Mattel: Buybacks, Barbie and dead babies

I used to be of the view that suggested that buybacks were just another way of distributing to shareholders - a bit like dividends, selectively applied.

You could turn a buyback into a dividend by selling your own shares in precisely the proportion that the company bought shares back. Then your percentage ownership was unchanged and you would have (in cash) your share of the monies that the company distributed to its owners.

I used to think that. But it isn't quite true because companies can impair themselves with buybacks in ways that you just couldn't with dividends. Few companies support paying dividends at 2x underlying cash generation. But debt funded buybacks of this size are alas fairly common.

Debt funded buybacks, applied to their illogical limit, will corrupt you, and turn you into a gebbeth - inhabited by the debt (and its evils) you have allowed into your body.

First however I need to recount a parable about how leverage corrupts morality.

Valeant and the price of Syprine

Syprine is an old drug, out of patent for years that is a treatment for Wilsons disease. Wilsons disease is a disorder where copper builds up in your blood eventually killing you. If you take Syprine you lead a symptom-free normal life. 

There are a few thousand people with Wilsons disease in the United States and as it was a minor disorder there was a single supplier of Syprine.

Valeant bought this single supplier. They cranked the price to $400,000 for a years supply and took every asset of every sufferer they could find.

Pay up or die.

Valeant instituted a patient subsidy program so that they could crank the prices to levels that no patient could afford and then drop the price (through the subsidy) to a level where they could strip every asset of every sufferer. They found precisely how much a Wilson's disease sufferer had, and they took the lot.

Valeant bought up all the raw-material suppliers for the drug so no alternative supply could make it the market. They either bought up or intimidated all the veterinary suppliers of Syprine so that veterinary supplies couldn't be diverted. Horses get Wilsons disease too but a few (hundred) dead horses were the collateral damage in Valeant's plan to extract huge rents from an old-and-out-patent drug.

Eventually this got to a Congressional hearing and Bill Ackman (the activist investor then on the board of directors of Valeant) promised to go to a director meeting and get Valeant to drop their prices on Syprine.

But Valeant didn't drop its price despite the promises of its (then) largest shareholder, because if they had dropped their prices on Syprine they would not have been able to pay their debt.

Normal people do not tell Congress they will do something and then do the exact opposite. But add in enough debt and decent people will become evil. 

That is what happened with Syprine and Valeant.

In the Valeant case the debt came from buying pharmaceutical companies at very high prices. But in the case I am going to show you (Mattel) the leverage can just come from buying back stock.

And the lesson for management teams is if you buy back enough stock at the wrong price you too can become evil.

But let's start with what went wrong with Mattel.

Mattel, a toy story

Toys are not an easy business. They have a competitor: computer games. Once upon a time if you looked at Mattel it broke down into girls toys and boys toys. Girls toys meant Barbie. Boys toys meant Matchbox (cars) and Hot Wheels. 

These were evergreen, growing sales year after year, decade after decade. 

Then along came computer games. And boys toys in particular were hit badly. Once upon a time you could sell a Matchbox car to a nine year old. Nowadays the competition is Mario Kart, and frankly Mario Kart is more exciting.

These days the only people who buy Matchbox cars are 3 years olds and creepy 45 year old men. 

It is not as if you can't grow a toy company - but the focus is generally younger and younger. Spin Master grew a large (listed) toy company from nowhere on the success of Hatchimals. A fairly large unlisted toy company was built on the success of Shopkins and other toys aimed at younger children. 

With a savvy enough social media strategy you could even make a success of some traditional boys toys. Nerf is an amazing success at least in part based on a craze for making astonishingly violent Nerf War videos and showing them to legions of fans on YouTube.

But that was Hasbro. Mattel was devoid of such success.

And Mattel had some failures too. The most notable one was American Girl an iconic up-market branded doll which Mattel took downmarket (stocking in Toys R Us) and blew up the cachet of the brand.

Once upon a time you could go with your precious daughter to an American Girl shop and have her clothed and her hair cut to match the doll. It was quite the experience. Stocking in mass market shops destroyed this.

What Mattel did have however was buybacks. Lots and lots of buybacks and they kept the earnings per share on a pleasant enough path. 

Mattel's buybacks

The extraordinary buyback binge undertaken by Mattel is best seen in their cashflow statement. If you want the full version I have prepared Mattel's accounts for over 20 years, standardised and as presented (courtesy of the wonderful CapitalIQ.com).

Here however is the key summary of the last few years of this binge:

Year	Buybacks ($M)
2010	447
2011	524
2012	67
2013	493
2014	177

The buybacks (plus ordinary dividends) were way in excess of available cash generated and Mattel accumulated a lot of debt.

The credit rating is now firmly in "junk" territory and is trading (slightly) distressed. The debt trades in the low 90s.

There are now no buybacks now or dividends as cash flow has evaporated.

It is hard to imagine that Mattel, owners of such staples as Barbie, could get itself so knotted, but net debt is now over $2.2 billion. And when there hasn't been a lick of operating cash flow for two years that becomes difficult.

And even Barbie is a little problematic these days. Comparing Barbie to other dolls on Amazon reveals a lack of pricing power. Indeed it seems the only place with pricing power is the collectables market (and with Barbie that means really creepy forty five year old men).

Why I am short Mattel

I am short Mattel based on seemingly dysfunctional management and too much debt. I regarded these in part as flip sides of the same problem. Too much debt meant that Mattel found it hard to take risks, to invent new toys, to hire and nurture the talent that keeps a toy company fresh.

Debt meant that Mattel had to "milk" brands, prioritising short-term cash for stock repurchase and eventually for interest payments. This led to cashing the iconic American Girl brand in for a short-term sugar hit when it was stocked in Toys R Us.

I knew management were dysfunctional. Churn in the c-suite proves it. But recent stories leave me reeling. Mattel have morphed into a truly evil company. One that kills babies.

Dead babies

The recent big news was that Mattel has recalled the Fisher-Price’s Rock ’n Play sleeper. The story is well told in the New York Times.

Here is the key quote:

When Fisher-Price agreed last week to recall all 4.7 million Rock ’n Plays on the market, it said it was not at fault for the more than 30 infant deaths the Consumer Product Safety Commission had linked to the sleeper. 

Instead, the company said the reported deaths stemmed from the sleeper’s being “used contrary to safety warnings and instructions” to buckle babies in with the harness and avoid putting other items in the sleeper. (The safety commission advises that it should not be used once children reach 3 months or show signs of being able to roll over.)

I want you to understand how twisted this is. The company knew babies were dying in this sleeper. But the company wasn't at fault - it was the parents who used the sleeper in ways that seem obvious if contrary to instructions.

The New York Times demonstrate that the ways people used the sleeper were consistent with Mattel's advertising/promotions but whatever. 

Parents bought this thing and their babies died.

