Must-know NQ Mobile equity research

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Part 5
Must-know NQ Mobile equity research PART 5 OF 5

Must-know: NQ Mobile faces fraud accusations from Muddy Waters

Muddy Waters risk and associated mitigants

In my mind, fraud is an extremely serious accusation—one that needs to be met fervently with refutation and substantive rebuttals by the accused. NQ has done as much as any company really can do in this degree. Some of its responses have been:

  • Conference call within 24 hours of the Muddy Waters report to address major concerns
  • Proof of cash through account balances and, more recently, an opening of a $100 million cash account—of which $16 thousand has been already transferred (Muddy Waters had said there was effectively zero cash)
    • On this point, the stance of Muddy Waters is that all of its cash (audited by a reputable firm) is Level 2, which it has stretched to say that this must mean it isn’t there, in some form. It should be noted Baidu and SINA also have significant amounts of cash classified as Level 2
  • Announced confirmation of NQ’s intention to buy back $35 million in stock (who would buy back stock in a fraudulent company?)
  • An extensive and compelling presentation refuting line by line Muddy Waters’ claim can be found here
  • Announcement of an agreement with China Mobile, Ltd. (the world’s largest wireless carrier) to license audio-based search technology from NQ Mobile

Must-know: NQ Mobile faces fraud accusations from Muddy Waters

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In a sense, I believe NQ has been aggressively destroyed for a couple of big reasons. Obviously, the report of fraud from Muddy Waters, a firm that has been right (and wrong) in fraud cases in the past, creates a sense of panic in any investor. But more so, NQ’s own strong growth (and for good reason) in its stock price has, in my view, created an exaggerated willingness to part ways with the company for many investors who were invested in the stock prior to the last several months. Instead of risking a potential fraud, these investors hastily (and I can’t blame them) rushed for the exit and saved some amount of profits or at least limited their loss because of the significant gain they had until this past week. Some others are seeing value here today as well. Macquarie has stepped in to say that this is a “rare opportunity” to buy a high-growth stock.

The Market Realist Take

NQ Mobile saw its shares tank nearly 50% after an 80-page report by Muddy Waters Research on October 24 stated it had misrepresented cash balances and inflated revenue. The report rated the company as a strong sell and alleged, among other things, that at least 72% of NQ Mobile’s purported China security revenue is fictitious. It alleged that NQ Mobile is its own largest customer and its actual market share in China is approximately 1.5%, versus the 55% claimed by NQ. The report alleged NQ’s Antivirus 7.0 is unsafe for sale to consumers, and it considers it to be spyware that makes users’ phones vulnerable to cyber attack. The report questioned the accuracy and veracity of NQ Mobile’s cash balances, its reported international revenue, and its financial statements filed with the State Administration for Industry & Commerce of the People’s Republic of China and the US Securities and Exchange Commission (the SEC).

In response, NQ refuted the allegations and said Muddy Waters’ report contains numerous errors, misleading speculations, and malicious interpretations of events. In order to provide the highest level of transparency to its shareholders, the company’s board of directors formed an independent special committee to review the allegations. It further held a conference call to address the allegations.

Muddy Waters on October 29 issued a second report highlighting the “Top Ten Lies” noted from NQ’s October 25 conference call, which was held in response to Muddy’s Waters’ first report. NQ Mobile (NQ) confirmed it’s suing Muddy Waters in a phone interview with Bloomberg. However, Muddy Waters said it has no direct knowledge of the lawsuit. Meanwhile, NQ is facing lawsuits from various law firms representing investors, according to news reports.

Despite all the negative reviews, NQ saw its shares rebound yesterday (October 30) to close at $12.25 after it confirmed it has completed the transfer of approximately an additional 150 million renminbi (or approximately $25 million) of its term deposits, formerly held at Industrials Bank Co. Ltd., to its account at Standard Chartered Bank. It said it’s committed to full financial integrity and clear, open transparency. It has also authorized Standard Chartered Bank to allow an independent verification of the account validity, as well as provide related details to any interested investor who requests the information in good faith. It further announced that China Mobile has licensed the company’s audio-based music search technology for integration into China Mobile’s Migu music service.

NQ is slated to release its 3Q 2013 results on November 12. Although the company has tried its best to restore investor confidence, it’s best for investors to be cautious until the findings of the investigations are revealed. Its competitors include Qihoo 360 (QIHU), Tencent (TCEHY) and Baidu (BIDU).

After seeing a peak in 2010, Chinese IPOs in the US declined in 2012 in light of allegations of accounting fraud and wrongdoing at some companies (especially those that went public via reverse mergers). A number of these companies were accused of accounting fraud by short-sellers like Muddy Waters. Notable names include Chinese companies like Sino-Forest, China Media Express Holdings, Focus Media Holding (FMCN), Orient Paper (ONP), Rino International (RINO), China Media Express, and the Singapore-based Olam International (O32.SI). Some of the companies were delisted from the markets due to a decline in share value.

In December 2012, the Securities and Exchange Commission (the SEC) said it has begun administrative proceedings against the China affiliates of each of the “Big Four” accounting firms and another large US accounting firm. This is for refusing to produce audit work papers and other documents related to China-based companies under investigation for potential accounting fraud against US investors. The SEC launched an initiative to address concerns arising from reverse mergers and foreign issuers. Through the work of the Cross Border Working Group, the agency deregistered the securities of nearly 50 companies and filed fraud cases involving more than 40 foreign issuers and executives. On May 24, 2013, the Public Company Accounting Oversight Board (PCAOB) announced that it had signed a Memorandum of Understanding with Chinese securities regulators that would enable the PCAOB—under certain circumstances—to obtain audit work papers of China-based audit firms. The MOU is the product of a nearly two-year effort by US regulators to gain access to audit records of US-listed Chinese companies suspected of improper accounting practices or fraudulent financial statements.

The NQ mobile accounting scandal news comes at a time when a number of Chinese companies—including 500.com, Baidu travel site Qunar, and 58.com—are looking to raise capital in the US.

NQ vies with companies like Qihoo360 (QHOO), Tencent (TCEHY), Baidu (BIDU), and Kingsoft (KSFTF) in the China mobile security space. Qihoo360 leads the Chinese Internet security market and faces competition from Tencent and search engine Baidu, which officially launched its anti-virus products in June. A report from Macquarie Research, which cited research from Sino MR, said that NQ has managed to grab 37.9% market share of mobile security users who installed mobile security software in 2Q13, and follows Qihoo, which had a 38.8% share. The report said that NQ has been trailing behind its competitors in user count mainly because of the freemium model it offers and has less organic traffic compared to its peers, which have high PC traffic.

In May 2013, there was speculation that Baidu and Tencent were in the running to acquire NQ. NQ had previously spoken about receiving interest from strategic and financial investors during its 1Q 2013 conference call but said “it remains focussed on delivering shareholder value by executing on its strategic plan and initiatives.”


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