While investors have placed most Chinese RTOs under heavy scrutiny, a few have slid by under the radar. Since investors have been attracted to the companies with the most difficult-to-believe reported financial performances, companies reporting less outlandish results have been able to escape the market’s skepticism. Cogo Group (COGO) has been one of these companies; with its trailing P/E that until recently had stayed at more than 10 and a bumpy series of recent quarters, the market has given the company the benefit of the doubt and assumed its operations are legitimate. Short interest is only two percent of the float (as of June 15th) – one of the lowest in the entire Chinese RTO space.
And while Cogo hasn’t reported seemingly impossible financial results, there are plenty of reasons for concern. In this Part 1, I discuss specific red flags and disturbing transactions that cast doubt on the integrity and judgment of Cogo’s management team. In Part 2, I will analyze Cogo's business more generally and show proof that it is in a general state of decline. And In Part 3, I will document how the company's newly-launched Cogo 3.0 online strategy is unlikely to revive the company's fading fortunes. Added together, the various red flags and structural business-related problems make me conclude that Cogo's still is greatly overpriced, and that a $2.00 target price is a entirely reasonable.
For those unfamiliar with the company, Cogo (until recently named Comtech) is a middleman within the semiconductor arena that designs, at no cost, products for customers and then attempts to get the customer to source some of the supplies for the custom-designed product through Cogo. If you're confused, just wait until you attempt to decifer the company's jargon-filled website:
Headquartered in Shenzhen, Cogo procures core technologies from leading global semiconductor suppliers and develops customized modules for our end market customers. We also serve as a gateway for our suppliers in accessing leading electronics manufacturers...
There is plenty of evidence that Cogo's business, whatever exactly it may be, is in a generally declining state. And there are several very acute signs of trouble. These include questionable acquisitions and seemingly undisclosed insider transactions. But I'll start off with an odd pair of facts. One: Cogo gave away 30% of the equity in its largest subsidiary, Comtech Broadband, to an employee as compensation late last year. Two: That subsidiary, which generates more than half of Cogo's revenues, lost almost half its market value from 2007 to 2010.
The Great Equity Giveaway
It's hard to believe that a publicly traded company would give away 30% of its largest revenue-producing subsidiary to an employee as a compensation award. But that's just what Cogo did. Cogo hasn't even told investors which employee received the gift; it seems like a gross violation of management's responsibility to simply give away millions of dollars of shareholder value without telling investors why it was necessary. Here is the relevant section of Cogo's 10-K disclosure:
On December 31, 2010, the Group entered into an agreement to award 6,000,000 shares of Comtech Broadband’s common stock (“Equity Shares”) to an employee of Comtech Broadband (the “Comtech Broadband Stock Grant”). The purpose of the Comtech Broadband Stock Grant is to provide additional incentive to the employee. The Comtech Broadband Stock Grant was immediately vested upon grant.
The fair value of the above equity shares vested during the year ended December 31, 2010 was USD 4,800[,000] [...]
The fair value is based on a discounted future cash flow that uses the Group’s estimates of revenue, driven by assumed market growth rates, and estimated costs as well as appropriate discount rates. Since Comtech Broadband is a private company, the Group applied a 20% marketability discount in carrying out the valuation. These estimates are consistent with the plans and estimates that the Group use to manage the business.
Why is management so willing to give away 30% of its largest subsidiary? And, who received this generous gift? $6 million (the stated $4.8 million plus the re-inclusion of the marketability discount) seems like an awfully large expense for an employee incentive. In addition, will Cogo be planning on giving away large chunks of its other subsidiaries to its unnamed but apparently highly valued employees in the future? The impact of this generous gift should be immediately felt by the company's investors; Cogo's largest subsidiary is now only 70% owned, and as such, it will produce roughly $65 million less revenue for Cogo (since that revenue will go to the minority interest) this year. For a company doing $420 million a year in annual revenues, a $65 million revenue hole is a significant problem.
Cogo's Own Internal Valuation: $2/Share
Shareholders have another reason to be alarmed. This gift allows us to reach another conclusion; by Cogo's own valuation, we find that the whole company is worth roughly $2/share. Here's how. Prior to 2007, Cogo owned 55% of Comtech Broadband. In 2007, Cogo purchased the remaining 45% of Cogo Broadband equity for 113 million RMB ($15 million at 2007 $/RMB exchange rate). This valuation would make Cogo Broadband as a whole worth $33 million. But, now Cogo Broadband is only worth $20 million. (Side note: According to this Cogo 10-K, in 2007, Comtech Broadband produced 14.4% of Cogo's revenues. Today, Comtech Broadband produces more than 50% of Cogo's revenues. And yet, Comtech Broadband's valuation has dropped sharply from 2007 until now. What's that say for the rest of the business?)
Further in the disclosure, Cogo also states that the gift was worth $4.8 million ($6 million minus a 20% marketability discount since Comtech Broadband is privately held) and that Cogo operates roughly 52.3% of its business through Comtech Broadband. Since 30% of Comtech Broadband is worth $6 million, we can deduce that the other 70% of it is worth $14 million.
Since, according to Cogo's own assessment, its subsidiary that produces 52% of its revenue is worth merely $20 million, how much is the rest of the company worth? The simple math would suggest the whole Cogo enterprise is worth no more than roughly $70 million (Comtech Broadband being worth $20 million, the other 48% of Cogo's revenue being worth another ~$20 million, and the difference between Cogo's cash balance and debts being around $30 million). Of course, it gets more difficult once you factor in accounts receivables, inventories, etc. across Cogo's myriad subsidiaries.