And it wasn't one death. One death is an accident. At the second death you are probably wondering "is this a product design issue". At the third death if you are not having serious doubts then you probably lacking basic human morality.

But this was over thirty deaths. 

That is thirty families that held funerals for their baby.

I don't know what you say to parent number 17 whose child died well after it was patently obvious that this thing was killing babies.

One day I guess we will find out what Mattel will say to a jury.

But this is a moral failure truly extraordinary for a company whose key staff have to love children, understand children and design things to make children happy.

Understanding children and designing and marketing things to make children happy

But from what I hear that isn't what Mattel is about any more. Their management were once from fast moving consumer goods companies (really attuned to milking brands).

Now they are Silicon Valley/social media types (which Hasbro has shown with Nerf might be better), but they seem too focused on selling their existing characters to Hollywood. 

But Hatchimals (to pick a success from Spin Master) was a toy aimed at young children designed by someone with flair and a deep empathy with the young children who are the target market. 

An empathy and an understanding that seems lacking at Mattel.

The morality of short-selling

I am a short-seller, and sometimes I am betting things fail when I really hope (for society) that they survive.

I am short a very small amount of Tesla and strangely I hope I lose on that bet. Elon Musk has demonstrated that electric cars can be better than internal combustion engines. He has improved the world. I think his finances are a mess and he has other problems. But deep down I hope he succeeds. I feel slightly dirty betting against what is fundamentally a good thing.

And I felt a little dirty betting against Barbie too. After all what is wrong with a toy company?

But there is plenty wrong with this toy company. It kills babies. It fails the basic test of a toy company. 

And it will probably go bust too. And it will be deserved. The world will be a better place when the toy company which doesn't love children and doesn't design things to make them happy finally fails.

And maybe the next deadly toy won't stay on the market quite as long. And there will be less grieving parents because this thing has finally filed chapter 11.

I truly hope so.

John

The conflict between managing funds and selling funds

BT Australia - before it was purchased by Principal Financial Group for AUD2.1 billion - was the dominant independent fund manager in Australia. Its position seemingly secured by a very good (albeit aging) record of funds management and an unbeatable sales force. That $2.1 billion was paid in the third quarter of 1999.

And then it all went wrong.

The bellwether for a spectacular decline was the launch of the TIME fund. TIME stood for Technology, Internet, Media and Entertainment. The launch date I believe was 14 March 2000, the exact date the NASDAQ peaked. Here is an article from May 2000 expecting 15-20 percent annual returns.

It did not work out quite that well.

As the 2003 Form 10K for Principal says:

On October 31, 2002, we sold substantially all of BT Financial Group to Westpac Banking Corporation ("Westpac") for proceeds of A$900.0 million Australian dollars ("A$") (U.S. $499.4 million), and future contingent proceeds in 2004 of up to A$150.0 million (approximately U.S. $80.0 million). The contingent proceeds will be based on Westpac's future success in growing retail funds under management. 

The decision to sell BT Financial Group was made with a view toward focusing our resources, executing on core strategic priorities and meeting shareholder expectations. Changing market dynamics since our acquisition of BT Financial Group, including industry consolidation, led us to conclude that the interests of The Principal shareholders, BT Financial Group clients and staff would be best served under Westpac's ownership.

Westpac later largely closed the funds management part of the business.

In three years the business was largely destroyed along with the career and reputation of the then Principal CEO.

The "retrospectoscope"* is a fine instrument - but it is still obvious what happened. BT launched a tech fund at the height of the dot-com boom because it was easy to sell. They put "sexy" dot-com stocks in their portfolio because they made the product easier to sell. And they burnt their clients beyond a cinder of recognition.

Pretty it was not.

They did it because they got led by their sales force. If you do what the sales force wants and you have a competent sales force you will sell lots of funds. As a funds management business you will be big and profitable.

But the target for BT Funds Management's sales force was a financial planner in Doncaster (10 miles from Melbourne) with gold-rim spectacles (or the same in Parramatta or any other middle suburban Australian center). These guys are the modern bell-boys. Whey they are putting their clients into tech stocks there is nobody left to sell to.

And so it is - the most extreme example I have ever seen of the conflict between managing money and selling funds management products.

Imagine the patter

I wish I had a recording of a BT "sales call" from say April 2000. The market was off pretty hard - but all was OK in the financial planner in Doncaster. Economic growth looked great. The record for the NASDAQ measured in Australian dollars was astounding - not only because the NASDAQ was astounding but the AUD had collapsed to below 50c in the dollar.

The image projected would have been competence, technical sophistication and certainty.

About this time I ran into David Drury, then CEO of Principal at a CSFB insurance conference in New York. He found out I was Australian and regaled a circled crowd with his version of the BT mid-2000 spin. BT Funds Management was a very fine asset. Later I told two of the people in the circle that I thought the acquisition would cost him his career - but I did not have the courage to tell Mr Drury himself. In my memory I like to kid myself I did have that courage - but whilst I had that view I was racked with doubt about it. Mr Drury was an important man with an illustrious career, BT had a great reputation and I was just a junior analyst.

Mr Drury was a better salesman than I will ever be. He projected the illusion of certainty. [See here and here for a discussion about that illusion...]

Good spin versus good funds management

What makes for good funds management is -

(a) contentious, but well thought through opinions,

and in direct contrast,

(b) doubt sufficient to make sure the downside is always well covered

This is a schizoid requirement. People who have both these features are strange - flat out weird.  People with only (a) are engaging but dangerous.

At Bronte we have both - but only because there are two of us. I am the contentious one. My business partner - his job is to extinguish any passions that I might have. [He is a real spoilsport - ed.]

How to manage financial product salesmen

A good financial product salesman knows things that a fund manager can't know. He knows for instance what is going through the mind of that financial planner with gold-rimmed spectacles in Doncaster. He knows what will sell.

At best he knows how to craft the message so that it will sell, so that it will not trigger any red-flags, so that it will make the recipient comfortable.

And that is good, you can say things in a glass half-empty way or glass half full way without bending the truth. Trivial example: risks are a bad thing, so focusing on the the risks does not sell your product whereas risk management is a good thing so focusing on that might help you sell. You can't actually do good risk management unless you focus on risks - but the angst that gives a good fund manager need not be seen by clients. A good salesman will hide that angst because - well - what sells is the illusion of certainty.

But a salesman who drives changes in the product because, so changed, the product will sell better is on the path that eventually destroyed both BT and Mr Drury's career. And good sales people are empathetic to the needs and desires of their targets so that is the path they tread...

But it is a dangerous path. Really dangerous.

I know (and respect) a fund manager with a very harsh solution to this. When the salesman tells him how to design his product he gives him a warning. The second time he fires him.

He has gone through a few sales people. And eventually he sold lots of product because the performance was too good to ignore.

