Focus Media - big rewards and big risks for private equity firms

I believe you judge the quality of a private equity firm by its ability to say no to a deal.

If you have a billion dollars (or 20 plus billion dollars as in the case of some PE firms) then everyone wants to sell you something. [When I was a fund manager at a firm with 20 billion dollars I used to joke that everyone wanted to be my friend!]

People will sell you anything based on numbers or projections and at minimum what you needed to do was follow Ronald Reagan's dictum: trust but verify.

Focus Media (my new obsession) is a deal requiring verification. 

Focus Media's buyout is attractive on the stated numbers. As of the last results Focus had 758 million dollars in cash, restricted cash and short term investments - and a little over 200 million in borrowings (net cash of above 500 million) and was earning roughly 83 million of operating profits (on their non-GAAP measure) per quarter (call that 330 million per year). Moreover the company has history of very fast growth. The incremental capital returned for growth is low - so incremental ROEs are very high. 

If these numbers are real and sustainable the Private Equity bid to take the company private is likely to be a lay-down winner. Especially if the growth continues.

However these numbers must be verified. Rat-bag short-sellers have argued this company has fraudulent numbers. Allegations to that effect are all over Seeking Apha for instance. Muddy Waters - the firm that bought down Sino Forest - have published an 80 page report detailing what they believe are frauds at Focus Media.

That said, short sellers can be wrong. And the Private Equity firms may be buying a bargain - a bargain driven to bargain levels by nefarious (or just plain erroneous) short sellers.

The PE firms have an advantage

Private Equity buyers can do something that us poor equity investors can't. They can do thorough due diligence. They can check the transactions, they can talk to staff at all levels, they can forensically examine the books. They can probably even ring Carson Block at Muddy Waters (the most prominent critic) and ask him to send his most damning evidence - and they can seek to confirm or falsify Carson's arguments.

If an ordinary investor tried to do what would be ordinary business for a PE firm they would be guilty of insider trading.

In other words they can check whether it is a fraud and you - dear readers - cannot. They have a competitive advantage over you and they have a competitive advantage over me.

And being competent (at least I presume Carlyle, FountainVest etc are competent) they will use that advantage.

To that end though I wish to start them on their way. 

The US Securities and exchange commission has specific correspondence with US listed firms when they question something in the accounts. Sometimes this correspondence is kept private. Sometimes it is included in filings. Sometimes it leads to formal SEC inquiries which may or may not be made public.

Here is a list - with links - of the released component of the formal public correspondence between the SEC and Focus Media. 

1. Letter dated 1 October 2010 requesting more time for answering questions from SEC staff.

2. A further letter - dated 28 October 2010 asking for more time for answering questions from SEC staff. 

3. A further letter - dated 19 November 2010 asking for still more time for answering questions from SEC staff. 

4. A relatively long set of answers dated 10 December 2010. There are a few things I learned here - like that the controller of Focus Media (Jason Jiang or JJ for short) has taken out Singapore citizenship. There are other things that travel closer to the Muddy Waters allegations (such as goodwill write-downs). This filing was accompanied by an amended annual report.

5. A letter dated 9 January 2012 requesting more time to answer SEC requests.

6. A longer reply dated 20 January 2012 which was also accompanied by an amended annual filing. There are a few strange disclosures in here - for instance the company removed their claim that they were a "leading provider of internet marketing solutions in China" from their report. (Other gems abound in these filings.)

7. Another long letter dated 13 February 2012 responding to more SEC questions. This letter was also accompanied by an amended annual filing. 

8. A letter dated 6 March 2012 which requests more time to respond to SEC inquiries.

9. A letter dated 22 March 2012 which also required amended annual filings.

10. A letter dated 3 April 2012 requesting more time to file amended annual filings.

11. A letter dated 18 April 2012 requesting more time to amend annual filings - but also answering basic questions of financial control (like possession of the chops). 

12. A letter dated 24 April 2012 accompanying amended filings. 

Phew - that was a lot. These letters are not easy reading.

Process and risks in due diligence

Here is my point: if a bunch of lawyers without access to inside information at the SEC office can think of such an extensive and difficult to answer set of questions then the private equity firms - with inside information - should be able to ask and answer many more questions.

These questions only scrape at the beginning of what the more vocal (but possibly less credible) shorts have been saying about the company. 

The private sector due diligence people are possibly more competent than the SEC officers (certainly they are paid far more) and they have full access to the books in China. So this due diligence should be done and it should be thorough.

Further because of the allegations around this company a thorough due diligence will be expected. It would be deeply embarrassing for a PE fund to close this deal and afterwards determine that they had been swindled (as per the way Richard Heckman was swindled in China).  

