China Media Express (CCME) was one of the original stocks in my China microcap stock basket. It was also one I felt held great promise, though as I noted in late January I took profits so I no longer hold shares. That was just selling into a spike — my active trading demands that I consistently hit sharp runups.
Some readers raised serious accusations about the company in the comments to the syndicated version of my article in Seeking Alpha. These accusations were fleshed out in more detail in recent reports by Citron Research, John Hempton of Bronte Capital, and yesterday by Muddy Waters — the firm that exposed the RINO International fraud. All three are short sellers. Both Citron and Muddy Waters are somewhat sketchy. John Hempton is not — he deservedly enjoys a good reputation and is a serious thinker.
The critics accuse China Media Express of inflating sales figures, claiming profits and per-screen revenues that grossly exceeding industry margins, and lying about customer accounts. For example, Muddy Waters calls CCME's listing of Apple (APPL) as a customer on its Switow.com b2c website an "egregious lie":
We caught CCME’s management telling a particularly egregious lie. It recently announced it had created an online shopping platform that has an agreement with Apple Inc. (AAPL – yes, THAT Apple) or one of AAPL’s distributors. AAPL made clear to us that it has no such relationship with CCME’s subsidiary. Further, AAPL keeps tight control over its distribution in China, with only two authorized online distributors [including Amazon.com’s (AMZN) China subsidiary]. None of AAPL’s China distributors have authority to sub-license.
John Hempton correctly points out that if China Media Express is caught lying about these contracts, the SEC will likely suspend the stock pending further information.
We have not heard a full response from the company, most likely because the Muddy Waters piece was released on the Chinese New Year (sneaky but not illegal short seller tactic). However, in its abbreviated press release management states:
In a separate but related note, CME today also announced its December 2010 contract with Eading Group, one of Apple Inc.’s official distributors in China to advertise Apple products, specifically iPads, in CME’s SWITOW magazine, a new B2C shopping platform for its contracted advertisers.
And the Apple controversy is just a side issue. Whether Apple is legitimately advertised on Switow or not, Switow is a recently launched non-core business. I can't imagine it amounts for more than 5% of revenues.
Investors should focus on the core business — running advertisements on LCD displays on inter-city buses. Muddy Waters claims that data provided to advertisers shows that CCME "has fewer than half of the 27,200 buses it claims to have" and believes that CCME only booked about a fifth of the revenues reported to investors. Hempton points out that it is difficult to find evidence of content creation costs that a media enterprise of CCME's purported size would generate.
On the other hand, Hank Greenberg's Starr International is CCME's largest outside investor and apparently did significant due diligence. My guess is that Starr did far more investigation than Muddy Waters and Citron Research combined. The presence of a serious institutional investor separates China Media Express from other Chinese smallcaps and microcaps. And it has engaged Deloitte, a big-4 accounting firm. That would typically be considered a "best practice" for a smaller Chinese company. Though the big-4 have proven themselves to be mediocre at rooting out fraud, they are certainly better than the smaller accountants often used by these Chinese companies. Finally, there is growing anecdotal evidence that some of the specific accusations are unfounded (thanks to Michael Anderson for aggregating all the information).
Bottom line: This story is way too early to read. I will consider repurchasing but I want to see the company's full response first.
DISCLOSURE: No position.