Camelot is the most famous castle and court associated with the legendary King Arthur. It’s in Camelot where stories of romance, bravery, nobility and chivalry have captured the imagination of readers and historians for hundreds of years. Yet most scholars today would agree that Camelot is purely fictional, and its precise location has never been determined.
Perhaps the story of Camelot is a cautionary tale for today’s investor romance for the shares of Camelot Information Systems (NYSE:CIS). Founded in 1994, Camelot is a provider of business solutions and IT services to corporations and financial institutions in mainland China, Taiwan, Hong Kong, and Japan through a network of 28 regional and local subsidiaries. Over the years, Camelot has been actively expanding its service offerings through acquisitions and investments in developing solutions and establishing strategic partnerships with leading international IT product providers.
CIS is one of a handful of Chinese IT service providers to come public in the United States in the past few years. Among its peers are recently listed Chinese IT service providers such as Vanceinfo Technologies (NYSE:VIT), HiSoft Technology Int’l (HSFT), iSoftStone Holdings (NYSE:ISS) and the alleged fraud, Longtop Financial (NYSE:LFT).
CIS’s Financial Model Shows Unusually High Revenues Per Employee
At the heart of every service business is the talented pool of professionals to work with clients in delivering solutions to their most challenging IT projects. It is no wonder that China has emerged as a burgeoning country for the outsourcing of technologically challenging work. It is estimated that China produced 5 million college graduates per year with nearly 700,000 engineers. The cost savings of utilizing this vast Chinese talent pool have been estimated at between 50 – 70% versus a comparable US IT service provider according to Chinaoutsourcing.com.
The industry growth and profitability within China has created an intense warfare for employee talent for companies to gain a competitive edge. In fact, among every financial filing we analyzed, this was listed as a top business risk factor facing the Chinese IT service industry.
To illustrate, we have included excerpts on this matter from a few industry participants.
From Camelot Information Systems, 2010 Annual Report [emphasis ours]:
Our business involves the delivery of professional services and is highly labor-intensive. Our ability to execute current and future projects and to obtain new customers depends largely on our ability to attract, train, motivate and retain highly skilled personnel, particularly project managers, independent consultants, project leaders and domain experts. We believe that there is significant demand for those personnel. The loss of a significant number of our professionals or the inability to attract, hire, develop, train and retain additional skilled personnel may materially and adversely affect our ability to manage, staff and successfully complete our existing projects and obtain new projects. Increasing competition for these individuals may also significantly increase our labor costs, which may materially and adversely affect our profit margins and results of operations.
From iSoftStone, 2010 Annual Report:
Our attrition rates were 17.7%, 12.8% and 19.8% per annum in 2008, 2009 and 2010, respectively. We may encounter higher attrition rates in the future, particularly if China continues to experience strong economic growth. There is significant competition in China for skilled personnel, especially experienced middle and senior level management, with the skills necessary to perform the services we offer to our clients.
From HiSoft, 2010 Annual Report:
The attrition rate among our employees who have worked for us for at least six months were 18.8%, 13.8% and 14.6% for 2008, 2009 and 2010, respectively. Due to the cost of hiring and training new professionals, high attrition rates can negatively affect our cost of revenues and net income. In addition, we may face increasing difficulties recruiting the talent we need to staff our outsourcing facilities in less developed cities in China with lower average wages and living standards.
From Chinasoft, 2010 Annual Report:
The average turnover rate of the Group through 2010 was 12.3% which was lower than the sector average level. Despite that the costs of human resources have increased continuously in recent years, the Group was still able to increase earnings capability constantly through the continuous increase in the scale of business income and a series of cost and performance management measures...
The most notable omission in CIS’s disclosure on the competitiveness for employee talent is the topic of the attrition rate. Is it possible that CIS somehow has a more productive, loyal and satisfied employee workforce than the rest of its competitors? Let’s explore this question in further detail.
The first red flag that caught our attention is CIS's unusually high revenue output per employee. As the chart and table below indicates, CIS is an extreme outlier compared with its peers, but matched only by Longtop Financial, an alleged fraud that was exposed by Citron Research.
