Spreadtrum: Is Muddy Waters Right?

Muddy Waters recently released an open letter to Spreadtrum Communications Corp. (NASDAQ: SPRD), and raised several issues questioning the credibility of the company’s financial statements and rationale underlying key management changes. As an investor who has followed SPRD for the past two years and specialized in emerging markets equities, I found most of Muddy Waters’ claims groundless, except for one question regarding taxes.

IV. SPRD’s lack of any cash income tax payment in 2010 is inconsistent with prior years as well as the PRC’s provisional tax payment requirements. The table below shows SPRD’s pre-tax income, income tax provisions, and cash taxes paid for 2008 – 2010.

My response: Though not a tax expert, it does raise some suspicion looking at the cash income taxes paid item on their cash flow statement.

According to PRC law, corporations should prepay income taxes quarterly based on their accounting income, plus a 25% tax rate. When the fiscal year is over, companies can either get refunds from or make up the shortage to the tax agencies in China when reconciled, the difference between taxable income and accounting income before May 31st. As a result, one should witness a cash outflow under the cash income taxes paid item, which is essentially the prepaid tax expense. However, there was no such cash outflow as pointed out by Muddy Waters.

Personally, I can only come up with two possible explanations:

1. There was some mutual agreement between the Chinese tax agencies and SPRD for the company to delay its prepaid tax expense. It is not unusual for a company to do so in China if the tax amount is large and the agency is comfortable that the due amount will be paid off without question in the subsequent year. As shown in SPRD’s 2011 Q1 financial results, the company incurred a USD 3.4 million income tax expense. Accordingly, there is an increase of income tax payable on the balance sheets of roughly the same amount. It also can be implied that up till the end of Q1 2011, the company has made no cash payments for income taxes.

One may ask then, why would some company want to delay their prepaid tax expenses? Firstly, SPRD was subject to a two-year tax exemption and three-year tax deduction prior to Jan 1, 2008 as a high tech company. Such tax benefits were revised in 2008 under PRC tax law, and also, SPRD no longer enjoyed tax holidays as the company did not fall into the high tech category anymore. It is possible that the company was/is in the process of applying for a high tech status, thus wanting to delay the prepaid tax expense in the hope of getting back the tax benefits. Noted, it is much easier to make up the shortage of tax expense than to get a refund from the tax agencies, which may take a few months to go through the process.

That being said, it is still suspicious that the company didn’t make any cash payments at all. Also, the management didn’t respond to the tax issue in their conference right after Muddy Waters’ open letter. (It is understandable though if such an agreement really did exist, since it is essentially ‘illegal’.)

2. Another explanation would be: it is simply a fraud that the company never earned the revenue, thus wouldn’t pay the tax at all. It is hard to do in practice, however. The tax agency would request a formal audited financial report, in order to reconcile any tax differences. As a public company with a USD 10 million tax due, I don’t think SPRD can easily get away with that.

(Note: SPRD made a mistake in its 2011 Q1 result that “Accrued expenses and other current liabilities” should be “Income tax payable”, the two lines should have been reversed in order to be consistent with their previous financial statements.)

I. SPRD reported that revenue increased 229.6% in 2010, after generally being flat in 2007-2009. Can you please explain the sales increase in light of the following 2009 management changes:

· Founder Ping Wu resigned as CEO in February 2009. According to a July 2010 interview in a respected business publication, Mr. Wu resigned because the board had lost confidence in him. SPRD’s sales cycle is four to nine months2 and the turnaround began almost immediately after Mr.Wu resigned – revenue grew quarter over quarter in Q3 2009 by 136.6%. Therefore, the improved sales pipeline would have been evident under Mr.Wu.

Why would the board have lost confidence in Mr. Wu when the sales pipeline was so promising?

My response: SPRD is a fabless semiconductor company that develops baseband and RF processor solutions for the wireless communication markets. The company was founded by Wu Ping along with a couple other Chinese entrepreneurs in 2001, with the idea to develop China’s own 3G cell phone chips. In the early years of the company, the management’s strategy was to focus on the yet developed 3G markets, and followed the TD-SCDMA standards endorsed by China Mobile (NYSE:CHL). The yet materialized 3G markets, misunderstanding of the market demands, and poor execution of management led to a dramatic drop in SPRD’s top line in 2008. (See co-founder Chen Da Tong’s interview.)