But it is harsh, unpleasant and not very effective as a sales strategy.

Anyone got a better idea?








John

*Retrospectoscope is - to my knowledge - a Trade Mark of Platinum Asset Management - a very fine firm who took over BT's dominant Australian position.

Self assessment Monday: an old letter to a client...

About two years ago I wrote a letter to our foundation client about how we viewed the equity markets. Mike* had sent Bronte a profoundly bearish broker note.

I posted the letter on the blog. The original (reproduced below) can be found at this link.

Dear Mike 

The bear case always sounds intellectually more convincing than the bull case. And it is in this broker note too. Intellectual sounding and convincing. 

But America is still an amazingly innovative country, humans are ingenious and most of the imbalances will sort themselves out. Big cap equities are cheap relative to almost all other assets (especially relative to small cap equities, cash and bonds and to many assets such as commercial property that require leverage). Cash yields almost minus 3 percent after inflation and less post tax. Bonds are scary as hell and yield minus 1% after tax and inflation. 

Big though difficult-to-run companies are at low teens multiples.  Great franchises are at mid-teens multiples.  Tesco (UK) which is a truly great franchise - is at a 14 PE ratio. And the Pound is historically cheap. WalMart and Target - both slightly less good franchises - are at 12 times. The difficult parts of Silicon Valley (eg HP) are well under 10 times PE ratios (and we feel no need to own that one). The less difficult parts of Silicon Valley (Google for instance) are at a high teens PE ratio once you take out the excess cash. We own that. 

Own equities.  Don't kid yourself.  Mega-cap equities are generationally cheap compared to other assets - and certainly compared to the cash/bond/levered asset complex. 

Just don't be blind about it. The places that there have been high returns (Asia, small caps, smaller resource companies) are riddled with fraud. Twenty five years of deregulation and the high levels of innovation mean we have high and rising levels of stock fraud. Fortunately there is much less fraud risk in mega-caps. 

Don't own Australia or the iron-ore-coal-steel complex. It has run too far and has been too easy to make money. Too many stupid/aggressive/greedy people are doing too much expansion. Some of these people are stupid - but they have made much more money than you or me so they must be right!

I can find dozens of reasons to be bearish - but I look at it dispassionately and I am bullish on big caps, and bullish on America. The problems will sort themselves out and the American exceptionalism (decent institutions, free enough markets and a willingness to take risks) will work their magic again. 

Anything that takes you out of real assets (businesses and property that generate real cash flow) and puts you into nominal assets is - with a ten year time-frame - a bad idea. (And why is your personal account any shorter dated than that?) 

Just don't get greedy by buying things you do not understand: you will be ripped off. The underlying fraud level is as high as I have ever seen it.

Oh, and we are also bullish on France and Germany. Old Europe has manufacturing and production power of enormous levels. (Remember what they produced to fight wars? Their productive capacity is very high and Americans have forgotten that. They do engineering as well as anybody. And Germany no longer has a restrictive monetary policy to crush its consumer market.) 

Also the French are in that lovely position of having convinced newly rich Asians that they are the arbiters of good taste. There are few higher ROE businesses. France has played Asia better than America.

We can see plenty of reasons to be bearish - but just the frauds makes our portfolio short enough. Indeed we are plenty short and likely to remain so until I can't find frauds with ease.

Beyond that, there is a lot of pessimism around. It has got to be time to be bullish. We certainly do not desire being 125 percent net long or hyper-aggressive like that - but we will take steps to become incrementally longer. We are if anything too short.

J

At Bronte we have done pretty well in the past two years - and a good part of the reason can be seen in this letter. Still it is worth assessing how we went on a line by line basis.

The starting call - Tesco which we still own has not been great and the turnaround is appearing more difficult. That was a dud.

The Great British Pound is slightly cheaper compared to the USD so that was also a dud. It was a dud we doubled down on by buying a large stake in Vodafone.

Walmart and Target have both been fine investments; up about 40 percent plus dividends. We only owned Target. It is pretty hard to pick the charts apart but we suspect that operationally we might be in the wrong stock. We did not think that income disparity in the US would continue to widen. However it has and a widening income disparity favors Walmart over Target. [Target is just too up-market.] Also we think the very-cheap-very-diversified retailers are the last ones displaced by the web. Walmart is about the safest name in retail.

Hewlett Packard, which we explicitly stated we did not own, was an okay short over that time. We were short but we did not do as well as the chart suggests as we were too aggressive with put options on the premise of an underfunded pension fund – which proved unfounded.

Google which we owned has been a fine stock. However after the appreciation we own much less of it. We were about 7 percent in the stock at $550 and are just above 4 percent in the stock at $870.

Explicitly not owning the Australian iron-ore-coal-steel complex has been a good call. We were short a few iron-ore names. Those mostly worked for us.

Our French and German industrial names have had more than adequate returns. Our French liquor companies have continued to sell a lot of highly priced Cognac in Asia.

The place we have been mostly wrong is on shorting some frauds. We have had irregular wins in this [alas we will not name names]. We have also had a few losses. This is a bull market and bull markets tend not to be the time-or-place for exposing frauds. Still our short book is not an abject failure.  It contains a few wins and very few disasters. The most prominent loss was that we bet hard that the Focus Media acquisition would not close. Focus Media has very funky accounts - but that did not stop a multi-billion dollar acquisition.

The general call to be long big-cap stocks and avoiding Asia/China/Resources was not a bad call. This continues to be our call but we are far less convinced about it now than we were two years ago simply because the price has changed.

Where to now?

I have another person - a close friend - who has just lost her job and wants some financial advice. I would love to give it to her - but I am finding it extremely difficult to write anything as clear and well supported as the advice above.






John

*Mike is not his real name.

Journos and short sellers getting it wrong

The last post I suggested the Wall Street Journal may be being played by stock promoters (re Focus Media). I still think that.

Many thought I was being harsh on journalists. In particular they rightly pointed out that the shorts were spectacularly wrong on Harbin Electric and the journalists (with a notable exception) were consistently right. I never wrote about that stock but I confess to having lost money on the short - and was surprised at the takeover. My inside-Asia rumour mill was insistent the deal would be done but I did not believe them. [There inside-Asia rumour mill does not insist the Focus Media deal will be done.]

Harbin reminds me (as if I need reminding) that it can go wrong for short sellers (especially the vocal kind).

But it can go wrong for journalists as well. The stock market has a way of reminding us we can all be wrong.

In the journalists-can-stuff-up light I will repeat the single most infamous instance of journalists being played by stock promoters. This was Leslie Stahl's Sixty Minutes piece on Biovail (a Canadian pharma company with extremely dodgy accounts). Stahl swallowed hook-line-and-sinker the view that there was a conspiracy of short sellers determined to spread lies about the stock and destroy the company (and hence the value of mom-and-pop investments). It was pitched as evil hedge funds versus Main Street.

