminates the problems and risks caused by the first-generation ChinaSat 9 receiver technology. However, some chip makers try to obtain the first-generation satellite demodulator specifications by illegal means, and then develop corresponding chips targeting the first-generation ChinaSat 9 satellite receiver markets. In peak, these illegal first-generation satellite receivers were produced up to 8 to 10 million units per month; even now, its production volume is at an average of 5 million units per month, which has formed a huge underground industry chain.
As the first-generation satellite broadcast standard has been abolished, satellite receiver manufacturers with legal qualifications are not allowed to produce and sell those outdated satellite receivers; in contrast, this provides the underground businesses and factories an opportunity. And also because Montage Technology does not obtain the authorization and license to use second-generation satellite channel standard, its production and sales of direct-broadcast satellite channel chips violates regulations. The company uses its foreign background to conduct "overseas production, domestic sales" strategy to circumvent domestic regulatory, manufactures and sells a mass amount of first-generation receiver demodulation and decoding chips, and manipulates prices illegally to earn high profits through monopolies.
As early as March 11, 2010, SARFT issued a "Notice to Conduct Market Check on Direct-Broadcast Satellite Channel Demodulator Chip and Set-top Boxes by SARFT Science and Technology Division", which explicitly prohibits the sale of related products. In its list of banned chips and set-top boxes, a channel demodulator chip, produced by Shanghai Montage Microelectronics, a Montage Technology subsidiary, was impressively listed.
However, SARFT found that Montage Technology continued to produce and sell those prohibited products after being named, therefore on November 19, 2010, SARFT issued a "SARFT Science and Technology Division's Official Notice to Shanghai Montage Electronic Technology Co., Ltd. to Stop Production and Sales of Its Direct-Broadcast Satellite Channel Chips and to Make Rectification", to demand Montage Technology to stop produce and sell related products and make rectifications.
In April this year, SARFT made its third notice to Montage Technology. This also shows that in the past four years, Montage Technology has disregarded the provisions of SARFT, has been in illegal production and sale of banned broadcast satellite channel chips.
As mentioned in SARFT's notice, "Montage Technology gravely violates the state's provisions, disrupts the order of the programming broadcasting, and impairs the interests of the people. We order Montage Technology to stop illegal production and sales activities immediately, to conduct self-examination and rectification immediately. SARFT will check back on the company's rectification results."
Montage's "unique" history
Relevant information indicates that Montage Technology is not a mainstream company in the industry. Its quick development relies on the fact that it got into the direct-broadcast satellite television business early, and has been wandering in the regulatory "gray areas", thereby earning huge profits.
With the rapid growing number of televisions in rural areas, "Shanzai" set-top box business, which is commonly known as the "big pot" satellite television receiving terminal business, has been growing rapidly. Montage Technology's main business is to provide supporting chips for those companies that produce such satellite television receivers. Therefore, the rapid growth of the industry provided great development opportunities for Montage Technology.
With the abolition of the first-generation satellite broadcast technology, Montage Technology, without the authorization and license to utilize second-generation satellite channel standard (safe mode), has been taking advantage of its foreign background, and has been illegally producing and selling those banned direct-broadcast satellite channel chips.
Direct-broadcast satellite business is strictly supervised and monitored by the SARFT. SARFT only allows legitimate direct-broadcast satellite demodulator chip production companies to sell those set-top box chips, and those chips could only be sold to the selected set-top box manufacturers. But the huge market demand for direct-broadcast satellites spawned a considerable amount of the illegal manufacturers, and Montage Technology provided majority of the chips used by those manufacturers, and has thus earned a huge profit. Therefore, illegally produced and sold chips became the biggest profit contribution to Montage Technology, which helped it successfully enter into the door of the Nasdaq in 2013.
Accused of Financial Fraud, Suffer Class Action in the United States
This March, Montage Technology was accused of "financial fraud". A U.S. law firm, Levi & Korsinsky, announced that it issued a class action against Montage Technology and its executives at a court in Downstate New York, by representing all investors who had bought Montage Technology's common stock between 09/25/2013 and 02/06/2014. The firm believes that the defendant published false or misleading statements, and failed to disclose unfavorable information about the company's business, operations, prospects and its financial performance. The firm also believes the financial report published by Montage Technology during the above period is misleading and full of serious errors.
The law firm accused of Montage Technology and its executives publishing false and misleading statements that does not match the company's real financial situation, and this behavior is in violation of the Federal Securities Act. As pointed out by a report published on February 6th by an investment research company - Gravity Research Group, the largest dealer for Montage Technology is actually a shell corporation; its main purpose is to produce the company's financial performance.
The latest news is that last week, Montage Technology announced that it received a mail notice from the NASDAQ on April 16th: because the company failed to submit Form 10-K annual report to U.S. Securities and Exchange Commission by the deadline December 31st, it does not comply requirements to be continuously listed on NASDAQ, according to NASDAQ listing rules.
As reported, on March 31st, 2014, Montage Technology submitted a notification document 12b-25 indicating its delay to submit its annual report. And as stated in the document, because (Internal) Audit Committee hasn't finished its investigation on Montage Technology's revenue data fraud issue pointed out by Gravity Research, the company is unable to submit its annual reports on time.
According to the Nasdaq Listing Rules 5101, the Nasdaq conducted an assessment on Montage Technology and asked the company to submit a plan before June 2nd to again meet Nasdaq listing requirements. If Nasdaq accepts the plan, Montage Technology will be permitted to re-meet the listing requirements before September 29th. If Montage Technology does not submit a plan, or Nasdaq does not accept its plan, Montage Technology may suffer delisting procedures.
Core Business traced illegal, privatization process became unpredictable
With the fact that the domestic semiconductor industry is always capturing eyes from the capital market, PDSTI has initiated a preliminary non-binding offer of privatization to Montage Technology; PDSTI has offered to use $21.50 per common share in cash to acquire all circulating shares of Montage Technology.
According to publications, Montage Technology's profits are mainly from the first-generation ChinaSat 9 receiver chips. With SARFT's more focused and intensive supervision and punishment on the illegal production and sale of direct-broadcast satellite receivers, Montage Technology business will suffer heavy losses. In the case of future situation unknown and final results unpredictable, if the state-owned investment company, PDSTI, launches non-binding privatization offer to Montage Technology at this moment, the security of state assets is difficult to be guaranteed.
Insiders say that both the class action lawsuit in the United States and the NASDAQ delisting warning have very little influence on Montage Technology continuously receiving privatization offers from more companies, but the SARFT's stern warning to Montage Technology will attack its core revenue-producing chip business, and make Montage Technology's future uncertain.
Disclosure: The author is short MONT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Aristides Capital manages hedge funds which at the time of submission hold various bearish positions (including short equity and long puts) in MONT. The principals and employees of Aristides Capital hold no positions in individual equities other than such interest derived from partnership interests in the funds we manage. Aristides Capital is not a Registered Investment Adviser. This is not an offer to sell any security. The funds managed by the firm are closed to new investors.