I am obsessed as to what the due-diligence on Focus Media done by the private equity firms might look like and what it might find.
Lets start with the easy stuff.
Probably the easiest place to do due-diligence on Focus Media is the theatre screen business. Focus Media claims to display advertising on roughly a quarter of the cinema screens in China - but this is still a relatively small number of cinema complexes (316 at last annual report).
It is almost impossible to audit more than 100 thousand LCD screens - at least without a small army and a sampling method. But checking out whether the numbers make sense in 316 theatres is relatively simple. A sample could include a large proportion of the total without being prohibitively expensive. Those 316 theatres probably have only 30-40 owners (most owners own chains). That will make the testing easier still.
And I think the private equity bidders probably will test this (as part of their due-diligence) because the theatre business raises red-flags which animate the bears in this stock. The central issue seems to be the number of theatres and the size of the multiplexes - however I think Focus have largely cleared up that story.
But I should run you through it anyway.
The controversy around the number of cinema screens Focus places adverts on
You would think that counting cinema screens and number of theatres is easy. They are big things. They don't run away. If I said I was opening a film on 270 screens you would know what I mean. These statistics have well defined meanings - and those meanings don't seem to change much.
Except in the case of Focus Media.
Here is a disclosure that mentions number of theatres focus runs adverts in (from a 20F for the year ended 2009.)
Net advertising service cost-movie theatre and traditional outdoor billboards. We incurred advertising service cost of $56.9 million in 2008, a 99.6% increase from $28.5 million in 2007. The increase is primarily due to (1) our acquisition of Huaguang, the subsidiary operating the traditional billboard business in 2007. We consolidated Huaguang’s results of operation only after the acquisition was consummated, while in 2008 we consolidated their full year costs of revenues; (2) the increase in the number of billboards leased from 492 in 2007 to 542 in 2008 in response to greater customer demand; and (3) increased leasing costs associated with time we rent on movie theatre screens as a result of an increase in the number of theaters we leased in our network from 10,930 in 2007 to 27,164 in 2008.The bold section is pretty clear... a result in the increase in the number of theatres we leased in our network ... to 27,164 in 2008.
This number and similarly large numbers are laced throughout Focus Media's filings. It is not a one-off number.
There is a problem with this number.
A big problem.
There are not that many theatres or screens in China!
In March 2011 the LA Times did a story on the cinema building binge in China. At that point there were 6,200 screens in all of China up very sharply since 2008. According to Government statistics there were only 1545 screens in all of China at the end of 2008.
Focus media says they had 27,164 screens. The government says there were only 1,545 screens in the country.
Unsurprisingly Focus has amended its numbers. Here is what they say in the latest annual filings:
Movie theater advertising network
We operate our movie theater advertising network by selling leased screen time as time slots to advertisers. We have the right to screen time prior to the screening of each movie shown in the theater. As of December 31, 2011, we had rights to lease advertising time on screens in 316 movie theaters (consisting 2,190 screens) in cities across China.
How did they reconcile these numbers?
Well they said that they counted as a "theatre" a "screen in which an advertiser had agreed to buy space". That means if 10 advertisers had chosen to show advertisements in a theatre with one physical screen they counted it as 10 theatres.
As of December 31, 2010, we had rights to lease advertising time on screens in 260 movie theaters (consisting 1,553 screens) in cities across China and Hong Kong SAR. Prior to 2009, we calculated the size of its movie theater network by calculating the number of screens on which each of its advertisers had purchased advertising and then summing the screen count for each advertiser to produce an aggregate number of screens. With a change in management in late 2008, we changed the method for calculating this operating metric beginning in 2009, basing it instead on the number of movie theaters for which we had rights to lease advertising time as of the relevant period, regardless of the number of screens in such theaters or the number of advertisers that had purchased advertising on each such screen. The large decrease in screen count for the movie theater network over this period was a reflection of this change in calculation methodology.That is a mess. At minimum it is a definition of theatres that I was previously unfamiliar with. But Focus now tell us what they say are the true numbers on standard definitions - numbers that I have no ability to prove, nor disprove, but that I would expect would be part of the due-diligence brief that the Carlyle and others will undertake.
The size of this business
Even on the amended numbers this business is large. In both 2010 and 2011 the number of screens is about a quarter of all screens in China. It is a business that should be highly visible and fairly easy for the PE funds buying Focus Media to do due diligence on. Here is a way to do it:
Ask them to tell you a list of all screens. Pick a screen out-of-town. Ask them to tell you what adverts are on it. They should have records because they need to bill the advertiser (if they claim no records you know they are fraudulent). Then take yourself to the cinema. Have some popcorn. If you really want a good time do it on a sample-basis - check five screens and catch up all the films you missed out on.