Further - given that the SEC has paid a fair bit of attention to this company - you can guess that at least some people at the SEC have their doubts about this company and its disclosures. If a PE firm were to buy this company and later discover it was a fraud they would run a real and nasty risk that the SEC would switch their investigation to them.

The risks to the private equity firms are thus uniquely high here. This is a large cheap transactions with an extensive SEC history of investigation and with untested fraud allegations.

If the PE buyers are right they make good money. And as it is the biggest deal in China that win could be huge.

But if the people alleging fraud are right not only will the PE firms lose money, but they will lose a lot of reputation and they will probably score a major SEC investigation into the process.

Big rewards. Big risks. And all soluble with thorough due diligence.

John

Focus Media giving away cash?

I am becoming obsessed by the disclosures about the businesses Focus Media disposed of in 2009. The full disclosure is in this post - and an explanation as to why Focus Media's accounting must be wrong is in this post.

But to summarize - Focus Media disposed of seven businesses in 2009.

All businesses were disposed of at a loss.

Six of these businesses were given away for no consideration at all. In one consideration of a low single digit number of millions of dollars was paid.

A majority of these businesses were given back to their original owners.

A majority of these businesses are in British Virgin Islands subsidiaries.

And the accounting for these transactions is messed up.

That said, the cash flow statement from the latest 20F provides more information.

Here is a section from the cash flow statement:

Year			2009				2010				2011
Investing activities:
Purchase of equipment		$	(10,654,598	)		$	(18,692,608	)		$	(38,918,317	)
Cash of disposed subsidiary			(27,315,949	)			(40,805,068	)			—
Proceeds from sale of a subsidiary			—				116,872,231				7,296,097
Purchase of subsidiaries and earn-out payment paid to acquire subsidiaries, net of cash acquired			(92,411,545	)			(40,186,684	)			(13,228,135	)
Investment in an equity method investee			—				—				(61,003,263	)
Deposit refunded to acquire subsidiaries			329,516				—				—
Proceeds from disposal of fixed assets			196,115				471,128				671,950
Increase in restricted cash			—				—				(199,346,126	)
Cash paid for short-term investments			(29,257,303	)			(137,551,150	)			(1,124,033,872	)
Sale of short-term investments			865,589				29,290,296				1,044,680,415
Net cash used in investing activities		$	(158,248,175	)		$	(90,601,855	)		$	(383,881,251	)

I want you to notice the highlighted line...

In those susbsidiaries disposed of in 2009 there was embedded 27,315,949 dollars in cash.

These subsidiaries were given away.

If you interpret the accounts literally this company has been giving away cash.

I have a handful of explanations for this behaviour but plausibility is becoming strained. Perhaps Focus Media's investor relations department can help (I have sent them this post in advance but have received no reply).

Anyone else with an explanation could you please put it in the comments.





John

Puzzled at the wealth of Chinese civil servants - Jiang Weiqiang and Focus Media edition

An old 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.

Now the only Jiang Weiqiang I can find works as a civil servant for one of the most powerful of Chinese departments - the State Council Information Office. Here is an English language CV:

Jiang Weiqiang

Director-General, International Bureau, State Council Information Office

Jiang Weiqiang and his State Council Information Office colleagues was set to play a leading role in Beijing's media courtship of Africa ahead of the fourth Forum on China-Africa Cooperation in Sharm el-Sheikh, Egypt in November 2009. At the FOCAC Media Seminar in Beijing, 15-19 July, Jiang tried to develop a united front with African state media organisations. He insisted that the message of China-Africa cooperation should be taken directly to the people and not depend on Western media, which he described as anti-China and anti-Africa. Representatives from 27 African countries attended, as did Assistant Foreign Minister Zhai Jun and Liu Yunshan, Politburo member and Director of the Central Propaganda Department. 

Trained as an engineer, Jiang entered the People's Liberation Army in 1970. While serving, he studied English at the Luoyang PLA College of Foreign Languages, responsible for training intelligence agents. In 1991, Jiang left the PLA to join the SCIO, the administration overseeing China's state media, including the People's Daily newspaper and Xinhua news agency. Xinhua is planning its own multi-billion dollar global and African media expansion.

My questions: is this the same Jiang Wieqiang? And if so (and it seems so) how does a Chinese civil servant come up with USD2.5 million to make an unsecured interest free loan to a business controlled by his son?

I seek help from anyone with a well-followed Weibo account. If this can be crowdsourced in China then I might get good answers.

Thanks in advance.

