Friday, August 31, 2012

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
  (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  
  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  
  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
  (7,615183,113  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(89,287119,551  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(84,341125,523  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(98,121103,187  160,812  
Net income (loss) from discontinued operations, net of tax
  28,048  (300,672(111,61283,078  —    

Net income (loss)
  145,130  (770,838(209,733186,265  160,812  
Less: Net income (loss) attributable to noncontrolling interests
  694  (1503,524  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.



equitval said...

The "in store" numbers jump off the page. I know nothing about what has transpired with that business, but it has gone from losing money at the operating line four years ago to 60% margins at lower scale last year.


David Merkel said...

I have a rule of thumb where I look at adjusted earnings period by period. In the short run, let management make their arguments for current profitability, but...

I also look at change in tangible book per share plus dividends over a long period -- that eliminates a lot of accounting shenanigans, and reveals management quality.

Just my 2 cents...

Anonymous said...

Love yr work on this. Did you follow Harbin?, a deal that defined Guanxi

Lucian Miers

Detlef Guertler said...

There may be a an interpretation E, John:
The write-offs, sell-backs and losses on disposal are related to numerous acts of window-dressing just before Focus Media's SPO in November 2007. Company and shareholders cashed in about 888 mn$ that day, and the management may have been tempted to activate all their friends and families to sell them dozens of hot or cool internet "companies" to show the dynamics and strength of Focus Media.
Just have a look at a (dismissed) lawsuit against the company claiming data falsification etc.
Of course the management has to get rid of these shadow acquisitions sooner or later - and the lion's share must have been written off in 2008 and 2009.
So we would talk about a one-off fraud five years ago.

Rowan said...

Sam said...

Just a correction: 2008 gross profit was $274m not $259m (that was COGS)

John Hempton said...

Sam - corrected. Thanks.

Anonymous said...

Great seriles of posts. My money is on option D. That would be the easiest wayto fool th eauditors especially if they are straight out of Uni.

Jason said...

Has there been an estimate of how long the due diligence period will last?

Anonymous said...

Citic Pacific lost US$1.6b in 2008.

Anonymous said...

We know that these types of business can have high profit margins, and that this company was one of the first movers in China and is a market leader. The losses were largely confined to a 2 year period following the IPO. So my vote is E (which is a variation on B).

Anonymous said...

John, did you catch that gross profit should be $270,144 for 2008 not 274,144. The remaining accounts are "right" mathematically at least. Seems an odd error to make and miss through 4 audit seasons.

KevinOn7 said...

If interpretation D is correct, maybe Olympus should send over a CEO and some auditors.

Anonymous said...

John, could you explain option C in a bit more detail. Why would this company in particular have had to pay such massive bribes in the past? Why would they need to do so again? (Isn't the controlling shareholder now going to remain a substantial shareholder after privatisation?) If the company does need to pay future bribes why couldn't they hide it by paying through a consultant/false supplier/other intermediary or through the current CEO?

Anonymous said...

All those losses were in 2008 & 2009. It seems that they made some high-risk investments that blew up when the global economy tanked.

In their 2009 20-F they gave fairly detailed explanations for the asset impairments & goodwill impairments. Basically it was the macroeconomic environment as well as some new regulations in China, including new anti-spam laws.

Although it does seem weird that they purchased CGEN Digital Media in early 2008, and then disposed of it later that same year.

eah said...

Good post with good info, but please proofread it.

What is the stock worth in interpretation D?

Why would you care? Would you seriously consider having anything to do with such ridiculous fraud? Are there not less 'muddy' waters to fish in?

At this point I will not touch a Chinese company under any circumstances. The country and its people simply cannot be trusted.

Anonymous said...

eah, please read the blog. John is often a short seller. If you happen to be short this stock then obviously you want to estimate how low the share price will go so you know when to cover.

Mario said...

this is fascinating. I love your work. Thank you for sharing.

My overall question is why would anyone do this? Simply to avoid paying taxes? hah! It all seems so funny that people would go through such trouble and create such "worlds without end" simply avoid taxes. So funny to me. Of course it could also be (and probably is) money laundering so that's a rather different story then. Thanks again and keep up the good fight!

JM said...

Not incredibly relevant, but probably a bit representative of the depth of the auditors work: The gross profit number in 2008 is wrong. If you calc through to the bottom, the numbers are fine, but the gross profit number is wrong.

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