Let's be logical here

[Fundy_]

Introduction

Rewind back just a few months and the sentiment was overwhelmingly bullish. Granted, there were some loud bears, but even the bearish articles written on various mediums were flooded with bullish comments pointing out the flaws. Now that the stock is doing badly, many mediums are overwhelmingly filled with bears. Can we take a minute and forget about this bull / bear (fraud) debate and just conduct a logical analysis of the company viewing both sides on a fundamental level? I don't think anyone here at SHU thinks that the Muddy Waters report has any merit and Carson Block himself has already admitted to covering his short and believes the audit will come back clean. The majority of shorts seem to believe that the audit will come back negative and I completely disagree, but I am not here to argue this in any way. At this stage in the ball game, everyone in it has already seen all the evidence and made their decision. The issue I am seeing is that so many people have been split into a psuedo political party / religion type system where they have made their decision and refuse to hear out the other side at all. So I thought that I would write a quick overview analysis of the company and I genuinely hope that everyone looks at it logically and does not ignore something you may not like simply because you not a part of that particular "long" or "short" political party.

Products

NQ Mobile has absolutely fantastic products. As some of you know, I reverse engineered their NQ Mobile Security application to verify the malicious allegations, and was pleasently surprised at how elegantly it was written and, of course, there was nothing malicious about it. Most of you think that their security application is their big hit, but according to Google Play's Top Grossing Android Applications NQ Vault is actually just about 15 rank points under WhatsApp for top grossing applications. Furthermore, according to App Annie NQ Vault is the #1 grossing business application on Android. Their products are growing at a massive rate and they are continuously adding new products into their pipeline. This is not even including the massive number of NQ Live installations they have already provided before it is even publicly available, via their various business partnerships with companies like Sprint.

Business

Now, on a business growth level, NQ Mobile is exceptional. Not only are their products phenomonal, as explained above, but they are consistently expanding their platform and growing at a very quick rate. They have created partnerships with giants such as Samsung, Sprint, China Mobile, and Ingram Micro, and they're taking very quick and decisive action to ensure their market control globally. They are consistently entering strategic alliances with mobile providers in developing countries as well which is an incredibly smart move considering how quickly mobile is growing worldwide. For those that don't know, there are actually more people with access to a mobile phone in the world than there are with access to indoor plumbing, and that's a fact. Believe it or not, 6 out of the 7 billion people on the planet already have access to a mobile phone, and that number is astonishingly still growing. NQ Mobile seems to understand this and are capitalizing on expanding their market share and product line in places many other companies are ignoring.

Finances

This is such a love hate relationship for me. They are growing revenues at an astonishing rate and I actually expect revenue to continue growing at a fairly similar rate for at least the next 5 years, but they are also spending money in very inefficient ways. Two major examples of this are their high valuations on their acquisitions and their share based compensation (SBC). They currently have cash of $283.0 million ($179.7 million in cash and cash equivalents and $103.3 million in term deposits) which is more than enough to continue operations at the same pace they have been, but they are also beginning to lose more cash given how they are spending money. Assuming NQ Mobile continues to decrease margins, spend so much revenue on SBC, and make unbelievably overvalued acquisitions, this cash will quickly evaporate.

Management

I think management is absolutely phenomonal at product development, but I also think they're quite terrible at many key aspects of running a business. A major problem is that they are consistently spending money in ways that benefit no shareholder, such as the high SBC. They spent an astonishing 28.6% of annual revenue on paying management in 2013, compared with the 5.6% Google spent or the less than 1% Baidu spent. You can see an image of the average SBC revenue percentage in various industries by clicking this link. As you can clearly see, NQ Mobile is not only an anomoly in regards to SBC revenue percentage, but they are absolutely astronomical in comparison to the average levels. They have also continued to make acquisitions with valuations that are beyond ridiculous, with their most recent being vLife, without elaborating on why they have spent so much. The company vLife has a few hundred thousand downloads at the most, calculated by analyzing Google Play and various Chinese app stores, and is a free application, yet NQ Mobile applied well over a $100 million valuation to them. This is ignoring the fact that they spent $45.5 million in stock while it was valued at $11.66. This means that if NQ Mobile reached pre Muddy Waters levels of $25.90 then they would have paid $101,010,000 in stock alone, not to mention the $34.4 million they paid in cash, and that's only for 58% of the company. Management also continuously relies on hype, but also continuously waits until the last minute to deliver. Their FQ4 results were delayed by months, did not contain audit results, and were not strong in earnings, although they did beat revenue. They have also now waited until the very last day before the 20-F even after assuring everyone it would be released on time, cutting it very close, and who knows if they will apply for an extension.

