NQ Mobile Is Oversold

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The earnings miss is due to one-off factors and fast growth in lower-margin business. The dramatic sell-off is, therefore, overdone.

NQ is in the midst of a fundamental change away from a near-commoditized business, and its new platform strategy is already starting to deliver.

New significant revenue streams are opening up.

While shares of NQ Mobile (NQ) sold off a whopping 20.5% on Friday due to an earnings miss and kept on falling in the days after, the truth is that one-off factors were mostly responsible for these, and top line growth remains very much intact. In fact, growth seems to be accelerating.

Let's start with the earnings miss. The company earned $14.9M (non-GAAP), or 22 cents per share in the fourth quarter, that was a rather substantial 10 cents below average analyst expectations. GAAP loss was $5.2M, or 9 cents per share (the difference is mainly the stock-based compensation). That's disappointing, but revenue is growing much faster than analysts had expected, and the company once again guided revenue higher for Q1 and FY2014.

So to put things in perspective, unless margins keep on collapsing, the growth in earnings in and by itself should result in an EPS FY2014 easily above $1. Considering the $10 and change the shares are doing (at the moment of writing), this is hardly expensive, in fact, it's rather cheap.

And there are good reasons to assume the Q4 earnings were unusually low, which is why analysts haven't dialed down their EPS forecast for FY2014 by all that much. On average, these have been reduced from $1.41 to $1.34. Big deal. Below, we'll go into these temporary factors in a little more detail, and also put some color on the growth story, which is still very much purring.

Earnings miss
There are a number of factors responsible for the miss:

  • High growth in lower-margin business (NationSky, advertising)
  • NationSky's hardware sales
  • Reduction in accounts payable
  • One-off cost related to the special audit
  • One-off cost from a convertible bond offering ($166M)

One-off factors
Here is how the company broke these down in a subsequent IR update:

there was almost $8 million in expenses and costs that impacted our operating and net results in the quarter. $2.4 million of direct professional services fees/costs tied to the work of the Special Committee/Fighting false allegations from short seller reports. $1 million in indirect expenses including extra marketing and PR which was not included in the one-time break out. $2.8 million in expenses and professional fees from the CB offering. And, we forfeited $1.6 million in interest income due to the early termination of term deposits from the transferring of ~ $103 million.

While substantial, these one-off factors weren't the only part of the earnings surprise.

Enterprise business
The lower-margin enterprise business and advertising together made up 60% of revenues. Indeed, both are growing very fast, and the fact that these generate lower-than-average NQ margins should not encumber the vision that the opportunities here are very significant. Take NationSky:

our pipeline has grown from just a couple hundred thousand seats a couple of quarters ago, to now over 1 million seats in our current pipeline.

The market opportunities are very large here. The company believes that healthcare will become its largest vertical. In China, healthcare composes just 5% of GDP (versus 18% in the US), and it is winning big contracts against serious opposition (for instance, West China Hospital in Sichuan Province, one of the world's largest hospitals, against rivals like IBM and Toshiba).

Of course, it has also made significant inroads into the public sector

We have now deployed and are supporting more than 700,000 seats with the National Bureau of Statistics in China, and that deal will grow further. [Henry Lin, CEO, Q4CC]

One might also want to keep in mind that NationSky's gross margin was lower than usual (20.6% versus 34.8% in Q3) due to a higher percentage of hardware sales, which has lower margins.

Advertising revenues was $36.6M for 2013, up from $8.9M in 2012. That's more than a four-fold increase. Exiting Q4, it already runs on a $65M yearly run rate and makes up a quarter of overall revenue. This business is a prime example of the benefits of its platform strategy which, through the generation of economies of scale and scope, the whole is bigger than the sum of the parts:

The robust growth was due to the increased monetization to advertising and promotional revenues in the form of third party application referrals through our mobile security products, mobile game and our advertising network platform. [K.B. Teo, CFO, Q4CC]

As its platform becomes bigger and more diverse, there is no reason to think that ad income can't grow significantly higher still, although the rate of growth will obviously slow from this torrent pace.

In the medium term, margins could revert back to mean, though:

This strength in those business lines will continue in the near term and especially at our emerging platform product like NQ Live and Music Radar still are ahead of monetization. [Teo, CFO, Q4CC]

That is, while NationSky and ad business are in the driver's seat at the moment and might be for some time to come, other businesses with higher margins will start to significantly contribute to revenues and bring back margins in line with its long-term model.

On the other hand, we see nothing alarming in the fall in margins, considering that it is the result of hyper-growth in some parts of the business which have below-average margins. Quite a few companies would like to have that kind of problem. It's clear that the growth opportunities in NationSky and ads are not disappearing anytime soon.


