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Muddy Waters, LLC NQ: You Can’t Fool All of the People All of the Time April 13, 2014
PwC’s Additional Scrutiny Ensured NQ Reported a Q4 Loss and Negative Operating Cash Flow Based on NQ’s disappointing Q4 results, including its surprising GAAP loss and negative operating cash flow, we strongly believe that NQ’s auditor, PriceWaterhouseCoopers Zhongtian (“PwC Zhongtian”), bolstered its level of due diligence during its 2013 audit of the company. Our view is supported by the fact that NQ took an extra month to release its Q4 earnings compared to last year. 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. As long as NQ has excuses for cash not flowing into its accounts (i.e., its negative operating cash flow), it can essentially report whatever revenue amount it wants. We saw these same shenanigans in our investigation of Sino-Forest, which was subsequently confirmed during the company’s bankruptcy proceedings. Sino-Forest’s bankruptcy monitor reported that over 95% of its reported gross profit never actually showed up in its bank accounts. Sino-Forest’s auditor was aware of this, but, like NQ, Sino-Forest was able to tell its auditor that it used the cash in its operations. Without needing to show cash in its bank accounts, there was nothing to stop Sino-Forest from overstating revenue and assets by billions of dollars. In its Q4 results, NQ’s uses a massive increase in prepayments to vendors and a big pay down in accounts payable as an excuse for not showing an increase in cash. As always, NQ’s accounts receivable Days Sales Outstanding remained implausibly high. Had we released our initial report during NQ’s audit (i.e., after December 31st), we believe that NQ would not have had time to adequately prepare its defenses and excuses against a more robust audit. To understand why NQ’s results were much worse than expected, investors need to realize that prior audits of the company were likely not as rigorous, and the extra scrutiny made it harder to fake profits and cash flow in Q4. As we have said multiple times before, audits of public companies are not designed to detect fraud. Auditing standards presume that company documents are genuine and management does not make misrepresentations about their numbers. Audits are generally performed from preconstructed checklists that are used in thousands of public company audits throughout the world.
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These checklists incorporate the standard presumption of honesty. As a result, auditors are not visiting a company’s customers to make sure revenue is accurate nor are they visiting suppliers to confirm whether the company’s volumes match up with the financials they are reporting. Auditors also do not review government files to confirm that a company’s filings with the government are the same as what they report on their financial statements. Auditors don’t view themselves as fraud detectors, which is why an audit has been one of the least likely ways to uncover wrongdoing. Instead, auditors follow their checklists. These can be made somewhat more robust when there are potential fraud concerns; but even so, the only anti-fraud measure in an auditor’s checklist is the cash confirmation procedure. Unfortunately, investors are never told whether an auditor confirmed cash merely by looking at the static balance as of December 31st, or whether it checked the balance on other dates and reviewed inflow and outflow transactions. NQ Continued its Pattern of Overpaying for Acquisitions in Order to Roundtrip Revenue NQ announced that it yet again spent a lot of money on what is likely a little company called Tianjin HuaYong Wireless Technology Ltd. (vLife). (vLife had only raised a total of $500,000 since inception in 2006, and appears to have previously operated a dating website.) NQ announced that it bought 58% of this company for approximately $80 million. Most of the acquisition consideration was in shares and U.S. dollars. NQ’s acquisition pattern is atypical for U.S.-listed Chinese companies (and frauds) in that it pays for much of its acquisitions in shares. This is especially strange considering that NQ has said it is preserving cash raised through its IPO and other share offerings. We believe the real reason NQ relies so heavily on share issuances is that it reports a significant level of fraudulent revenue from outside of China. (Note that it seems very little of NQ’s non-China revenue comes from the U.S. or other developed markets.) Because of China’s capital controls, NQ needs to have offshore cash in order to fake its non-China revenue. It is highly likely that much of the monetized stock issued for the acquisition will be recorded on the books as international “revenue” in the future. NQ’s Revenue Growth is a Desperate Attempt to Keep a Floor under the Stock Price NQ’s larger than expected revenue growth and increased guidance are the only tools it has as it attempts to keep its stock price up. However, NQ had to do some back flips in order to report this inflated revenue, including reporting a mix of revenue that was not in accordance with its previous guidance. In Q4 2013, advertising revenue was much larger than NQ had led investors to expect. Some types of revenue are easier to fake than others. Our observation is that advertising revenue-based frauds in China are among the easiest to commit. Legitimate operators in the advertising industry deal with numerous intermediaries, and pricing structures are among the most opaque of any industry. For a fraudster, it’s easy pickings. In NQ’s case, its advertising