Among the set of companies with approximately $200m in annual revenue, CIS is reporting nearly twice the average revenue per employee and has the fewest employees in the peer group. This trend has remained consistent for the past few years.
click to enlarge images
We looked at CIS's overall business profile to see if we could explain this dramatic difference, but its business does not appear significantly different from its peers. As illustrated in the tables below, CIS’s revenue and customer mix is not materially different from its competitors. For example, CIS’s top ten customer revenue concentration and percentage of revenues from fixed-price contracts is comparable to its peer group. CIS also serves some of the same global, price sensitive customers such as IBM (NYSE:IBM), Lenovo (OTCPK:LNVGY) and Hitachi (HIT) as its competitors.
These facts make it highly unlikely that CIS is capable of generating an equal amount of revenue, with nearly half the workforce of the competition. Accounting for ~30% of revenues, IBM is CIS’s largest customer and attributable to a contract to establish a delivery center to provide enterprise application services exclusively for IBM’s customers. It is noteworthy that IBM recently renewed this contract with CIS in May 2011, but omitted a key clause that gave IBM a call option to purchase CIS’s Delivery Company at net asset value plus a percentage of cumulative revenues.
It may be inferred from this omission that IBM no longer sees value in acquiring this business from CIS, for whatever reason. The materiality of the IBM contract to CIS also underscores a unique risk facing CIS; IBM can terminate the contract at any time if certain conditions are met. CIS may also face termination if they are found to be competing with overlapping customers, a real risk we will explore when we discuss CIS’s recent acquisitions.
Later in this report, we will also call into question the idea that CIS’s employee workforce is somehow more experienced and higher-skilled, which allows them to charge a premium for their services.
CIS’s largest segment appears to be enterprise application services, a business that primarily focuses on SAP-based ERP services in two forms (i) packaged software services and (ii) software development and maintenance services. They provide services for systems ranging from traditional ERP systems, such as those offered by SAP (NYSE:SAP) and Oracle (NYSE:ORCL), to new dimension applications, such as customer relationship management, business intelligence, supply chain management, integration tools and manufacturing supply execution.
From the links below, it becomes clear that CIS competes broadly against all its peers in this business segment, and does not appear to offer anything unique that places them at a strong competitive advantage in this business.
- iSoftStone Enterprise Solutions with SAP and Oracle - here
- VanceInfo Enterprise Solutions with SAP and Oracle - here, here and here
- HiSoft Enterprise Solutions with SAP and Oracle - here
The analysis also reveals that CIS’s largest industry single group is financial services. This business primarily consists of system software support and maintenance, application software development and implementation services as well as consulting services in the financial industry, principally for banks and insurance companies. While all of these peers also provide solutions to the financial service sector, there are two public Chinese IT companies that exclusively work in this industry and they are Longtop Financial (LFT) and Yucheng Technologies (NASDAQ:YTEC). Upon reviewing their disclosure on their competitive landscape, neither company even mentions CIS.
Slide 9 of Yucheng’s March 2010 investor presentation shows a good competitive landscape overview of the Chinese financial technology market. The slide was produced with the help of an independent IDC report, and presumably the company’s own market knowledge. While showing the industry is fragmented, it is clear that neither Yucheng nor IDC considers CIS to be a materially important industry participant. Given the size of CIS’s reported financial service revenues of $67m in relation to Yucheng’s reported revenues of $61m, we find this to be a noteworthy result.
Longtop Financial’s last Annual Report also fails to mention CIS:
We also face competition from well-funded international platform providers, such as Accenture and IBM, domestic IT solution providers for the financial services industry, such as Digital China Holdings Limited, Yucheng Technologies Limited, Global InfoTech Group, Sinosoft, and other targeted solutions providers in certain market segments in which we operate.
The omission of CIS is not just limited from competitors’ viewpoints. For example, a recently released, independent research report on the state of the Chinese banking solutions market in March 2011 fails to indentify CIS as a meaningful participant in the industry; however, they do note both Yucheng and Longtop.
