Seeking Alpha
Hedge fund manager, long/short equity, small-cap
Profile| Send Message| ()  
Global Sources Ltd. (Nasdaq: GSOL) is perhaps the original and oldest existing China Reverse Takeover ("RTO") Company in the US stock market. In March 2000, Global Sources exchanged 100% of its shares for a 95% stake in Fairchild (Bermuda) Ltd., a subsidiary spun-off from the now bankrupt Fairchild Corp. Through this deal, Global Sources obtained a public listing on the Nasdaq in order to provide liquidity to shareholders and a venue for raising an additional source of funds for expansion.
A closer look at GSOL’s business model reveals indications of weakening fundamentals, and significant customer dissatisfaction with online media services, which is the company's largest and fastest growing revenue source. We also find a number of unusual issues with its financial reporting including a lack of standardized reporting metrics, voluntary changes in accounting standards from GAAP to IFRS, changes in auditors over "fees," and multiple CFO and executive transitions. Furthermore, we believe the Company has an unusual financial strategy, which has focused on misallocating significant capital to real estate purchases, at the expense of internal investment to its core businesses. Through our research, we are unable to explain or justify any of these financial actions, and conclude the Company is not run for the benefit of public shareholders.
What does Global Sources do?
Global Sources is a business-to-business (“B2B”) media Company that provides information and integrated marketing services to connect buyers and sellers for a range of products, with a particular focus on the Greater China market. The Company’s revenue is generated through one of three segments:
  1. Print media – Publication and distribution of trade and product catalogues. Suppliers pay for advertising in trade magazines to promote their companies’ products. Other revenue is derived from buyers that subscribe to the trade publications and sourcing research reports
  2. Online media – Website allowing buyers to find product suppliers. Suppliers are charged fees for the hosting and presentation of their products. Other revenues are derived from banner advertising and distribution of a digital e-magazine
  3. Trade shows and exhibitions – Organized shows to match buyers and suppliers. Revenue is primarily from exhibit space rentals, but also from advertising and sponsorship fees in show guides and other locations in and around event venues

GSOL claims more than 1 million active international buyers use the site from more than 240 countries and territories to connect with suppliers. In mainland China, the Company has a network of more than 40 office locations (60 global locations) and a community of nearly 3 million registered online users and magazine readers of its Chinese-language media. GSOL delivers information on over 5.7 million products and more than 262,000 suppliers annually through 14 online marketplaces, 13 monthly print and 18 digital magazines, over 90 sourcing research reports and 73 specialized trade shows a year across nine cities.

(Click charts to expand)

GSOL’s Fundamentals are Weakening

If we take a closer look at each GSOL’s three revenue segments we can better understand why the foundation for growth may be weakening. The table below shows the revenue trend for each of the three segments.

In the Print Services segment, revenue has been declining for each of the past three years, primarily from the secular shift occurring to online media advertising and the intensely competitive pricing environment. For the six months ended 2011 compared with 2010, this segment’s revenue has declined by 23%. The trends are expected to continue in this segment in the future.

Offsetting the decline in Print Services segment, Online Media Services revenue grew 25% for the six months ended 2011 compared with 2010 as a result of greater revenue from hosting online websites and digital magazines. We estimate a long-term growth rate for this segment at 10-15%.

The Exhibitions business was started in 2003 and after a period of rapid growth appears to have matured relatively quickly having grown only 5% for the six months ended 2011, compared with 2010. We estimate long-term growth may be constrained by the frequency and type of shows that can be hosted in GSOL’s current markets.

The exhibition business is also competitive; the Company competes with others, including Hong Kong Trade Development Company (HKTDC), which is government-subvented statutory body and the largest trade show organizer in Hong Kong with deep financial resources. The success in this segment has been historically heavily dependent upon shows in China. Additional revenue growth will have to come from successfully entering new markets such as India and U.S.

Taken as a whole, GSOL’s main pillar of growth rests on its ability to execute in the Online Media Services segment. However, this is not without its challenges as the Company has numerous competitors, some with significantly more resources such as Alibaba.com (OTC:ALBCF) and also HKTDC. Other noteworthy competitors include HC International (OTC:HCINF), ECVV.com as well as a variety of other competitors since barriers to entry are low. Below is just a sample of a few companies offering B2B services online.

To assess GSOL’s relative position in the online space, we’ve looked at the page ranking using public sources such as Alexa. The statistics indicate that GSOL is losing share to strong rivals such as Alibaba and HC International. Both sites have been posting increasing traffic rank and daily reach metrics over the past few years, while GSOL has largely seen a stagnation of traffic. It would certainly be easier to evaluate GSOL’s online business if it disclosed information such as new customer additions, customer churn, revenue per average user, number of paying members, customer acquisition costs, etc. However, GSOL is opaque on these matters and does not report regular operating metrics for investors to evaluate its ongoing performance.

