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 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: My new obsession - original version with annotations

There are days I should not be allowed to hang around a spreadsheet. This post had not one but two - nearly identical mistakes in it. I simply read off the wrong line in my tables and quoted gross margins not operating margins. I have corrected below and put in an addendum with the original sources of the correct data in it. I have also republished the post as it should have been in the first place.  

Just to make it clear - phrases removed from this post are in strike through and additions are in italics. 

If you have not read this post - just go straight to the corrected versions.

The announced "go-private" transaction for Focus Media has me obsessed. It seems to cover a whole gamut of my interests, Asian private equity, alleged Chinese fraud, connections with major property developers and numbers and accounts I find surprising. The whole works! It may not be the most important thing in financial markets this year - but it is one of the most interesting.

Readers might need some background here. Focus Media is a display advertising business in China which has analogue and digital poster frames in elevators and shopping centers as well as LCD screens placing advertisements more generally. Most of these adverts are small (the LCD screens are mostly 17 inch according to the annual report and many of the posters are smaller). Here are pictures of a few...

(My source for these photos is a Seeking Alpha bull on the stock here...)

A lot of what used to be counted as LCD screens are simple posters:

The reason for using posters is inconveniences like having no available power supply. There has been some dispute about the number of screens and posters but there is no doubt that the company has a lot of these - they are visible around major cities in China.

The company also claims to have the right to sell advertising on a large number of movie cinema screens. Again there is a dispute about the number of these screens.

The mechanics of Focus's business

Focus Media is a relatively simple business. They rent sites (for instance by entering a lease with the managers of a large tower with elevators they wish to place adverts in). They sell the advertising space and they maintain all their screens and update your posters and deal with the inevitable things like vandalism, theft and the like. For the number of sites that Focus deals with they would need a fairly large number of lowly paid staff for maintenance and another group of staff selling advertisements and a third group negotiating lease arrangements with building and cinema owners. The second and third group will have higher salaries.

The maintenance cannot be neglected because it devalues adverts when kids scrawl little goatie-beards on the pictured women (or worse).

The profitability of Focus's business

The most notable thing about Focus from the accounts is their startling profitability. Their last annual report shows revenues (net of business taxes) of USD793 million and operating gross profit of 503 million, operating profit is 259 million. This is an operating of margin of 32.7 percent in a which is at the high end for a media business. In my experience media businesses are 10-35 percent margin businesses - with the high numbers reserved for very special franchises. A monopoly newspaper in a city of a million people (say Perth Australia) used to have a 35 percent margin before the internet threatened the monopoly. Most businesses are closer 20 percent. Most display advertising businesses (which are without strongly identifiable franchises) earn closer to 10 percent margins.

Moreover, this is a 63 a 33 percent margin where the company itself describes the landscape as "competitive" in their annual filings. The margins are surprising – but China is a surprising place in many ways – and it is possible that margins are fat because the landlords who lease the space to Focus are stupid. The fat margins may be possible for other reasons I don't understand.

First let me stress though just how fat these margins are. The largest player globally in display advertising is JCDecaux (the French multinational founded by Jean-Claude Decaux). They have - according to their last accounts - €2463 million in revenue and 23.6 percent operating gross margins. The 63 percent gross margin at Focus is fully 40 percentage points higher than the gross margin of JCDecaux. The net margin of JCDecaux is a mere 8.7 percent - Focus Media margins are 3.7 times higher than JCDecaux.

Moreover JCDecaux has fatter and thinner margin businesses. It has a mid teens operating gross margin outside their (franchise) street furniture business.

There are several possible explanations for the very fat margins at Focus. The most obvious explanation is that they were early... when you go around to a landlord and offer to rent their space they don't know what that space is worth (because the idea is new to them) and they lease it to you for too little. Over time margins contract because the landlords "wise-up". This is certainly true in the street-furniture business at JCDecaux where the company goes to the local government and offers to maintain their bus-stops for "nothing" and the local government (with the intellectual panache that describes that sector) just accepts. But local governments have wised up over time.