Who said being an investment banker or PE guy you don't have time to go to the flicks!
Sustainability of Focus Media's margin
Focus Media's theatre screen business has a fat margin. According to the last annual filing the revenue associated with this business was USD50.8 million. The costs USD25.7 million. This is a gross margin a little over 50 percent - considerably larger than display advertising businesses outside China. Indeed this is a fatter margin than any non-Chinese display advertising business I can find.
I guess that is possible if Chinese screen operators are very stupid and lease space to Focus Media at rents that are too low. (Relatively dumb local governments have long been the explanation for JCDecaux's relatively fat margin in street furniture advertising...)
But the margin has been that fat for years. And the multiplex developers are almost by definition large property developers used to screwing as much revenue out of projects as possible. Moreover this company is on-the-numbers very heavily into multiplexes. Between 2010 and 2011 they added 56 theatres and 637 screens. The incremental theatre seemed to have something like 11 screens.
An explanation that large-scale property developers are more stupid than local governments looks difficult to sustain. Maybe they are - but local governments don't stay that stupid (the renegotiated street furniture terms are never as sweet) and Chinese multiplex owners will learn too. The largest Chinese multiplex owner now owns AMC in America. AMC probably know a few things about maximizing the revenue on their screens.
Unless I am mistaken - as the screen owners wise-up (just like local governments wise-up) the margin in this business is going to come down. Unless there is some magic-secret-sauce in this business I don't understand. Sustainability of margin is likely to be a problem.
Revenue per screen
The number of screens started 2011 at 1553 according to the disclosures above. They ended at 2190. A simple arithmetic average suggests the company averaged about 1870 screens.
Revenue for the year was USD50.8 million. That is revenue per screen of USD27,144.
I spent a lot of time trying to work out whether this number was plausible - and found that it was high but still plausible. I found an American media executive familiar with this industry who told me that the revenue per screen in the US was about USD20-30 thousand. Focus Media is on the high-end of that but still within the range.
Advertising rates in China are usually a fair bit lower than the US - perhaps cinema screens are an exception. On these numbers rates look to be about the same as the US.
That Focus Media secret magic sauce
I have no particular reason to doubt the new number of screens that Focus Media claim to run. The old number was false - but according to Focus Media the problem was one of counting methodology - not fraud.
The new number of screens is about a quarter the total in China - that would surely make them one of the major players.
And they are very multiplex focused with average screens per theatre way higher than average and climbing sharply.
Usually I would assume that multiplex owners were a sophisticated lot who did not leave a fat margin on the table for a player like Focus Media. But there is a 50 percent margin here in a business you would normally expect to have a thin margin. After all the eyeballs belong to the theatre owner and not to Focus Media.
They must be doing something special. Some magical secret sauce if you will.
If I were the private equity buyers I would like to work out what that is - because without knowing you can't assume that the secret sauce is sustainable. (My bet is that it would not be sustainable.)
Oh, to be a fly-on-the-wall
As I said in the first post I wish I were a fly-on-the-wall whilst due diligence is done on that company. I want to understand that secret sauce. It is clearly a way of making money and that is what my clients pay me for.
John
16 comments:
Bravo, sir. Some of your finest work in my estimation. Can't wait.
I worked on some cinema investments in China and we would model 50-70k RMB/year for screen advertising revenue. This is for a good location in a tier 1 city. It would probably be 30-50% lower as you move out into the sticks or into lower tier cities.
There are only a handful of property developers that actually hold on to their properties and operate on a nationwide basis. Most of those do not operate very well and are a lot more concerned with leasing out the millions of sq ft of office/retail space in their building than the lift lobby space for LCDs. Maybe the secret sauce is that they go to the building manager to lease the space, he gets the owner to approve it and then gets a night out at KTV with the FMCN sales guy or a fat red envelope in return. Possibly same with the FMCN ad sales guy and the (underpaid) media buyer. This is complete speculation, but would explain the high margins and sounds about right for China.
John, have a look at Clear Media (100 HK), which is the Chinese subsidiary of Clear Channel Outdoor (CCO)and by all accounts a legitimate business. They operate a different business model (street furniture) but for comparison's sake, their gross profit margin has been c. 40% for the last 10 years, i.e. not that far from FMCN's margins.
With regards to FMCN's early definition of theatre, it might have been lost in translation first time around (replace the word "theatre" with "slot").
I still wouldn't be convinced this wasn't a fraud, if the PE guys go to the movies and see the Focus Media ads playing.
I am not so concerned that the advertisements don't exist. I would be much more concerned that the advertisements don't make nearly as much money as Focus Media says they do.
