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Richard N. Davis
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15 years of experience as an amateur investor. Fundamental Long Short investor.
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  • Why The Bull Is Wrong On NQ And Muddy Water

    In the past few weeks since Muddy Water came our with their report calling NQ Mobile (NYSE:NQ) a fraud, we have watched various articles on Seeking Alpha, both on the long side and the short side. The undisputed champion of the long side is Toro Investment Partners, which has repeatedly attacked Muddy Waters' credibility and claims. Toro's principal, Taek-Geun Kwon, slammed Muddy Waters in a CNBC Asia interview. But after some fact checking of Toro's research our conclusion is that this obscure fund manager that seems to run money for the heirs to The Gap fortune is seriously distorting important facts about Muddy Waters and NQ. So, is Toro a serious investor with valuable insight on NQ or a cheap stock promoter? That's what we wanted to find out.

    Since the Muddy Waters report, Toro has published multiple articles and dozens of comments on Seeking Alpha to defend NQ. Kwon has only ever published 10 articles on Seeking Alpha - 8 of them on NQ. The strong criticism by Kwon of Muddy Waters' work brings to memory some past similar incidents of analysts and investors who came to the defense of the companies that Muddy Waters accused of being a fraud and a "Zero". In particular, this reminds us of Global Hunter's analyst Ping Luo's strong defense of CCME, Another company Muddy Waters accused of being a big fraud. After MW's report, Mrs. Luo strongly defended the company and supported her defense with her Due Diligence findings:

    We were in China last week to conduct additional due diligence on CCME…. We visited CCME's headquarters again, and reviewed all of its contracts with advertising clients and bus operators, tax filings, and bank statements for the last three years.... Based on our due diligence to date, our thesis remains unchanged: CCME is a leader in the inter-city bus advertising market with a unique business model and large growth potential.

    Sound familiar? You could almost do a Find -> Replace with "NQ" in place of "CCME". Of course CCME turned out to be a fraud and ended up being delisted shortly after from the Nasdaq. Mrs. Luo left Global Hunter soon after, not surprisingly after such a publicly bad call.

    Another example that comes to mind is Dundee Securities' Richard Kelertas, who called Muddy Water's research on Sino Forest "a pile of crap":

    We are going to provide you with some information on why Muddy Waters research is a pile of crap…. We believe there's nothing true in that report

    Mr. Kelertas wrote.

    Mr. Kelertas was also very critical of Muddy Waters' Due Diligence work, and believed the company would clear its name fairly easily. Once again, sound familiar anyone? Sino Forest turned out to be a fraud as well, has been delisted from the exchanges, went bankrupt, and the OSC is now suing 5 of its top executives for fraud charges. Mr. Kelertas also subsequently left his job at Dundee Securities.

    Apparently this time it's Kwon's turn to wave the anti Muddy Waters flag. Will Kwon end up being fired from his firm as well? Probably not.

    From what we have learned, it seems Toro Investments Partners is a tiny shop, with less then a handful of employees, run out of a single room inside another firm's office, and managing about $32 million in AUM.

    Toro might be the Yidatong of investing.

    We asked one of our San Francisco contacts to pay a visit to Kwon's offices on the 15th floor of One Maritime Plaza in San Francisco's financial district. When following the signs to Toro's offices, our contact arrived to the office of the Pisces Foundation, which is run by Gap heir Bob Fisher. Toro's Form ADV shows that their largest investors include trusts for the Fisher family where the trustee is John Fisher (Bob's brother).

    When our contact asked where Toro's office is, he was pointed to a single small room inside Pisces Foundation's offices with only two desks. One desk was occupied by a woman, and the other was empty. The woman confirmed this room was Toro's office and the empty desk is indeed Taek-Geun Kwon's. While the name Toro Investments Partners might seem powerful, nothing else in this shop does. Being that it's inside it's client's office, Toro's setup is more like the investment world version of living at home with parents.

    (click to enlarge)toro

    (click to enlarge)toroSeeing how harsh and hostile Kwon's writing has been on Muddy Waters' due diligence made us think there could be something more than what meets the eye in this case. Well, sure enough, Toro has disclosed a passive stake in NQ Mobile worth about 2/3 of Toro's AUM, so it's easy to see Kwon has a lot on the line. Is Kwon desperately doubling down on a bad bet, or is he a savvy investor? We think it's more likely the former.

    Examining more closely Kwon's track record we found another incident where Kwon has been very vocal about his investment, again strongly supporting what turned out to be another Chinese fraud, Ambow Education Holdings (NYSE:AMBO). In a June 23, 2012 Barrons article, after Ambow's shares sold off over 40% because the company could not file its 10-K, Kwon said he believe the shares should double from where they were ($4.34), and noted that more than 40% of the shares are owned by Private Equity investors that bought the shares at higher prices. Guess what happened to Ambow? Ambow's shares were halted in March 2013 at $0.94, and ordered into provisional liquidation on June 11, 2013.