The bears in this stock - and there are many (see the many seeking alpha articles) - would suggest the margins are made up. As an outsider that is pretty hard to test - but going through the claims and counter-claims with a fine comb is the sort of thing that excites a guy like me. (Any private equity party doing thorough due diligence can check those claims.)

The main fraud allegation

The main allegation against Focus came from Muddy Waters - the same firm that exposed the fraud at Sino Forest. MW gave us an 80 page report (that is freely available on their website). Sino-Forest was deep within my area of expertise and I was more-or-less instantly convinced that the whole Sino Forest story was made up. Focus Media is a much harder target for Muddy Waters because the company clearly exists. Their LCD screens and picture frames are pervasive in many large cities in China.

Whilst I was instantly convinced by the Sino Forest case (and hence was happy to short the stock to zero) it is harder to be convinced when the business so clearly does exist.

That said Carson Block and his Muddy Waters firm comes with some credibility because they predicated the complete demise of Rhino International and Sino Forest (both multi-billion dollar firms). Given Carson's street-cred I was surprised that Focus Media stock held up so well after Carson's attack.

Some people clearly saw a lot of value in Focus even if some part of Carson's allegations was correct.

The private equity bid for Focus

The people who saw value in Focus Equity include some of the most important private equity firms operating in Asia who are bidding for the whole company. Here is the release:

Aug.13, 2012 -- Focus Media Holding Limited ("Focus Media") today announced that its Board of Directors has received a preliminary non-binding proposal letter, dated August 12, 2012, from affiliates of FountainVest Partners, The Carlyle Group, 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 for $27.00 in cash per American depositary share, or $5.40 in cash per ordinary share... 

The bidders are a who-is-who of reputable private equity firms. FountainVest is run by Frank Tang who used to head China investments for Temasek (the Singapore Sovereign Wealth Fund). He represents Singapore Inc as much as a private individual can. The Carlyle Group is one of the largest private equity firms in the world. I have had my doubts about their China investments before - but they are large and reputable. CITIC Capital is a private equity firm associated with China International Trust and Investment Corporation which is effectively the Chinese sovereign wealth fund. CITIC Capital however is not the Sovereign Fund - rather an associated private fund. By all accounts it is Princeling Central. China Everbright is a Hong Kong listed financial firm clearly with links to the Chinese establishment. Bo Xilai's brother recently quit as a director. This group is a mix of Chinese, other Asian and Western establishment firms.

One bank mentioned in the press release is DBS - which again represents Singapore Inc. The only other bank mentioned is Citigroup - and they have provided a "confident" letter.

So where are we now?

What we have are some high-profile but rat-bag shorts on one side squealing fraud. And on the other side we have a who's who of Asian business wanting to take this private for the not-so-trivial sum of USD3.5 billion.

You see why I am obsessed? Right up my alley. And perhaps a test of my Guanxi vs Analyst thesis.

Is this a done deal?

This sounds like a done-deal. The largest shareholder in Focus is Fosun International - an HK conglomerate. They have publicly called the bid "attractive". The bid team contains Mr. Jason Nanchun Jiang - the CEO/Founder of Focus - and a man critical to the running of the business (apart from anything he controls the variable interest entity). Given that it contains the critical person and the main shareholder wants to accept it is likely the board will go along. And the bid is cheap enough that it is unlikely that - absent absolutely grotesque fraud - nothing that is found on due diligence will dissuade the buyers.

The parties are rich enough that $3.5 billion is a big - but not an intolerably large bite. They are up for it.

It is however subject to due diligence. The letter sent by the buyers to the company is attached to the press release. The last paragraph says it clearly:

13. No Binding Commitment.  This letter constitutes only a preliminary indication of our interest, and does not constitute any binding commitment with respect to the Acquisition. A binding commitment will result only from the execution of Definitive Agreements, and then will be on terms and conditions provided in such documentation.

And so we have a due-diligence period in which some of the most reputable and largest private equity firms will do due diligence on a company that one of the most famous rat-bag short-sellers asserts is a fraud.