Furthermore, industry trade organizations such as China Sourcing (here) do not reference CIS as an industry participant. However, peers such as iSoftStone, HiSoft, Longtop, VanceInfo, and Chinasoft are all recognized independently among their list of “The Top 10 Leading Service Providers.” Meanwhile, CIS is not even listed among “The Top 100 Growing Service Providers.” The International Association of Outsourcing Professionals (IAOP) also compiles a list of the top 100 global outsourcing corporations and omits CIS, but names all of the same competitors listed above (here). Lastly, CIS is also absent from the China Global Services Alliance (here).
Given that CIS is very comparable in terms of revenue size, reported growth rate, and business/industry mix, we find these consistent omissions by both peers and independent sources to be a cautionary sign.
CIS’s Cost Structure Also Appears Inconsistent
We have established that CIS is claiming extraordinarily revenue productivity for a workforce that is performing similar services, to similar clients, in similar industries to many of its peers. Now let’s take a closer look at their reported cost structure.
The gross margins over the past three years are illustrated below:
Gross margin is impacted by cost of revenues for IT service companies, which mainly consists of outsourcing costs, compensation and benefit expenses (including share-based compensation expenses), travel expenses and material costs.
A deeper dive into the cost of revenues yields some interesting observations; In particular, we note that CIS’s compensation costs are primarily outsourcing costs, and that total wage expenses as a percentage of total cost of revenues is materially lower for CIS than its peers.
From this perspective, it appears that CIS is acting more like a staffing and placement operation, rather than a Company with deep technical knowledge and capable of achieving premium prices for its services as they suggest. CIS’s trend of outsourcing has accelerated in recent years, whereas its peers that disclose outsourcing costs have scaled back this practice.
The point is illustrated clearer in the chart below. While the trend for higher wage costs as a percentage of total revenue costs is rising, the differential gap to peers is certainly striking.
Furthermore, a closer look at selling, general and administrative expenses also highlights some important observations: CIS has consistently reported the lowest SG&A expense margin in the industry.
CIS’s SG&A margin has remained constant while it has been increasing industry-wide to support growth and general cost inflation. Recall that CIS has been reporting revenue growth consistent with the industry, so steady margins implies their cost structure is also growing at approximately the same rate. While plausible, this is very unlikely, especially in light of CIS's acquisition spree and need to integrate disparate business operations. Many in the industry have been indicating the increase in wage pressure due to the war for talent and overall cost inflation in China. This is best illustrated by some relevant disclosures.
From iSoftStone, Annual Report:
Our most significant costs are the salaries and other compensation expenses for our professionals and other employees. Wage costs for professionals in China are lower than those in more developed countries and India. However, because of rapid economic growth, increased productivity levels, and increased competition for skilled employees in China, wages for highly skilled employees in China, in particular middle- and senior-level managers, are increasing at a faster rate than in the past. We may need to increase the levels of employee compensation more rapidly than in the past to remain competitive in attracting and retaining the quality and number of employees that our business requires.
From VanceInfo, Annual Report:
Wage costs for professionals in China are lower than comparable wage costs in more developed countries and India. However, the wage costs in China’s IT services industry may increase at a faster rate than in the past. In the long term, wage increases may make us less competitive unless we are able to increase the efficiency and productivity of our professionals as well as the prices we can charge for our services. Increases in wage costs, may reduce our profit margins.
If we look closer at total wages (including outsourcing costs) and SG&A expenses per employee, we again find CIS to be an extreme outlier in its industry. The higher cost trend accelerated in 2010 as CIS’s wages cost grew by 80%, yet their stated employee growth was only 20%.
A View Into CIS From Its Employees
LinkedIn provides a valuable window inside a company. Technology professionals by their nature are technology savvy, and tend to embrace the LinkedIn platform. Therefore, we find it incredibly striking that CIS has virtually no employees registered on LinkedIn:
In fact, the user statistics indicate that almost all CIS employee profiles were created on LinkedIn shortly after going public and not a single employee has joined the site thereafter. For comparison purposes, each of CIS’s competitors has shown steady growth in employee profiles on LinkedIn.
