OWC Securities has decided to initiate coverage on 10 U.S.-listed Chinese companies that we believe have low to moderate fraud risk. The first stock we have chosen to cover is Zoom Technologies, Inc. Our goal in publishing these reports is to present investors with clear data and inform them of the risks they are taking. These U.S.-listed Chinese companies are incredibly cheap and, although it is very hard to determine, the majority of them should be worth easily 3 to 4 times their current value if they are not involved in any fraudulent activity. But that is very hard to determine. We ran our screen of the 284 U.S.-listed Chinese companies and picked 10 companies that, through the comprehensive analysis you will see below, pose only a modest fraud risk. Please visit our website to view the full report and graphs.
Zoom Technologies, Inc., (ZOOM) through its subsidiaries, operates as a technology company that engages in electronic and telecommunication product design, development, and manufacturing. The company provides electronic manufacturing services (EMS) for original equipment manufacturer (OEM) customers, as well as the design and production of mobile phone products through its original design manufacturing (ODM) business. It markets its mobile phone products through retail distributors in 31 provinces in the People's Republic of China, and also supplies GSM and CDMA mobile phones directly to customers. Zoom also exports its products to Asia, South America, India and the Middle-East. The company was founded in 1999 and is headquartered in Beijing, the People's Republic of China.
Zoom is in the telecommunications equipment industry, which consists of companies that manufacture communication equipment and products, including mobile handsets. This industry is extremely competitive and is known for swiftly changing technologies, changes in customer preferences, and new product introductions and enhancements. Development in this industry requires high levels of innovation and the ability to understand market trends. The key factors that companies compete on are product performance, quality, technological innovation, and price. The Chinese mobile market is evolving and growing 13.5% per year as cable and telecom network operators expand their video, data and voice services. Zoom has the ability to capitalize on China's mobile telecommunications market, where the penetration rate of mobile phones is only 64%, compared to near 100% in many developed countries.
Zoom is a vertically integrated mobile phone designer, manufacturer and sales service provider. Through effective vertical integration, the Company aims to increase its gross profit margin in addition to providing the Company with a competitive advantage within the telecommunications industry. The Company has visibly expanded its vertical integration with multiple acquisitions over the past two years. On June 1, 2010 the Company acquired 100% ownership of Silver Tech Enterprises, Ltd., a holding company which owns 100% of Ever Elite Corporation, Ltd., which owns 100% of Nollec Wireless. Nollec Wireless is a mobile phone and wireless communication design company that contributes to the overall R&D for the Company.
On January 4, 2011 the Company, through its acquisition of Profit Harvest, acquired 100% of Celestial Digital Entertainment, Ltd., a mobile platform video game development company. Most recently, on October 12, 2011 the Company purchased 50.5% of Portables Unlimited, L.L.C., an exclusive wholesale distributor of T-Mobile products in the U.S. They purchased Portables for two reasons: to diversify its revenue sources and to gain access to the most mature mobile handset market in the world. This represents Zoom's ODM strategy of providing complete mobile phone solutions from raw material acquisition through in-store sales.
Operations and Our Analysis of First Quarter '12 Earnings
We are very excited about Zoom's first quarter financials. While the Company only showed modest income, it showed strong revenue growth as Zoom's operations continue to move in the right direction. Zoom is continuing its shift into complete mobile phone solutions, a market with higher margins and profitability than Zoom's traditional EMS business. Sales of Zoom's own brand products in the first quarter of 2012 represented $28.1 million or 31% of total revenue, supporting the ODM trend. Zoom plans on maintaining its current EMS business while continuing to grow their market share within ODM.
Because of a default on a payment due to Portables Unlimited, Zoom's ownership of Portables Unlimited has been reduced to 50.5%. If Zoom loses majority control of Portables Unlimited, then the Company will have to switch to the equity method of accounting. We asked Patrick Wang, the Vice President of Corporate Finance, in the earnings call what sort of impact this would have on Zoom's bottom line. He said that Zoom's recognition of Portables Unlimited's revenue would decrease from 50.5% to about 46%. Mr. Wang stated:
In the event that the Company is not able to maintain its majority ownership of Portables, the Company would account for its investment in Portables using the equity method of accounting. We cannot at this time assess the probability of our success in this dispute.
