Something’s very wrong with China Digital TV (STV). No, not for the obvious reason that the company’s shares have declined 80% from their all time high of $55.31 set in October, or that they have fallen over 45% since reporting better than expected earnings on 5/14/08.
What’s most concerning is the 32% decline that has occurred over the past two weeks for no apparent reason. Adding intrigue to the equation is that the majority of the recent sell off came during the past four trading sessions on significantly heavier than normal volume. Sessions that normally experience light trading volume do the July 4th holiday.
Puzzling? You bet. Suspicious? Perhaps.
Some may equate the sell off to the abrupt 15% decline in US markets or the Shanghai Exchange being down more than 50% or even that shares of fellow conditional access providers like Kudelski and DVN Holdings LTD have fallen more than 70% from their all time highs, however these factors cannot fully explain the drop in share price for STV. Even with world markets in bear mode, record commodity prices and a pending US recession, a company in a rapidly expanding industry with market share of 52% and growing, revenue growth north of 65%, net margins of over 60% and a net cash position of $257M does not trade for 18x trailing earnings.
That is, it doesn’t unless something is fundamentally wrong.
This got me searching for answers and I may have found them in the company’s annual report, Form 20-F that was filed on 6/19/08.
In the filing, the company listed a number of risks investors may face by investing in the company’s shares. While it is the norm for all companies to do so, several of the risks listed by China Digital TV are not “run of the mill” risks and are of particular concern.
First, the company indicated that it has filed for, but has not yet obtained an encryption product sales license, a license required by the Peoples Republic of China [PRC] Encryption Authority. The company goes on to say that their conditional access systems have not been certified by the Encryption Authority because the company has not adopted the government's designated algorithms. Yikes! This is a major risk and could potentially put the company out of conditional access business if the government wanted to play hardball. In fairness, the company states there are other conditional access companies that are not compliant; nevertheless, this is a major risk for STV.
Second, the company mentions several times that it faces intense competition and may have to lower prices in order to compete. Specifically, they cite domestic competitors who sell their products at lower prices. DVN Holdings LTD, their largest competitor with 14% market share, has the powerful CITIC Group and Motorola (MOT) as investors. This gives the company deep pockets and flexibility to compete on price if they have to. More importantly, the CITIC Group is China ’s largest state run investment company and as such likely has leverage with what goes on in Beijing . Leverage they could possibly use to impede STV from getting licenses and winning future contracts.
Finally, and possibly most important, the company reported that their independent registered public accounting firm found significant deficiencies with their internal control over financial reporting. The company states that they plan to remediate the control deficiencies identified in time to meet the deadline imposed by requirement of Section 404, but may be unable to do so. They go on to say that if they fail to maintain adequacy of their internal control over financial reporting, they could suffer material misstatements and fail to meet reporting obligations. Double yikes! Accounting problems are never good for a company’s share price and normally are a signal to sell.
In conclusion, the items I've outlined above combined with current market conditions make the company’s shares a risky investment at this point. For those who currently own shares, I'm not necessarily recommending selling now since the share price has already fallen by 80%; however, I would not be putting new money to work in this company until the risk items listed above are resolved and the company re-affirms their earnings guidance for 2008.
To date, this is the third article I have written about the company. In March, I accurately predicted a pending short squeeze and in May I wrote about how the company’s share price was baffling based on their fundamentals and historical/anticipated financial performance.
In both of the articles, I highlighted that the company’s shares appeared undervalued and could return to the high $20s or even $30 within the next 6-12 months if the overall stock market improved and if they continued to deliver great results.
Needless to say, since that time the overall stock market has deteriorated significantly. This coupled with the risks I’ve outlined make any 6-12 month target above $20 very unlikely barring an acquisition. Even then, it’s doubtful the company could substantiate a premium of more than 100% above current price levels. Therefore, I anticipate the company’s shares will languish in a trading range between $10-$13 until a week or so prior to the release fo their Q2 earnings report in August.
On the positive side, should the company clear up these risks and pre-announce positive results prior to the August reporting date, the shares could quickly vault back to the high teens in a matter of days via another short squeeze as once again the number of shares sold short is back above 2.5M. This may not seem like much considering the company has over 61M shares outstanding, however over 70% of the company’s shares are held by company officers and major investors. This leaves less than 20M available for daily trading. Since the average daily trading volume is just over 500K, it would take nearly 5 days for short sellers to cover their positions.
Finally, Morgan Stanley, one of the underwriters of the IPO and a consistent “pumper” of the stock over the past 9 months, still maintains a lofty price target of well over $30 as do several other firms. I look for many of the analysts who cover the stock to use the recent sell off and the risks listed in the annual report as cover to lower their ratings and issue revised price targets in the $20 range.
Thus far, Roth Capital has been the most accurate when evaluating the company’s shares, initiating coverage with a hold rating and a $20 price target in February and then lowering their price target to $16 in June.
As always, investors should do their own research before making any investment decision and exercise extreme caution when investing in speculative growth stocks, especially those located outside the United States.
The author currently maintains an actively traded long position in shares of China Digital TV.