And it was entirely wrong. Biovail was faking its accounts and it eventually dismissed the CEO Eugene Melnyk. Melnyk was later banned from public companies in Canada and paid large fines in the US. But not until well after he completely hoodwinked Leslie Stahl.

All the short allegations were correct.

Sixty Minutes has now taken down the piece which means I cannot replay it to you in all its ignominy. However to the best of my knowledge they never apologized to the people they defamed.

To be fair though not all journalists fell for it. Joe Nocera of the New York Times was sceptical of the Sixty Minutes piece almost straight away. The Ludwig von Mises institute (not my usual source) sided with Nocera.

In other words there were good reasons - at the time Sixty Minutes went to air - to doubt the story Stahl presented.

Sufficient evidence and getting it wrong

We are all going to get it wrong sometimes.

Financial markets however are full of people with an incentive to report falsehoods whether it be stock promoters (as per Eugene Melnyk) or - dare I say it - the odd short-seller. Because so much money is involved you can safely assume that most sources are dripping with vested self-interest. And some are flat lying.

The hurdle rate for a financial journalist is thus high. "Anonymous sources close to the deal" is something that journalists should take with caution. Double caution in China where the fraud level is high.

When financial journalists get it wrong they facilitate criminal activity.

Just ask the haplessly played Leslie Stahl. Her report increased the profits of insider-sellers of Biovail at the expense of her Main Street audience. Oops.

I think the Wall Street Journal has been played here just like Leslie Stahl. And I could be wrong too.

Give it four weeks and I will report back.




John


PS. I have spent a lot of time trying to work out what went wrong with Harbin. Harbin Electric's accounts did not meet the plausibility test. The company was actively misleading on many occasions - and yet the deal did close and whilst the above mentioned Asia-rumour-mill tells me the deal will be a failure it will not be an abject failure.

There was something there at Harbin and it was not obvious in the accounts.

Here is my best theory as to what happened.

In some Chinese cities you were not allowed to buy land unless you had an industrial business to put on that land.

So people started fake businesses to buy and speculate on real land.

Later they reverse-merged the fake business (complete with fake accounts) into the US market.

That was for most of these fake businesses the end of it.

However in some instances (Harbin and at least one other) the land appreciated so much that the company was worth owning even though its business was largely fake.

And so a go-private transaction made sense.

The shorts were right that the accounts were nonsense. But they were wrong on the thing that mattered. There was value there - just not the value everyone thought!

You can be wrong in ways you never predicted. The unknown unknowns if you will...




J

Scepticism and good finance journalism: Focus Media edition

On the 13th of August 2012 Focus Media received a go-private proposal from its founder and a collection of private equity firms.

That was 94 days ago - a bit over three months.

In that time there has been very few announcements from the company.

Second quarter results were announced 22 August. All they said about the deal was as follows:

Announced Receipt of "Going Private" Proposal 

On August 13, 2012, the Company announced that its Board of Directors had received a preliminary non-binding proposal letter, dated August 12, 2012, from affiliates of The Carlyle Group , FountainVest Partners,  CITIC Capital Partners, CDH Investments and China Everbright Limited and Mr. Jason Nanchun Jiang, Chairman of the Board and Chief Executive Officer of Focus Media, and his affiliates (together, the "Consortium Members"), that proposes a "going-private" transaction (the "Transaction") for $27.00 in cash per American depositary share, or $5.40 in cash per ordinary share.  According to the proposal letter, the Consortium Members will form an acquisition company for the purpose of implementing the Transaction, and the Transaction is intended to be financed with a combination of debt and equity capital. The proposal letter states that the Consortium Members have been in discussions with Citigroup Global Markets Asia Limited, Credit Suisse AG, Singapore Branch and DBS Bank Ltd. about financing the Transaction and that these banks have provided certain of the Consortium Members with a letter dated August 11, 2012 indicating that they are highly confident of their ability to fully underwrite the debt financing of the Transaction subject to the terms and conditions set out therein.  

The Company's Board of Directors has formed a committee of independent directors (the "Independent Committee") to consider the proposed transaction. 

No decisions have been made by the Independent Committee with respect to the Company's response to the Transaction. There can be no assurance that any definitive offer will be made, that any agreement will be executed or that this or any other transaction will be approved or consummated.  The Company does not undertake any obligation to provide any updates with respect to this or any other transaction, except as required under applicable law.

On 23 August the company announced that the independent directors had hired advisers to help them assess any bid. To quote:

SHANGHAI, Aug. 23, 2012 /PRNewswire-Asia/ -- Focus Media Holding Limited ("Focus Media" or the "Company") (Nasdaq: FMCN) today announced that a committee of independent directors of the Company's board of directors (the "Independent Committee") has selected J.P. Morgan Securities (Asia Pacific) Limited ("J.P. Morgan") as its financial advisor and Kirkland & Ellis International LLP ("Kirkland & Ellis") as its legal counsel.

There has been no announcement since.

That is 83 days of nothing. Well not quite nothing - the company announced that they were having an AGM but did not mention the go-private proposal.

83 days is a long time for there to be no-progress on a deal which had "highly confident" funding. Surely there is some development - positive or negative - to report in that 83 days.

The Focus Media go-private deal is controversial

Even without 83 days of nothing this deal would be controversial. Muddy Waters - the research firm that exposed the fraud at Sino Forest - has been very critical of Focus Media's accounts.

I have released a many-part series exploring peculiarities in Focus Media's accounts - see Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11, Part 12, Part 13, Part 14, Part 15, Part 16, and Part 17.

My many part series did not prove that the accounts are fraudulent. It did however demonstrate some peculiar things - for instance the company purchased many seemingly unrelated businesses registered in the British Virgin Islands where all of those businesses somehow had the same address at the same lawyers office. Moreover in at least one instance they closed on the purchase of a business (by purchasing its holding company) before that holding company was even registered.

Here is the rub. Either this deal is real and just very slow or this deal is a complete show pony whereby insiders are dumping huge amounts of their shares - shares valued on a multiple of earnings from highly peculiar accounts.

In one instance the stock should go to $27 - the take-out price. In the other instance the stock should go to single digits (possibly zero) because it is a show-pony dressed up to extract monies from Western investors.

83 days since the latest news, 94 days since the announcement of the deal. Remember that.

The "Fourth Estate" has not been silent

Progress of this deal is newsworthy. This is the largest leveraged buyout deal ever in China - a watershed for the Chinese private equity business. And the media abhor a vacuum.

There have been two key news stories since the deal was announced. Each has acted to support the stock.

The first story was in Basis Point (an industry magazine) and repeated by Reuters. To quote Reuters:

Citigroup, Credit Suisse and DBS Bank are leading the three-part buyout financing, which consists of a $950 million to $1 billion term loan, a $200 million to $300 million bridge-to-bond facility and a $450 million cash bridge, Basis Point reported. 

