Focus Media: One strange disclosure, three interpretations

Here is a disclosure from the Focus Media 20F filing:

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.

I want you dear readers to read and try to understand this disclosure.

It says that we (Focus Media) were planning to IPO our internet advertising segment but we aborted that plan "due to the economic recession of late 2008". In other words we thought they were businesses worth taking to IPO.

Instead we took seven of our businesses and disposed of them at losses.

Six of them we disposed of to the original owner.

WonderAd and several others were given to the original owners. 14,926,003 dollars was paid for WonderAd. That was also the loss on disposal - so presumably the business was given back to the original owner. Same is true of Jiahua, Wangmai, Jichuang and 1024. Donggyuan Yaya was also given away.

There was a loss on disposal of $44.1 million from these subsidiaries.

Prior to disposal these subsidiaries had $127.6 million in revenue and $45.4 million in pre-tax losses. So they were big revenue earners - but presumably they had over $170 million in costs. In China where wages are low that is a lot of costs - they appear to have been large operations with a lot of staff.

Because they had large losses ($45.4 million pre-tax) and they did not collapse I presume that Focus Media injected a great deal of cash into the subsidiaries before it gave them back to the original owner for whom in most cases the ownership vehicle was an untraceable British Virgin Islands company.

I have three possible interpretations - and without doing due diligence I could not easily be certain which (if any) is the correct interpretation.

Interpretation A: the accounting statements are entirely accurate

In interpretation A the accounts are entirely straight. Focus Media purchased many independent British Virgin Island companies running internet advertising businesses in China.

These businesses had well over $100 million revenue.

However they all failed and cash - probably $40 plus million - needed to be used to fund operating losses.

Given the (not inconsiderable) pain of funding those operating losses they wanted to close the businesses. But rather than close them they found that the original owners were happy to take them back for no consideration. Presumably the original owners can fund the losses and know how to turn the businesses around.

So they gave the businesses back to their original owners for no consideration and closed the book on the whole sorry saga.

Interpretation B: Focus Media management participated in the looting of Focus Media

These businesses were good or bad or possibly even non-existent. However over $40 million dollars was paid for the businesses and the businesses were given back to the original owner (making the original owners $40 million better off). Moreover a further $40 million was injected into the businesses to just zip up the scale of the looting to something even more attractive for the thieves.

That is why you would do it in the British Virgin Islands. No tax to pay on stolen money - and the companies are untraceable. Yipee!

Interpretation C: The money was never there, the losses are fake and they are used to wash fake profits

In interpretation C, Focus Media reports fake profits over its main businesses. These fake profits result in fake cash on the balance sheet (something that is easily found by auditors). So they produce fake losses to offset them.

What better way to fake losses than buy some businesses, have operating losses and write them off?

And where better to locate the fake businesses but the British Virgin Islands where they are untraceable?

In this interpretation the underlying profitability of Focus Media is grotesquely overstated. When the fake transactions stop the fake losses stop and the fake profits get revealed. The poor private equity buyers (and the suckers who lent them 1.5 billion dollars) are left holding a turkey.

Summary

As I said it is very hard to tell which interpretation is correct without doing due diligence. But due diligence is going to be very hard because the losses are buried in untraceable British Virgin Island subsidiaries. I hope Focus retained enough documentation to verify the first interpretation - and I hope the auditor has traced the BVI subs. Moreover I hope the original owners can be found.

Which interpretation is found to be correct under due diligence matters a lot for the take-private deal.

The first two interpretations are acceptable to the PE buyers and if either is true the deal will probably close.

If the acquisitions were bad (as per the first interpretation) then the PE buyers can stop that prospectively. After all PE buyers can do due diligence and do not have to close bad acquisitions.

If the company was looted (as per the second interpretation) then the PE buyers can stop that prospectively - after all Carlyle and Fountainvest should be competent to construct rigorous financial control of businesses that they acquire.

The third interpretation is utterly terrible for Focus Media stock. In that case Focus Media is a Chinese display media company that uses very complex BVI transactions to fake their profits. Real profitability would be low - but ultimately unknowable. The privatisation will fail under due diligence.

Moreover what is left would be a Chinese display media company which fakes their accounts using untraceable BVI entities. What is that worth? Certainly far less than the current multi-billion dollar market cap.

Now of course off the disclosure I can't tell which of these three interpretations is correct. But if the deal fails then intellectually you are led to the third interpretation. The upside for the stock is to $27 - the bid price. The downside? Large.


John

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