Global Sources Not Immune to Problems Plaguing the Industry

Fraud has been a major issue facing the online providers of B2B trade services. The story typically goes as follows. An unscrupulous supplier gains access to a trade website and advertises a particular product and convinces a buyer to purchases the product. The seller then either does not deliver the product or delivers a product not meeting the advertised specifications or is of inferior quality.

The problem has become so rampant that The Office of U.S. Trade Representative named the online China B2B/B2C markets as a “Notorious Market,” (pdf) and called for more action from local authorities to combat the issue. The industry leader Alibaba (OTC:ALBCF) had to confront the issue headlong by issuing a statement that the Company will visit the facilities of all paying members of its China Gold Supplier program over the course of a year after more than 2,300 vendors used Alibaba’s website to defraud buyers, and about 100 employees were responsible for letting sellers create bogus storefronts. Alibaba’s Gold Supplier program for Chinese exporters fell by more than 4,200 in the quarter ended June to about 112,000, Alibaba said last month. In the previous three months, the Company lost more than 4,800 Gold Supplier members.

B2B websites like Alibaba and GSOL advertise suppliers as “Gold” members or some other form of internally developed ranking system. The fact remains that these rankings appear to be nothing more than marketing gimmicks that the customers can pay for to receive more favorable rankings or profile appearance on the B2B website. For example, GSOL says on the website that it conducts “3 or more visits or calls to a supplier company” and checks “business licenses” as part of the supplier verification process. As we can all imagine and have witnessed in numerous cases, these protection measures are easily circumvented by any motivated fraudster. Independent credit checks and protections are listed as optional by GSOL suppliers.

When it comes to buying products on GSOL’s website, the mantra "buyer beware" cannot be stressed more. The critics have certainly expressed their scathing opinions of the protection measures the Company has used to combat fraudulent suppliers. A simple web search reveals numerous customer complaints from bad experiences on GSOL’s website, even from suppliers purported to be ranked highly.

I had a bad experience getting connected by GlobalSources.com to a Chinese company CATIC. The company CATIC had none of the capabilities listed on GlobalSources.com who gave the top rating as a 'verified supplier.'"

One exceptionally dissatisfied customer even posted his own report of his customer experience on the internet entitled “Global Sources: A Pirates Nest Covering Pirates” (pdf).
The dissatisfaction with GSOL’s website is not limited to its inability to curtail cases of fraud. The reviews on Alexa.com show a preponderance of 1 star ratings of the site, and point to user dissatisfaction with the website’s functionality and pricing.

I have an account at this site for over a year. Customer service is relatively quick to respond and professional. However, the user interface for sellers and manufacturers trying to list their products and create categories is one of the worst designed I had ever experienced and I've designed and created about three dozen web sites in my career so far. Trying to remove a product is a nightmare. Their product creation tools are simply very poorly designed.

I used the website 2 years, but not enough buyers contact me. It's very expensive. I will not use it.

Basically, Global Sources charges a lot and offers little. Look at the following 5 star rating from a user about Global Sources. It is an exact copy of a marketing statement and slogan by one of its competitors. Global Sources copied it!


Global Sources’ Unusual Financial Reporting

GSOL has the most unusual financial practices of all the companies we have looked at over the years.

For starters, let’s consider its recent change in accounting standard. The Company adopted IFRS effective as of and for the fiscal year ended December 31, 2010. For the previous 10 years as a pubic company, GSOL reported under U.S. GAAP. The move strikes us as unusual given that the adoption is completely voluntary. We’ve not seen any companies recently undertake a voluntary switch of standards. Our research indicates ~8% of US listed Chinese companies with market capitalizations between $100m to $1bn report under IFRS (Appendix 1). The time and cost involved with implementing the change are not trivial and require an experienced and dedicated internal team of finance professionals to properly oversee. The Company has not announced any external management hires in the finance department, nor have there been additional disclosures of the steps taken to oversee proper implementation.
What we have seen at the executive level, and at the CFO role in particular, at GSOL does not inspire confidence. For starters, the Company has switched CFOs three times since 2009. The long-time CFO Eddie Heng announced his retirement in 2009, and was replaced by a company-outsider David Gillian. We raise a cautionary point that Mr. Gillian then left the CFO position and the Company in less than 1 year to “pursue personal business opportunities.” Eddie Heng returned for a brief interim period, and was then replaced by another company insider, Connie Lai, who has had a short tenure of only 3 years at the Company. Given the revolving door at the CFO position, and somewhat capricious change to IFRS, we have a skeptical posture toward the financial reporting. The recent executive turnover has not been limited to just the CFO role. In the past few months, the CEO, CIO, and COO have all been shuffled around, and 1 Board member has resigned.
Why would GSOL consider a change to IFRS in the first place? The answer is not entirely clear because the Company does not disclose the reason for the change. One thing we do know is that IFRS accounting gives management more leeway in choosing accounting methods than GAAP. GAAP is a more rules based and rigid accounting standard. GSOL’s business is certainly international, which could be a motivating factor, but there are plenty of international companies with US listings that conform to US GAAP, and would not switch to IFRS unless it were mandatory in order to avoid the time, cost, and aggravation. GSOL has plenty of U.S. shareholders too, so the accounting switch raises question marks.
It’s also noteworthy that GSOL switched auditors not long ago in 2008 from Ernest and Young to PWC. The reason cited was “cost.” Elevated audit fees can be a red flag of problems to come for a company, say three recent academic studies that together warn about increased chances of fraud, stock price declines or financial restatements.

