By Dune Lawrence and Belinda Cao
Nov. 4 (Bloomberg) -- Research firm Muddy Waters LLC was
correct to focus on NQ Mobile Inc.’s delays in collecting
customers’ payments as part of an 81-page report that labeled
the Beijing-based mobile service provider a “massive fraud,”
according to three accounting experts.
At the same time, accountants, professors and a lawyer
interviewed by Bloomberg News said the report’s criticism of
NQ’s cash accounting and the way the Chinese company got funds
from its U.S. public offering may be unfounded. On other points
Muddy Waters raised in its Oct. 24 report, it’s still hard for
observers to gauge their validity.
That mixed scorecard helps explain why the stock declined
more than 60 percent three days after the report, then pared the
loss to 44 percent by the Nov. 1 close in New York. It fell 4.5
percent to $12.20 at 11:02 a.m. in New York today. Muddy Waters,
run by Carson Block and best known for exposing fraud at Sino-
Forest Corp. in 2011, gave NQ a strong sell rating and called it
“a zero.”
“I am on the fence,” said Rocky Lee, Asia managing
partner and head of Greater China corporate practice at
Cadwalader, Wickersham & Taft LLP in Beijing. “When I see a
short seller report, I expect it to be indisputably convincing
and this one, unlike some of Block’s other, better reports, does
not do it for me.”
NQ has defended itself vigorously, in a conference call,
presentations, press releases and interviews.
Uncollected Payments
The report criticized NQ’s delays in collecting payments
from customers, evidenced in a measure called daily sales
outstanding. At the second quarter’s end, the company’s DSO
measure was 198 days, according to Muddy Waters, which made the
calculation based on NQ’s revenue for the 12 months to June 30.
That would mean the company’s customers are taking more than six
months to pay, on average.
NQ calculated a DSO figure of 145 days for the second
quarter of 2013, based on the average of accounts receivable for
the first and second quarters, according to Michelle Ma, the
company’s head of investor relations. The company is working to
shorten the time it takes to get paid, Matt Mathison, vice
president of capital markets, said on a conference call on Oct.
25, particularly in the Middle East and Southeast Asia where
delays are the longest.
Data compiled and calculated by Bloomberg show NQ’s DSO for
the second quarter at 144 days. That’s almost five months.
‘Red Flag’
A high DSO “to me sounds like a red flag with a siren
going off,” said James Angel, a finance professor at Georgetown
University. “This is one of the classic signs of a fraud. You
can easily manufacture sales with the stroke of a pen, but if
you don’t have cash, what you have is a receivable.”
NQ’s public filings say the company offers customers credit
terms ranging from 60 to 210 days in international markets and
30 to 90 days in China. The Muddy Waters report also alleged
that it took the company 167 days on average in 2012 to collect
payments from Tianjin Yidatong Technology Development Co.
despite a contract requiring settlement within 30 days. Tianjin
Yidatong is a payment processor through which NQ collects 22
percent of its revenue in China, according to NQ filings.
Xu Rong, Yidatong’s owner, said in an e-mail that his
company pays NQ within 30 days of collecting from users. Still,
it can take 90 days or more for Yidatong to collect from
corporate customers, which pushes its payments to NQ to 120 days
or longer, Xu said -- “a common thing” in the industry.
Carriers’ Delays
During the Oct. 25 conference call, NQ’s Mathison also
cited the time it takes to collect from mobile carriers as the
reason his company’s DSO within China, excluding international
markets, is in the range of 90 to 100 days.
“Accounts-receivable balances that dwarf the stated
payment terms, that’s always a red flag, it always increases the
risk of fraud or misstatement,” said David Bassett, an analyst
covering Asia at CFRA, a New York-based forensic accounting and
analytics company.
Qihoo 360 Technology Co., operator of China’s second-
largest search engine and maker of a competing mobile security
application, had daily sales outstanding of 22.4 days in fiscal
2012. Tencent Holdings Ltd. measured 18.2 in fiscal 2012.
Longer Terms
It takes larger customers longer to make payments,
according to Drew Bernstein, co-managing partner of Marcum
Bernstein & Pinchuk LLP, a New York-based accounting firm
focused on Chinese companies, who said he’s seen companies with
collection periods of as long as two years in China. AsiaInfo-
Linkage Inc., a Beijing-based telecom software developer whose
main customers are the biggest phone carriers in China, measured
189.5 days for sales outstanding in 2012.