Oh to be a fly-on-the-wall

I would love to be a fly-on-the-wall as they work out how to test the Muddy Waters allegations. Due diligence is sometimes (incorrectly) treated as a formality. But in this case the stakes are real. Billions of dollars are on the line and the very credibility of some firms (especially Carlye) are on the line with it. Carlyle has been burnt by some frauds in Asia before. If - after warning by Muddy Waters - Carlyle were to buy this firm and it turned out to be fraudulent the question would arise as to whether Carlyle staff were deliberately buying frauds to loot the Carlyle funds. My guess is that the very existence of Carlyle is at stake.

But Carlyle have competent staff laced throughout their organization. They will do their due diligence - and if the deal closes I think you can presume that Muddy Waters was wrong.

If the deal doesn't close with the backing of the the largest shareholder and at this pricing then you probably have to conclude that Muddy Waters is right. If Muddy Waters is right then the revenue and the margins of this firm are grotesquely overstated and the stock is probably going to settle somewhere below two dollars.

And with that you understand my obsession.






John

Disclosure: I think there is a reasonable chance that Carlyle - and perhaps some of the other firms in this syndicate will walk. In all honesty I have no idea whether they will or not but as the stock will wind up at $2 (or less) if they walk the bet is worth taking. So I am short and risk losing the difference between the current price (25 and change) and the bid price (27) if the deal does close.


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

Data sources for the addendum:

Here is the P&L for Focus Media from the last annual report:

FOCUS MEDIA HOLDING LIMITED

CONSOLIDATED STATEMENTS OF OPERATIONS

		For the years ended December 31,
		2009				2010				2011
		(In U.S. Dollars, except share and per share data, unless otherwise stated)
Net revenues		$	397,164,522			$	516,314,697			$	792,620,177
Cost of revenues			241,073,203				221,690,034				289,644,266
Gross profit			156,091,319				294,624,663				502,975,911
Operating expenses:
General and administrative			88,833,305				79,759,757				127,012,894
Selling and marketing			79,786,861				103,722,237				147,716,437
Impairment loss			63,646,227				5,736,134				—
Other operating expenses (income), net			13,111,043				(14,143,945	)			(16,137,695	)
Total operating expenses			245,377,436				175,074,183				258,591,636
Income (loss) from operations			(89,286,117	)			119,550,480				244,384,275
Interest income			4,945,946				7,259,508				15,538,943
Interest expense			—				—				716,956
Investment loss			—				1,287,881				—
Income (loss) from continuing operations before income taxes			(84,340,171	)			125,522,107				259,206,262
Income taxes			13,780,065				22,335,579				54,761,394
Loss from equity method investment			—				—				43,632,613
Net income (loss) from continuing operations			(98,120,236	)			103,186,528				160,812,255
Net income (loss) from discontinued operations, net of tax			(111,612,420	)			83,077,575				—
Net income (loss)			(209,732,656	)			186,264,103				160,812,255
Less: Net income (loss) attributable to noncontrolling interests			3,524,388				1,990,626				(1,864,783	)
Net income (loss) attributable to Focus Media Holding Limited Shareholders		$	(213,257,044	)		$	184,273,477			$	162,677,038
Income (loss) per share from continuing operations — basic		$	(0.15	)		$	0.15			$	0.24
Income (loss) per share from continuing operations — diluted		$	(0.15	)		$	0.14			$	0.23
Income (loss) per share from discontinued operations — basic		$	(0.17	)		$	0.12			$	—
Income (loss) per share from discontinued operations — diluted		$	(0.17	)		$	0.11			$	—
Income (loss) per share — basic		$	(0.33	)		$	0.26			$	0.24
Income (loss) per share — diluted		$	(0.33	)		$	0.25			$	0.23
Shares used in calculating basic income (loss) per share			651,654,345				707,846,570				671,401,000
Shares used in calculating diluted income (loss) per share			651,654,345				731,658,265				693,971,258

The accompanying notes are an integral part of these consolidated financial statements.

And here is JCDecaux's P&L - snapshot picture from their annual report...

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