Conclusion

The products are fantastic, management is made up of very smart product people, they are expanding both their product line and their global market share, partnerships with mobile giants are growing every month, and they are continuously executing their plans with efficiency. Everything looks good when you look at it that way - a massively growing company in a massively growing industry with ever growing market share at a low (forward) valuation. The problem is that they are terrible at growing EPS, terrible at meeting share holder deadlines, and terrible at instilling confidence in investors. Assuming they had the same SBC as Google, which is actually above average, they should have put out an EPS of $1.31 for 2013, instead of a loss of -$0.05, which would give a trailing P/E of 10 and a much brighter outlook. Pile that on to more fair valuations of their acquisitions and their cash would be significantly higher as well. My opinion is that Omar Khan and Dr. Henry Lin should be replaced as CEO and put as heads of product development, a single CEO that can better manage a public company in shareholders interest should be brought on board, a single head of global expansion should be brought on board, and their board of directors should be replaced and nominated / voted in by the share holders. All SBC and other major financial decisions should be voted on by a non partisan board with no affiliation with management and salaries should be capped at fair values and adjusted based on company performance. Given these changes, NQ Mobile would easily be a $40 stock by the end of the year and far higher in the years to follow.

[SmugHug]

Thank you for this. I'm in agreement that fundamentally, it's pretty juicy relative to its peers, and definitely at these prices.

[admin]

Yes, thanks for these interesting thoughts. Although still bullish, I do have some concerns though (apart from the audits, but my working assumption is that these will come up clean, if not, then all bets are off but that seems unlikely I gather from the IR communications and even the shorts seem resigned to that.)

I'm less critical of management in how they handled the MW crisis, the delays in earnings were, in all likelihood, caused by the audits, I think they were hoping, or perhaps even expecting, they would be finished earlier.

My biggest concern is actually the SBC, that's really rather large, I would really like to see that coming down substantially this year, then earnings could actually keep pace with revenue growth, or at least to a considerable extent. There is also a good deal of stuff that's difficult to judge. The amount they paid for the wallpaper company. It's probably justified on the basis of the earnings (mostly ad) potential of NQ live, but this is simply stuff that's difficult to judge.

It will probably take some time to restore the brand name of the shares, so to speak. I was quite hopeful that would happen faster on the basis of the substantial number of institutional investors NQ attracted in the wake of the MW report, but lately it seems to have suffered a second blow.

[tradestar2012]

Fundy,

I'll defer to your analysis on NQ's products. Your commentary on the acquisitions and SBC is off. SBC is a non-cash expense. The company actually gets a tax benefit for the large stock based compensation. Its not to say that its a phantom expense. Stock as a form of compensation is a real expense to shareholders in the form of dilution. The SBC you see in the financials is an estimated value of the optionality of the underlying issued stock. Its not an actual expense where physical dollars are spent. That said, different people have different views on how to treat SBC. For a small, fast growing company like NQ, I would normally exclude SBC from an eps calculation as its not a fair estimate of long term earnings potential. Its like trying to value a company that just turned eps positive on a P/E basis (small eps, large PE multiple). You just dont do it because its not meaningful. Hence the add back of SBC to calculate EPS. For a large, mature company like GE, i would include SBC as an expense as the impact is not a material a % of total eps. The key question is when does that switch happen, from adj. eps to gaap eps. There are lots and lots of small companies valued on a adj. eps or Cash EPS or any multiple of a derivation of EPS. It comes down to what form of EPS is the most accurate view of what earnings will look like in the long run. So the question is, will NQ be adding an Omar Khan every year for 10-15% of the business, thus continuing the large SBC? Probably not. In fact, the SBC related to Omar will taper off in about 2-3 more years once all his shares completely vest. Will NQ be doing acquisitions with 100% equity or move more towards a cash/stock mix like nationsky and nq live? Probably the latter. As the acquisitions they do with stock vest, the sbc related to those deals will eventually drop. Will they do more deals? Probably, hence new SBC. But as a % of revenues, it will probably drop as acquisitions become a smaller part of the business.