LinkedIn also allows us to examine management’s claims that the experience and knowledge of their workforce is related to their ability to achieve superior pricing on contract terms. LinkedIn compiles statistics from its members that analyze both the education and work experience level for a given company and compares it with the average for the industry.
The charts below indicate that CIS’s workforce, albeit on a limited sample set, has greater percentage of workers with bachelor’s degrees (lower % of master’s degrees) than the industry. Furthermore, their workforce tends to be less experienced with nearly one third of employees having less than 5 years professional experience. Their IBM contract does tie prices to the experience level of its employees as indicated in Annex B of their agreement.
These results cast further doubt on management’s claims that they are able to achieve higher revenues per employee than their competition.
7Yes.com (Chinese version of Glassdoor.com)
If we are to take the company’s claims at face value, employees are supposed to be highly productive as indicated by the extreme measure of revenue per employee. Furthermore, we would expect employees to be satisfied with their compensation given that CIS is spending nearly twice the amount of money per employee on wages than its industry competitors.
Unfortunately, we find a contradictory view to these claims thanks to a Chinese career social networking website called 7yes.com. This website is analogous to the U.S. website called Glassdoor.com, which provides employee reviews and feedback on companies. Below are recent excerpts from the site.
We did not simply pick or chose negative posts; all of the posts, dating back to 2005 to the present, had scathing comments, particularly on the topic of HR recruitment, pay, and career opportunities (reference link is here):
"I received the offer from the company, who pushed for a contract. I told them I was not able to join, but the recruiter threatened me that I would not be able to look for the next job if I refuse."
"It is really bad. I know a friend owed half a month salary after leaving. Garbage."
"Garbage outsourcing company. Poor benefits. No bonus. No subsidy. Got taken off two month salary after resignation."
"Many people left like water. Those who are still there had better leave soon."
"Many boring positions without a future. Waste your opportunity if you go there."
"Camelot is truly awful. They break the laws. Go bankrupt soon! They did not give me my April salary even in June (now). They are a bunch of cyber-junkies (those who get paid for pumping)."
"Many boring positions without a future. You will waste your opportunity if you go there."
Questionable Acquisitions Are Generating CIS’s Growth
CIS has completed over 9 acquisitions in the past few years as part of its growth strategy, yet offers investors very limited disclosure on these deals. Below we take a closer look at 4 of the acquisitions recently completed and have highlighted areas of interest in grey.
- Unusually high goodwill and intangibles representing 75-100% of the acquisition price
- Companies acquired have limited to no property, plant and equipment value
- Companies acquired have limited contract backlog value and are being amortized in most cases over just 1 year
- Stock issued in most cases valued at under $6.00/ADS
It’s not uncommon for technology companies to be asset light business models, with much of the value comprised of employees, relationships, tech “know-how,” and brand value. Nonetheless, we find the high goodwill and intangibles, low PP&E and limited value attributed to contract backlog concerning. To illustrate, we point to the recent acquisition of Beijing Tansun Software Technology Co., Ltd. According to the company’s website (here), they’ve been in business for 10 years and have over 600 employees. At their stated $1m PP&E level, that equates to less than $1,700 per employee which seems incredibly low by any measure. The contract backlog value of $580,000 also doesn’t seem large enough to justify a fully employed workforce of 600 people.
Unfortunately, due to limited disclosure, we are not able to analyze the revenue and profitability for any of CIS’s acquisitions on an individual basis. Furthermore, the company has not even communicated these acquisitions to shareholders through press release announcements. For example, the most recent acquisition of Dimension InfoTech Ltd. in January 2011, CIS’s first transaction since coming public in 2010, wasn’t announced to shareholders.
The deal was quietly included as a note in the company’s annual report. It’s not hard to understand why CIS might not want to draw attention to this deal. For starters, Dimension shareholders received 4.4 million shares at $18.54/ADS; a healthy discount to the trading price for CIS stock, which averaged $25.00/ADS for the month of Jan 2011, and the 3 month trailing price average of $21.90/ADS. More importantly, the Dimension acquisition potentially places CIS in direction competition with IBM, their largest customer.