The term loan is expected to have a five-year tenor, while the bridge financings will have six- to nine-month maturities, the report added. 

The company is looking to put together an underwriter group of six or seven banks and terms of the financing are likely to be finalised in about two to three weeks, Basis Point said.

That story was dated 11 September. They said the deal would take two to three weeks to be finalized.

It is two months now and there is no news. I think we can safely conclude that the Basis Point/Reuters report is wrong at least with respect to the timing.

More recently Prudence Ho and Isabella Steger of the Wall Street Journal said that Merrill Lynch, Deutsche Bank and UBS were going to help finance the Focus Media deal. That story was sourced to "two people familiar with the transaction". In other words anonymous sources.

Those banks were to be joining the three original banks on the deal (Credit Suisse and DBS). Again sourced to "the people".

These anonymous people were very specific: "the six banks plan to provide a total of $1.65 billion in financing, made up of a cash bridge loan, a long-term loan and a high-yield bond".

The Wall Street Journal story was dated 2 November. One of the Ho/Steger anonymous sources said "the banks will sign the formal financing documents next week at the earliest".

Needless to say that has not happened either.

Has the Wall Street Journal been played?

Good anonymous sources are part of journalism - but any journalist should ensure that they are not being played with self-interested falsehoods by these sources.

It looks awful like Basis Point were played. They published the financing was likely to be finalised in "two to three weeks" and it is now two months. The information could have been good and the timetable slipped - but as there was no follow up from Basis Point it is likely the information was flat false.

It is also possible that Ho & Steger (and the WSJ) have been played as well. It might be true that Merrills, Deutche and UBS have all joined forces to close this deal (in which case the Wall Street Journal has a story). But if not the story is a journalist's train-wreck - and should cast into doubt all the work by these fine journalists.

I started writing what I thought a journalist should do with an anonymous source when the source has been lied to them - but there are people far more versed in journalist ethics than me. But forget the ethical issue - this is for financial newspapers a business issue.

The financial press is the only part of the print media that has managed to establish pay-walls around their content. And for good reason too - reading the financial press is about making money and you can justify paying for that.

But when gullible journalists are played then acting on information in the financial press becomes a way to lose money. And what is the point in paying for that?



John

Focus media bank loans

Focus Media has accounts that suggest it is massively cash generative. According to their accounts they are sitting on over $500 million in cash - in this case all in Renminbi.

They also have expanding bank loans - now over USD200 million.  These loans are made in US dollars backed by LOCs issued by a Chinese bank.

I have heard several (contradictory) theories for why these transactions were made in this manner.

I figured if I put this disclosure up readers might propose even more contradictory theories in their comments.

At least that is what I am looking for.



John...

14. Bank Loans

		Notes		December 31, 2011
Short -term revolving loan		a)		$	100,000,000
Long -term revolving loan		b)			71,000,000
Total				$	171,000,000
Additional available long -term loan facilities		b)		$	29,000,000

a)

The short-term revolving loan is denominated in U.S. Dollars, was obtained from a large commercial institution outside of the PRC (“Bank A”), and is secured by a stand-by letter of credit issued by PRC based financial institution (“Bank B”). The stand-by letter of credit is secured by short-term deposits of RMB628,030,000 (equivalent to $99,673,063), which is recorded as restricted cash on the Group’s balance sheet. The Group paid RMB 4,095,000 (equivalent to $649,907) to Bank B to issue the stand-by letter of credit to Bank A. The short-term revolving loan bears interest, which is payable monthly, at the rate of two-week LIBOR plus 2.1% per annum. The weighted average interest rate of this loan for the year ended December 31, 2011 was approximately 2.4%. The short-term loan is payable in November 2012.

b)

The long -term revolving loan is denominated in U.S. Dollars, was obtained from Bank A, and is secured by a stand-by letter of credit issued by Bank B. The stand-by letter of credit is secured by restricted long-term deposits of RMB 628,030,000 (equivalent to $99,673,063) deposited in Bank B, The deposit is recorded as restricted cash on the Group’s balance sheet. The Group paid RMB 3,965,000 (equivalent to $629,275) to Bank B to issue the stand-by letter of credit required by Bank A, The costs incurred in connection with the stand-by letter of credit are being amortized to interest expense over the term of the loan. The loan bears interest, which is payable monthly, at the rate of two-week LIBOR plus 2.1%, 2.4% and 2.7% per annum for each of the twelve months ending December 8, 2012, 2013 and 2014, respectively. The weighted average interest rate of this loan for the year ended December 31, 2011 was about 2.4%. The principal of the loan is payable in two installments of $17,750,000 and $53,250,000, which are due in December 2013 and December 2014, respectively.

Neither the short-term or long-term bank loan contains financial covenants.

Source: here.

Focus Media: what happened to the airports?

The adverts on an LCD screen are worth more in a high-traffic location than a low traffic location. They are worth more when people are predisposed to shop rather than say on the way into their apartment.

They are worth more where rich people congregate.

Airports are top-of-the-pile. At airports people of well above average income sit around and wait. And they are surrounded by shops or about to go to exotic locations where they will spend-up.

So it is worth exploring Focus Media's history in placing LCD advertisements at airports.

The 20-F filing for 2005 described their plan to expand their LCD network:

into new cities and regions in China and diversify into new networks and advertising channels such as airports, hospitals and other possible commercial locations;

And they already had some panels placed in airports as well as airport shuttle buses and on flights as per this disclosure:

our commercial location network, which refers to our network of flat-panel television displays placed in high-traffic areas of commercial buildings, such as in lobbies and near elevators, as well as in beauty parlors, karaoke parlors, golf country clubs, auto shops, banks, pharmacies, hotels, airports, airport shuttle buses and in-air flights. Our commercial location network is also marketed to advertisers as six separate channels targeting different types of consumers: our premier A and B office building channels, our travel channel, our fashion channel, our elite channel and our healthcare channel.

Exactly the same disclosures occur in the 20-F filing for 2006. 

In the 2007 filing the panels placed in airport shuttle buses and flights disappeared, but they still had the panels in airports. The loss of the shuttle buses and in-air flights was never explained. Did they sell the business? Did the owners of the sites kick them out? Simply unexplained.

By the 2008 filing the only airport disclosure remaining was that they planned to expand into new channels such as airports (the exact wording from the 2005 filing remained). They no longer operated in airports.

Was the airport business disposed of? Did they forget they owned it?

The word "airport" does not occur in the 2009 filing or in any of the amended filings that year.

By the 2010 filing they are back in airports as per this disclosure:

The majority of displays on our LCD display network are currently placed in heavy-traffic areas of commercial office buildings. The locations in our LCD display network also include shopping malls, banks, hotels and certain airports. We market our LCD display network to advertisers of consumer products and services, such as automobiles, home electronics, mobile communications devices and services, cosmetics, health products and financial services.

