My last post indicated that it was either (a) one of the best businesses in the history of capitalism or (b) one of the most brazen frauds in the history of capitalism. That post was linked by Forbes (disapprovingly) or Fortune (somewhat approvingly).
I noted that extraordinary claims require extraordinary evidence – and that neither side (long or short) had presented extraordinary evidence.
I also noted that the basis for my short was that the numbers were too good to be true – but I did not state in what way they were too good to be true. (Many people in the comments and by email questioned my assertion that the numbers were too good to be true.)
Finally I suggested that there was a relatively simple way of checking the bona-fides of CCME which was to check the veracity of a claim that they had contractual arrangement with Apple. Apple of course would tell the truth to the SEC if asked.
Since I wrote all this the stock is down about 40 percent. My (very small) short position is ex-post too small – but then as I noted the evidence that I had to support that short was flimsy and did not justify a large short position.
I was short simply because it was “too good to be true”. Alas really good does not mean false – so this was a tiny bet. I was (and remain) more interested in the drama than the result.
The Muddy Waters Report
Yesterday (last night my time) the stock fell a third fairly rapidly after a small China-based research outfit (Muddy Waters) released a report. Muddy Waters has released two prior reports alleging fraud – one on Orient Paper (Amex:ONP) and one on Rino International. ONP denied the charges and the results to date only marginally vindicate Muddy Waters. (The stock is down – but nobody has admitted fraud.) Rino International however is one of the great hits of all time. Rino has admitted fraud, been delisted from the Nasdaq and now trades on the Pink Sheets and have filed with the SEC to say they will no longer be filing with the SEC. It is – as John Cleese might say – pushing up daisies. (I remain short RINO.PK and will cover in the pennies. There doesn't seem any reason to allow the longs an exit above $1 when they hold clearly worthless paper.)
Muddy Waters shoots one (and a bit) from two.
And Muddy Waters claims are extraordinary. They don't suggest the company does not exist (it clearly does – and indeed they visited them in many guises). They just suggest that it is egregiously overstated both in the number of buses used and the revenue from each bus. They suggest earnings per share are (generously) about 5c (compared to the stated $2.37 historical). These are big claims and Muddy Waters present considerable evidence to back them up. They claim that major advertisers (such as people who handle the Coca Cola account) could not verify the existence of this company. This was strange because the company claimed considerable revenue from Coca Cola. (The company does exist. Muddy Waters just asserts it is a minnow.)
Moreover Muddy Waters claimed to have checked the Apple contract. I quote:
We caught CCME’s management telling a particularly egregious lie. It recently announced it had created an online shopping platform that has an agreement with Apple Inc. (NASDAQ:AAPL – yes, THAT Apple) or one of AAPL’s distributors. AAPL made clear to us that it has no such relationship with CCME’s subsidiary. Further, AAPL keeps tight control over its distribution in China, with only two authorized online distributors (including Amazon.com’s China subsidiary). None of AAPL’s China distributors have authority to sub-license.This is pretty incontrovertible. If Apple will verify this to the SEC the SEC has no choice but to suspend the stock - send it to the Pink Sheets and leave the corpse to the class-action lawyers to clean up. If Apple will not verify this to the SEC then Muddy Waters has some questions to answer. This issue alone is sufficient to say who is telling the truth.
But I am not here to talk about the Muddy Waters report (although it is an impressive piece of due diligence). I am here to explain what it was that you could check from your desk in Sydney, New York or London that made me think that CCME was a strange company.
It was the payments for media content.
How media content is paid for
TV shows are expensive to produce. The stars are paid well (sometimes very well). Scripts are expensive. Studios and their staff more so. Tens of billions of dollars annually is spent producing TV content.
People don't spend all that money on TV content and then give it away. Those tens of billions of dollars have to be recovered from somewhere. Indeed they are usually recovered eventually from either advertisers or pay TV subscriptions.
Content deals come in two forms. Either (a) I pay a fee for the content or (b) I broadcast the content on my distribution (say a TV station) and I allow you a share of the advertising revenue or give you a proportion of the total advertising time in which to sell adverts.
In the US most TV content is sold by networks to regional TV stations in exchange for “minutes” of advertising time. If a network is selling a hot show (like American Idol) it might demand 10 minutes of advertising time per hour. If its a very cool show the network might demand 4 minutes of time leaving a larger piece of the smaller pie to distribution.
But its one or the other. I either pay for the content in hard cash or I pay for it by giving up revenue.
If I pay for it in hard cash that cash outflow will show in the accounts (and reported margins will be lower).