Regardless of the outcome, we do not think this will have a significant impact on Zoom's performance moving forward. Newly acquired Portables Unlimited contributed $6.16M to gross profit and managed to add over $200K to the bottom line despite numerous acquisition related expenses and costs associated to transferring accounting systems.
Mr. Wang in the quarterly earnings call commented on new developments moving forward. He said to expect to see Zoom branded phones in the U.S. and Europe soon because of their new, well-positioned distribution network provided by Portables Unlimited.
As stated in Zoom's 2011 annual report:
Recently, U.S. public companies that have substantially all of their operations in China, particularly companies like us which have completed so-called reverse merger transactions, have been the subject of intense scrutiny, criticism and negative publicity by investors, financial commentators and regulatory agencies, such as the SEC. Much of the scrutiny, criticism and negative publicity has centered on financial and accounting irregularities, a lack of effective internal controls over financial accounting, inadequate corporate governance policies or a lack of adherence thereto and, in many cases, allegations of fraud.
Of the 284 Chinese stocks listed on U.S. markets, the average stock price change from the beginning of 2011 to July 15, 2012 has been negative 79%. Due to a lack of transparency, the market has been experiencing a clean-house movement where one by one these stocks have been accused of being fraudulent. While almost all of these allegations have been rumors, many have been proved true.
This exposure has driven fear into investors and caused a significant decrease in stock prices across the board, even for companies with no formal fraud allegations. We call this the "fraud discount" - the underlying discount in a U.S.-listed Chinese company's stock price that reflects the level of investor fear that the Company will be exposed as fraudulent.
The U.S.-listed Chinese market has been flooded with short seller and fraud allegations. The majority of short sellers have pointed out differences between SEC & SAIC (State Administration of Industry & Commerce) filings, and used these differences to drive fear into investors and drive down the stock prices. While investors should be slightly worried if these numbers are drastically different, there are also valid reasons for them to differ.
Each year companies in China are required to file a Company Annual Inspection Report (CAIR) between March & June. It serves as a way to renew the company's business license and to estimate tax payments to the State Administration of Taxation (SAT). A CAIR report needs to be filed for each subsidiary that a company owns, and the numbers are not verified or audited by the SAIC. So in Zoom's case, the Company has to file a CAIR report for each of its eight Chinese subsidiaries that it owns.
So even if a short seller got a hold of one of the subsidiaries' CAIR filings, they would need all eight to prove that Zoom is involved in fraudulent activities. Also, a Chinese company's CAIR report is used each year to estimate its taxes payable, so the company has an incentive to show as little income as possible. Compared to the company's filing with the SEC, where there is incentive to show as much income as possible for American investors, there should be some differences.
Specific to Zoom
While it is almost impossible to positively determine whether Zoom is involved in fraudulent activity, there are a few key indicators that can help. The first positive sign for Zoom is its poor earnings. This may seem odd, but Zoom's negative and inconsistent earnings growth is a good sign. If you were part of management in a fraudulent Chinese company, you'd want the stock price to be as high as possible so you can sell out your shares at a nice profit. The easiest way to increase your stock price is to post consistent, positive earnings quarter to quarter. If you are a fraudulent company and can make up your earnings numbers, then why make up bad numbers?
The second is that Zoom just invested heavily in Portables Unlimited which is an American company. It is much easier to do due-diligence on companies based in the U.S. In 2008, Portables Unlimited received the award for the largest National Wholesaler for T-Mobile USA. The bottom line is that T-Mobile does not do business with bad companies. While visiting a T-Mobile store in Westminster, MD, the manager confirmed that Portables Unlimited still has a master dealer contract with T-Mobile, and on March 1st, 2012, Portables Unlimited was granted exclusive rights to distribute T-Mobile products in Puerto Rico. T-Mobile would not be dealing with Portables Unlimited for over four years if the company was not legitimate.
When looking at Zoom's management, there are a few significant positive signs. The Chief Financial Officer Anthony Chan, a graduate of the University of California at Berkeley, has worked as both the CEO and CFO of various public companies in the U.S. and China. Unlike the rest of Zoom's management and board members, Chan is a U.S. citizen and will be punished under U.S. law if the Company is found to be a fraud.