By the 2011 filing the airports had disappeared again.

So I will leave it as a question for the due diligence team. What happened to the business placing screens in airports, airport shuttle buses and in-air flights?

You can of course ask Jason Jiang, the CEO, because all the standard biographies of the man indicate that is how he cut-his-business teeth - installing screens in airport shuttle buses.

John

PS. Possibly the most spectacular Chinese reverse merger fraud, China Media Express supposedly had screens on airport shuttle buses. Indeed even today you can see Youku videos purporting to count the (non-existent) CCME screens on airport shuttle buses.

I will never look at a video on an airport shuttle bus the same way.

Focus Media revenue plausibility test: Part two

Focus Media makes a lot of revenue per screen compared to US Television.

Many people in the comments to the last post worked out rough ratios. There are at Focus Media roughly 130 thousand screens (more now, less at the beginning of the year) generating 221 million in revenue in the last six months (see press release).

That is rough $3400 per screen per year per year.

In the fourth quarter of last year the revenue from LCD screens was 150.4 million. There were about 120 thousand screens average over the quarter. Annualized that is almost $5000 revenue per screen.

Television advertising revenue in the US is about $72 billion. 

There are roughly 310 million televisions in the US. (See here suggesting lower or here suggesting higher...)

Revenue per screen is roughly $235.

It depends a little on quarter - but Focus Media revenue per screen is 14 to 20 times higher than US Television revenue per screen.

Almost (but note entirely) everyone I have shown this to thinks that the revenue-per-screen at Focus Media seems high. [That includes many industry insiders.]

Overstated revenue per screen is consistent with interpretation (c) as per this post.

Other possible comparisons

It seemed to some people unfair to compare advertising in lift wells (which sometimes 20 people are forced to watch) with the TV in your kitchen (which may be on in background with one person or nobody watching). Some people thought I should compare with other out-of-home advertising companies.

The problem is that not all screens are born equal.

Screens are more valuable where rich people with high disposable income congregate. That are even more valuable if viewers have a willingness to spend that income.

They are more valuable where you are forced to wait (and hence watch the screen).

They are less valuable where only a few dozen people pass them per hour (say in the lobby of residential building). Also in the lobby of a residential building you see the screen when you are going home. Advertisers would prefer show their adverts to people who are near shops or about to go to the shops.

Probably the single most valuable screens are in airports. Airports are full of relatively well-to-do-people. They are also full of shops with fatter than average margins. People are forced to wait. Often they are travelling and extremely willing to spend on hotels, tourist attractions, luxury goods. Some even have expense accounts.

One comparable is Air Media - who probably have the best-placed screens in China - they dominate the airport space.

One part of that business is directly comparable to Focus Media. It has 42 inch panels which intersperse advertisements and content in airport waiting areas as per this quote from the annual:

We strategically place our digital TV screens in high-traffic areas of airports such as departure halls, security check areas, boarding gates, baggage claim areas and arrival halls, where there tend to be significant waiting time. A majority of our standard digital TV screens are 42-inch plasma display panels or LCDs. As of March 1, 2012, we operated approximately 2,690 digital TV screens in 36 airports in China under various concession rights contracts. These 36 airports accounted for approximately 81% of the total air travelers in China in 2011, according to the General Administration of Civil Aviation of China.

That business generated 21.9 million dollars in revenue in the last year. That is just over $8000 per screen - or more than double Focus Media. However these screens are at least 4 times the size of Focus Media screens and have many times the views.

Bluntly: these are optimally placed large screens. Amongst locations in China really.

By contrast, Focus Media screens have been spotted in the basement of office buildings where the janitors and maintenance staff congregate. They also place screens on every floor of some office buildings - this one is on the 21st floor of an office building in Shanghai:

It has the usual number of people watching it. (Nobody...)

They are in lobbies of residential buildings in third-tier cities - where people watch them before they  go back to their apartment rather than before they shop.

My guess: either revenue per screen at Air Media is low and likely to rise - or the revenue per screen at Focus Media is high or possibly overstated and likely to fall.

==============

Some further calculations:

I work on the 21st floor of an office building in Sydney. It is unlikely that more than 20 people per hour catch the elevator at this floor. (That still makes the lobby busy...)

Work on 9 hours per day, 275 days per year, and you get about 50 thousand impressions per year.

The cost per thousand impressions for a Superbowl advertisement is about $35 (probably less). At Superbowl rates this screen would garner roughly $1500 revenue per annum.

Residential buildings in third tier cities would produce lower revenue.

If the revenue really is over $3000 a screen I doubt it is sustainable.

Being a cynical fellow I keep getting drawn back to interpretation C in this post.




John

PS. Air Media revenue per screen has been falling. I have talked to several people in the industry and they all say the same things. Revenue is growing but only because number of screens is growing. The pricing pressure in this industry is down simply because there are increasing numbers of screens.

Focus Media plausibility test part one

This post is being written for everyone on the deal-team bidding for Focus Media.

It is also been written for everybody who is considering whether to lend the bid 1.5 billion dollars to consummate this deal.

Finally it is being written for Ashish Goyal from Prudential Investments who is Focus Media's largest shareholder and was quoted in the WSJ stating he wanted more than $30 for his shares. [Someone please forward this to Mr Goyal. He seems a reasonable man.]

I just want you to guess the numbers. Don't look them up. Don't calculate. Just guess. Put your guess in the comments - anonymously if you wish.

TV Revenue per screen in the US

There are about 310 million TV sets in the US - roughly one per person. People deliberately watch these for several hours a day. Indeed people sit their family down in front of them to eat dinner.

Their main economic purposes is to show advertisements - the content on them is the lure to get people to sit in front of them.

And there is an enormous industry producing content for them (whose costs have to be covered by advertising). A good part of the city of Los Angeles exists to produce TV content. TV advertising supports the lifestyles of every camera grip and editor and some very large indulgent lifestyles (Charlie Sheen).

TV advertising is still the biggest advertising category in the US.

So take a guess at the advertising revenue per screen. Per month, per year, I don't care. Just guess the revenue per screen.

LCD Revenue per screen in China

Focus Media has about 130 thousand LCD screens - the main format being 17 inch LCDs displaying almost entirely adverts.

The majority of these screens are in elevator lobbies and other low-traffic locations.

Here is a typical screen from a low-traffic area - this one 1030 Hua Min Empire Plaza Shanghai.

Nobody sits themselves down in front of these screens - but they are forced to watch (or at least be around) the adverts when waiting for an elevator.

On the plus side these screens don't waste precious time with content - they just show adverts (which would tend to make them more valuable). And you can't fast-forward through the adverts.

However they are in China where advertising rates (per thousand impressions) are generally lower than the US.