    (click to enlarge)

    Interestingly, Muddy Waters had been critical of Ambow in their report on New Oriental Education (NYSE:EDU) in July 2012: "We are skeptical of the financials of several of EDU's publicly-traded peers, specifically Ambow Education Holdings" Muddy Waters wrote, which proved to be correct. Toro reported that it owned 4,344,536 shares of Ambow as of December 31, 2012, or about 8.1% of the company. We estimate Kwon's investors lost about $15m on Ambow's shares.

    Toro seems to have lost a lot of AUM - Institutional Investor reported that at the end of 2011, the firm managed about $120 million. Investors either lost confidence or money - or both.

    This drop in assets mirrors Kwon's previous experience as Friendster's fourth CEO. He rode that puppy down from a value of $50 million to only $3 million in 10 months. When he was appointed CEO, it wasn't smiles all around. John Doerr might have seen the disaster coming - he resigned right after Kwon got the job. Someway or another Kwon managed to fall up after that debacle, and ended up at TPG.

    Small interesting note: Ambow was audited by PWC, just like NQ is. NQ and Kwon toss around PWC's name as some sort of a guarantee that their financials are real. From past experience, the fact a Big-4 auditor signed the numbers for the company, does not give it much credibility in the wake of fraud allegations. Sino Forest was audited by E&Y, Longtop Financial was audited by Deloitte, which was also the audited of choice for other Chinese frauds, including CCME. The bottom line is that a Big-4 auditor is not a guarantee against fraudsters. Kwon should know that from his experience with Ambow, but for his own reason, prefers to ignore it.

    Ok, enough with Kwon. Let's look at his allegations against Muddy's research and findings.

    Kwon claimed Muddy had a track record of 0-8 in IPOs. This is obviously false to anyone who cares to check. The falsity of this claim only shows that Kwon has a clear agenda to trash Muddy's reputation. Does Kwon feel he can't win the argument over NQ on the substance alone? Muddy Waters' website provides the track record of its reports, so let's examine it.

    In reaching his 0-8 figure, Kwon lists Muddy's Carson Block's mentioning at a convention that he likes shorting Standard Chartered debt via 5-year CDS. Several newspapers (including the WSJ) quoted Block saying he does not believe Stan Chart's debt costs are pricing the risks the banks is facing in his Asia loan book. Kwon lists this as a flop. Well, the 5Y CDS which was trading at 85 bp is now trading at 114, after touching 200. A gain of 34% so far, assuming Block didn't close his short at the higher prices the CDS has traded since then So, 0-8? Stan Chart? Really?

    (click to enlarge)

    Furthermore, Kwon refers to two incidents where Block made a tweet and an open letter (6 pages) as if these are "reports" by Block. Well, Not in our view. Block may have been wrong on shorting SPRD and VIPS (depending on where he closed his short), but he certainly did not have a full report published on it, and did not call these companies frauds or "Zeros". Kwon also refers to the short report on AMT (Which Block said it's an overvalued and a Sell, but not a Zero or a fraud), which is up to date 5%, while the market is up 7%.

    Kwon misrepresents Muddy Waters' work on Olam, the Singapore commodity trader. The financial media all ran stories about Block calling the short on November 19, 2012 when he spoke at a conference in London and the stock was at $1.74. Olam sued Muddy Waters, and Muddy Waters released a report anyway about one week later. Olam's shares are now at $1.54, down 12% in one year - even after Temasek bailed it out with a $750 emergency injection, only 2 days after Olam's CEO stated that the company does not need or intend to borrow any money for at least 6 months. For comparison, The Straits Times index is UP 8% at the same time.

    (click to enlarge)

    Olam subsequently completely changed its strategic plan because of the short call and board members have resigned. Even just the other day the FT wrote that a lot of investors still have doubts about Olam. But Kwon bluntly comments: "Muddy Waters concerns dismissed by market". Why can't Kwon play it straight with investors?

    Lastly, Mr. Kwon perhaps did not notice (or did he?) that Duoyuan Global Water (DGW), which was also outed by Muddy Waters as a fraud, and was subsequently delisted after going to a "Zero", was actually an IPO and not a reverse merger? Kwon claimed that all of the IPOs that Muddy Waters have wrote about were a flock…

    Kwon seems to also be trying to twist several of Muddy's statement for the convenience of his arguments. Let's review Kwon inaccuracies relating to Muddy's claims:

    Toro: Muddy Waters says: "NQ has no cash"

    This is false. A simple search of the report easily shows this. What Muddy did say, and Kwon and the company chose not to comment on, was that it's practically impossible to move the IPO money to the company's VIE in mainland China. NQ never answered this in its 91-page response and its conference call.