John

Focus Media - the key post: Four interpretations of the accounts

Focus Media is - on the published accounts - a very profitable company. It has 63 percent margins gross margins and net margins over 30 percent (all cash returns) in a business where industry comparable net margins are generally substantially lower.

However, over time, Focus Media has taken some enormous write-downs. Here are the five year profit and loss accounts:

	For the years ended December 31
		2007				2008				2009				2010				2011
		(In thousands of U.S. Dollars, except share and per share data)
Selected Consolidated Statements of Operations Data:
Net revenues:(1)
LCD displays		$	184,643			$	244,540			$	208,799			$	297,642			$	444,365
In-store			27,444				60,719				30,346				37,777				56,374
Poster frame(2)			85,472				146,751				98,962				121,893				185,449
Movie theatre			5,259				10,335				9,436				18,095				50,835
Traditional outdoor billboard			32,046				66,843				49,621				40,908				55,597
Total net revenues			334,864				529,188				397,164				516,315				792,620
Cost of revenues:
LCD displays			52,648				80,451				76,418				67,513				85,847
In-store			23,502				61,834				24,170				23,432				20,582
Poster frame(2)			28,086				59,815				95,401				84,487				110,370
Movie theatre			2,941				6,598				7,063				13,849				25,753
Traditional outdoor billboard			25,555				50,346				38,022				32,409				47,092
Total cost of revenues			132,732				259,044				241,074				221,690				289,644
Gross profit			202,132				274,144				156,090				294,625				502,976
Operating expenses:
General and administrative			42,452				79,162				88,833				79,760				127,013
Selling and marketing			53,523				82,258				79,787				103,722				147,717
Impairment loss			—				377,629				63,646				5,736				—
Other operating expenses (income), net			(7,615	)			183,113				13,111				(14,144	)			(16,138	)
Total operating expenses			88,360				722,162				245,377				175,074				258,592
Income (loss) from operations			113,772				(452,018	)			(89,287	)			119,551				244,384
Investment loss			—				—				—				1,288				—
Interest income			9,239				7,130				4,946				7,260				15,539
Interest expense			17				—				—				—				717
Income (loss) from continuing operations before income taxes			122,994				(444,888	)			(84,341	)			125,523				259,206
Income taxes			5,912				25,278				13,780				22,336				54,761
Loss from equity method investee			—				—				—				—				43,633
Net income (loss) from continuing operations			117,082				(470,166	)			(98,121	)			103,187				160,812
Net income (loss) from discontinued operations, net of tax			28,048				(300,672	)			(111,612	)			83,078				—
Net income (loss)			145,130				(770,838	)			(209,733	)			186,265				160,812
Less: Net income (loss) attributable to noncontrolling interests			694				(150	)			3,524				1,991				(1,865	)
Net income (loss) attributable to Focus Media Holdings Limited Shareholders		$	144,436			$	(770,688	)		$	(213,257	)		$	184,274			$	162,677

I want you (dear readers) to study these as they are key to the whole Focus Media story and this is the key post in this sequence.

In 2008 for instance Focus Media had gross profit of $274 million. But it also had an impairment loss of 377.6 million and other operating expenses (associated with discontinued businesses) of a further 183 million. On top of this it had a loss of 300.7 million from discontinued operations.

This wound up in the small manner of USD770.7 million in loss for the year.

I stand to be corrected but that is one of the largest losses ever incurred by a public company in China. Whatever - it is a very big number.

Write downs and losses from discontinued operations were a feature of 2009 as well.

The profits and losses (just taken from the above table) over the last five years are as follows:

2007 - USD 144.4 million
2008 - USD 770.7 million LOSS
2009 - USD 213.3 million LOSS
2010 - USD 184.3 million
2011 - USD 162.7 million

The aggregate profit for Focus Media over five years is a net loss of over half a billion dollars.

This is very strange. Focus Media is a hyper-profitable business that makes huge losses.

They made these losses on businesses that they have purchased and disposed of (at a loss) and businesses that they have purchased and discontinued after operating losses.

Some of the disclosures regarding the disposals are unusual. For instance there are many instances I can find of a company being purchased for a lot of money and then given back to the original owners (see the discussion of 2009 dispositions for a few examples).

When a business is purchased for a lot of money and then given away to its original owners you would expect the SEC to raise their eyebrows. However Focus Media has insisted in multiple documents that the recipients of this largesse are not related parties.

Four possible interpretations of the accounts

I am going to give you four possible interpretations of the accounts. I am not doing due diligence on this company, I have no access to inside information and can only make educated guesses as to the probability that any of these interpretations is correct. However as the company has been audited you would have to guess that (A) below is most likely.

