Death, Ferraris and naked exotic girls: racism, politics and garbage data in China

The Western Press is following a mid-ranking story in Chinese politics with more than average fervour because it is so salacious.

Ling Jihua - an aide to Hu Jintao - it seems will have a hard time being elevated to the Politburo Standing Committee. Why? Because his son (Ling Gu) died in a high speed car crash in a Ferrari.

This post is about the propaganda part of the story as reported by the South China Morning Post:

The semi-naked passengers were ethnic Tibetan and Uighur students from Beijing’s Minzu University, one of whom was now paralysed.

Now a Ferarri Spider 458 is not exactly a big car. And playing with not one but two semi-naked students in such a confined space whilst driving at (say) 200 kilometres per hour stretches my imagination (but then I am a happily and conventionally married man so maybe my imagination does not go very far).

It seems significant that the other passengers were a Tibetan and an Uighur - their race matters.

Bill Bishop - a fairly astute China watcher - tweeted that he was sceptical of that detail - a detail released to cause maximum damage to Ling Gu's (and hence Ling Jihua's) reputation. Bill Bishop's scepticism is well-founded. If you are going to do a character assassination doing it in a race baiting manner works in China as it does in other countries.

That said, I asked the best connected China watcher I know whether he though the story as presented (two naked students of minority race in a small car) was plausible. This China watcher knew Ling Gu personally. And the response came back that that seemed just like the kid.

The death is real. But like everything else in China it all comes wrapped in a story where you have to question every detail.

And even when you question them its hard to decide what parts of the story are true.

That is how it is with most Chinese data. Spin beats truth enough of the time to make you question everything.





John

PS. I have been reliably assured that the Chinese gossip version of this story is that the women were high class hookers - and the deceased's dad is responsible for much Tibetan and Uighur policy.

The mysterious case of the disappearing competitor: Focus Media edition

JCDecaux - the French multinational giant - is the largest display advertising company in the world. They also claim in their latest annual report to be the largest display advertising business in China.

Every year they publish in their annual report a list of the largest display advertising businesses in the world - their competitors.

Here is that list from the 2007 annual report :

On this list, Focus Media is the 8th largest company in the world in this space.

And here is the list from the 2008 annual report:

Again we see Focus Media - now the sixth largest display advertising company in the world.

Here is the 2009 list:

Peculiarly Focus Media is nowhere to be seen on this list (by the end of 2009 it should have risen to fifth place).

Focus Media is no longer mentioned in JCDecaux's 2010 and 2011 accounts.

Why?

Well I can think of two hypotheses:

The first is that JCDecaux want to sustain their claim of being the biggest display advertising business in China - a claim that is simply not tenable if they include Focus Media in the comparison. Moreover they don't want to increase the credibility with advertisers of Focus Media and its products. After all Focus Media has substantially outperformed JCDecaux in China - growing much faster and at much fatter margins.

An alternative hypothesis is that they don't believe Focus Media's numbers.






John

PS. I first found these lists when researching China Media Express. CCME supposedly competed with JCDecaux in placing adverts on public transport (in CCME's case mostly buses including airport buses). CCME however was a complete fraud and the stock now trades at 2c. Focus Media is obviously real - their displays are widespread.

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

Focus Media - focus on movie screens

I am obsessed as to what the due-diligence on Focus Media done by the private equity firms might look like and what it might find.

Lets start with the easy stuff.

Probably the easiest place to do due-diligence on Focus Media is the theatre screen business. Focus Media claims to display advertising on roughly a quarter of the cinema screens in China - but this is still a relatively small number of cinema complexes (316 at last annual report).

It is almost impossible to audit more than 100 thousand LCD screens - at least without a small army and a sampling method. But checking out whether the numbers make sense in 316 theatres is relatively simple. A sample could include a large proportion of the total without being prohibitively expensive. Those 316 theatres probably have only 30-40 owners (most owners own chains). That will make the testing easier still.

And I think the private equity bidders probably will test this (as part of their due-diligence) because the theatre business raises red-flags which animate the bears in this stock. The central issue seems to be the number of theatres and the size of the multiplexes - however I think Focus have largely cleared up that story.

But I should run you through it anyway.

The controversy around the number of cinema screens Focus places adverts on

You would think that counting cinema screens and number of theatres is easy. They are big things. They don't run away. If I said I was opening a film on 270 screens you would know what I mean. These statistics have well defined meanings - and those meanings don't seem to change much.

Except in the case of Focus Media.

Here is a disclosure that mentions number of theatres focus runs adverts in (from a 20F for the year ended 2009.)

Net advertising service cost-movie theatre and traditional outdoor billboards. We incurred advertising service cost of $56.9 million in 2008, a 99.6% increase from $28.5 million in 2007. The increase is primarily due to (1) our acquisition of Huaguang, the subsidiary operating the traditional billboard business in 2007. We consolidated Huaguang’s results of operation only after the acquisition was consummated, while in 2008 we consolidated their full year costs of revenues; (2) the increase in the number of billboards leased from 492 in 2007 to 542 in 2008 in response to greater customer demand; and (3) increased leasing costs associated with time we rent on movie theatre screens as a result of an increase in the number of theaters we leased in our network from 10,930 in 2007 to 27,164 in 2008.

The bold section is pretty clear... a result in the increase in the number of theatres we leased in our network ... to 27,164 in 2008.

This number and similarly large numbers are laced throughout Focus Media's filings. It is not a one-off number.

There is a problem with this number.

A big problem.

There are not that many theatres or screens in China!