    Even NQ's annual filling make it clear that moving the IPO money into the VIE is highly unlikely:

    PRC regulation of loans to, and direct investment in, PRC entities by offshore holding companies and governmental control of currency conversion may restrict or prevent us from making loans to our PRC subsidiary and consolidated affiliated entities or making additional capital contributions to our PRC subsidiary, which may materially and adversely affect our liquidity and our ability to fund and expand our business. In light of the various requirements imposed by PRC regulations on loans to and direct investment in PRC entities by offshore holding companies, including SAFE Circular 142, we cannot assure you that we will be able to complete the necessary government registrations or obtain the necessary government approvals on a timely basis, if at all, with respect to future loans by us to our PRC subsidiary or any consolidated affiliated entities or with respect to future capital contributions by us to our PRC subsidiary.

    In addition, Paul Gill, the accounting professor that NQ's advocates like to quote as support to their claims, wrote on this matter in his blog:

    the movement of funds is more interesting. Muddy Water's alleged that it was impossible for NQ Mobile to transfer the proceeds of the offering to the VIE without violating Chinese law. A couple of experts disagreed with that. Accountant Drew Bernstein said well-connected people can work around the rules. Carson Block says these people don't have that kind of clout. I side with Block on this. I seriously doubt that the company could have convinced a Chinese bank to simply ignore the law and allow them to exchange dollars into renminbi and then transfer the funds to a privately held company.

    Just for the fun of it, we searched online a bit about Mr. Drew Bernstein who is quoted in support of NQ. Mr. Bernstein, who sat on the audit committee of ONP when Muddy Waters issued its ONP short report, has told the FT reports that:

    From an emotional standpoint, you not only want to sue the shorts but do something worse like break their legs.

    Clearly an excellent unbiased source to talk to regarding accounting and short sellers like Muddy Waters.

    This charge from Muddy hasn't yet been answered by NQ or Kwon.

    Toro: Muddy Waters says YDT does not exist

    This is false again. Muddy's report concludes that YDT is a related party and a shell, not that it does not "physically exist" as Kwon is saying. But let's see what other inquiries have found on YDT. According to Bloomberg's article on YDT, after the company provided YDT's "real" address (which funny enough is not in YDT's name…):

    The building directory contains no listing for Yidatong, and two guards at the first-floor security desk said they'd never heard of the company.

    So YDT is a company that no one ever visits and it does not even receive mail or packages? Does Kwon really believe this, or is he so invested in NQ that he would ignore such glaring red flags? Maybe, just maybe, it's possible that NQ had time to "set up" everything to look nice for the foreigners coming to check this out? (Kwon isn't Chinese.) Kwon's report shows a photo of YDT's new sign as some kind of proof it's not a related party. Come on. How much do you think that sign costs in China, Taek-Geun?

    Toro: Bloomberg Says NQ's numbers are Kosher

    In this part Kwon claims Bloomberg's accountant said the numbers of NQ are "Kosher". Yet this reference is actually to Bloomberg's anchor interviewing Carson Block, and she was referring to what she thought was in an upcoming article Bloomberg was publishing on YDT. When Bloomberg published the article, no one said anybody's numbers were "Kosher". Bloomberg quoted Paul Gillis (also quoted above) saying that Level 2 cash isn't a huge problem. Taking this and saying that Bloomberg's accountant confirmed the numbers are "Kosher" is nowhere near the truth.

    Toro: Muddy Waters says NQ has no partners in China

    This is false again. Muddy Waters claimed that one of NQ's partners is a related party and shell company. The report did not address any other "partners" that Kwon provided links to press releases supposedly confirming their "partnership". Muddy Waters even provided a list of which phones and models had NQ's apps installed.

    Maybe Kwon was twisting the fact that Muddy Waters translated articles from the Chinese press that said the partnerships aren't real. It's clear that these are the media's research, and not Muddy's. Again, why can't Toro / Kwon play it straight with investors?

    Kwon assails Muddy Waters for lack of transparency, but for some reason the business cards he presents to prove he met with high ranking employees from NQ's partners who supposedly confirmed the relationships, have all their names and contact details blurred out. We find this odd. If these employees represent the official view of the company they work for, why should their identity be hidden? Block has said he had Chinese gangsters and security forces looking for him and his guys. Why does Kwon insist Muddy Waters name their people (and put their freedom or lives at risk) when he won't disclose who told him NQ isn't a fraud?