See: Corporate audit fees up? Beware of trouble ahead


GSOL’s reported audit fees doubled between 2006 and 2007, and again rose sharply from 2009 to 2010, even though the underlying business hardly changed. An even more interesting observation is that GSOL’s fees for tax work were a paltry $2,000 in 2006, 2007, and 2009. For a mere $2,000 investment (yes two thousand dollars), GSOL has received tax planning, and advice that has allowed it to pay an average effective tax rate in the past 5 years of 3.22%. This is quite a striking accomplishment considering that GSOL is the only company we can find incorporated in Bermuda, has 61 subsidiaries in 16 different jurisdictions, yet reports doing nearly 80% of its business in China. To analyze just how remarkable the tax achievements are, we’ve also included our benchmarking results in Appendix 1. The results certainly beg the question: If GSOL has identified a great tax strategy to pay consistently low taxes, why hasn’t every other company followed?


Lastly, we note that the recent audit opinion was signed from PWC’s Singapore office, which again raises eyebrows considering GSOL is the only Chinese listed company we could identify that is audited from this location. PWC certainly has branch offices in China; both of GSOL’s closest peers, Alibaba and HC international, are audited from the PWC Hong Kong office.
Our concerns over GSOL financial reporting do not stop here. Turning our attention to the presentation of the income statement, we have found something so unusual that we’ve never seen in our entire investing career spanning decades. GSOL does not report any information on its cost of sales directly related to revenue, and hence no presentation of its consolidated gross profit. It is inconceivable to us that GSOL does not present costs that are directly related to generating revenue for each of its reported revenue segments. As a result, investors cannot easily ascertain the contribution margin from each of the businesses.




Furthermore, the operating expenses lines are ambiguous and confusing. Take for example the “community” expense line, which appears to be an amalgamation of expenses related to each of the revenue segments. The Company’s description of community expenses is noted below.

Community costs consist of the costs incurred for servicing our buyer community and for marketing our products and services to the global buyer community. Community costs also include costs relating to our trade magazine publishing business and marketing inserts business, specifically printing, paper, bulk circulation, magazine subscription promotions, promotions for our on-line services, customer services costs and the event specific promotions costs incurred for promoting the China Sourcing Fairs events and the technical conferences, exhibitions and seminars to the buyer community. The event specific promotion costs incurred for events are expensed during the event months in the year in which the expenses are incurred. (Global Sources 20-F Annual Report)


We could drill down even further but won't belabor the main point: GSOL’s financial reports should be viewed with extreme caution given the recent and unexplained accounting standard change, high CFO turnover, change in auditors, and highly unusual presentation of its income statement.
Global Sources’ Unusual Financial Strategy

GSOL’s financial strategy appears to indicate a tacit decision not to invest in the operating business, but rather filter the cash flow out of the Company and into non-core assets. The table below summarizes the Company’s sources and uses of operating cash flow over the past five years.


The one clear conclusion from this table is that GSOL has invested very little to grow the core business via acquisitions or investment in capital expenditures, but rather views share repurchases and property acquisitions as the most attractive return on its capital.

Two stock tenders were completed in 2008 and 2010. The first tender was for $50m at $8.00/share and the second for $100m at $9.00/share. These prices serve as handy high water marks for what GSOL’s stock may ever be worth.
The more fascinating observation is that GSOL has reported acquiring nearly $125m of property acquisitions since 2004 and just recently announced the largest acquisition ever of $51m for property in Shanghai to support “future growth.” The recent transaction is all cash, and no bank financing was used in the transaction. Despite the materiality of this transaction (representing over 20% of GSOL’s assets), none of the purchase and sale contracts for this deal has been filed, or for any of the property transaction since 2004.

GSOL Announces Purchase of Shanghai Office

According to the press release, the location is close to Shanghai Hongqiao Airport, a regional transportation hub and metro stations. Additionally, we know that the location is in Changning District and the Company paid RMB 326m for 6,668 square meters, which is equivalent to 48,890 RMB per square meter, or $700 per square foot.