Wu Ping lost the confidence from the board in 2008 instead of 2009. As a result, Wu Ping invited his former co-worker Leo Li, the current CEO, to join SPRD in the hopes of turning around the company in mid-2008.

Leo Li and Wu Ping used to be co-workers at Moblink Telecom; Leo Li served as the head of cell phone department and Wu Ping worked under him, responsible for VLSI design.

Leo Li implemented several measures to improve the product quality and operation efficiency. The successful launch of a star product 6600L made SPRD - for the first time - comparable to its direct competitor Mediatek in terms of product quality.

Also, according to Chen Da Tong, Leo Li was able to secure a major contract with China Mobile in early 2009, which explained the revenue surge in the subsequent quarters.

II. We note that CFO Richard Wei resigned in April 2009, which was one month before SPRD completed a $44 million financing. Because it would be unusual to fire a CFO during the financing process, is it fair to assume that he chose to leave? If “yes”, why would he have left with such strong sales in the pipeline?

My response: According to what I know, Mr. Wei was asked to leave the company instead of resigned because of his poor performance.

MediaTek (2454.TW) had approximately 90% of the mainland China mobile handset chip market in 2009. Mobile handset chips are by far its largest revenue source – currently accounting for more than 70% of revenue.3 Estimates now place MediaTek’s mainland market share at only 70%, with SPRD at 20% (an increase of about 15 percentage points). (It appears that these estimates are based in part on SPRD’s reported numbers.) However, MediaTek reported that its 2010 revenue decreased by 1.4%. For MediaTek, which relies heavily on mobile handset chips, to have reported a sales decline of only 1.4% while seemingly losing 15 percentage points of market share to SPRD, the mainland China market for mobile handset chips must have grown substantially in 2010. However, we note that both SPRD and MediaTek faced headwinds as mainland China authorities cracked down in 2010 on gray market handset manufacturers. At the high end of the market, Qualcomm (NASDAQ:QCOM) only grew its 2010 revenue 5.5%. By how much did SPRD’s mainland China markets (by product type) grow in 2010?

My response: Muddy Waters’ question showed little understanding of China’s cell phone industry. The Chinese feature phone markets started to grow in 2008, exploded in 2009, matured in 2010 and slowed down in 2011. (For example, feature phone shipments increased by 30% in 2009.) Mediatek’s flat revenue and lost market share contributed to a growing feature phone market and strong competition from SPRD.

SPRD’s disclosure related to its 2010 revenue is unhelpful and opaque. The 2009 20-F disclosed RF transceiver and baseband semiconductor sales figures. However, the 2010 20-F does not discuss sales of these products. Instead the 2010 20-F discusses the percentage gains for sales of all bundled semiconductors (without ascribing any dollar values).We take issue with the opaque 2010 disclosure because we believe that issuers should provide “apples to apples” information in successive periods, and the 2010 disclosure is frankly vague and unhelpful. What were 2010 sales of RF transceivers, baseband semiconductors, and any other products SPRD began selling in 2010?

My response: It is true that the company didn’t release specific segment sales information regarding baseband chips and RF transceivers. However, the issue is the mere quality of financial statements instead of “material misstatements” claimed by Muddy Waters.

V. The near simultaneous turnover in 2009 among SPRD’s CFO, audit committee, and auditor is troubling. In October 2009, SPRD’s CFO, David Wu, resigned after only four months in the role. This was the second CFO in 2009 to resign. In September 2009, audit committee member Ken Lu resigned from the board. In September 2009, Deloitte Touche Tohmatsu was “removed” as auditor, and replaced by another Big Four auditor, PriceWaterhouseCoopers Zhong Tian. Given that the turnover occurred while SPRD was in the midst of a stunning turnaround, did the resignations and removal have anything to do with discomfort about SPRD’s accounting? If not, what were the reasons each resigned (or was removed in the case of Deloitte)?

My response: Given the recent Chinese fraud, I would consider PWC a better auditor as compared to Deloitte. Deloitte has a well-established reputation in North America. However, it is probably the weakest among the bigger four in Mainland China. In order to grow in China, Deloitte acquired a Chinese local accounting firm called Tian Jian in 2005. It is said in the industry that Deloitte’s aggressive market expansion through taking many small companies as clients, as well as its merger with Beijing Tian Jian, cast doubts on its professional level.