    Toro: Muddy Waters says NQ Has Practically No Users in China

    This is actually true. Muddy Waters did claim NQ is massively overstating its user base in China and provided ample evidence for that, such as payments channels that are not able to process payments, clients' representatives of billing partners that claim not to work with NQ and others. Even the company backed away from its market share claims after Muddy exposed them as massively exaggerated.

    Toro: Muddy Waters says NQ software sucks and nobody wants to use it

    Kwon seems to say one thing, and answer something completely different. In its report, Muddy Waters described how they hired software engineers to work on the code of NQ's Mobile Security and Anti-virus 7.0 app. According to the report, the engineers concluded that the application compromises the privacy of users, can be used as malware, and is actually more dangerous for its users rather then not having it installed at all. Muddy Waters' engineers also concluded that the application is sending users' private information to servers in China in an unsecure way. Even Bloomberg reported that ViaForensics, a mobile security app and testing company, found:

    • that he application has poor security leading to leaked sensitive data. The app does appear to generate fake virus alerts;
    • indications that the application sends contacts and contents of text messages back to the company
    • that the application raises a serious privacy concern.

    This is a third party confirming what Muddy Waters' engineers' have been claiming.

    Final remarks

    To summarize, Kwan's theory is that frauds happen only is small reverse mergers and cannot happen to NQ. Kwon quotes a professor with no public track record of investing as saying:

    The vast majority of Chinese frauds had several things in common. They tended to be micro-caps, they were rarely audited by reputable accounting firms, their sell-side coverage and corporate access were effectively non-existent.

    Sino Forest was audited by E&Y, had a market cap of about $6 billion, and was covered on the debt and equity sides by numerous major firms. CCME was audited by Deloitte, had a peak market cap close to $1 billion, and it's largest outside investor was arguably the most experienced American investor in China - Hank Greenberg of CV Starr. Duoyuan Global Water was audited by Grant Thornton, and was owned at one time by Oberweis Asset Management. Orient Paper was audited by BDO. Longtop was a Goldman Sachs IPO, was audited by Deloitte, had a market cap around $1 billion before crashing, and was defended by analysts at big banks. Ambow, as Kwon and his investors have found out, was audited by PWC, NQ's auditor.

    We rest our case.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: NQ, short-ideas
    Nov 21 1:52 PM | Link | 2 Comments
  • MagicJack Losses The Battle On 911 Fees

    As we have anticipated in our April article this year, MagicJack (NASDAQ:CALL) is starting to collect E911 fees from its clients, increasing their bill by $6-$60 p.a.

    This is the email MagicJack's clients received:

    Dear customer:

    This is not a bill, but a choice for you as described below. If you decide you will not pay, you do not have to take any action.

    Due to recent changes, magicJack will start to charge for 911 services for 911 capability. If you decide to continue to receive certain limited 911 calling privileges as described in our TOS, you will need to go to and fill out the necessary forms and give new debit/credit card information.

    magicJack will not profit by collecting these pass through charges for the 911 authorities.

    The charges will be billed annually by email and may cost anywhere from $6.00 to over $60.00 a year. On average throughout the country it will cost about $12.00 a year.

    magicJack will provide limited exceptions for hardship cases for people who made a 911 call before July 1, 2013 and will post notification or email these certain customers later concerning the eligibility.

    These unfortunate changes were made necessary because certain emergency 911 Districts in certain jurisdictions requested we attempt to bill on their behalf and benefit.


    As we have reported, we believe the fact that MagicJack did not collect the E911 fees was unfair competition and now regulators have caught up with the company. We believe this will make MagicJack's service significantly more expensive to users and considering the track-record of service and complaints, will cause many subscribers to terminate their subscription with the company.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: CALL, short-ideas
    Sep 06 4:36 PM | Link | Comment!
  • MagicJack And The FCC Loopholes

    The shares of MagicJack (NASDAQ:CALL), referred herein as "MJ", have for a long time topped the list of the most shorted stocks on the Nasdaq. For our readers that are less familiar with the details of this company and with its management's history, we highly recommend reading also the detailed analysis of Copperfield Research published in January 2013 which caused a drop of 13% in the company's share price and triggered several class action lawsuits.

    What makes MJ's shares attractive for retail investor and causes a headache for short sellers, is the fact that the company is generating a strong cash flow. In this article we will explain why this is going to end why MJ's share price will collapse as a result. We will highlight MJ's unfair competitive advantage through the use of loopholes in FCC regulation in order to avoid the payments of taxes and fees, allowing it to offer cheaper priced services than its competitors. In addition, we will provide evidence that the FCC is in the process of closing these loopholes which will result in MJ losing its unfair advantage. Regardless if the SEC will intervene first, as suggested by Copperfield Research (an opinion we share), the new legislation will have a destructive effect on MJ's business and we believe MJ's days of being a profitable company are short lived.