W/re to your observations on acquisitions. If you read the fine print to the transactions (they're in the 20f from last year), you'll see that each deal they did included hefty earnout clauses in order for the stock portion of the deals to trigger. We wont know how Nq live was structured until the 20f comes out, but if it was anything like their prior deals, I would not be surprised if NQ live has to be a blockbuster in terms of revenues and profit in order for the full value to be achieved.

I cannot stress this enough, but reading what you read on SA from some of the short authors questioning the acquisitions made by NQ will be a fairly extensive waste of your time. A colossal waste of time. Yes, the company does use too much stock. Thats a given. But are they doing too many deals or paying too much for them? I do not agree. 2/3rds of the company is now made up of NS and FL. To me thats revenue diversification and growth, it 2 hot sectors in mobile internet and computing. 2 things you want to have in a company. Were they expensive? Yes. but they also had lofty earnout clauses to EARN their shares. Does NQ do a lot of tiny acquisitions, sorta. Most tech companies that are mid sized do tons of partnerships and equity investments all the time. NQ just discloses more information than most companies. In a given quarter, most companies will do tons of small investments and tuck-ins and just never mention them to any significant detail.

Anyhow, my point is, their acquisition history and sbc is probably one of the EASIEST things for most finance professionals to get comfort around. I would lump myself in that bucket. I rely on people like you to get comfort around the technology as thats where I'm not as well versed in.

[admin]

["For a small, fast growing company like NQ, I would normally exclude SBC from an eps calculation as its not a fair estimate of long term earnings potential."]

While I agree with that in principle and it's why I wasn't worried before, but it's still a fairly hefty number and I'd like to see some tapering in the near future.

It's unfortunate that perception seems to be such an important part of the stock price. Without the MW piece, I doubt many people would make much song and dance about the SBC, but unfortunately, we're not in that world.

[Fundy_]

Tradestar, I can certainly see where you're coming from but this is just a fundamental difference of opinion. NQ Mobile may be a growing company, but so is Tableau Software, both have almost the same revenue and growth, and Tableau has far better financial decision making (i.e management payouts were incredibly small with salaries capped at $300k and very little SBC). I certainly consider SBC a valid expense, regardless of company size, and this is a good overview of my thoughts on that. As far as their acquisitions go, I didn't even read the short report on Seeking Alpha from Goldbaum because I dislike the authors manipulation and lack of evidence, I wrote my own vLife acquisition analysis on SHU more than 10 days before the Goldbaum article even came out. Having a hyper growth company have very low (or nonexistent) earnings is normal; I just dislike particular decisions being made by management, not the lack of earnings alone.

[maplell2002]

It's too early to judge Omar's sign up package or whether vLife acquisition worth it. Imagine Milwaukee Bucks signed a 100M/5yr contract with Lebron James, you can’t judge the deal until a couple of seasons later.

[tradestar2012]

Fundy,

Damadoran is a well respected finance professor and I agree with what hes written. In fact, his book on valuations, Damadoran on Valuations is why I went into banking in the first place. Anyhow, I digress... My point however is that the issue of size of company needs to be factored into whether or not SBC should be included or excluded. Just like a p/e of 10000000 or negative p/e is not meaningful for a small, fast growing company, I think a company such as NQ, which is still fairly small should not be valued on a gaap eps basis. Its just not a meaningful number, in my opinion. Anyhow, if gaap eps is that big an issue for you, the NQ would not be a very good investment. I'm not familar with tableau, but I would point to twitter or salesforce as examples where sbc is high and gaap eps not considered meaningful. Those are fairly large companies. I'm not suggesting NQ should be on an adj. eps basis when it gets to their size, but what I am suggesting is that at its current size, gaap eps is not meaningful.

Anyhow, its not worth arguing. I can understand why people value on a gaap vs eps basis. I'm just more selective on which companies I apply that rule to. Valuation is more art than science, afterall.