Longs have called it "The Best Stock in the World". Shorts have accused it of being a brazen fraud that has overstated its revenue by many multiples. There have been accusations of forgery, fraud, and market manipulation coming from both sides. A quick look at the comments on the web reveal personal attacks, and people publishing the home addresses and photos of short sellers. This has become a dangerous and dirty game. One thing everyone can agree on is that CCME is one of the most polarizing stocks in the world.
Why is this stock so polarizing?
Reason #1: Whoever is right stands to make a lot of money - the stock is either grossly undervalued or overvalued, depending on whom you believe. People are taking oversized positions in the name. Both sides are "interested parties." I would advise all to not take anyone's word for anything here. People will lie to you to make money at your expense. Neither shorts nor longs have a monopoly on bad behavior, but clearly either the shorts or the longs must be correct. So the fact that someone has "bad" people on their side does not make them wrong.
Reason #2: Most investors are depending on others for due diligence. The reason for this is the language and distance barriers. Most US market participants lack fluency in Chinese and/or the ability to do proper due diligence in mainland China. The result is that most investors cannot evaluate the other side's arguments on their merits. This creates a situation where a many smart people will end up being wrong, because they may be depending on the advice, interpretations, and translations of others. Also, since they cannot interpret a Chinese language document that is presented, they instead attack the presenter. Personal attacks, which have been rampant in this discussion, have a tendency to snowball.
Reason #3: The volume and tenor of discussion are unusual. CCME is one of the most heavily trafficked names on popular stock websites. And the tone of these discussions has been 'echo chamber'-like. Similar to the situation in the political "blogosphere", investors are grouping together with others who are on their side. Dissenters are ostracized. The result is confirmation bias.
I am short CCME. I see a very high probability that revenues are overstated. The reason for this is that there are simply too many red flags and inconsistencies in the company's story. Any one or two of these red flags could be explained away. However, I cannot explain them all with a consistent story.
In making the short case, I am intentionally including only information that can be easily checked by an English speaker. I exclude some of the strongest short arguments, which require Chinese fluency to evaluate. However, even based solely on my list of "English" red flags, I don't trust the management of this company or their numbers.
Following is a list of suspicious statements and actions by management:
COMPANY RESPONSE TO SHORTS
The CEO's letter (.pdf) does not respond to the primary claim of the shorts--that their customers' media buyers do not know who they are. Muddy Waters implied that CCME's customer relationships do not exist. If the company is legitimate, they should come out and state that the customers are real, and publish letters from major customers to that effect. The company's silence is a "dog that did not bark".
The CEO claims that FMCN, VISN, and AMCN are not aware of CCME because these companies are each in a different "industry group" from the others. Of course, this is absurd for many reasons. One reason easily verified through filings, is that these companies all list each other as competitors, except that no one lists CCME, while CCME lists everyone else. Another reason is that CCME claims margins which should be the envy of every media company in China. Other companies should be desperately trying to reproduce CCME's success, and certainly should know of the company’s existence.
The CEO's letter claims that Eading Group is an Apple (NASDAQ:AAPL) distributor (wholesaler). Actually, Eading appears to be an authorized reseller (retailer) based on the photos on their website. The difference is material. If it is a retailer then no margin is left for CCME. Also, a wholesale agreement implies volume; a retail agreement implies nothing. I don't think this is a case of "careless translation" because the rest of the letter is very well translated. In the press release about SWITOW, the company is clearly implying something bigger than working with a retailer, although it was toned down slightly in the CEO letter.
The CEO implies that there may be some investor misperceptions due to translation uncertainty ("however you want to translate…"). Interesting that the company strongly implies, but does not directly say, that the shorts made translation errors. If that were the case, wouldn't it be easier just to say so? I would paraphrase the CEO's response as "even if we mistranslated, it doesn't matter, just look at our earnings". Is it believable that a company claiming $170 million in the bank and $50 million quarterly cashflow cannot or will not hire a proper translator, and prefers to "unintentionally" mislead investors?
The lack of a scheduled conference call to discuss the short allegations is troubling. The company should immediately schedule a conference call, and it should not be a scripted PR affair, but an open call where they take all questions. (If they wish to duck a specific question for trade secrecy reasons, that is fine, but it should be on record that they refused to answer.)
CASH BALANCE AND DELOITTE
The interest rate CCME is earning on its cash is much lower than outdoor advertising comps (FMCN, VISN). If anything, CCME should be earning more because they have such a strong balance sheet. CCME is earning less than 0.3% annualized vs 1.3%-1.5% annualized for comps. Interest rates in China are highly regulated and the rate for a demand deposit account (equivalent of a checking account) is 0.35%. Much higher rates can be obtained by committing money for short time periods (equivalent of CDs). I estimated the interest rate as interest income divided by (BOP cash&STI + EOP cash&STI) / 2. For CCME I analyzed Q2 and Q3. Q1 was excluded because of the capital transactions.
