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NQ - Why Still So Cheap?

|Includes: Link Motion Inc. (LKM)

This is the translation of two recent analyses of NQ on, the Chinese counterpart of Seeking Alpha (original URL

NQ: riding high, but can it reach escape velocity?

Every bull of NQ stock repeatedly cites a third party market research firm's mobile security market share data. But one must be careful about relying on market research data in China as they are often paid for, and therefore one has to combine it with on the ground observation and survey. Mobile security software survey is actually very easy if you can talk to enough average Chinese. The reality is, IT industry folks in China predominantly doubt NQ's China revenue, but think it's very successful overseas. But American analysts typically recite management supplied information and assumes NQ makes gobbles of money from China, which can be used to experiment with the nascent US market. Soon, both sides may realize the other side's story is not so reliable.

First, the more readily visible side, NQ's China business. This may be not surprise many IT veterans in China, but American investors hold on steadfastly to company provided market share and subscriber data, a typical behavior of "not doing your own work". This China "revenue" is meaningful. Filings show that in the 12 months ending Sep 30, 2012, China revenue reached $43M, or 58% of total. $37M of this was derived from mobile subscribers, and there were 5.6M paying users in China. Monthly active users in China was 49.7M, which grew 83% year over year. The remaining $6M revenue was generated from NQ-majority owned NationSky, whose revenue primarily comes from distributing/reselling handsets to corporate customers.

Based on ground research in five Chinese cities (covering all tiers from capital to provincial capital to 3-4th tier cities), covering mobile users, carrier stores, phone retailers, and prepaid card vendors, we found that there was no pre-installation of NQ software, no user who has paid for mobile security, no user intends to pay for mobile security, and worse yet, no prepaid card vendor who has heard of the name NQ (some of them are aware of mobile security software's existence, but they only mentioned Tencent, Qihoo, and Kingsoft). In common perception, Chinese mobile security market is dominated by Qihoo, Tencent, and Kingsoft. In this context, NQ's monthly active users of 50M and total registered user of 142M are startling figures, because the total smartphone installed base in China in the third quarter of last year was between 100M and 200M. While this total number may be different depending on whose number one quotes, no one in China will dispute that Qihoo, Tencent, and Kingsoft's combined security user far far exceeds NQ, and NQ cannot have more than 50% installed base market share (NQ supplied third party data shows greater than 60% market share). Even stranger is the fact that NQ's monthly active user in China jumped 83% in the third quarter last year, but during this time, Qihoo and Tencent were swiftly taking market share in China.

In light of such extreme ground checks, how can we explain NQ's revenue from Chinese mobile users? Unauthorized fee deduction is one possibility, and inflated revenue is another.

Due to the fact that many prepaid mobile users cannot easily monitor their fee balance in China, unauthorized fee deduction was a major source of income for Chinese Wireless Value Added Service market. However, as China Mobile cracked down and cleaned up this value chain, this road is getting narrower and narrower, and cannot be a reliable source of growth. In other words, even if this revenue was real cash revenue, it's not sustainable. As a matter of fact, NQ's revenue derived from China Mobile dropped to 1% of total revenue in 2011 from 48% of total in 2009.

Inflating revenue needs a cooperating partner to manufacture evidence of revenue, but the cooperating partner is unlikely to provide assistance with cash flow, leading to the outcome of skyrocketing receivable days (revenue grows strongly, but cash flow stays low). As a matter of fact, NQ's receivable days skyrocketed in 2010, and has stayed at this level since then, which is much higher than similar companies: receivable days was 69 at end of 2009, 208 at end of 2010, 192 at end of 2011, and was flat year over year in the first 3 quarters of 2012. Similar businesses (in terms of having to collect from China Mobile) are KongZhong, with a receivable days of 40-50, and Linktone, with a receivable days of 70-100.

Who could this cooperating partner be? Filings show that revenue from Tianjin Yidatong successively increased as a proportion of total revenue. It accounted for 25% of NQ's China revenue in 2009, 33% in 2010, 46% in 2011, and 48% in first quarter of 2012. Though this is not defined as a related party, in reality it's very likely to be closely allied with NQ. Web search shows that the two companies have close relationship. This is the Web address of a consumer complaints site and an excerpt (in Chinese):

"北京网秦天下科技有限公司成立时间:2005-10 和天津市易达通科技发展有限公司属于来一家SP公司,地址:北京市东城区和平里东街11号院内四号楼(100013) 客服电话:400-6331919

该公司与移动合作的业务提供有:梦网短信、手机WAP。但是该公司目前的业务提供是由北京网秦天下公司提供的手机通讯管家、手机杀毒、手机防盗等软件,来代与移动合作的梦网短信拇指赢家单次点播每次两元和手机上网单次点播每次两元收取费用,梦网短信拇指赢家的业务介绍:拇指赢家主要给用户提供动作、射击类电视互动游戏,以及投票、留言、竞拍、跟主持人互动等电视互动游戏。用户参与游戏即可获得积分,积分可以兑换相应的礼品,还能参加随机抽大奖。 手机上网的业务介绍暂时尚未查询到。"

In China, circumventing the definition of related party should not be difficult.