  • Full pipeline of deals (reported at several injunctions during the CC)
  • Platform strategy
  • Music Radar
  • NQ Live

Platform strategy
We've already explained NQ's platform strategy in an earlier article, but the stream of partnerships and acquisitions isn't likely to come to a halt anytime soon, and these keep increasing the opportunities for cross-selling, revenue sharing, and bundling (for instance, bundling security with insurance products, which increases the attach rate in retail channels from 20% to 60%).

The CC contained snippets which describe the parts of the platform strategy:

  • We must have compelling and engaging products and services, products and services that address user needs and delight them.
  • Second, we must have dominant user acquisition channels and an ability to distribute products and services directly to end users, and on behalf of third-party carriers and our manufacturing partners.
  • Finally, we must be able to monetize for ourselves and for our platform partners.
  • NQ is unique, in that we do not bear the full burden of investing, in scaling these new businesses alone. Our products and services are critical to a broad set of channel partners, who invest alongside us, in product customization and user acquisition.
  • In addition to our own products and services, and user acquisition channels that comprise our platform, I mentioned earlier the ability to open that platform to enable third parties to acquire users and generate traffic for their own products and services. This becomes extremely valuable for our advertising partners.

Considering the speed of transformation from commoditized Android security firm to this platform strategy with multiple revenue streams, it seems to be working.

Music Radar
NQ's music search engine, Music Radar has been off to a flying start, with approximately 20 million downloads already.

We expect to exceed 10 million daily search queries later this year. This is an enormous milestone [Q4CC]

iSMS Mobile Messaging
Not everybody is aware that NQ has a mobile messaging product called iSMS, which has nearly 2 million active users. The company expects this to grow rapidly, and once again, it has embarked on some smart strategies to bring this about:

this messaging client is preloaded on more of MediaTek's most successful smartphone chipset solutions. [Q4CC]

MediaTek might not be a household name in the West, it is very big in Asia. Its ARM-based processors have a very strong position below the top of the smartphone market, and together with Qualcomm (NASDAQ:QCOM), it dominates the baseband chip market. What are the expectations?

I mean, iMessage service to IOS platform. We have integrated the short message service with the IP message service together in one application. So I mean, it had been bundled with MediaTek, I mean, most popular chipset, to global market. So we can [foresee] [ph] this service will get at least several hundred million users in the near future.

I think for MediaTek smartphone chipset the sales this year it will exceed 300 million. So long term I believe it will be nearly 500 million per year. [Henry Lin CEO Q4CC]

If only half of that comes true, it will be rather significant, needless to say.

NQ Live
Given the strategic location of the home screen and the myriad of opportunities, NQ Live could be one of NQ's biggest growth opportunities. NQ has already announced partnerships and pre-load relationships with Sprint, China Telecom, VTE, and numerous other manufacturers. It has already more than 8 million monthly active users, with daily active user accounts exceeding 2 million, and it has been shipped on more than 35 million devices, with the roll-out expected to accelerate in the second half of this year.

the number of monthly active users on our NQ Live platform will reach 60 million users next year... we have a strong pipeline of still unannounced channel and content partners. [Q4CC]

How is this going to be monetized? Here is co-CEO Omar Khan in the Q&A session of the CC:

The two primary means are really advertising and also premium content revenue sharing to the extent where premium content is exposed and sold or discovered through NQ Live. But the former, meaning advertising, will be the dominant revenue monetization model for NQ Live per our expectations and our partners' expectation.

Of course, NQ Mobile isn't without its critics, like Muddy Waters and Goldbaum. Both argue that NQ Mobile is a fraud. With respect to the platform strategy, Goldbaum Research argues that:

the strategy is nothing more than just acquiring companies in China most people have never heard of and in industries which NQ have no business or expertise in previously. After acquiring the companies, NQ would later tell investors how they are supposedly in all these great new mobile business areas in China.

This is funny, sort of. Few people will have heard about small Chinese companies, and the one reason to acquire companies is exactly when they add capabilities you yourself lack. And after already having discussed NationSky's very impressive progress, who can question that they are indeed enmeshed in great new mobile business areas in China?

Here is another one from Goldbaum:

NQ Mobile acquired Best Partner Ltd ("WAPS"), a supposed Chinese mobile advertising company, on July 24, 2013. Later the company started touting how they have a mobile advertising platform and how the mobile advertising business is taking off.