Confirming sales and AR balances with customers should give more comfort over the accuracy of revenue. I assume FM has some reputable clients? It should be fairly easy to confirm sales or and AR with the customers.
does anyone have a guess on the time frame of this due diligence? how long does this sort of thing take?
also...
let's say they do the due diligence, and then they want to buy the firm, why in the world would (if im a shareholder) would i want to sell to them? i'm all thanks in the world for clearing the name of the current management, but i still dont want to trade against you, especially now that you have definitive information about the value of the company that i didnt when i bot it.
A US comp would be National Cinemedia (ticker NCMI). They have 50%+ OIBDA margins.
I have no view on FMCN.
"Indeed this is a fatter margin than any non-Chinese display advertising business I can find."
See NCMI, a US pure-play movie theater advertising network. Operating Margins of 50% are similar to what Focus Media claims to have. NCMI's 'secret sauce' is the network effects of being by far the largest player in the US.
Gosh I wish I had seen NCMI before this.
They have - get this - 18,670 screens and 435 million in revenue.
The fat margin comes from paying in advance to use those screens (payments that need to be amortised off...)
But that is 23 thousand revenue per screen.
Oh, and in that they have digital advertising, panels in the lobbies, events etc -
My source that said 20-30 thousand per screen was right - but Focus earns more per screen in China that NCMI does in America.
So the FMCN numbers seem to be in the right ballpark. This was clearly not the case with the frauds you detected and elaborated on earlier. Why would somebody be just a little bit fraudulent? It makes no sense because of the risk/reward ratio. Until something much more serious is unearthed I do not think the planned deal will collapse.
How come you are not addressing FMCN acquisition spree that they engaged a few years(which of which they wrote down to $0)?
Management clearly are scumbags, its a matter of what type of scumbaggery they are engaged in
John,
Take a look at the 4th quarter of 2011 for some "above average" numbers for the movie theater network. Revenue was $20,783 and average screens were 2,095, for an annualized revenue per screen of nearly $40,000. Cost of revenue was $6,980, for a gross profit percentage of 66%. All this despite "continuing competition from our competitors."
John, New to this blog but so far a great read. I have not read all your posts but regarding FMCN, you should go back and look at the investigation in 2006/2007 into a related party transaction between Focus and Everease. I recall sitting in a conf room at the Four Seasons (NYC) when Jason Jiang trumpeted the investigation was concluded sending the shares higher. It was not until the 20-f was filed did this little nugget get revealed. Everease refused to provide documents and information to the audit committee as it was run by JJ's family. As such, they "closed the inquiry".
As a result of the Audit Committee investigation of allegations raised by attorneys representing an anonymous investor, we failed to timely file our 2006 annual report on Form 20-F. The unnamed investor, described as currently holding a short position in our ADSs, alleged that: (a) Everease, a company previously run by Focus Media’s founder and CEO, Jason Jiang, is a related party as a result of ongoing ties between Everease and Mr. Jiang and members of Mr. Jiang’s family; and (b) Focus Media was making undisclosed rebate payments to a third-party advertising agency through Everease in order to inflate Focus Media’s reported financial performance.
The Audit Committee commenced its investigation of the allegations on June 28, 2007. It hired independent U.S. legal counsel and independent forensic accountants, who reviewed documents and interviewed witnesses. Everease and the third-party advertising agency declined investigators’ request to provide access to specified witnesses and documents.
One possible way to think is that the privatization is the covering up costs for the looting scheme the 2nd generation guanxi guys in Carlyle and its likes were playing since FMCN's IPO.
Given that the stock went above $60 at some point, if these insiders sold their undisclosed positions at the peak, even if the "rebates" were not really attractive, the gains from buying and selling of stocks can theoretically cover all the costs paid in privatization. If this were true, the DD process is just a drama to be played by insiders.
Just a possibility.
John - Does it pass the smell test that each screen in China earns MORE than each screen in the US? My impression of Chinese ad rates in general is that they are materially lower than CPMs in the US. It would strike me as odd that this one medium had higher rates than in the US, given the disparity in per capita income. I suppose the limited supply in China makes it POSSIBLE, but how LIKELY is it, really?
A quick google suggests, rather surprisingly, that cinema ticket prices in China are actually higher than in the US. $6 to $12 equivalent or higher in China Vs $7 to $8 in the US.
And since there are far fewer screens per capita in China its reasonable to assume the audience is a much more select group in terms of disposable income and therefor relatively much more attractive to advertisers. So more per screen in China could pass the smell test. That said these guys are probably a bit scummy, the question is just how scummy?
John, isn't there a third outcome here? Go ahead as stated, walk away, or renegotiate - privatize but a lower price. We have established its a real business but that there are some questionable things going on, and these should be identified in DD. No one wants the PE funds to walk away and have the share price go to $2 (except the shorts), so the PE funds will use what they find to negotiate a lower price - everyone happy (sort of) (except the shorts).
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