As can be seen here, Dimension InfoTech is a certified SAP consulting partner. However, according to CIS’s technical service agreement with IBM, they agreed to a non-compete clause for SAP consulting services, that if violated, could result in a termination of their IBM contract (section 16.0, non compete is here).
CIS’s Recent Acquisitions
CIS’s Balance Sheet Is Notably Weak
The impact of CIS’s acquisitions is evident when comparing its balance sheet among its peers. CIS has unusually high goodwill and intangibles, and low property, plant and equipment among its assets. High days sales outstanding and payables also indicate delays in paying and receiving cash.
Metrics shaded in grey indicated the weakest among the peer group.
Cash Management Strategy at Odds With Capital Requirements
The Chinese IT industry has grown over the years not only by serving its own domestic clients’ needs, but also by expanding to serve a global client base looking to tap into its cheap, and abundant workforce with localized knowledge. However, not every company in the industry has experienced the same international growth pattern. For example, CIS has seen little change in its overall business mix of revenues from customers outside of China and Taiwan. Their strategy has been to grow organically in China and Asia, but also through acquisitions as illustrated earlier.
The following pie charts indicate that China and Taiwan have become a greater proportion of CIS’s revenue mix on the past three years.
CIS’s Historical Revenues By Customer Origination
For comparison, we can see that Camelot has the highest proportion of Chinese and Taiwanese sales, and, therefore the lowest proportion of sales to the U.S. among its peer group.
CIS discusses the effect of its geographic business mix on its foreign currency exposure and reporting in its financial filings.
Camelot Information Systems, Annual Report:
A majority of our net revenues and a significant majority of our expenses are denominated in Renminbi, the legal currency of China .. For the year ended 2010, our net revenues denominated in Renminbi, New Taiwan Dollar, Japanese Yen and other currencies accounted for 83.4%,7.8%,7.6% and 1.2% respectively, of total net revenues.
As illustrated, it does not appear that CIS has material economic exposure to the U.S. Dollar other than “translation risk.” This is further supported by the fact that CIS does not have any operating subsidiaries in the United States, as indicated here.
CIS’s business entities with functional currency of RMB, Yen, NT$ and HK$ translate their operating results and financial position into the U.S. dollar, the company's reporting currency. Translation adjustments are reported as cumulative translation adjustments and are shown as a separate component of other comprehensive income. These translations are book entries only and do not require the physical movement of currencies.
Given the foregoing discussion, we turn our attention to the location of CIS’s cash accounts. A detailed comparison of cash management practices for industry peers is provided in the table below.
The analysis indicates that CIS keeps a majority of its cash in a U.S. bank account with Citibank. Given our understanding that CIS has limited business in U.S. dollars, and no U.S. operating subsidiaries, this appears unusual and out-of-line with industry practice. By comparison, its peers report sales to U.S. customers of between 25% – 55% of revenues, yet keep only minimum cash balances in the U.S.
All foreign exchange transactions involving RMB must take place through the People's Bank of China or other institutions authorized to trade. RMB is freely convertible only to the extent of current account items. For FX transactions under capital account items, such as making inbound and outbound direct investment, borrowing foreign loans, and repatriation of investments, prior approval of, or registration with, the State Administration on Foreign Exchange (“SAFE”) or its local branches is required.
CIS raised money in its IPO for working capital and general corporate purposes, as well as funding possible future strategic acquisitions. Keeping funds in the U.S. appears at odds with CIS’s financial needs and objectives:
- US$ yields are unattractive vs. RMB; the U.S. dollar is depreciating against the RMB
- Working capital needs are in RMB
- Acquisitions have predominately been in China and,
- RMB foreign exchange capital controls make keeping funds outside of China less liquid
Internal Controls Casts Doubt on Reliability of Financials
By its own recognition, CIS has a “significant deficiency” over its internal controls for the financial reporting period ending December 31, 2010. The significant deficiency identified primarily relates to a lack of continuing professional training on U.S. GAAP and SEC regulation and rules for key accounting personnel. Furthermore, CIS had a “material weakness,” which is a more severe issue, for the FY 2009 period and prior to going public.