    When comparing MJ to its competitors, it is clear that two factors contribute to MJ's profitability: (1) low pricing of its services which attract subscribers and allowed it to gain market share; and (2) the fact that MJ does not pay various taxes and fees that its competitors pay. Would MJ be paying these amounts, it would have had either to: (1) substantially increase the subscription fees to offset these extra costs; or (2) bear these extra costs and report a profit significantly lower than it does today. Since it is clear from thousands of complains posted on various websites that MJ subscribers join because of the low cost and not of the quality of service provided, the increase in prices to offset these extra costs would cause MJ to lose business to its competitors.

    We believe MJ structured its corporate structure in a way that would enable it to exploit loopholes in the FCC regulation and we provide evidence that the FCC has started the process of closing these loopholes. These relevant taxes, fees and charges include:

    1. E911 fees (Enhanced 911). 911 fees are collected monthly by telecom providers to fund 911 operation centers around the country. In 2006 the FCC added all VoIP providers to the list of telecommunication providers that are required to collect and remit 911 fees (E911).
    2. USF fund. All telecommunication providers have to contribute to a fund which was set up to promote the quality of service, provide affordable rates and advance the availability of telecommunication to all customers.
    3. Local taxes. Telecommunication providers are subject to various local taxes according to the location of the subscriber.

    911 fees - MJ has been providing its subscribers with an E911 (Enhanced 911) service which is similar in many ways to the traditional 911 service and relies on local communities to provide the emergency service. The FCC introduced a law requiring all providers of "Interconnect VoIP" service to collect these fees from their subscribers and remit them to the local counties, as do traditional phone service providers. These fees vary by state and county and are in general in the range of $0.2 to $3.0. The FCC's definition of an Interconnect VoIP provider includes (among others) providers that "permit users to receive calls from and terminate calls to thepublic switched telephone network". Vonage (NYSE:VG) for example, a MJ competitor, is an Interconnected VoIP provider as its users are able to place and receive calls to and from other phone users. MJ claims in its SEC filings that it does not need to bill its subscribers for E911 services, as it is not an Interconnected VoIP provider. Would MJ charge these amounts to its subscribers, the bill of an average MJ user would increase by an estimated $12 (based on an estimated average of $1 per month per line). This corresponds to a 40% price increase after MJ had already increased rates by approx. 50% in early 2012. Such an increase will obviously reduce the attractiveness of the MJ service. In its 2012 10-K filings, the company provided the following disclosure:

    "The Company cannot predict whether the collection of such additional fees or limitations on where its services are available would impact customers' interest in purchasing its products."

    MJ claims that it is not an Interconnected VoIP provider as defined by the FCC. MJ is relying on a loophole in order to work around the definition: One of the MJ group companies, MagicJack LP, sells the MagicJack device and provides free incoming calls while a second company, Ymax communications, provides the free outgoing calls, so that none of the companies, on a standalone basis, is providing both services (each is providing only One Way VoIP). Sounds fishy? Well it is.

    Subscribers of MJ see only one combined service, which is the ability to receive andplace calls. This is also how MJ markets the service and even how MJ presented it to the FCC on various occasions:

    "Using the Internet (including a cable modem, DSL, Wi-Fi or other system), customers are able to call other magicJack devices wherever located, any PSTN-connected telephone as well as customers of other VoIP services. The magicJack device also enables customers to receive calls from any other magicJack device, PSTN-connected telephone and other VoIP services."

    Obviously local governments which are losing 911 fees from MJ subscribers did not swallow this frog and have been zeroing-in on MJ to collect these fees. In March 2010 the Emergency Operation Center of Kanawha County filed an official complaintto the Public Service Commission of West Virginia and claimed MJ failed to collect and remit E911 fees.

    MJ argued in front of the Commission that due to its corporate structure, none of the group's companies provides both services and therefore it is not an Interconnected VoIP provider as defined by the FCC and therefore it does not need to collect and remit E911 fees. During the hearing two experts provided their opinions and testified that according to their understanding, MJ does provide Interconnected VoIP services (link 1, link 2). In addition, the experts provided evidence that MJ does not actually offer or allow subscribers to receive only incoming or outgoing calls.

    We believe that MJ did not want a court to rule on whether MJ is an Interconnected VoIP provider and therefore decided to settle in September 2011 and to start collecting and remitting the E911 fees to the Kanawha County.

