Wednesday, April 27, 2011

Capital management in a Chinese software firm

Longtop Financial Technology (NYSE:LFT – market cap $1.5 billion) is not a Chinese reverse takeover.

The stock came to the market the conventional way: through an IPO. And its not like CCME (you can confirm its existence). Moreover when I do a quick run through board members I don't find any with easily identifiable links to organized crime.

Finally the CFO used to work for reputable companies. You don't find an unbroken litany of failed companies and stock promotes in his history. Same seems to apply for the other directors but I have not done a comprehensive search.

Finally Longtop even paid a dividend once. None of my Chinese frauds ever paid a dividend – after all why give cash to your victims (ahem: shareholders)?

Longtop you see is a software and bank-outsource service company. It claims as clients three of the four Chinese megabanks, China Life and a slew of lesser companies. In China this is a blue-chip customer list and might reasonably support a nice business with good economics. Some of Longtop's blue-chip customers can be easily verified which is a pleasant change from some other Chinese companies I have looked at.

Nonetheless Longtop still leaves me puzzled.

The first puzzle (and the subject of the first post) is capital management. You see Longtop has very little need for capital (at least as reported in their balance sheet) - and yet they have gone to market to raise cash.

In the last annual report (on form 20F) fixed assets (net) were $26.3 million. Gross fixed assets (ie before depreciation) was $35.8 million. Buildings were the bulk of that (almost 20 million). Equipment and fixtures was only 13.0 million. Apart from buildings there is not very much fixed asset on this balance sheet – and renting rather than owning buildings is always an option. They purchased 13.0 million of fixed assets during the year and presumably much of that were buildings.

By the end of the third quarter (December 2010) fixed assets had risen from $26.3 million to $27.9 million – a modest rise of $1.6 million. Also during that time revenue rose 40-50 percent (depending on which quarters you compared).

You see – looking at the accounts this company can do amazing things: it can add 40-50 percent to revenue without increasing fixtures, fittings etc. The only incremental capital employed is in receivables which grew from 65 to 97 million. Receivables are high relative to revenue but grew only slightly faster than revenue.

You might say “doh – its a software company – why do they need capital?” And - based on the accounts - I couldn't help but agree. All I am saying is that the company does not – on its accounts – seem to have any need for capital from financial markets. Which begs the question: why are they listed? But lets ignore that for the moment (Microsoft and Coca Cola – both companies with no need for external capital are listed.)

But it sure as hell makes me query their capital management. Here is the quarterly cash balance:

2010-12     $423.2 million
2010-09     $379.0 million
2010-06     $342.4 million
2010-03    $331.9 million - note the drop here was because $70 million went out for an acquisition
2009-12    $389.7 million - note the large rise here is because the company raised $127 million
2009-09   $226.4 million
2009-06   $215.1 million

Debt throughout this time has been trivial - typically less than $10 million.

Now this is - at least according to its accounts - an inordinately cash generative business. It is almost without fixed assets - it grows its revenue very fast.

But for the life of me I can't see any reason why it really needed to raise $127 million in cash in December 2009 quarter? Its sort of like a mini-version of Microsoft going to the market to raise money. They are - according to their accounts - swimming in money.

Indeed their current cash holdings represent something like 200 quarters of capital expenditure. Come to think of it - the company has enough cash for 26 quarters - more than 6 years - of all pre-tax operating expenditures. Lets put this in context. Microsoft has about 36 billion in cash and short term investments and $38 billion in annual operating expenditure. Relative to expenses (and hence needs) Longtop has over 6 times as much cash as Microsoft.

They are swimming in it.

But they still went to market and raised more.

To be fair they have announced but - as far as I can tell - not executed a buy-back plan for $50 million in stock.  If they do that over a year they will still have six times more cash relative to needs than Microsoft.

What can I say? I am puzzled. Puzzles are interesting. Expect me to look further at this company.




John

PS.  I have been sitting on this post for a while - thinking what else I might put in it.  Someone else has published - which in blogger terms is to be trumped.  That someone is Citron who are  more strident than I would ever be.

I disclose being short though.  Puzzled is enough to be short.

J

17 comments:

Anonymous said...

Most of your shorts have been reasonably convincing to date, but besides the puzzle, there must be more to your story.