Moreover, nobody sits their family around these screens to eat dinner.

So take a guess at revenue per screen for Focus Media's LCD screens. Per month, per year, I don't care. Just guess the revenue per screen.

Ratios

Have a look at your guesses.

Calculate the ratio of Focus Media revenue per screen to US Television revenue per screen. Is Focus Media:

* 5 pernent of the revenue per screen of US TV?
* 10 percent of the revenue per screen?
* 25 percent of the revenue per screen?
* 50 percent of the revenue per screen?
* About the same revenue per screen as US TV?
* Double the revenue per screen of US TV?
* Four times the revenue per screen of US TV?
* Ten times the revenue per screen of US TV?
* Twenty times the revenue per screen of US TV?

Please put your estimate in the comments.

More tomorrow.







John

Focus Media: Three interpretations - which one is right

This blog has demonstrated a bunch of bizarre transactions in Focus Media's accounts. In particular I have focussed on transactions during 2009 in which vast sums appear to have been lost in businesses that were acquired from companies formed only months before acquisition. In each of these cases the business was sold or mostly given back to the original owner.

Here is the disclosure I focussed on (but there are other strange disclosures I could pick):

2009 Disposition

In 2009, we aborted a contemplated initial public offering for its Internet advertising segment due to the economic recession in late 2008. As a result, between August and December 2009, we disposed of six underperforming subsidiaries in that segment through a series of individual transactions with their respective original owners. Each of the subsidiaries was considered a component of our company, and their results have been included in discontinued operations in the consolidated statements of operations. The results of discontinued operations include net revenues and pretax losses of $127.6 million and $45.4 million, respectively, related to these subsidiaries. We recorded a loss on disposal of $44.1 million.

The following table summarizes the acquired subsidiaries in the mobile handset advertising services segment and Internet advertising segment that were sold back to their original owners in 2009:

		Acquisitions		Date of acquisition				Business segment		Proceeds paid				Date of Disposal				Loss on disposal
1.		Catchstone(1)			2007-4-16			Internet advertising		$	14,489,647				2009-12-22			$	11,560,617
2.		WonderAd(2)			2007-9-15			Internet advertising		$	14,926,003				2009-11-30			$	14,926,003
3.		Jiahua(3)			2007-8-15			Internet advertising		$	7,659,158				2009-12-1			$	7,659,158
4.		Wangmai(4)			2007-9-1			Internet advertising		$	2,749,158				2009-12-14			$	2,749,158
5.		Jichuang(5)			2007-12-1			Internet advertising		$	366,032				2009-8-24			$	366,032
6.		1024(6)			2008-3-1			Internet advertising		$	3,397,124				2009-12-18			$	3,397,124
7.		Dongguan Yaya(7)			2007-10-1			Mobile handset advertising services		$	1,540,612				2009-2-28			$	1,588,110

(1)	The original sellers which subsequently repurchased Catchstone were Only Education Holding Limited and Maxnew Holdings Limited, BVI companies owned by a single PRC individual unrelated to our company.

(2)	The original seller which subsequently repurchased WonderAd was Megajoy Pacific Limited, a BVI company ultimately owned by seven PRC individuals unrelated to our company.

(3)	The original sellers which subsequently repurchased Jiahua were two PRC individuals unrelated to our company.

(4)	The original seller which subsequently repurchased Jichuang was Richcom International Limited, a BVI company owned by a single PRC individual unrelated to our company.

(5)	The original sellers which subsequently repurchased Keylink Global Limited were four PRC individuals unrelated to our company.

(6)	The original sellers which subsequently repurchased 1024 were two PRC individuals unrelated to our company.

(7)	The original sellers which subsequently repurchased Dongguan Yaya were Sinoalpha Limited and Max Planet Limited, BVI companies each of which is owned by a separate single PRC individual unrelated to our company.

The main thing demonstrated was that all the British Virgin Island (BVI) companies above:

* had the same address despite being explicitly unrelated parties, 

* had the same phone number despite their non-related status, 

* in all cases except one had been formed only a few months before they sold a business for millions of dollars to Focus Media 

* in the exception had been formed after they sold the business to Focus Media 

* had in all but one case later been struck off the register for non-payment of a fee.

Moreover the companies given back in 2009 were given back with a lot of cash (some 27 million dollars) embedded in the companies as they were given away. Focus Media on the disclosed accounts appear to have given away cash.

Three interpretations 

I originally had three interpretations of this disclosure. These were

(a). The accounting statements absolutely straight, Focus Media really did buy all these businesses, lose a huge sum of money on them and gave them back to their original owners,

(b). Focus Media used these transactions facilitate the mass looting of the company. That is the money was not really lost, but rather the business were purchased and given back to their original owner as part of some scheme to steal from the company.

(c). That the losses were fake - a form of profit washing. In this interpretation Focus Media reports fake earnings (say inflated revenue or deflated cost, most likely inflated revenue) and this loads the balance sheet with fake cash. The fake cash needs to be removed (or the auditors will find it or shareholders demand it) so the fake cash gets removed from the balance sheet with fake losses on rubbery transactions.

Two interpretations left

On the information as discovered so far interpretation (a) above requires one to believe that all these seemingly unrelated parties found the same lawyer to register their BVI entities and that these businesses generated millions of dollars in net worth in a few months before they were sold to Focus Media.

Indeed you need to believe that Richcom, which was not even in existence, had a business that Focus Media was happy to buy for millions of dollars.

There are scenarios where interpretation (a) remains possible. For instance if all the Chinese entrepreneurs had the same lawyer and hence all the addresses are the same, and that lawyer was sloppy and forgot to actually register Richcom. They might have the same lawyer because they socialize at the same Karaoke bar.

However interpretation (a) requires this unlikely combination of circumstances.

This leaves two remaining interpretations (b) and (c) above. Either the company was being looted or there were fake profits and the losses described above were fake losses whose accounting function was to make the books balance when there were fake profits elsewhere.

These two interpretations have wildly different implications for the future of Focus Media

The main response to my posts is to say that all I have demonstrated was that Focus Media prior to 2009 was a very dodgy company. Bill Bishop - one of the more sophisticated China watchers - tweeted as much:

10 SepBill Bishop ‏@niubi

@LongShortTrader @John_Hempton Pre crash fmcn had lots of the crap you and muddy waters have documented, post crash fmcn cleaned up

Expand

•  Reply 
 
•  Retweet 
 
•  Favorite

Indeed this was also the response to Muddy Waters who alleged fraud at Focus Media about a year ago. There were just a bunch of dodgy transactions.

But my interpretations (b) and (c) above have wildly different outcomes for the stock.

If the company was being looted - as say Bill Bishop and many others imply - then there was something there to loot.

Something there to loot suggests the company really is valuable.