    Even though MJ agreed to start remitting E911 fees, MJ failed to disclose this important precedent to its shareholders in any of its filling, although this precedent has a material effect on the company's financial performance. In addition, it opens the door for additional counties to claim E911 fees from MJ going forward and significantly increases the risk of MJ being liable for the payment of fees related to prior periods. In its 2011 10-K filling (the year in which MJ agreed to start paying E911 fees), MJ still made the following statement and failed to mention it had already agreed to start paying E911 fees at least in once county:

    "Many state and local governments have sought to impose fees on customers of VoIP providers, or to collect fees from VoIP providers, to support implementation of E911 services in their area. Such fees are often put in terms of a fee placed on monthly bills, or focused on use from a specific location. The application of such fees with respect to magicJack users and the Company is not clear because the Company does not bill its customers monthly, nor does it bill customers at all for telecommunication services. The fees in the great majority of cases could be owed by the end user and not the Company, as the Company does not know the end user's location because the magicJack device is nomadic. Should a regulatory authority require payment of money from the Company for such support, magicJack LP may decide to not offer its 911 service in that area or to develop a mechanism to collect such fees from its customers. The Company cannot predict whether the collection of such additional fees or limitations on where its services are available would impact customers' interest in purchasing its products."

    This is not a theoretical isolated future problem for MJ. In January 2011, in response to the FCC's inquiry of whether to extend the E911 obligation also to cover non-Interconnected VoIP providers (such as MJ claims to be), three Colorado counties filed their suggestion to the FCC to close this loophole. These counties go further and even name specifically MJ in their letter (emphasis added):

    "It is too easy for a company to organize its VoIP business model to avoid being subject to the 911 mandates established for interconnected VoIP service providers. One company with a growing presence in Colorado and around the country is the YMax Communications Corporation ("YMax CC"), which sells a device called magicJack". Moreover the counties continue and argued: "YMax's corporate strategy in avoiding payment of E-911 fees has the potential to become widespread as more and more households give up the traditional landline telephones and turn to less expensive, broadband based options for voice communication. Thus, customers will rely on the YMax CC phone service as their sole telephone service, without the same protection afforded customers of other VoIP providers that are interconnected. YMax CC could decide at any time to discontinue provision of 911 services, to the detriment of its customers' safety."

    MJ still claimed in its latest annual filing that it is not clear whether it liable for the payment, although it has already agreed to start and collect this fee at least in one county, if not more. In its 2012 10-K, the company provided a bit more details (emphasis added):

    "Certain E911 regulatory authorities have asserted or may assert in the future that the Company is liable for damages, including end user assessed E911 taxes, surcharges and/or fees, for not having billed and collected E911 fees from its customers in the past or in the future. Although the Company strongly disagrees with these assertions and believes that any such authority's claims are without merit, if a jurisdiction were to prevail, the decision could have an adverse effect on the Company's financial condition and results of operations. The Company may attempt in the future to act as a billing agent for certain 911agencies."

    It is obvious from reading between the lines that MJ received claims for amounts owed to local governments for failing to collect these fees in the past. Yet MJ's management failed again to disclose it has already set a precedent and agreed to start paying these fees. Vonage's 2012 filings provide some more color on similar claims made against other VoIP providers and it has also started to collect and remit 911 fees (emphasis added):

    "We have received inquiries or demands from a number of state and municipal taxing and 911 agencies seeking payment of Taxes that are applied to or collected from customers of providers of traditional public switched telephone network services. Although we have consistently maintained that these Taxes do not apply to our service for a variety of reasons depending on the statute or rule that establishes such obligations, we are now collecting and remitting sales taxes in certain of those states including a number of states that have changed their statutes to expressly include VoIP."; "In addition, many states address how VoIP providers should contribute to support public safety agencies, and in those states we remit fees to the appropriate state agencies. We could also be contacted by state or municipal taxing and 911 agencies regarding Taxes that do explicitly apply to VoIP and these agencies could seek retroactive payment of Taxes."

    As the FCC is considering changing the regulation to broaden the E911 fee net, counties and states have started to close in on MJ and other VoIP providers. MJ has already set a precedent of agreeing to pay at least one county and therefore it is probable that MJ will be required to collect and remit E911 fees going forward also in other locations.

    Assuming that on average a MJ subscriber subscribes for a period of two years, and that 80% of the 10 million devices sold were in the US (MJ does not disclose on a regular basis the number of devices sold or the number of active users), MJ could be liable, without accounting for fines, damages and interest, for an amount in the range of $200 million for its past failure to collect and remit E911 fees.

    Going forward, MJ can either add the E911 fee to the subscription fee, reducing the attractiveness of MJ's offering, or bear the increased cost, cutting its annual profit by an estimated $36 million (assuming 3 million active subscribers and 1$ per month E911 fee per line), which would amount to about 75% of the company's 2012 Profit Before Tax.