It does not make sense that the company would throw away 1% per year--over $1 million--by depositing over $100 million into the rough equivalent of a checking account. But even if they were doing this, they should be STILL earning more interest than what appears on their income statements.
Deloitte's presence does not prove anything. They have only been auditor for 1 year, were crammed in at year end '09, and quarterlies are unaudited. And Deloitte has made mistakes before. The big 4 auditors including Deloitte were caught up in the S-Chip scandals in 2009 (see FibreChem and Ferrochina). In some cases, company cash balances were created through temporary borrowings to deceive auditors or were illegally and secretly promised as collateral for personal loans. See Satyam for another case where large cash balances audited by a big 4 firm turned out to be fictional.
The longs like to point out that the CFO has 8 years of experience with PwC. However, this could be construed as a negative. If I wanted to execute a sophisticated accounting fraud, what better person to hire than someone who is intimately familiar with audit processes and has personal connections within the auditor community?
The company chose to go public through a SPAC. They could have gotten a much higher valuation via a normal IPO. The company would claim that the IPO market was closed when they wanted to go public. However there was no rush to be listed since they had no capital needs, due to their cash balance and strong cashflow. They could have simply waited for the IPO market to reopen. If any shareholders needed liquidity, they could have participated in the private placement with Starr.
SPACs are particularly attractive to frauds for raising money quietly. The reason is that the warrants require investors to pay cash to the company upon exercise. The company can thus avoid the scrutiny that normally accompanies stock issuance, since the warrants are already outstanding. The earn-out terms created an additional "obscured" share issuance. These are not accidents, the company made an active decision to use this structure and deal terms. Also, the obscured nature of these share issuances was observable in market dynamics as the shareholders voting on the SPAC transaction were special situation players primarily concerned about perception, not long-term investors focused on per-share economics.
This SPAC that had an unusual provision that allowed shareholders to get their money back without voting against the acquisition. There is only one logical reason for such a provision--to ensure transaction approval even if the majority of shareholders think it is a bad deal. In fact, the majority did not want to be a part of this, and asked for their money back.
The earn-out is extremely large (15 million shares), on very aggressive growth targets. This creates a very strong incentive for the management to inflate the numbers. Was there ever any doubt that they would "make" these earnings targets? Perverse incentives routinely lead to accounting misconduct even in markets like the US where legal protections and investor oversight are much stronger than they are in China.
One of the promoters, Ou Wen Lin, filed form 144 with the SEC that he was planning to sell 1,060,000 shares. After the stock tanked, the company issued a press release basically claiming that this was a typo or similar mistake, and that the correct number was 60,000 shares. One month later, Lin sold 1,000,000 shares through his vehicle Thousand Space Holdings. The company had no legitimate incentive and clear disincentives to issue this press release. Lin sold at a very low valuation and the company tried to cover it up.
It does not make sense that the company would sell shares to Starr at such a low valuation. Taking into account the deep ITM warrants, they sold equity to Starr at a very low single-digit P/E at a time when the company had NO legitimate need for capital.
On Dec 9, 2010, the CFO purchased 100,000 shares at $15 according to a filing. However, the insider vehicle Bright Elite Management also sold 100,000 shares at $15 on the same date according to a different filing. This was not a normal insider purchase, but a deceptive investor relations stunt.
On Sep 16, 2010, the company authorized a $30 million buyback and issued a press release. However, as far as I know, no shares have been repurchased. The failure to follow through is highly suspicious given the balance sheet and valuation.
We do not know Starr’s true motivation or whether they have hedged their investment. However, a few points: (1) Chinese private equity does not have a great track record in PIPE deals. A much more prestigious firm, Carlyle, was recently left holding the bag with a $40 mn investment in China Forestry, and may have made a mistake investing in CAGC. (2) To my knowledge, Starr is not a particularly prestigious investor. For many of the longs, their involvement in CCME is the first they have heard about Starr. (3) PE firms routinely “sponsor” their portfolio companies to get the story out to the institutional community so that they can realize a return on their investment. I view it as a negative that they haven’t done so here. (4) Starr negotiated a fairly onerous “put option” that triggers if certain net income targets are not met. This greatly reduces the validation value of the transaction and also contributes to the “perverse incentives” pointed out above.
GOVERNMENT EXCLUSIVITY DEAL
The company claims some kind of government exclusivity for inter-city buses. The exact nature of this deal has always been kept vague by CCME. (There is a very long statement in the 10-K which, strangely, does not actually clarify the deal.) The description has even changed over time. There is no reason to be vague about the exclusivity deal if it is real. Trade secrecy is a non-issue in this case. This is the public company analogue of someone saying, "I know a guy". I conclude that the deal is not what they imply it is.