In response to Muddy Waters’ question, I wouldn’t think it's a big problem for a new CEO to make some management changes.

VI. We note that the sizes of five balance sheet / cash flow statement accounts grew tremendously in 2010. These accounts are among those that we consider high risk because they are primarily evidenced by paper documentation, rather than their physical presence (as in machinery and equipment). The abundance of paper accounts on the balance sheet was one of the early signs to us that Rino International Corp. was a fraud. It is clear that auditors in China are having significant problems evaluating the veracity of documents. As discussed infra, we note that 44.8% of SPRD’s 2010 year-end inventory is “deferred cost”, which means that the inventory has been shipped to customers, but has not yet been booked as revenue. We therefore assume that the auditors did not lay eyes on most (if not all) of the deferred cost inventory. The cash flow statement accounts that bother us the most because of their unusual sizes in 2010 (compared to earlier years) are shown below – note that all are operating cash flow accounts.

As a general matter, can you explain why the size (in absolute value terms) of each of these accounts is much larger than in the past? What processes did the auditors undertake to confirm the sizes of each of these accounts?

VII. Among the accounts shown in the prior question, we are most concerned about the increases in inventory (especially the deferred cost sub-account) and advances from customers. We believe that having enormous simultaneous increases in advances from customers and deferred costs is implausible. A blogger recently stated that SPRD’s new clients are being given up to 90 days to inspect the chips because SPRD is a new supplier, which is the reason for the deferred cost. If SPRD agrees with that assessment, we are a bit perplexed as to how SPRD would maintain good relationships with its existing clients – presumably they would be unhappy with the preferential treatment being given to new clients. We note that MediaTek has no deferred cost account, and thus does not appear to extend this policy. The rationale that new customers want the inspection period because SPRD is a new supplier also strikes us as odd because SPRD and its main competitor.

MediaTek are fabless semiconductor companies. SPRD’s chips are assembled by TSMC. Supplier-specific product defects would therefore be more likely due to design issues than manufacturing, and SPRD’s 20-F indicates that clients test the designs before ordering. Why have each of advances from customers and deferred cost become so significant?

My response: I would like to answer the above two questions together. The inventory issue has been raised by a number of sell-side analysts in SPRD’s earnings conference call. It is explained by the management that the company has recently changed its revenue recognition policy that clients are given 60 to 90 days as an inspection period.

The key question here is that among the piled up inventory, how many are the newly shipped chips and how many are left from last quarter, which may result in a huge inventory write off in the subsequent quarter. According to some blogger familiar with the case, in the total 200 million worth of inventory, around 20 to 30 million is the actual inventory, 70 to 80 million is the result from its overseas sales adopting the new accounting policy, and the rest is due to conservative revenue recognition policy.

Personally, I do not like the way the company recognizes its revenue. It is subject to earnings manipulation in the sense that the management is given more flexibility to determine the top line. Based on my research and conversations with industry people, I believe it is less likely that SPRD has fraud in their financial statements in order to boost earnings, but rather to smooth out revenue fluctuations.

That said, we will have to wait till the next earning season to check if SPRD will release the “hidden” revenue, if at all.

Is SPRD acquiring MobilePeak in two stages because MobilePeak had an urgent need for liquidity? Why is SPRD acquiring a company that evidently was unable to raise additional funds from its existing investors? Given that SPRD’s previous acquisition of Quorum Systems from large venture capital investors resulted in impairment charges of $49.8 million (71.1%)9 within the same year of completing the acquisition, what assurance can you offer that the MobilePeak acquisition will be more successful?

My response: It wasn’t a failure when SPRD acquired Quorum as the company has successfully utilized Quorum’s RF technology and become a major supplier for Samsung (OTC:SSNLF). It is also mentioned by Muddy Waters that SPRD’s sales surged when they bundled RF with baseband semiconductors.

MobilePeak is a developer for low-cost full featured baseband and RF semiconductor solutions for 3GPP, WCDMA, HSPA and HSPA+ standards. SPRD has a strong command to enter the WCDMA markets and it would take years for the company to develop its own chips. MobilePeak’s technology is for sure rough as compared to Qualcomm’s (QCOM), however it’s cost efficient. The synergy regarding this acquisition couldn’t be more obvious.

That being said, it ultimately depends on the management to play out the 3G game.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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