NQ is trying to reduce its reliance on Chinese consumer "business" through frequent acquisitions. But its big move was on NationSky, whose main business was selling smartphones, low margin, low cash flow, and the only purpose was to maintain China revenue growth through financial consolidation. Feiliu's value is yet to be seen, but the "3/15" consumer expose and the white hot competitive market it is in, apps store (with strong players like Qihoo, 91, Tencent, Jifeng, Wandoujia, etc.), makes it hard to get optimistic on Feiliu. Feiliu's acquisition price was an order of magnitude lower than the estimated valuation of the aforementioned app stores, implying a negative growth outlook on Feiliu. NQ also acquired stakes in 3 other small companies. If a company's main business has a lot of room to grow, it should invest capital into its main business, not into lateral acquisitions. If it claims to be asset light and doesn't need reinvestment, then it will attract competition. If it claims to have a high barrier to entry, and no one else can compete with it, then it must demonstrate its barrier to entry. Is it highly sticky and paying user group (really can't find evidence of that)? Is it meaningfully stronger technology (it's a commodity product)?

NQ's auditor is PWC Zhongtian. Though it doesn't have so many problematic customers as Deloitte, it also stumbled badly on Ambow. Even though NQ's P/E has always been very low, its VC investors were in a rush to exit, and was forced to withdraw a secondary offering. The difficult prospect of its Chinese business may be the reason.

Now on to the overseas business. First of all, NQ's heavy hope is on the US market, but there has been no number disclosure on this market (too immaterial, even though NQ claimed to have entered the US market very early). The considerable overseas business (42% of total revenue) only came with very high level disclosure. Qatar Telecom was the only named customer overseas, but as far as we know, Qatar Telecom has switched vendor (it won't bring much revenue anyways). Eastern Europe and Middle Eastern countries' popoulation and user volume are negligible, and the big population country in Southeast Asia is Indonesia. But there is no sign of NQ working with Indonesia's main carrier. Then there is Latin America. But AMX, the big carrier in Latin America, just signed in the past few days. So where does this historical overseas revenue come from? Hard to guess. The high receivable days of NQ gives some clue.

What about the prospect of overseas market? In the US, NQ is a latecomer, facing LookOut (two top tier Silicon Valley VC backed, ample cash, on par with post-IPO NQ), and McAfee, Symantec the traditional security vendors. On Google Play store, it's pretty much game over, because this channel makes the incumbent hard to displace (LookOut). This is because Play ranking is determined by existing popularity ranking. Going through carriers is a less appealing strategy. Historically, there was never any small company that got successful by relying on carriers to go to market. But NQ has to do this. Three of the big 4 carriers in the US have already signed with LookOut and other US vendors (LookOut is different, it already has a leadership position in app store, and is not beholden to the carrier channel), with VZ left. But in light of the high commoditization of the mobile security software, the bargaining power of the giant carrier is even stronger. And to convince the premium subscriber targeting VZ to overlook NQ's governance risks will be difficult. The two carriers that signed with NQ are in struggling mode. There are several VZ distributors and NationSky-like corporate facing smartphone vendors too, but their decision basis was a third party report sponsored by NQ.

AMX is a partner with real potential, because of its large user base and good profitability. But trouble is, AMX's main business is in developing countries in Latin America. Even though it has presence in the US, it's mainly targeting the low income (including illegal immigrant) population. The willingness to pay of this population is not necessarily higher than Chinese. Security software commoditization will also give AMX very strong bargaining power.

The best outcome of NQ will be for investors to continue to ignore the authenticity of its China business (close to 50%), and give it enough time to experiment with overseas market. The fundamentals of the overseas market is not great, but there's a chance that the US CEO and overseas brokerages can prop it up for a short while. But even if this is the case, the two CEOs and the two teams will need to significantly re-allocate the economics, which could bring big uncertainty to the operations of the company.

Translation of a follow up post:

AMX, due to its status as belonging to the world's richest person, has a halo effect no less than Buffett. But in reality, the revenue potential for NQ will not be that great. Filings show that AMX's US subsidiary has an ARPU of only $18, far below mainstream carriers' $45-$55, strongly suggesting its customers' ability to pay (let alone willingness to pay). Other markets are all in Latin America, and Mexico has the highest ARPU, of only $14. Secondly, from a channel influence perspective, 80-90% of AMX's users are prepaid (not contract) users, and bought their own handsets, so AMX cannot effectively preload NQ software onto those smartphones, greatly reducing its marketing effectiveness. AMX's cost control should be superior, as it can reach 10% pretax profit margin for its US subsidiary with such a low ARPU. Conversely, they must keep their supplier prices very low. Low ARPU population plus strong carrier as a gatekeeper (AMX will use its own brand, not NQ brand), and one can imagine, the economic benefits from the AMX partnership to NQ will not be great.

However, AMX is a respectable company, and it does increase the legitimacy of the overseas business, despite the fact that 60% of NQ's reported revenue was from China and very gray, and the 40% of revenue from overseas is also very non-transparent. If the US CEO realizes that his business is in fact the only real business for NQ, he may not be happy to keep working for the Chinese owner.