Chan has held many management positions prior to being CFO at Zoom, and he would risk his freedom and reputation if Zoom was found fraudulent. On Zoom's board of directors is another highly reputable individual. Dr. Leo Li, an independent director on the board has more than 20 years of experience in the wireless communications industry and has served as a visiting scholar at the prestigious School of Economics at Brown University for two years.
Finally, Zoom has just signed some big contracts with large, reputable mobile operators. Micromax of India is the 12th largest mobile phone manufacturer in the world. Viettel of Vietnam is the largest mobile operator in Vietnam with a 51% market share. The mobile operator covers more than 170 million people and has revenues north of $6 billion. These mobile operators would not be placing large orders with Zoom if they did not believe the Company could fill them.
Zoom has a complex corporate structure and has made many acquisitions in the past few years. With multiple acquisitions, it would make it easier to hide fraudulent activities, but there is no evidence that any are in place. In addition, Zoom's complex corporate structure does make it harder to prove fraudulent activity if someone wanted to, therefore adding some extra protection to investors.
After our initial due-diligence on Zoom, we believe the Company has a low to moderate fraud risk. Over the next few months we will continue to perform a much more in depth analysis, which will include company visits to Zoom headquarters and operations in China.
Other Potential Risks / Threats
There are many risks that Zoom faces today, but very few are uncharacteristic of any foreign telecommunications company with operations in multiple countries. With plans to introduce Zoom branded products into the U.S., Europe, India, & Indonesia, the Company will face significant challenges related to branding and market penetration. This is a big step for Zoom, but with orders already placed in India & Indonesia, we will know soon how successful the Company will be internationally.
Zoom also faces distribution risks with its new acquisition of Portables Unlimited. "Operations of Portables are heavily dependent on the license granted by T-Mobile. If Portables could not renew its license with T-Mobile on acceptable terms, its operations will be significantly affected."
Gross margins is one of the most important metrics within the telecommunication industry and because of a highly competitive market place and the lack of bargaining power, Zoom has recently shown very weak profit margins. For the entirety of 2011, the Company faced a tightening credit market as Chinese monetary policies reflected a more conservative approach on growth; weighing on their overall profitability.
In the first quarter of 2012, the increase in sale of Leimone phones and the addition of Portables Unlimited contributed to a growth in profit. The Company's gross profit as a percentage of revenue was 6.8%, an increase of 2.4% from the previous quarter. Mr. Wang said in the 1st quarter conference call that their EMS business is changing for the better. Zoom was able to improve its gross margin in the 1st quarter while still taking highly competitive orders.
During the 1st quarter earnings call, the Company stated that the key to improving margins is bringing on larger customers. Wang stated that these larger customers will be placing larger orders which will lead to an increase in bargaining power with suppliers and therefore higher gross margins. In addition, dealing with larger, more reputable customers will decrease bad debt expense and decrease receivables as a percentage of revenue. Following up on their promise, one month later, Zoom received large orders from Micromax of India and Maxtron of Indonesia for 550,000 original design and manufacturing (ODM) phones. Micromax is the most recognized mobile phone brand in India and Maxtron is the second largest phone brand in Indonesia.
These customers are expected to return and the Company estimates that orders could reasonably be close to 600,000 per month moving forward. Furthermore, Zoom has signed an agreement with Viettel Mobile of Vietnam, with an initial order of 400,000 ODM mobile phones. Viettel is the largest mobile operator in Vietnam capturing over 40% of the local market and is "one of the fastest growing telecom operators in the world." This is significant because the 1,833,000 Leimone phone sales from 2011 contributed to 30.65% of revenue, and that is Zoom's most profitable line of business from a percentage standpoint. If these orders continue, then expect revenue and earnings for the company to increase dramatically.
As the company becomes more vertically integrated, their margins should also improve. This is exactly what the acquisition of Portables Unlimited should do. By acquiring the distributor, there is one less margin that Zoom is forced to pay for.
Our main concern relating to Zoom's operations over the past two quarters has been margins. As seen in the graph above, Zoom saw a sharp decrease in gross margin for the fourth quarter of 2011 which led to a two million dollar loss for the quarter. In the first quarter of 2012, the Company saw a gross margin improvement of 2.4% bringing it to 6.8%. Because of the reasons stated above, there is reason to believe that these margins will continue to improve.
