A few months ago, I wrote about Muddy Waters, a hedge fund that targets dodgy US-listed Chinese companies, shorts them and then documents their fraud. They now have an impressive list on companies that they have exposed, including China Media Express, Duoyuan Water and RINO International. These companies appear to have two things in common: they did not have real businesses—or at least not at the levels they claimed, and they all went public through reverse takeovers (RTOs). We have written about the RTO industry here and Barron’s has an excellent piece on it here.
Short sellers love RTOs because the fraud tends to be blatant and so easy to uncover that it does not take long to put together a damning report. It’s been a known scam for so long that we were even told in 2006 the practice was not long for this world. Well they are still here.
But it is becoming increasingly apparent that if many RTOs are scams hidden just under the surface, China’s frothy IPO market has a few duds that you need only read public filings to uncover. It turns out that companies which go through the standard IPO process—with big-four auditing firms and well known underwriters—often have just as many problems as their RTO counterparts. But they actually document their issues.
Three separate examples of Chinese companies that went through the IPO process should raise bright red flags for investors for different reasons: NetQin, VisionChina and RenRen.
NetQin: This is probably the most obvious problem child of the group. NetQin’s business is anti-virus software for mobile phones. The fact that this company was able to list at all is surprising, given the following information in its own SEC filing:
On March 15, 2011, a live program broadcast by China Central Television Station, or CCTV, the national television broadcasting network owned by China’s central government, in celebration of China’s consumer rights protection day, reported various complaints of certain alleged fraudulent practices by Beijing Feiliu, a company in which we hold a 33% equity interest, and by us. Such alleged fraudulent practices generally included, among other things, uploading malware or viruses to imported mobile phones to promote our mobile security products.
Netqin’s SEC filing goes on to say:
Although we do not believe that we have committed any wrongdoings and we do not have any reason to believe at this stage that Beijing Feiliu has engaged in any fraudulent practices, CCTV has wide coverage and perceived authority over public opinion and the negative publicity by CCTV and other media about Beijing Feiliu and us may have adversely damaged our brand, public image and reputation, which may seriously harm our ability to attract and retain users and result in a material adverse impact on our results of operations and prospects. For example, as of the date of this prospectus, each of Nokia, China Mobile and China Telecom has removed our applications from its respective official online mobile application store
One thing you have to say about these guys is they have serious chutzpah: not only did they IPO only weeks after the damaging CCTV report, but they filed the paperwork for the IPO the day after the report aired.
Best case scenario: The accusations are false, but most of their partners are nonetheless backing out of cooperation agreements.
Worst case scenario: Netqin only protects consumers from viruses that a subsidiary creates and loads onto their cell phones.
At least investors were paying enough attention to make Netqin the worst performing IPO of the year.
VisionChina: You may remember these guys who do outdoor television on buses and subways for their ongoing lawsuit with the former investors in DMG, a competitor VisionChina bought. VisionChina appears to have played some games that warrant a second look. According to public documents
- VisionChina went public via standard IPO in late 2007.
- In April, May and June of 2008 it bought six industry players. While the six deals together were cumulatively material to VisionChina’s business, the company deemed each individually not to be. This allowed management to skip SEC filings announcing the specifics of each of the acquisitions.
It also allowed them to bury an interesting feature of all six contracts in a quarterly earnings release. VisionChina structured the deals as “earn outs,” which allowed VisionChina to immediately report all of the revenue from the acquisitions before actually integrating the company or incurring large expenses. Of course, this is only an advantage if you need to boost short-term revenue, which leads us to the following:
- VisionChina held a follow-on offering in August 2008, months after the six acquisitons, while revenues were still high from the boosted income flowing from the earn out deals. According to the SEC filing, the chairman and CEO of the company (Limin Li) and two directors (Yanqing Liang and Yunli Lou) sold 3.7 million shares into the offering at $16 a share for a total of more than $60 million. Not bad, considering this was only eight months after going public.
- The stock price collapsed when the financial crisis hit a month after the offering. The share price has never able to recover its mojo as the earn out acquisitions were never integrated. In fact, in a March 2010 earnings call, management seemed to admit that the earn out structure had always been doomed to failure, when then-CFO Scott Chen, who was not involved in the original earn out purchases, said:
These earn outs are coming to an end. This is of course by design. I for one do not believe in the benefit of long term earn outs. I think there are better ways to manage, to incentivize sales forces and to incentivize management. So I think this is a good thing that these earn outs are coming to an end….
* * * *
earn out related revenue has been a decreasing percentage of our business over the year 2009. For the fourth quarter, earn out related revenue accounted for about 35% of our total revenue.
Analysts read this to mean that 35% of VisionChina’s fourth quarter revenue would soon disappear, and following the conference call, its stock price fell 37% in a single day as it dawned on investors that none of its six earlier purchases had been integrated for long-term sustainable revenue contribution. The stock price now hovers around $4, about one quarter of the price at which management had sold so many of its shares. Lucky them.
Best case scenario: Management got extremely lucky in the timing of the follow-on offering and mismanaged the integration of the six acquisitions.
Worst case scenario: Management deliberately structured the six acquisitions to boost short-term revenue so they could cash in and leave investors holding the bag.
Renren: As you’ve no doubt heard, these guys are the Facebook of China, except without the cool movie. Maybe anyway.
When Renren filed its F-1 with the SEC, one number in it raised more than a few eyebrows. Kai Lukoff of TechRice summed it up well:
By far the most surprising finding in Renren’s F-1 filing for IPO? After two years of sluggish growth (Dec 2008-Dec 2010), Renren claims explosive active user growth over the last 3 months to the end of March 2011. It claims to have added as many active users over the past 3 months as it did the previous two years (7 million monthly active users (MAU))
Could this in fact be a surge in Renren’s popularity? Just a seasonal difference (less usage in December and more in March)? Or just a reflection that all of Renren’s log-in numbers are “approximate”? A massaging of the “approximate” numbers for the IPO?
None of my contacts in the tech industry report a surge in Renren’s popularity (if anything the opposite), but chime in if you know different.
As it turns out, Kai nailed it on the head as Renren had to change its F-1 filing a week later. Reuters reported:
According to the revised filing on April 27, the Chinese Facebook clone’s monthly unique log-in user base grew by only 5 million, or 19 percent, in the first quarter of 2011 — not the 7 million, or 29 percent, it reported in its first filing.
That did not stop Renren from having a gangbusters opening day (albeit followed by a very weak day 2).
Best Case Scenario: Renren had problems accounting for how many new users were actually active or else it inadvertently attributed two quarters of growth to one.
Worst Case Scenario: Renren thought no one would notice that its numbers were highly inflated.
Bottom Line: Whether you are looking for a JV partner, involved in a merger or acquisition, buying product from a Chinese supplier, or buying Chinese stocks, you must always do your homework/due diligence. Because sometimes scams are sitting in plain view and sometimes they are not.
What do you think?