In March 2011 the LA Times did a story on the cinema building binge in China. At that point there were 6,200 screens in all of China up very sharply since 2008. According to Government statistics there were only 1545 screens in all of China at the end of 2008. 

Focus media says they had 27,164 screens. The government says there were only 1,545 screens in the country.

Unsurprisingly Focus has amended its numbers. Here is what they say in the latest annual filings:

Movie theater advertising network

We operate our movie theater advertising network by selling leased screen time as time slots to advertisers. We have the right to screen time prior to the screening of each movie shown in the theater. As of December 31, 2011, we had rights to lease advertising time on screens in 316 movie theaters (consisting 2,190 screens) in cities across China.

How did they reconcile these numbers?

Well they said that they counted as a "theatre" a "screen in which an advertiser had agreed to buy space". That means if 10 advertisers had chosen to show advertisements in a theatre with one physical screen they counted it as 10 theatres.

As of December 31, 2010, we had rights to lease advertising time on screens in 260 movie theaters (consisting 1,553 screens) in cities across China and Hong Kong SAR. Prior to 2009, we calculated the size of its movie theater network by calculating the number of screens on which each of its advertisers had purchased advertising and then summing the screen count for each advertiser to produce an aggregate number of screens. With a change in management in late 2008, we changed the method for calculating this operating metric beginning in 2009, basing it instead on the number of movie theaters for which we had rights to lease advertising time as of the relevant period, regardless of the number of screens in such theaters or the number of advertisers that had purchased advertising on each such screen. The large decrease in screen count for the movie theater network over this period was a reflection of this change in calculation methodology.

That is a mess. At minimum it is a definition of theatres that I was previously unfamiliar with. But Focus now tell us what they say are the true numbers on standard definitions - numbers that I have no ability to prove, nor disprove, but that I would expect would be part of the due-diligence brief that the Carlyle and others will undertake.

The size of this business

Even on the amended numbers this business is large. In both 2010 and 2011 the number of screens is about a quarter of all screens in China. It is a business that should be highly visible and fairly easy for the PE funds buying Focus Media to do due diligence on. Here is a way to do it:

Ask them to tell you a list of all screens. Pick a screen out-of-town. Ask them to tell you what adverts are on it. They should have records because they need to bill the advertiser (if they claim no records you know they are fraudulent). Then take yourself to the cinema. Have some popcorn. If you really want a good time do it on a sample-basis - check five screens and catch up all the films you missed out on.

Who said being an investment banker or PE guy you don't have time to go to the flicks!

Sustainability of Focus Media's margin

Focus Media's theatre screen business has a fat margin. According to the last annual filing the revenue associated with this business was USD50.8 million. The costs USD25.7 million. This is a gross margin a little over 50 percent - considerably larger than display advertising businesses outside China. Indeed this is a fatter margin than any non-Chinese display advertising business I can find.

I guess that is possible if Chinese screen operators are very stupid and lease space to Focus Media at rents that are too low. (Relatively dumb local governments have long been the explanation for JCDecaux's relatively fat margin in street furniture advertising...)

But the margin has been that fat for years. And the multiplex developers are almost by definition large property developers used to screwing as much revenue out of projects as possible. Moreover this company is on-the-numbers very heavily into multiplexes. Between 2010 and 2011 they added 56 theatres and 637 screens. The incremental theatre seemed to have something like 11 screens.

An explanation that large-scale property developers are more stupid than local governments looks difficult to sustain. Maybe they are - but local governments don't stay that stupid (the renegotiated street furniture terms are never as sweet) and Chinese multiplex owners will learn too. The largest Chinese multiplex owner now owns AMC in America. AMC probably know a few things about maximizing the revenue on their screens.

Unless I am mistaken - as the screen owners wise-up (just like local governments wise-up) the margin in this business is going to come down. Unless there is some magic-secret-sauce in this business I don't understand. Sustainability of margin is likely to be a problem.

Revenue per screen

The number of screens started 2011 at 1553 according to the disclosures above. They ended at 2190. A simple arithmetic average suggests the company averaged about 1870 screens.

Revenue for the year was USD50.8 million. That is revenue per screen of USD27,144.

I spent a lot of time trying to work out whether this number was plausible - and found that it was high but still plausible. I found an American media executive familiar with this industry who told me that the revenue per screen in the US was about USD20-30 thousand. Focus Media is on the high-end of that but still within the range.

Advertising rates in China are usually a fair bit lower than the US - perhaps cinema screens are an exception. On these numbers rates look to be about the same as the US.

That Focus Media secret magic sauce

I have no particular reason to doubt the new number of screens that Focus Media claim to run. The old number was false - but according to Focus Media the problem was one of counting methodology - not fraud.

The new number of screens is about a quarter the total in China - that would surely make them one of the major players.

And they are very multiplex focused with average screens per theatre way higher than average and climbing sharply.

Usually I would assume that multiplex owners were a sophisticated lot who did not leave a fat margin on the table for a player like Focus Media. But there is a 50 percent margin here in a business you would normally expect to have a thin margin. After all the eyeballs belong to the theatre owner and not to Focus Media.

They must be doing something special. Some magical secret sauce if you will.

If I were the private equity buyers I would like to work out what that is - because without knowing you can't assume that the secret sauce is sustainable. (My bet is that it would not be sustainable.)

Oh, to be a fly-on-the-wall

As I said in the first post I wish I were a fly-on-the-wall whilst due diligence is done on that company. I want to understand that secret sauce. It is clearly a way of making money and that is what my clients pay me for.



John

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