With ad revenue exploding and new avenues like NQ Live just starting (as discussed above), we get the distinct impression that its ad business is indeed taking off. Of course, there is Muddy Waters arguing that this revenue is all fake. Curiously, they also argued:

"NQ surprised investors by reporting a reduction in gross margin and negative operating cash flow in its Q4 results. This indicates to us that PwC was doing its job in a more robust manner than in prior years, although we expect NQ to receive an unqualified audit opinion before the end of the month.

But they go on to argue that audits of public companies are:

not designed to detect fraud... Audits are generally performed from pre-constructed checklists that are used in thousands of public company audits throughout the world.

Well, Muddy Waters can't have it both ways. PricewaterhouseCoopers (PCW, NQ's regular auditor), warned by Muddy Waters' allegations already for over half a year, went the extra mile, even according to Muddy Waters, but is supposed to have done nothing but standard checklists that are not designed to reveal any fraud? We guess PCW isn't concerned about its reputation either.

Goldbaum also argues that its user growth is "disappointing".

So premium users grew just 5% QOQ in Q4 compared to over 30% in Q3. [Goldbaum]

Never mind that a sequential quarterly 5% growth is something most companies would die for, the very fact that NQ has embarked on a platform strategy means that it's opened up new revenue streams that are not reflected in these figures. Did Goldbaum listen to the CC? It was all there, on more than a single occasion:

We are currently not counting the majority of our advertising users and traffic, as well as numerous new products, like NQ Live, Music Radar and iSMS in any of our operating metrics. We are in the process of determining the best way to demonstrate our direct users, along with our platform traffic user metrics and premium total, and we will do that in the future.

The operating metrics detailed in today's earnings release do not include some very important products and traffic users, as well as premium user totals. We will begin reporting these user metrics, to more accurately reflect this platform in the future. [Q4CC]

Like Muddy Waters, Goldbaum can't have it both ways. They critique the platform strategy for bringing in new business and its existing business for not growing fast enough, but a quick check reveals that its old business is still growing rather nicely, and much of its new business isn't included in the metrics Goldbaum singles out for criticism.

We're also not sure whether they have fully understood the following:

The increase in mobile value-added service revenues was primarily due to the growth of mobile games revenues, and partially offset by the decline of mobile security subscription revenues, as we migrate the monetization of security and productivity applications into advertising. [Q4CC]

That is, NQ's bread-and-butter product, Android security, is moving from a subscription basis to an ad-based revenue model. Without the platform strategy, this wouldn't be half as viable.

Both critics seem already resigned to NQ receiving two clean audits (the 20F from PCW and the independent audit), and preempt this by arguing the independent audit (lasting well over half a year!) won't be independent enough.

Well, this would be more impressive if they simply managed to have anything near a smoking gun. So far, all of their allegations are highly speculative and have shifted the burden of proof onto NQ.

Some issues
We are not entirely enamored with the company. Compensation for co-CEO Omar Khan is rather steep. The company paid a hefty $80M (in shares and cash) for vLife, which is difficult to assess. We assume the technology is really crucial for NQ Life and the acquisition was necessary to protect the IP, so the jury is still very much out on that one.

Share-based compensation is also rather high. For the whole of 2013, it was a whopping $55.4M. Non-GAAP income increased from $34 in 2012 to $57.8M in 2013, but share-based compensation turned this into a GAAP loss of $2.8M.

Of course, we also still await the audits, although the wait is almost over and even the critics seem resigned to these coming up clean. With these expectations, needless to say, it would be very bad if they weren't, although we don't discount the possibility that Muddy Waters is purposely driving expectations for a clean audit. If successful in driving expectations, there is only upside for it.

It is remarkable how NQ has evolved from a bread-and-butter Android security proposition (a product that is a near-commodity) into a fully-fledged mobile platform company with multiple fast-growing revenue streams. While we would have liked to see earnings coming in stronger, this is just one quarter, and the earnings disappointment is at least partly the result of one-off costs and circumstances, and reinforced by a bad market and lingering uncertainty over audits.

Further, with the platform strategy just emerging, it is to be expected that revenue growth trumps earnings growth at this early stage. We think the punishment of the shares is exaggerated, for several reasons:

  • The one-off factors will disappear, so will the lingering uncertainty about the audits.
  • Revenue continues to grow extremely fast, and the company is really very well-placed in a number of very high-growth mobile segments.
  • While it isn't a given and timing is unsure, we expect the platform to reach critical mass in the near future, after which it will start to leverage earnings.
  • Monetization of new revenue streams from NQ Live and Music Radar will start to kick in in the second half of the year.

It might take some time for NQ to recover from this, but barring a disasterous audit, we can't see much, if any, downside from $10 and change, certainly not permanently.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NQ over 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.