Once the looting stops (and you would presume it would stop after being taken private) then the cash flow is real and can service lots of debt and make the PE buyers rich.

If however (c) is true then the losses recorded in 2009 were fake losses - then the profits recorded were fake profits. If this is the case then the company can't service lots of debt (the profits were fake and you can't service real debt with fake profits) and the PE deal will collapse.

Indeed if the profits were not real then there is nothing there to loot, nothing of any real value - and an end value for the stock is below $2 (and I think probably below $1).

The accounts since 2009

The accounts since 2009 have shown a fairly steady build up of cash and financial assets. The two interpretations have something to say about that.

In interpretation (b) the company was heavily looted in 2009. However it is a valuable company and since then that value has accumulated as cash on the balance sheet. To believe this you have to assume that the management were evil but they somehow turned good.

In interpretation (c) the company was not looted in 2009, just a huge pile of accumulated fake cash was removed from the balance sheet by having fake losses. Since 2009 the company has continued to accumulate fake cash. Eventually that fake cash will also need to be removed from the balance sheet. This situation is just like at the end of 2008 where this interpretation would imply the company had also accumulated a bunch of fake cash only to have it removed by fake losses in 2009. To believe this you have to believe the company is currently accumulating fake assets (including some fake cash).

It is of critical importance to the stock to work out which is true. If (b) is true this deal will close and you will get $27 a share. If (c) is true the deal is likely to fail - and the downside is to maybe a dollar or two a share. [There are reasonable scenarios where the downside is to zero...]

Indications that it might be C and the shares are nearly worthless

There are several things that indicate that it is more likely to be (c) than (b). Here are a few.

The company had a Renminbi shortage in 2006

I know it is a long time ago - but this is a startling disclosure:

In March 2006, Weiqiang Jiang, the father of Jason Nanchun Jiang (the CEO/controller of Focus Media), provided a short-term loan to the Group of approximately $2.5 million to relieve a temporary shortage of Renminbi the Group experienced at that time. The loan is unsecured and was provided to us at no interest. The loan will become due and payable in full on June 30, 2006.

The company disclosed a "temporary shortage of Renminbi". At the time the balance sheet showed plenty of cash and cash generation. The only way that there could have been a Renminbi shortage is if the cash was fake. And the cash was only fake if the earnings were fake. Moreover a Renminbi shortage implies almost no net cash generation - consistent with a worthless or nearly worthless share.

The disclosure of a Renminbi shortage is consistent with interpretation C.

The company appeared to pay cash to a company that did not yet exist

In August 2007 Focus Media purchased a business from Richcom International for over $2 million. The only problem is that Richcom International was not formed until October 2007. In other words it appeared to pay cash to a company that did not exist.

A company that does not exist has a very hard time opening a bank account and hence has a hard time receiving cash.

But it has no problem receiving fake cash (you don't need a bank account for that).

This is consistent with interpretation C. Fake cash paid comes from fake profits.

In 2009 the company essentially gave away almost all the subsidiaries it disposed of, but the accounts showed that those subsidiaries had 27 million in embedded cash

Above there is a list of companies disposed of in 2009. All of those were given back to their original owners. In some cases a small consideration was paid.

However the cash flow statement for the year shows that in excess of 27 million dollars was embedded in the companies that were given back to their owners in 2009.

This could be looting - but is particularly blatant - just giving away cash.

The alternative hypothesis is that the cash embedded was fake. This appears more reasonable to me than actually blatantly just giving away cash.

The company used to overstate its number of movie screens

Overstating things like numbers of movie screens is consistent with overstating revenue. Overstating revenue will give you fake cash as per (c) above.

The company used to say that it had 27,164 theatres on which it displayed averts. There were less than 1600 in all of China at the time. This sort of overstatement leads one to question whether other things are being overstated - and hence fake cash is being produced.

That is supportive of interpretation (c) above.

The company claims extremely high revenue per movie screen

The company later restated down the number of movie theatres it displayed in - but it never restated down the revenue from those theatres. Revenue per theatre ran at over $27 thousand average last year - above the average and near the high-end of US revenue per theatre.

Moreover it was running at roughly a $40 thousand per theatre run-rate in the fourth quarter of last year. That is above the peak in the US.

Advertising rates in China are substantially lower than the US. Moreover my independent inquiries suggest the revenue per screen in China is closer to $7,500 per year.

Overstated revenues means fake earnings and fake cash as per interpretation (c) above.

The company overstated and restated down the number of LCD screens it has

The company recently reclassified a whole lot of screens in the LCD business to the poster-frame business. The reason given was that they were originated by the LCD business and hence counted as LCDs. Perhaps plausible but also consistent with generally overstating things and hence overstating revenue.

Overstated revenue leads to fake cash as per explanation (c) above.

The company claims to make huge margins from a business that nobody finds profitable elsewhere in the world

How many 17 inch displays showing adverts have you seen in residential buildings in countries other than China? They do not exist in Australia. I have not seen them in New York. Sometimes in office buildings or hotels (usually advertising the facilities of the hotel). Never in residential buildings.

That is because nobody can make them profitable in residential buildings outside China.

However they claim over $3000 per screen of revenue in China. If you could get that much revenue in China (where advertising rates are low) you could get more elsewhere and the screens would grow like mushrooms in dark elevator lobbies all over the planet.

They are not.

Either China is really different or the revenue and profits are overstated in China as per interpretation (c) above.

Summary

Most of the evidence is consistent with (c) above. The strange transactions are not looting as the bulls in the stock would suggest. Interpretation (c) is that these transactions are the washing of fake profits by producing offsetting fake losses.

In that case the business earnings are not real and the business cannot support all the debt that the PE firms will laden it with. The private equity deal will fail as the debt defaults.

It is hard to tell what the stock is worth absent a PE bid. However as nobody can make an LCD business substantially profitable in (say) America what is it worth in China where advertising rates are lower?



John


PS. There is someone associated with this deal who has been arrogantly telling friends that they love this blog. They say I am keeping the pricing pressure down and making this deal easier.

If interpretation (c) is right this deal will collapse spectacularly after it closes (the debt will default, the PE buyers will get nothing). And you were warned and continued regardless.

The explanation for your recent arrogance is probably "deal fever". But as I said at the beginning of this sequence of posts private equity has the ability to due diligence and your limited partners will be expecting rigour over hubris.

If you do the deal and it fails spectacularly (despite ample warnings) your limited partners and the regulators will believe something worse than hubris. Probably far worse.

My guess for what they will believe: that you did this deal knowing it to be fraudulent and that you got kick-backs for doing it. They will believe you looted your own funds. That belief may or may not be true - but that is what they will suspect.

If interpretation (c) proves correct and you close this deal your career (and possibly your whole life) will get very difficult indeed.

Of course if I am wrong and interpretation (a) or (b) is true this will be a great deal. Go for it.




J