Interpretation A - the accounts are straight

The first interpretation is that the accounts are absolutely straight and the company is absolutely straight. As these accounts are audited by Deloitte this is the situation you would normally expect.

In that case this is a stupendously profitable company where the profits over the years (and then another half a billion dollars) have been squandered by existing management on a bunch of really bad acquisitions.

If Interpretation A is correct the Private Equity buyers will get a fantastic deal with this transaction. After all - they will be buying a stupendously profitable company and the PE buyers - if they have any skill at all - will take over the capital allocation. The really bad acquisitions will stop.

Interpretation B - the company is being looted through deliberately awful acquisitions

The second interpretation is that this is a hugely profitable company that has over time over half a billion dollars in operating profits - but the management of the company are venal and have stolen this money by buying assets from friends (or related parties) at inflated prices.

When I see a set of accounts that look like this looting is the first thing I think of. After all - audited accounts for 2011 show that this is a really great company - however over time that greatness has accrued primarily to the people they have purchased assets from.

I guess that is why the SEC wanted - in their correspondence - to assure themselves that the parties that sold assets to Focus Media were not related parties. I have no particular reason to believe or disbelieve the assurances of Focus Media on that issue other than that I would expect Deloitte to have examined the matter.

If Interpretation B is the case then the PE buyers should still probably close the deal (they will be buying a stupendously profitable business). But PE buyers will have their work cut out. The current management (who it appears have done a fantastic job of running the business) are - in this interpretation - crooks - who need to be watched abnormally closely. You probably want to leave then running the business - but you certainly don't want them near the money.

[If this interpretation is correct the management probably won't stick around anyway - they have already got rich on looting...]

Interpretation C - that the disclosed losses are a cover for political corruption


A third interpretation is that the money was deliberately lost by the company through all those acquisitions and the losses funded bribes.

In this interpretation the company did not really “lose” the money. Its payments was bribes that if honestly accounted the company might have expensed.

If this interpretation is correct then the private equity buyers will walk. Firstly, if properly accounted the bribes would be expensed - and that would bring the business down to a normal level of profitability. This is - in interpretation C - not a massively profitable business.

Moreover Carlyle in particular cannot run this business – because after the change in ownership the recipients of the bribes won't stay bought – and Carlyle - as owners - can't buy them again because it would expose Carlyle to the Foreign Corrupt Practices Act. The FCPA is probably the most commonly criminally enforced white-collar crime provision in the US. A reputable American firm does not want to go there.


Interpretation D - the company is faking its profits and balancing its books through fake losses on acquisitions and fake losses on discontinued business

Interpretation D suggests that no looting is involved. Instead the company has consistently faked its revenue up by reporting as revenue money it never received and never will receive.

The problem with reporting as revenue money never received is that over time the books don't balance. Auditors go looking for the cash and it is not there because it was never received.

In that case the company has to pull some stunts to make the books balance. The easiest way is to take their fake cash and make a fake acquisition. That makes the fake cash disappear into fake goodwill.

Over time you have to write off that fake goodwill otherwise the auditor will go looking for the attached asset. To make sure the auditor can't look for the fake asset you either close it or give it away. Then it is gone for good - but you get a write-off as you do this. In this interpretation those write-offs have tallied over a billion dollars.

In this case the PE buyers don't want to buy the company. They are buying a business that is break-even not profitable. The acquisitions made (and losses taken) are simply the way in which the books balance.

Muddy Waters and interpretation D

Muddy Waters published quite a deal of material that was consistent with but did not prove interpretation D. Some of this is well known. For instance this company has a habit of buying assets for large sums, running them for a while and giving them back to the original vendor. That is certainly consistent with Interpretation D.

Moreover some evidence exists that the revenue numbers are on the high side. For instance the seemingly high level of revenue per screen (as per this post) is consistent with Interpretation D. Previous disclosures where they appear to have overstated the number of screens are also consistent with Interpretation D.

To the Private Equity buyers: in doing due-diligence on this company you need to think about Interpretation D and how you test for it. Because if D is right then - dear Private Equity buyers - you are buying a turkey.

What is the stock worth in interpretation D?

Interpretation D is the interpretation with the sharpest negative implications for the stock. What is says is that the entire numbers of this company are garbage - and the real profitability - evidenced over the last five years - is likely negative or somewhere near it.

If interpretation D is correct the stock should settle at a very low value. (I have some ideas on how to work out the value but they are quite speculative... diligent readers might make some estimates themselves. My estimates come in under $2 at a maximum...)

For consideration.








John