    USF Fund - the USF fund was established in order to fund various telecommunication causes of the government, such as providing affordable telecommunication services to schools, libraries, low income consumers etc. All telecom providers contribute to the USF fund based on their interstate revenue. In 2006 the FCC added the Interconnected VoIP providers to the list of contributors in order to allow for fair competition between traditional and VoIP providers.

    MJ provided the following disclosure in its 2012 10-K (emphasis added):

    "Universal Service Fund ("USF") and Other Funds - The FCC and many PUCs have established USF programs to ensure that affordable telecommunications services are widely available in high cost areas and for income-eligible telephone subscribers. Other fees are imposed to meet the costs of establishing and maintaining a numbering administration system, to recover the shared costs of long-term number portability, and to contribute to the Telecommunications Relay Services Fund. All telecommunications carriers contribute to these funds, and the requirements have been expanded to interconnected VoIP providers. The FCC and many PUCs have for a number of years been considering substantial changes to the USF system including changes in contribution methodology. Some proposals, if adopted, could have a material adverse effect on the Company. Federal USF fees have to date only applied if a company bills for telecommunication services. magicJack LP does not bill for domestic local and long distance telecommunication calling services.

    MJ does not contribute to the USF fund as it claims it is not billing its subscribers for local and long distance calls, but rather bills them for an access right to its servers, while providing phone calls for free. How long will the FCC tolerate this?

    Vonage provides the following disclosure in its 2012 10-K (emphasis added):

    "On April 30, 2012, the FCC released a Further Notice of Proposed Rulemaking on reforming federal universal service fund ("USF") contributions. Currently USF contributions are assessed on the interstate and international revenue of traditional telephone carriers and interconnected VoIP providers like Vonage. The level of USF assessments on these providers has been going up over time because of decreases in the revenue subject to assessment due to substitution of non-assessable services such as non-interconnected VoIP services. If the FCC does reform USF contributions, it is likely that Vonage's contribution burden will decline"

    The FCC published the following request for comments on how to increase the number of contributors to the fund and minimizing competitive distortions (emphasis added) :

    "Furthermore, the USF contribution base, largely comprised of assessable telecommunications service revenues reported by companies, has recently begun to shrink as residential and business customers have begun to migrate to communication services that do not contribute to the Fund. Who should contribute?We seek comment on clarifying or modifying the Commission's rules on what services and service providers must contribute to the USF in order to reduce uncertainty, minimize competitive distortions, and ensure the sustainability of the Fund. In particular, we seek comment on two alternative approaches to defining what services or providers should be subject to contribution obligations: (1) using our permissive authority, and/or other tools to clarify or modify on a service-by service basis whether particular services or providers are required to contribute to the Fund; or (2) adopting a more general definition of contributing interstate telecommunications providers that could be more future proof as the marketplace continues to evolve."

    In addition the FCC is dealing specifically with One-Way VoIp - the service MJ claims to provide (emphasis added):

    "In particular, we seek comment on whether competitive neutrality concerns now support the inclusion of one-way VoIP services within the contribution base. Some parties argue that the one-way VoIP exemption is "an enormous loophole" that creates competitive disparities. USTelecom has argued that the current system "unfairly penalizes traditional voice providers (and ultimately their customers) and artificially skews the market." One-way VoIP providers, on one hand, and providers of traditional telephone and interconnected VoIP services, on the other hand, have acknowledged that they compete against each other. XO, for example, argues that the exemption provides "a significant artificial cost advantage" for non-assessable services that provides "a powerful incentive for consumers to replace [assessable services] with less costly non-assessable services." We seek comment on the extent of competition between one-way VoIP and other services that are subject to assessment, and how that should affect our analysis. Commenters are encouraged to provide data to support their analysis. If one-way VoIP providers are brought into the contribution base, what would be the appropriate transition period?"

    It is most certain that when the FCC revises its USF fund contribution criteria, it will eliminate the loophole which MJ uses to avoid the contribution. The current rate of contribution to the fund is approx. 15% of the provider's interstate revenues, while a safe harbor rule exists to determine the percentage of a VoIP provider's interstate revenues. This safe harbor rule provides for a 64.9% contribution factor on the provider's revenues to determine the interstate revenues. Assuming MJ would have contributed to the USF fund in 2012, it would have had to write a $15 million check which would account for 34% of MJ's 2012 Operating Income.