Bernstein said his firm, which provides services to
companies’ audit committees and management teams as well as to
investors, has met with NQ’s management since the Muddy Waters
report was published. NQ hasn’t retained his firm, he said.
Bernstein and Block have squared off previously. In 2010,
Muddy Waters accused Orient Paper Inc., a paper maker based in
Baoding, of overstating revenue in 2008 and 2009. Bernstein was
the chairman of the company’s audit committee.
“I believe we ran a very thorough and credible process to
address his claims,” Bernstein said in an e-mail.
Accounting Criticized
After Muddy Waters labeled Orient a fraud, the company
appointed Loeb & Loeb LLP, Deloitte & Touche Financial Advisory
Services and TransAsia Layers to probe the allegations. That
four-month investigation found no evidence to support the short-
seller’s claims, the company said. Orient paper’s share price,
which was $8.33 on June 28, 2010, the day the report was
published, fell by more than 50 percent in the two months
afterward. Though it recovered to $7.28 by November 2010, it
closed at $2.37 on Nov. 1. Muddy Waters hasn’t covered the
company since 2010.
The Muddy Waters report on NQ also lambasted its accounting
treatment of its cash, cash equivalents and term deposits, which
the company reclassified as so-called Level 2 inputs, from Level
1, in 2011. Companies use three levels to classify assets, with
1 being the easiest to value and 3 the most difficult.
Level 2 assets are those that don’t necessarily have public
quotes, like a stock price, but which can be valued using data
from public markets.
Treating cash and term deposits that way constitutes
“significant red flags,” Muddy Waters’s report said. “This
raises questions about how NQ is claiming to hold its cash, and
how NQ’s auditor confirmed the balances.”
Rules Change
NQ appears to have changed the classification to meet a
change in accounting rules, according to Paul Gillis, a
professor and co-director of the International Master’s of
Business Administration program at Peking University’s Guanghua
School of Management in Beijing. The company is following proper
accounting procedures and all U.S.-listed Chinese companies
should follow its example on this, Gillis wrote on his China
Accounting blog on Oct. 27.
While the Muddy Waters report says the change was
suspicious, the change alone doesn’t suggest any issues, said
CFRA’s Bassett.
“I don’t think you can conclude that the cash is
nonexistent because it’s classified Level 2,” he said. “Cash
is a hard thing for us as outsiders to really audit, but it’s
not a conclusion that I would go with.”
NQ’s accounting for its cash is in line with U.S.
accounting rules, the company said in a presentation responding
to the Muddy Waters’s report on Oct. 25.
Possible Clue
NQ is alone in having all cash classified as Level 2, Block
said in a telephone interview on Nov. 1, including the ones
cited by NQ’s management in their response to Muddy Waters.
Classifying all of the company’s cash as level 2 may also be a
clue that NQ’s auditor hadn’t done the cash verification the way
they would have liked to do it, he said.
Web portal Sohu.com Inc. and its listed online games unit
Changyou.com Ltd. have more than 30 percent of their cash
classified as Level 2 according to calculations based on their
2012 annual reports. Perfect World Co., another Chinese online
gaming company, had 17 percent of its cash balances classified
as Level 2. NQ cited the three companies during its conference
call.
A related allegation -- that NQ reported moving cash from
its U.S. public offering into its China operations “in a way
that almost certainly would not have been permitted” -- may
also be more red herring than red flag.
Complex Structure
NQ uses a complex corporate structure designed to get
around Chinese government restrictions on direct investment by
foreigners in sectors including the Internet and
telecommunications. The listed company doesn’t technically own
the main business or assets in China, but has a right to profits
from them based on contracts with a “variable interest entity”
-- a domestic Chinese company that owns and operates the main
business. The structure is used by many Chinese companies listed
in the U.S.
Even under the VIE arrangement, transferring cash from
abroad into China is complicated by the country’s controls on
its foreign exchange. NQ’s disclosures show that its U.S.-listed
company transferred $47 million in IPO proceeds directly to its
VIE, according to Muddy Waters. Such a loan from offshore into a
VIE would require permission from one of two Chinese government
agencies and is almost impossible for a private company to get,
according to Muddy Waters.