If I pay for it in minutes then the cash outflow will not show in the accounts – but the revenue per screen will be lower.
Its one or the other. Either cash outflow shows in the accounts or revenue per screen is lower. No choice in that.
So lets look at the accounts to see which:
Here is the cost-of-revenue section in the last annual report. To quote:
CME’s cost of revenue increased to $25.1 million for the year ended December 31, 2008 from $13.2 million for the year ended December 31, 2007 due to the following reasons:
Concession fees. Concession fees charged by inter-city express bus operators increased to $20.0 million for the year ended December 31, 2008 from $10.7 million for the year ended December 31, 2007. The substantial increase was attributable to the concession fees payable to the group of bus operators participating in CME’s network through the execution of long-term framework agreements for the year ended December 31, 2008 as well as an increase in the number of inter-city express buses carrying CME’s network to 15,260 as of December 31, 2008 from 10,053 as of December 31, 2007.
Depreciation. Depreciation for CME’s digital television displays and hard disk drives increased to $2.8 million for the year ended December 31, 2008 from $1.6 million for the year ended December 31, 2007. The increase was attributable to installation of new equipment and control systems in connection with the increase in the number of inter-city express buses in the CME’s networks.
Business tax. Business tax increased to $2.1 million for the year ended December 31, 2008 from $0.7 million for the year ended December 31, 2007. The increase was primarily attributable to business taxes arising from consulting services Fujian Express provided to Fujian Fenzhong in the year ended December 31, 2008.
Salary. Salaries increased to the amount of $203,000 for the year ended December 31, 2008 from the amount of $156,000 for year ended December 31, 2007. The increase was primarily attributable to the increase in number of staff in production and maintenance department in 2008.
Other operating costs. Other operating costs decreased slightly to approximately $9,000 for the year ended December 31, 2008 from approximately $13,000 for the year ended December 31, 2007. The decrease was primarily attributable to the decrease in production costs in 2008.Now lets add this up. Concession fees were 20.0 million dollars, depreciation another 2.0 million, business tax 2.1 million. Salary was a paltry 0.2 million. Other expenses were trivial. That adds up to 24.3 million. Total cost of revenue is 25.1 million. There is $800 thousand unexplained.
That $800 thousand must include all content payments. There is no other place that content payments in cash can go.
That is not much – relative to huge revenues to pay for content.
So we can presume they are not paying much for content.
That is OK of course. Regional TV stations don't pay much cash for content - they yield minutes of advertising time instead. Its entirely possible that CCME yielded minutes of advertising time.
Indeed I questioned one of the stock brokers pushing the stock about this and they told me – after discussion with the company – that the low payments for content were explained by yielding minutes of advertising time.
Alright – then you would expect revenue per screen to be lower than the competition because – after all – the company does not own all the advertising time on the screens.
I did the calculation – and it is repeated in the Citron Research blog post. Advertising revenue per screen was roughly double the competition.
No cash outflows for content are visible in the accounts and revenue per screen is higher than the competition (suggesting but not proving that they are not paying much for content by yielding minutes).
As I note: this is not proof of fraud. Checking fraud is difficult: though physically checking say the contract with Apple exists would probably constitute proof of fraud.
I did not try to check fraud. My standard of proof was low - but then so was my position size.
After all, it is possible that CCME had worked out how to sell adverts for 4 times what the competition sell them (thus producing double the revenue per screen whilst sharing half the advertising time with the suppliers).
But I thought that was “too good to be true” so I shorted the stock.
Was I confident about this? No. That is one reason why my position was small.
Does the Muddy Waters research surprise me?
No. I was kind of expecting an end game somewhat like that – and it makes sense of my observations.
Does the Muddy Waters research constitute proof? Not directly - you would either need to confirm some of their observations yourself or wait for the SEC to do it for you.
However confirming the claim about Apple would be pretty convincing. The SEC should do this and – with that proof – they should suspend the stock.
I am not holding my breath. The SEC are regulators with a reputation for being slow.
If the short case is right (and I have a small bet on that it is right) then some prominent people have some egg on their face. Starr Asia - associated with Hank Greenberg - looks really stupid. They have repeatedly purchased stock in this company and claim to have done due diligence. That I guess will further tarnish Hank's reputation. Deloittes is the auditor. Knock one more failure up for a major audit firm - albeit a particularly embarrassing failure.
At this point you know my (weakly held) view. I still welcome criticism in the comments.
Finally to the new readers who came from Forbes or Fortune. Welcome.