The material weaknesses identified primarily related to: (i) lack of a comprehensive accounting policies and procedures manual in accordance with U.S. GAAP accessible to accounting personnel to ensure that accounting policies and procedures are followed; and (ii) lack of dedicated resources to take responsibility for finance and accounting functions and the preparation of financial statements in compliance with U.S. GAAP.
Who Is Overseeing the Finance and Accounting Function at CIS?
CIS’s current CFO is Mr. Gordon Lau. According to his published biography, Mr. Lau served as the CFO of BJB Career Education Company Limited (a company that failed to go public with Goldman and Credit Suisse underwriting it in Dec 2010 due to “market conditions,” a period when dozens of Chinese companies came public in the US), and as the CFO of Xinhua Finance Limited, a financial information company listed on the Tokyo Stock Exchange.
Certain readers may recall that Xinhua Finance also used to trade here in the U.S. on the Nasdaq under the ticker XFML, but was eventually delisted. Three former executives of Xinhua Finance are currently facing fraud charges and are set to go to trial (here). Mr. Lau was not implicated in the alleged fraud, but given the connection to the XFML and the foregoing statements on internal control weaknesses, we believe our cautionary stance on CIS’s financial disclosures are warranted.
Conclusion and Price Target
Our analysis has highlighted numerous concerns with CIS’s business model. While providing similar services in similar industries to its peers, CIS reports significantly higher revenues and costs per employee. Are we to conclude that CIS offers unique services, achieves premium pricing, and has a highly productive and well-paid workforce?
To the contrary, we find no evidence they offer unique services that deserve premium prices, and we find compelling evidence that employees are dissatisfied in a number of areas including recruitment, pay, and the quality of career opportunities. Unlike its peers that report significant employee turnover, CIS does not, so we wonder if CIS is intentionally concealing troubles with retaining employees, or just a staffing company cloaked as an IT services specialist?
We also illustrated that employees are nearly absent from LinkedIn, a popular and global career website. This observation makes us wonder: Is CIS’s business growing as fast as they are disclosing? One thing that is growing is the company’s pace of acquisitions. We present evidence that indicates CIS is paying extreme premiums for business that appear to have little in operating assets and contract backlogs, funded with stock at a large discount to its current value.
We also find evidence of an unusual cash management strategy at odds with industry practice and the company’s own financial needs. For a company that has acknowledged material weaknesses in its financial reporting, we are extremely cautious and conclude that Camelot’s stock value may be closer to fantasy than reality.
Given our concerns about the quality of Camelot’s business, and the reliability of its financial statements, we believe the stock should trade between a range of $2.50 - $5.00 per ADS, where the low end is cash value and high end is the average implied share price of Camelot’s stock issued for recent acquisitions.
Therefore, our target price is the midpoint of our range or $3.75 per ADS.
Value of Camelot’s Share Price Implied From Recent Acquisitions
Disclaimer: Use of the research produced by Spruce Point Capital Management, LLC is at your own risk. You should assume the author of this report holds positions in the securities and derivative securities of Camelot Information Systems that will benefit from a drop in the price of the common stock. Following publication of the report, the author (including members, partners, affiliates, employees, and/or consultants) may transact in the securities of the company covered herein. The author of this report has obtained all information contained herein from sources believed to be accurate and reliable and has included references where available and practical. However, such information is presented “as is,” without warranty of any kind– whether express or implied. The author of this report makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any of the information contained herein. Spruce Point Capital Management, LLC is not a broker/dealer or your financial advisor and nothing contained herein should be construed as an offer to or solicitation to buy or sell, or recommendation, for any investment or security mentioned in this report. You should do your own research and due diligence before making any investment decision with respect to securities covered herein, including, but not limited to, the suitability of any transaction to your risk tolerance and investment objectives and consult your own tax, financial and legal experts as warranted.