Connections Count
“NQ’s purported implausible movement of funds makes it
easier to divert funds without detection,” the report says.
“This claim is reminiscent of Sino-Forest, which also purported
to have moved cash in ways that contravened China’s exchange
controls.”
A well-connected company can work around such rules, said
Bernstein of Marcum Bernstein. “I would certainly classify NQ
as a company that is well connected,” Bernstein said. The issue
may be poor disclosure rather than fraud, he said.
“Our lawyer’s take on it is, first of all these people
don’t have that kind of political clout,” Block said.
There’s more than one way to transfer money directly into a
VIE, said Cadwalader’s Lee, who’s an expert on the corporate
structure. For example, a company might make a directed loan to
an offshore bank and then the same bank, onshore in China, lends
to an individual shareholder of the VIE. That borrower injects
the money into the VIE, he said.
Security Concerns
“It’s not illegal,” Lee said. “I might want to disclose
it, but that’s the company’s decision. The key question is
whether the actual money arrived in the VIE entity.”
Moving beyond accounting questions, the Muddy Waters report
also attacks NQ’s products, calling its antivirus application
“spyware” that’s “unsafe for sale to consumers,” based on
analysis of the code and its functioning by software engineers
that the report doesn’t name.
The application creates vulnerabilities in users’ phones
that make them less secure, sends far more data than necessary
to servers in China, doesn’t use basic industry standards to
secure the data and creates fake alerts for viruses, according
to the report.
An analysis obtained by Bloomberg news of NQ’s Mobile
Security & Antivirus application by ViaForensics, a mobile
security app and testing company, found that the application has
poor security leading to leaked sensitive data. The app does
appear to generate fake virus alerts, according to ViaForensics’
analysis, which also found indications that it sends contacts
and contents of text messages back to the company, “a serious
privacy concern.”
Virus Database
“In terms of the data it collects and sends back to the
vendor, that’s not atypical, because antivirus apps need to
collect a lot of data to protect the phone,” said Thomas
Cannon, director of research and development at Oak Park,
Illinois-based ViaForensics. “The concern is the security is
very poor. You wouldn’t expect that in a security application.”
NQ Chief Product Officer Gavin Kim denied that NQ sends
sensitive private data to China in the Oct. 25 conference call
with investors. He also said that the virus alerts mentioned by
Muddy Waters are simply a notice to new users of the company’s
virus database about the latest virus discoveries.
Some of the issues Muddy Waters raised remain difficult to
parse. The report alleged that Yidatong, the payment processor,
is secretly controlled by NQ, calling that revenue into
question. Muddy Waters reported visiting 10 addresses pulled
from China filings, Yidatong’s website and NQ filings, and
finding that five did not exist at all.
‘Virtual Addresses’
Bloomberg News visited the address that NQ said on Oct. 25
was Yidatong’s “main operating facility,” in a business park
21 kilometers (13 miles) southwest of Beijing. There, about 15
of its workers share space with another company -- both of them
owned by Xu Rong. The 10 addresses that Muddy Waters visited
were “virtual addresses” set up to comply with regulations
that the company have a registered address in each region where
it processes payments, Xu said.
While Muddy Waters may be correct that Yidatong is a
related party, that alone doesn’t suggest fraud, Cadwalader’s
Lee said.
“In principle I have no problem with that,” he said. “So
long as the customer is a captive company of theirs under NQ’s
control and the money is real, I am then less worried.”
Block expressed confidence that time will prove Muddy
Waters’s portrait of the company as a “massive fraud.”
“Our goal is to get this thing delisted and I think it’s a
very good candidate for that,” he said. “It’s not a close
one.”
‘Higher Bar’
Omar Khan, NQ’s co-chief executive officer continued the
company’s campaign of defense in an interview on Bloomberg
Television on Nov. 1.
“We just hold ourselves to a higher bar, frankly,” he
said. “You’ve seen our responses in the last week after these
false and malicious accusations. We did nothing but completely
open up and be very transparent.”
Determining who’s right may take time. For NQ, “there are
probably some issues that the company at the very least has to
address, and there are aspects in Carson’s report that are
correct,” said Bernstein. “There’s a big leap between a
company that commits fraudulent acts and, perhaps, very bad
management positions.”