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revenue comes from almost impossible to verify channels such as “third party application referrals through our mobile security products, mobile game and our advertising network platform”.1 If just one year ago, an investor predicted that NQ would generate any advertising revenue in 2013 – let alone $16.7 million in Q4 – they would have been easily dismissed. NQ founder and chairman Yu Lin even made this statement in January 2013: “Why don’t we take ads? I think the format of ads on mobile phones is not mature yet. Furthermore, there is a fundamental conflict between our safety service, by its very nature, and the advertising model. If you want to target ads accurately, there will be privacy issues.”2 Co-CEO Omar Khan indicated that Q1 2014 results will also be heavily reliant on advertising revenue. If NQ reports strong Q1 2014 advertising revenue, as Mr. Khan indicates, it would be absurd given the contradiction in Mr. Khan’s own comment: “Q1 is typically seasonally lower in enterprise and advertising. Yet we are seeing continued strength in these businesses, sequentially.”3 Because NQ’s numbers are not real, NQ exhibits strange changes in revenue contributions that would never occur with a real business. Investors Should Not be Surprised by the Q4 Loss Investors might feel caught off-guard by NQ’s disappointing Q4, given that some long-holders claimed to have conducted due diligence following our initial report. Frankly, we are puzzled that any investor would put so much faith in due diligence meetings that were held after our report came out. Like a child outside of the principal’s, NQ, its suppliers and customers have had the time to get their stories straight to avoid detention – or in this case to continue defrauding investors out of hundreds of millions of dollars. Making that belief even more misplaced is that these meetings are occurring in China – not Kansas City. Seasoned China businesspeople can frequently recount staged meetings that have taken place at state-owned banks, other state-owned enterprises, and government ministries. To have a staged meeting at a private company is a slam dunk – it’s not uncommon to be able to borrow another company’s factory, changing the sign and the workers’ uniforms just for the day in order to fool investors. We’ve seen this a number of times in our investigations and in China there are even companies that arrange for frauds to rent employees, inventory, computers and other equipment for the day to enable the companies to get through investor due diligence visits. .
K.B. Teo, Q4 2013 conference call. http://knowledge.wharton.upenn.edu/article/nq-mobiles-henry-lin-we-have-been-a-global-company-from-day-one/ 3 Omar Sharif Khan, Q4 2013 conference call.
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Investors should remember that in NQ’s stock fraud, there are hundreds of millions of dollars in illicit profits at stake, and roughly zero chance that anybody on the China side who colludes with management will ever be punished. Making such due diligence even more pointless is the PRC government’s open antipathy toward short-sellers, particularly Muddy Waters. (As has been reported, we have been hunted by China’s internal espionage agency, the Ministry of State Security.4 But didn’t investors confirm NQ’s cash balances? In our initial report, we failed to mention that NQ’s purported cash balance was exactly the same as the amount of money it has raised since inception. In other words, its cash balance shows nothing about the veracity of its reported revenues. Even so, NQ’s cash balance is cannot be legitimate because the money it claims to have in the PRC could not have made it into the country in the way NQ claims, given China’s capital controls. Did NQ really post $103 million in cash in its Beijing Standard Chartered account in November 2013? We cannot say for sure because NQ has refused to allow us to verify the balance in that account, but it wouldn’t surprise us if it actually did post the cash. China has a massive gray market for lending money - the so-called “shadow banking system” - that has grown to over $2 trillion in annual lending.5 Many of these loans are made to highly risky mining and real estate borrowers, but a two-month loan to a company like NQ, which only uses it to show that it has cash in its back account is a pretty attractive bet – especially when secured by a pledge of shares. We weren’t that surprised when NQ approved an amendment to the articles of association on Dec. 23, 2013 that made it easier for Chairman Lin to pledge his shares.6 NQ Management Sent a Clear Signal that it Lacks Confidence in NQ’s Future In Q4, NQ insiders made clear they lack of confidence in the future of the company. In response to our initial report, NQ announced that senior management would demonstrate its “strong confidence in the company” by buying (a token amount of) shares in the open market. Buried in the middle of NQ’s verbose Q4 press release, we learned that NQ’s management failed to purchase even a single share of stock with their personal funds despite the supposedly low prices at which the stock was trading and its promise to do so. On November 12, 2013, NQ issued a press release titled “NQ Mobile Announces Senior Manager Share Purchase Plan,” which told investors that senior management was willing to commit an aggregate of $3 million to buy shares. The following excerpt from the press release explains the logic:
http://www.bloomberg.com/news/2012-12-10/carson-block-goes-short-unafraid-as-gangsters-in-china-chasehim.html 5 http://www.forbes.com/sites/afontevecchia/2013/06/17/china-massive-credit-bubbled-fueled-by-shadow-bankingand-securitization-could-collapse-banks/ 6 http://www.valuewalk.com/2013/12/nq-mobile-now-pledge-shares-for-loans/
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"We consider the recent drop in NQ Mobile's share price to be artificially created by false allegations and we believe our stock to be currently undervalued," commented Dr. Henry Lin, Chairman and Co-CEO of NQ Mobile. "The plan to purchase NQ Mobile shares by the NQ Mobile senior management team demonstrates our strong confidence in the company and reflects our commitment to executing our business plan and delivering shareholder value." To call a spade a spade, $3 million is a token amount. But even we are surprised that management did not spend a single dollar buying shares in Q4 – particularly considering that during much of December, the stock was trading in the $11 range. NQ’s “excuse” can be found in deep in the Q4 press release: “To comply with on the applicable laws and the Company's securities trading policies, the Senior Management team was unable to purchase shares on the open market during Q4 2013.” When a company craps out new shares the way NQ does, it’s hard to believe there is a draconian – let alone merely responsible – share trading policy in place. So, if formulating a plan to purchase up to $3 million of shares “demonstrates [their] strong confidence in the company”, then what does the failure to spend one dollar demonstrate? What Role Would Omar Khan Have at a Real Company? It is not lost on us that if NQ were a real company, Omar Khan would have been fired long ago. Mr. Khan’s stock compensation package has been worth approximately $100 million. Yet, he has delivered little more than press releases. It is clear that almost all of NQ’s reported revenue comes from the book that Henry Lin manages. Mr. Lin is apparently a wizard at generating millions of dollars in annual revenue from countries where NQ lacks even a basic website. (We discuss the phenomenon of NQ’s investment-less emerging markets revenue in detail in our letter to PwC available at: https://www.documentcloud.org/documents/1008238-mw-letter.html.) Taken at face value, Chairman Lin is one of the most successful salesman in modern history. In contrast, all NQ manages to do in the U.S. is pump out press releases with names of “partners”, but produce no meaningful revenue – despite having a prodigious “energy, excitement level and vision” in the U.S. operation.7 (We challenge NQ to release its 2012 and 2013 U.S. revenue if it takes issue with us on this point.) Any real company would never keep such a highly paid and poorly performing Co-CEO as Omar Khan – particularly when the other Co-CEO is diluting his holdings to keep Mr. Khan around. In reality, Mr. Khan is merely a $100 million sock puppet. His true value to Chairman Lin, beyond his ability to speak a dialect of English known as Consultant Speak, is to spew
Omar Sharif Khan, Q4 2013 conference call.
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meaningless drivel such as: “We have more tools at our disposal that make us more relevant to a broader set of constituents than the days when I was at Samsung or Motorola.”8 (Samsung’s 2013 revenue was $220 billion.) Second Straight Filibustered Conference Call NQ has stressed in response to our reports that it is “transparent”. However, its two filibustered earnings calls since our report belie that claim. For the recent call, it was Mr. Khan’s turn to run out the clock (Chairman Lin did an excellent job of that last time). The result was that NQ only had to take questions from the four sell-side analysts covering the stock, all of whom presently rate it a Buy. We have noted that China frauds generally try to avoid calling on buy-side questioners because their views are not as easy for management to gauge ahead of time. The strange thing about the dynamic during this particular Q&A is that each of the sell-side analysts asked numerous questions without shame, eschewing the usual courtesy shown to other questioners of asking only one to two questions. Did NQ arrange for these analysts to provide an assist in running out the clock? We don’t know, but NQ certainly seems to have a different definition of transparency. Be Cautious of Independent Committee Investigations As we wrote in an op-ed in the Financial Times that ran one week after NQ’s “flash crash”, internal investigations conducted by supposedly independent directors are fraught with conflicts of interest and are frequently worthless endeavors that lead to more pain for investors.9 For these reasons, it is unfortunate that NQ denied investors the transparency that would have been provided by accepting our offer to have Plante & Moran PLLC review the committee’s findings. Regardless, if NQ’s independent committee reports that there is no evidence of significant wrongdoing, this will be an attempt at a whitewash.
Omar Sharif Khan, Q4 2013 conference call. http://www.ft.com/intl/cms/s/0/813828da-9fe1-11e3-9c65-00144feab7de.html?siteedition=uk#axzz2ynM05x9t
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