    Other taxes - In general, the following taxes and assessments apply to Interconnected VoIP services: sales and use taxes, gross receipts taxes, excise taxes, franchise taxes, utility taxes and various state and local assessments and charges. For example, Illinois imposes a 7% telecommunications excise tax applicable to all gross charges assessed by a provider to a service address within the state of Illinois. The tax specifically applies to VoIP services. Pennsylvania applies a 6% sales tax to all telecommunications services, including interconnected VoIP services. Still, MJ claims it is not subject to any of these taxes (emphasis added):

    "State and Municipal Taxes - The Company believes that it files all required tax returns and pays all required taxes (such as sales, excise, utility, and ad valorem taxes), fees and surcharges. It believes that it is exempt from certain taxes, fees and surcharges because it does not charge for telephone services or render bills to its customers. The Company remits sales tax in Florida on sales of magicJack units because its magicJack LP subsidiary's personnel, property and activities are in Florida. Certain states and municipalities may disagree with the Company's policies and may believe the Company should be remitting taxes for past or future sales on certain items or services. Although the Company strongly disagrees and believes any possible claims are without merit, if a state or municipality were to prevail, the decision could have an adverse effect on the Company's financial condition and results of operation. magicJack LP does not have activities or have representation in any other state. However, many states are changing their statutes and interpretations thereof as part of new streamlined sales tax initiatives to collect sales taxes from non-resident vendors that sell merchandise over the Internet to in state customers. The Company may at some time be required to collect and remit sales taxes to states other than Florida. It may also become required to pay other taxes, fees and surcharges to a large number of states and municipalities as a result of statutory changes in the basis on which such taxes, fees and surcharges are imposed. In the event that the Company is required to collect sales taxes or other taxes from direct sales for states other than Florida on sales of magicJack device or renewal of its service offerings, it will bill and collect such taxes from its customers.The Company will examine any future fees and surcharges imposed as a result of statutory changes and determine on case by case bases whether to bill its customers or increase its initial or access right renewal sales prices to cover the additional fees and surcharges."

    How long can the company hide behind the claim that it does not provide incoming and outgoing calls or does not charge for telephone service, but rather bills for "access" to its servers? It's only a matter of time until the local tax authorities zoom in on MJ which will have to start and pay these taxes as do other providers. Vonage yet again provides some more color on what is really happening in the VoIP industry and the fact that local government are going after VoIP providers for non-payment of taxes. Vonage disclosed it started to pay local taxes and that it has created a reserve relating its past exposure (MJ, although subject to the same risks has not provided such a reserve):

    "For a period of time, we did not collect or remit state or municipal taxes (such as sales, excise, utility, use, and ad valorem taxes), fees or surcharges("Taxes") on the charges to our customers for our services, except that we historically complied with the New Jersey sales tax. We have received inquiries or demands from a number of state and municipal taxing and 911 agencies seeking payment of Taxes that are applied to or collected from customers of providers of traditional public switched telephone network services. Although we have consistently maintained that these Taxes do not apply to our service for a variety of reasons depending on the statute or rule that establishes such obligations, we are now collecting and remitting sales taxes in certain of those states including a number of states that have changed their statutes to expressly include VoIP. In addition, many states address how VoIP providers should contribute to support public safety agencies, and in those states we remit fees to the appropriate state agencies. We could also be contacted by state or municipal taxing and 911 agencies regarding Taxes that do explicitly apply to VoIP and these agencies could seek retroactive payment of Taxes."

    The table below illustrates the effect on the 2012 Operating Profit of MJ, if it had paid the E911 fess and contributed its share to the USF fund. Obviously one could argue MJ could have increased the amount it charges to subscribers to offset the costs, but then its market share and revenues would have dropped significantly.


    FY 2012







    Cost of revenues


    51,440 (1)


    Gross Profit


    51,440 (1)


    Operating Expenses




    Operating Profit/Loss




    1.Adjustments to reflect the payment of $1 per user per month, according to an estimated 3 million active users (from the 10 million devices sold), and the contribution to the USF of 15% on the applicable safe harbor rule of 64.9%.

    Finally, to tie this information to the Copperfield report. It has been claimed that Dan Borislow, the company's founder and prior CEO, has engaged in a scheme that will allow him to dump shares in the market without reporting it (through trusts he set up), at the same time while the company has an active buyback program. If this is true, that would enable Borislow to exit most/part of his holdings, without reporting it to the public, before the FCC issues any new legislation that covers non-Interconnected VoIP providers.

    To summarize, we believe that these loopholes which are used by MJ for unfair competition will be closed by the FCC during 2013. MJ will have the option of either bearing the cost of these added fees and taxes in order to maintain its market share, or significantly increase the amount it charges for its services, which would make if far less appealing to subscribers, as MJ is not really know for its quality of service (voice quality and support). On top of that, MJ has probably a huge undisclosed liability relating to past non-payment of taxes and fees, probably higher than its cash balance or even market cap.

    Disclosure: I am short CALL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Disclosure: I am short CALL.

    Tags: CALL, VG
    Apr 19 11:42 AM | Link | 7 Comments
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