There are many methods and formulas that can be used to measure a company's value and its stock price. Zoom is a company with strong short-term earnings potential and strong long-term earnings growth as the company expands and takes market position in India, Indonesia, Vietnam, the U.S., and Europe.
One of the first valuation metrics we like to use is Price to Tangible Book Value (P/TBV). This ratio helps understand the amount that an investor would receive if the Company went bankrupt and was liquidated immediately. As of March 31, 2012, Zoom had a Tangible Book Value of $42,718,000. As of July 15, 2012, Zoom has a market cap of $24,582,000. This gives Zoom a P/TBV ratio of .58 and a TBV per share of $1.77. If the Company was liquidated tomorrow, then investors would receive $1.77 per share, and the stock is currently priced at $1.02. Assuming Zoom's financial statements are accurate, there is no reason for Zoom to be trading below $1.77. To put that in perspective, the industry average P/TBV ratio in the telecommunications industry is 4.4. If Zoom followed that average, it would be trading at $7.80.
In pricing Zoom's stock using future earnings, we believe the Price to Trailing Twelve Month (TTM) Earnings (P/E) ratio is the most appropriate. Zoom's current P/E ratio is 13.3, which is well below the communications industry average of 25.1. However, the Company's P/E ratio is currently inflated because of incredibly weak fourth quarter 2011 earnings, and we do not feel the P/E ratio is the most appropriate pricing method to utilize until Zoom starts to show consistent earnings.
In Zoom's case, pricing the stock using the market method with the Enterprise Value (EV) to TTM Revenue (EV/Rev) is a very appropriate method. "Enterprise value can be thought of as the true price of a business since buying a business includes receiving its cash and taking on its debt. Using enterprise value instead of market cap in a valuation metric has the effect of penalizing debt and rewarding cash." The EV/Rev ratio can be thought of as how much it costs to buy the Company's sales. The Company has an Enterprise Value of $71,910,000 and TTM Revenues of $338,671,000 (financials) which gives it an EV/Rev 0.21.
This number is drastically below the telecommunications industry average of 4.76 and median of 3.88. This ratio shows just how undervalued Zoom's stock is - it has the lowest EV/Rev ratio in the entire telecommunications industry. Zoom could be understating its revenue by 94.5% and it would still fall at an industry median EV/Rev of 3.88. So while we do not believe that Zoom should be trading at an EV/Rev of 3.88, we do believe that it should be trading at an EV/Rev of close to 1. This would mean that the buyer of the Company today would receive that same amount back in sales the following year. At an EV/Rev of 1, Zoom's stock should be trading at $12.10
Our 2012 Price target for Zoom is $2.50. This is significantly discounted for two reasons: 1) investors will remain skeptical until Zoom starts to show consistent growth and positive earnings and 2) investors are still scared of U.S.-listed Chinese companies. The $2.50 price target accounts for the Company's tangible book value and a very small amount of discounted future earnings.
There is tremendous value hidden in U.S.-listed Chinese companies, and Zoom is no exception. The entire sector has been plagued by a few rotten companies, and many healthy Chinese companies are being punished just because they are Chinese. There are still transparency and credibility issues within the market, but investors now understand the risk and it seems to be priced into the market. The best way to protect yourself as an investor is to do your research and due diligence and choose what you believe is the best of the bunch.
OWC Securities' outlook on Zoom is very positive. The company is clearly undervalued, and management is following through on their promises. Margins are expected to improve with the new large customers in India, Indonesia, & Vietnam, and because Zoom has a distribution strategy to move into the U.S. when they decide to. We believe Zoom will see a large increase in revenue moving forward with the new orders of 900,000 Zoom ODM phones. The increased margins, larger customer, & less acquisition related expenses should lead to much better earnings moving forward.
Based on the analysis above, we believe that Zoom stock is incredibly cheap and undervalued with a low to moderate fraud risk. Our 2012 price target is $2.50.
Disclosure: OWC Securites currently owns Zoom Technologies, Inc. stock and is long the position. We have no intention of trading Zoom stock within 72 hours of publication of this article. This article is dated July 15, 2012, and will be published on July 20, 2012.
Disclaimer: Please read the entire article before commenting on or contacting the authors of this report. All opinions are those of OWC Securites and are not necessarily predictive of the future performance of Zoom stock.