There are any of a dozen reasons why they are raising capital and everything that you have described might also apply to a superior business in this space.

Finally, glancing at Citron's analysis leads to suspicions, but not necessary much more than ordinary course of business in China (backed by quite possibly a viable/thriving business model.)

I'm not saying that this is not a fraud just that the details provided do not even remotely present that case in my view.

---Marc

Amphimedon said...

Fascinating stuff. Thanks as usual for the interesting story, John.

Anonymous said...

I suspect they are raising capital because the financials are cooked and they don't have the cash they claim to have.

A look at the shareholding of insiders shows that insiders control a majority of the voting shares so corporate governance is suspect.

And if they are earning 65% ave margin, and don't need cash, why raise capital through a share offering? They could presumably get cheaper money through a syndicated loan. Provided they would pass the bank's sniff test.

Anonymous said...

John,

forget about it. It's Wall Street, everything is corrupt.

Jonathan Yan said...

Quite a few public companies listed in Hong Kong have excessive cash like LFT. Some of them probably even trade below or near their cash balance. HK stocks 281 and 1889 came to mind quickly as examples but I'm sure there are more.

Even highly respected companies like China Mobile seem to have more cash than they ever need.

Typical reason used by management is that they need the cash for future investments. Experiences of financial crisis probably convinced them it would be difficult to raise cash precisely when it is seriously needed.

Market rumor says some companies appropriate corporate cash for other uses. For example, large cash can appear to earn savings rate at 0.40% per year in China on income statement while in reality management lend the cash to local developer or factory owners at 20% or more per year, pocketing the difference for themselves. I have no reports to confirm it, could be just a wild guess.

Anonymous said...

Just to add since I wasn't specific: It makes sense to me that they raised capital in anticipation of the extremely attractive acquisition environment in 2009. One acquisition that they executed and possibly others they were contemplating.

---Marc

Highgamma said...

The explanation is so simple that I'm surprised that you didn't think of it yourself. All of the cash is actually in a Brazilian subsidiary. It's all part of a tax avoidance strategy on the part of the parent company. They keep needing to raise capital because the cash balance in Brazil keeps rising. Soon, they'll be tapping the convertible market. (Oh, wait, that was Parmalat. Never mind.)

Richard said...

John,

Regarding Citron: After reading you comments on SGX, I could never accuse you of being strident!?

John Hempton said...

Regarding Singapore I am not strident. You can't be strident there with their defamation laws and the like.

My real views a much stronger.

I thought referring to their financial market as syphilitic puss was genuinely unkind to nineteenth century whores who - at least individually - probably were not entirely lacking in social merit.

Besides, at least antibiotics cured their disease. Singapore would best fall into the ocean and disappear under the waves - and even then I would regard the place as some kind of Bermuda triangle - to be avoided on pain of catching something much nastier than syphilis.

J

The Fundamentalist said...

John,

what are your thoughts on the recent spate of accounting irregularities on China companies listed on overseas exchanges?

Anonymous said...

LFT has strong ties to executives and local and provincial Chinese banks and state-owned-enterprises. Mgmt needs to maintain their relationships with these executives to ensure that their business with the banks continues. Gift giving is a cultural norm in China and I would not be surprised if the cash is on hand to purchase such gifts.

With regard to the large stock option balance reserved for "employees", I suspect this too is part of the large and growing gift basket.

McKenzieG1 said...

$400+ million? That is quite a "gift basket"...

Nemo Incognito said...

Mckenzie bribing central SOEs is not cheap. But it can be done....

MPC said...

Well, the company's conference call seemed like a complete joke today. This still smells like a great short and I'll add more if it gets back up to $25.

Anonymous said...

So the business structure here is kind of byzantine, but is the big problem here that LFT achieves its margins because it compensates its employees through share grants from its Chairman laundered through a Cayman Islands entity so that they don't go on the income statement?

Questions indeed. I really look forward to Citron's next report (and yours too, if you're still digging).

Anonymous said...

John - Here's a hypothesis: Do you think that LFT has a covert deal with their programmers to provide shares in lieu of salary? Wouldn't this be consistent with their "capital efficiency", raising of capital, the huge number of shares gifted by their CEO, and the related party transaction from the Citron Report...

---Marc

Anonymous said...

This short obviously worked out nicely.

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