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NQ – How Real Is The Enterprise Story?

|Includes:NQ Mobile Inc. (NQ)

NQ acquired NationSky (NYSE:NS) in a two-step transaction in 2012 and 2013, and declared its entry into enterprise mobility. NS resells mobile phones and associated device management software and services to Chinese corporates. Due to the low gross margin of device sales, NS carried an overall gross margin of 25% in 2012, which was boosted to 34% in H1 2013.

Several things raise a red flag. First of all, NS carries little to no inventory (since NQ's consolidated inventory was only $0.5M at year end 2012, against NS revenue of $12.6M in 2012), but supposedly makes a gross profit from selling phones. IT distribution giant Digital China, as long as its global counterparts like TechData, carries significant working capital, because that's a big part of their value add in the supply chain, and in return, they get to earn a 5% gross margin in the hardware distribution business. What entitles NS to earn any gross margin on its cell phone resale if it carries little to no inventory? At best, NS can earn a 2-3% gross margin selling hardware.

Secondly, what software and services could Chinese corporate clients be paying NS for? Note that these clients are characterized by NQ as the corporate who's who in China. Large Chinese corporations have the wallets and desire (for image purposes) to spend with the likes of IBM, SAP, Oracle. It's a bragging right to say that one runs on SAP, or engaged IBM, for example. What value-added services could NS be providing to these rich companies?

Conversations with recent employees (both during and after their tenure at NS) reveal that beyond hardware, NS was primarily selling Blackberry Enterprise Server licenses, which should be quite small by now, and now NS's non-hardware revenue is all custom app development revenues (contract software development), which carries a 10%-15% gross margin. When asked if NS generated any MDM software with a subscription revenue model, the answer was no, and in fact AirWatch pulled back from the Chinese market due to the fact that MDM is not a tangible demand there yet.

So here we are: hardware revenue, which should be the majority of NS revenue, carries low single digit gross margin; custom development work revenue carries a 10%-15% gross margin. How do these two lines combine to generate 34% gross margin in H1 2013 (assuming BES resale is de minimus)? And how can NQ analogize its NS division with MobileIron and AirWatch, who derives revenue from recurring software subscription?

Having gone into some depth on all NQ's growth call options (not stock options, lest some gets confused), we believe these call options are hopes and dreams at best. As such, the more ominous questions of the authenticity of NQ's revenue and profit for security and mobile gaming and advertising will return to the center stage of the bull-bear battle. Bulls have clung to management statements and company initiated market research as the foundation of their belief in the company, but on-the-ground end user survey, retail POS check, and industry interviews firmly point to a strong likelihood of fabrication, and the existence of significant stock based compensation calls into question the objectivity of the favorable market research.

With shaky foundations under FL and NS, chances of NQ becoming a true powerhouse in mobile Internet are slim. The convertible bond sale was completely expected by us because the dry powder will allow NQ to continue operating essentially as a blank-check company hunting for those acquisitions that can transform itself into a legitimate business.

Jun Zhang, analyst at Wedge Partners, which has an unusually cozy relationship with NQ via the appointment of its portfolio manager Matt Mathison as VP of Capital Markets for NQ and possible ownership of NQ stocks, intimated that mobile game developers will be the target area of acquisition. Assuming this is true, it doesn't augur well for NQ's longevity. With lifespans of less than six months for even the hit titles, NQ will need to acquire a lot of those mobile game developers to sustain revenue growth, and meanwhile the 4% interest on $150M is $6M a year, not trivial for a company that net added only $18M cash to its balance sheet over the past 2.5 years.

And the more NQ acquires, the less convincing the M&A/takeout exit "thesis" becomes.

Stocks: NQ