To those who are not familiar with Changning District, it is the part of Shanghai that spans the west part of the city. Hongqiao Airport is on its west edge. Three city belt ways, the Inner Loop, the Middle Loop and the Outer Loop, run through it and naturally further define the land in Changning district based on its locations relative to the belt ways. Not surprisingly, the land within the Inner Loop has the highest value and the land outside of the Outer Loop is the cheapest. GSOL’s description of the real estate purchase puts the most likely location outside the Outer Loop, where Hongqiao Airport is. The second likely location is between the Outer Loop and the Middle Loop.
China’s real estate sales are no secret. Soufun.com a (SFUN) keeps many real estate records.



Source

Soufun shows all the office space currently on sale in the Changning District, only four of them – the top two listings are sponsored listings and do not belong to the district. No building is listed outside of the Outer Loop. The only one property between the Outer Loop and the Middle Loop is offered at RMB 27,000 per square meter. The most expensive one, which is located within the Inner Loop, is offered at
RMB 45,000 per square meter, lower than the price paid by GSOL and in a much more desirable location.

The information provided by the Company on the real estate transaction is not consistent with our knowledge of the Shanghai real estate market and more information needs to be disclosed by the Company.
A list of all of the property acquisitions has been provided in the table below




Given our foregoing discussion about GSOL’s business fundamentals, and observations that its capital allocation does not favor internal investment, how can we be confident that this property acquisition is truly to “support future growth?”

How can GSOL’s management actually defend paying peak prices for a property in Shanghai when the business model is not one that even depends on owning real estate as a core asset, and there are indications that property prices are beginning to decline? See: China Housing Prices Inch Lower

After all, let’s recall that their three businesses are print and online advertising, as well as organizing trade show exhibitions. The exhibitions are certainly not being held on these commercial properties, and management even discloses that they incur venue rental charges for hosting the conferences. Besides, the conferences are mostly held in Shanghai, and globally at locations such as Miami, Dubai, and Johannesburg. Therefore, we can rule out that the property is actually being used for legitimate purposes related to the exhibition business. Does the Company need to own almost 300,000-square feet of property to run a B2B website and trade publication business? We think the answer is certainly no.
Let’s now examine the property question from a different perspective by looking at the Company’s workforce. The table below summarizes GSOL’s historical employee composition in the past three years.

The two most striking observations are: 1) Almost 90% of the workforce is classified as independent contractors with almost 70% of the workforce being independent sales staff and; 2) Total headcount is still down by almost 450 people from the end of 2008 to 2010, which again calls into question why GSOL would spend $51m on its recent property purchase.
Who are these independent contractors? According to Company disclosures, GSOL uses six main sales representative companies in mainland China, which are responsible for approximately 71% of total revenue for the year ended December 31, 2010. Sales representatives are located in 60 cities worldwide, with 44 of these locations in Greater China. So what has us concerned with all of this? First, it appears that the property acquisitions have been concentrated in Shenzen, which accounts for over 65% of the real estate square footage. This appears inconsistent with a globally dispersed sales force. Secondly, we assume that having an outsourced sales force is designed to reduce fixed costs and provide added labor flexibility. Therefore, owning real estate appears inconsistent with this strategy vis-à-vis the alternative of leasing office space, which if structured properly can allow a cheaper and more flexible solution.
Attempts to contact management for answers to the vexing financial reporting and more information on their property purchases have so far gone unanswered.
Conclusion and Price Target

Global Sources does not appear to be a business that is run for the benefit of public shareholders. The financial strategies undertaken by the Company do not appear transparent and serve the prospects of maximizing shareholder value. Furthermore, there are indications that the underlying businesses are mature and facing significant headwinds, which may explain the recent executive turnover. The Company has determined that investing in Chinese real estate is in the best interest of shareholders, despite the fact that their business model does not appear to justify it from multiple perspectives. We are also concerned by its recent $51m acquisition of Shanghai property at peak prices for no compelling reason. A complicated organizational structure and opaque financial reporting adds further doubt in our minds over the reliability of the financials. We arrive at a $2.50 price target, the midpoint of our range, by giving full credit to the cash on the balance sheet, and discounting the value of the real estate, given our concerns on the legitimacy of the transactions and the illiquidity. We apply a generous 2x – 3x multiple to a through-a-cycle EBITDA to value the operating business, which we deem to be low growth, operating in a highly competitive environment, and difficult to evaluate due to limitations on financial disclosure.



Appendix 1





Disclosure: I am short GSOL.
Disclaimer: Use 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 of Global Sources Ltd. 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 financial advisor and nothing contained herein should be construed as an offer to or solicitation to buy or sell 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.
Source: Global Sources: Major Concerns With One Of The Oldest China Reverse Takeovers