In any case, since half of Cogo's revenues are worth $20 million, one has to seriously question the market assigning more than $135 million in value to the other half. If all of Cogo's enterprise were valued at the same market price that Cogo itself valued its Comtech Broadband subsidiary, Cogo would have a market cap of $70 million ($40 million enterprise value and $30 million of net cash) and a share price a hair south of $2.00 (Cogo presently trades at better than $4/share).
Unending Acquistions: Cogo's Version of Growth
Cogo has had a consistently spotty record of growing by internal innovation. My scan through Cogo's AIC filings found that several of its subsidiaries have seen sharply falling sales, profit margins heading into the negative, and even in one case, a nearly-complete cessation of operations. Lacking consistent internal growth, Cogo has turned into a serial acquirer. A look at Cogo's historical cash flow statements shows that the company has spent a significant chunk of money in each year from 2006 onward on new acquisitions.
These acquisitions just about define the phrase "buying revenue". Cogo's press releases breathlessly tout the company's growing top-line while attempting to hide the fact that operating margins keep shrinking. As we'll see in part 2, Cogo's top-line revenue growth is merely a red herring that disguises sinking business performance. This is in large part due to the low quality of the acquisitions Cogo has made.
All Sizzle, No Steak: Exploring Cogo's Buyout Targets
As the old saying goes, a good salesmen "sells the sizzle, not the steak." Cogo is clearly outmatched. Almost every time Cogo goes to the bargaining table, the salesman has seemingly gotten the best of Cogo. The company has consistently purchased assets at dubiously high prices, thus making one conclude that the company is either a bad bargainer, or more darkly, that it is consistently overpaying for acquisitions to funnel money out of the company.
Cogo has a track record of purchasing companies with little to no (or even negative) tangible net equity. Cogo buys a company with tons of "intangible assets" such as customer relations or non-compete agreements, but almost no actual tangible assets such as factories, cash, or inventories. I've put together a table showing the details (all prices in RMB) (data courtesy of Joshua Wallis' report, page 2):
Total Intangibles |
|2006 -- Viewtran||57 million||59 million||47 million||10 million|
|2006 -- 40% of Shanghai E&T||9 million||16 million||5 million||4 million|
|2007 -- 45% of Comtech Broadband||113 million||113 million||75 million||48 million|
|2007 -- Keen Awards||73 million||66 million||73 million||0 million|
|2008 -- 70% of Longrise||56 million||61 million||35 million||21 million|
|2009 -- Mega Smart||131 million||122 million||51 million||80 million|
|2011 -- MDC Technologies||163 million||144 million||113 million||50 million|
As you can see, Cogo tends to purchase assets with almost no tangible assets. In three cases (Keen Awards, Mega Smart, MDC Technologies), the companies purchased had more intangible assets than total assets. This leads us to the remarkable conclusion that Cogo has made a habit of buying companies with negative equity. Cogo is clearly desperate to grow revenue at any cost, and as such is willing, it seems, to acquire just about any going concern with revenues in order to keep up appearances of growth. Needless to say, shareholder equity is continuously squandered in these dubious transactions, as we'll explore more in part 2.
Seemingly Undisclosed Related-Party Transaction: Uh-Oh
Making matters worse, one must suspect management is up to something more than just bad business judgment with its unending stream of purchases, given the fact that the company appears to have hidden a seeming related-party transaction.
In Cogo's 2004 10-K, we learned that Cogo CEO Jeffrey Kang owned close to 7% of Viewtran's equity as Viewtran was listed as a related-party to Cogo (Cogo purchased products from Viewtran and also received non-interest bearing loans from Viewtran). Also an 8-K from 2004 indicates that Mr. Kang had a controlling interest in Viewtran. In 2006, Cogo purchased Viewtran at what seems to have been an inflated price (59 million RMB ($9 million) purchase price of which 47 million RMB ($7 million) was goodwill). Cogo did not, as best as I can tell, disclose any related party connection when making the Viewtran purchase or in any subsequent filings. Cogo did, however, state that Viewtran had not been profitable prior to the acquisition.
Let's review. Cogo bought an unprofitable company with nearly no tangible equity the Cogo's CEO Jeffrey Kang had a controlling interest in. On top of that, Viewtran had a track record of business dealings with Cogo and even gave a Cogo subsidiary interest-free loans. These businesses were closely intertwined. At best, the transaction seems suspect, and at worst, management could perhaps be funneling funds out of Cogo with transactions such as the Viewtran acquisition. When a company pays a high price for an asset of questionable value that the CEO owns a controlling stake in, one can't help but wonder if something inappropriate occurred. Cogo discloses almost no information on the subsidiaries it has acquired; we don't know past ownership and have no way of knowing if CEO Jeffrey Kang was involved in other companies that Cogo subsequently purchased.
Cogo: Another Dangerous Chinese RTO
As we've seen, Cogo has some specific worrisome characteristics. Its management team attempts to grow revenues with a questionable merger roll-up strategy. It is apparently willing to give away large chunks of the company to anonymous employees without explanation. And, Cogo's management has shown a willingness to engage in unseemly related-party transactions. According to Cogo's own valuation of its revenue, the company is worth a bit less than $2/share. I concur with that estimate, and I've found no good reason to disagree with that price target. In fact, with Cogo's underlying business in steady decline, and with its online strategy seemingly dead on arrival, as we'll see in parts 2 and 3 of this series, I wouldn't be surprised if Cogo shares are worth even less than $2/share.
Disclosure: I am short COGO.
Additional disclosure: I and researchers who assisted me have short positions in or own options on the equity covered in this article. We stand to gain significantly if the equity of the company discussed markedly declines in price. Following publication, we may transact in securities of the company discussed. To the best of my knowledge, all information in this article is accurate, reliable, and has been obtained from public sources. However, I present the information "as is" and I will not necessarily update or supplement this article in the future. This information is not a recommendation or solicitation to buy or sell securities, nor am I a registered investment advisor.