The latest wording is "designation as the exclusive inter-city bus TV media by China's Ministry of Transport". However, this is confusing, because CCME claims lower than 100% marketshare. Their 10-K says: "[CCME] competes directly with existing smaller advertising network operators who place their network on inter-city buses that travel primarily between villages or on highways in China". You're not exclusive if others are doing the same thing as you.
BUSINESS ECONOMICS & ACCOUNTING ISSUES
Margins are significantly higher than public comps. 2009 gross margin% was 65.6% vs 49.4% for VISN, the strongest comp. EBIT margin% was 59% vs 22.4% for VISN. It does not make any sense that such a strong business would have any difficulty going public or obtaining financing on good terms.
The company has less than 100% marketshare. Since other companies have some ability to compete, I would have expected the excess margins to be competed away. Their product is essentially a commodity.
The company claims higher margin on airport shuttles versus inter-city buses. This does not make sense if the abnormal margins are a result of the government exclusivity deal, because the deal is for inter-city buses and not airport shuttles. Superior demographics may lead to higher revenues but not margins.
The advertising business is sensitive to the macro economy. All of CCME's public comps suffered gross profit declines in 2009. Yet CCME claims it grew GP by 65% in 2009.
For the period from 2008 (year-end) to 2010 (Q3 or run rate for revenues):
Display network equipment, gross of depreciation, grew 39%
Bus count grew 53%
Revenues grew 227%
I define “equipment efficiency ratio” as revenue $ per equipment $. This ratio grew by 135% over this period. However, ad rates grew only 16% (to Q2’10). Ad minutes grew by 33% due to the addition of embedded ads. This leaves a gap of ~80% unaccounted for. It does not make a significant difference if we substitute bus count for equipment $.
The company claims their CPMs are ~3% of comparable media. (1) Why should it be so low? Market exclusivity should give them pricing power. A "97% off sale" seems unnecessary. (2) Achieving CPM parity would imply a 33x gain even with flat bus count and utilization. 33x 2010E revenue would be $7 billion. Since costs presumably would not rise much, op margin would be nearly 100%. Does this scenario sound plausible? Baidu has TTM revenue of $1.2 billion.
The company implies to investors a >$7 billion market opportunity, and yet they concede industry low revenue share to bus operators and pay zero for their content. How does this make any sense?
The concession contracts have annual escalators of 10-30% per year, 15% is typical. These are very generous terms. (1) This is not consistent with the market power they should have as the exclusive provider (2) Margins will collapse when current contracts expire. The straight-line accounting will reset a higher rate. (3) This looks like CCME is desperate to put up growth numbers.
Even if the numbers are real, the shareholders are still screwed. They do not have legal ownership of the operating company, rather, there is a "contractual agreement" with the opco, which is controlled by the CEO, who can expropriate value at any time without legal consequence. (See S-chips scandal for examples.) This might be an acceptable cost of doing business in China if management is trustworthy, but in this case they are not.
Outside of Starr, quant funds, and index or closet index funds, there is virtually zero institutional ownership. Nor is there reputable sell-side coverage or buyout interest. This is completely unexpected for one of the largest advertising companies in China, especially one that claims such attractive economics and growth relative to share price. It is one thing to say that a couple organizations (Deloitte, Starr) are making a mistake. But how could ALMOST EVERY SINGLE INSTITUTION have missed this investment opportunity? Given the two choices, the second is much less likely.
Context is extremely relevant. Corruption is widespread in Chinese business and government, making it easy to get key parties (customers, partners, bankers, even auditors) to assist in a fraud. This is exacerbated by the prevalence of organized crime and incentives created by very low incomes. One only needs to go back to the S-Chips scandal in 2009 to see how widespread and sophisticated securities fraud is in China and the disadvantage at which foreign investors stand relative to Chinese stock promoters. Munger's "lollapalooza" effect is present here. From management's perspective, you have a combination of envy (your peers are getting rich, many illegitimately), and incentive bias (huge payoff, little consequence for defrauding foreign investors). Even if a manager started out honest in this environment, it would be quite difficult for him to remain honest.
There are also numerous red flags based on what longs have stated that they were told by the CFO or IR. However, since I did not hear these statements first hand, I will not repeat them. You can easily find them online.
N.N. Taleb, author of The Black Swan, tells an interesting story. A coin is flipped 50 times, and it lands heads 50 times in a row. The mathematician is asked what the probability is that the coin will land heads on the next flip. He answers, "50%". He argues that a coin's historical results do not affect future probabilities. The trader is asked the same question and he answers "100%". The trader has been around, and he realizes that the coin is rigged.
There is an old saying on Wall Street: "there are no coincidences". It is unlikely that the preponderance of red flags here is simply a coincidence. Even if it turns out that CCME is not a massive fraud, I think it would be a terrible idea to trust management.
Disclosure: We are short CCME through the stock and options, and we may change our position at any time without disclosure. This does not constitute investment advice.