Tag Archives: possible frauds

ZAGG: Anatomy of a Stock Market Triple-Team Takedown

7 Jul

While the past 6-12 months have seen a marked increase in the number of “short-seller” reports (or hit pieces, depending on your perspective), seldom have we encountered situations wherein more than one participant or observer highlights warning signs at the same time, or wherein the company releases potentially troubling news concurrent with these reports.

Today is one of these rare occasions where the short-sellers stars align.  The trifecta of pain, in no particular order:

1. (In)famous short-seller-cum-analysis-shop Citron Research released a report on ZAGG, Inc, a maker of cellphone protectors and other accessories raising a number of orange and red flags.  I strongly suggest you read it in its entirety before continuing.

2. Roddy Boyd – author of the authoritative book on the rise and fall of AIGreleased a report on his website highlighting not only the shady past of ZAGG‘s executives and directors, but the firm’s reliance upon one commoditized product to generate HUGE revenue gains and margins in an industry known for razor thin ones.  ZAGG’s balooning inventory balance should be of particular concern, increasing 5-fold year over year and almost 19% in the past three months, as Roddy explains:

It even continued to spike after a sharp revenue drop from the fourth quarter last year to this year’s first quarter, something that made no sense (then or now.) Some growth in inventory is naturally warranted as sales expand but this seems to defy logic. From an investors point of view, the “beauty” of this business is that it’s easy to rapidly produce a large volume of finished product, so maintaining large inventories of raw materials and work-in-progress is unnecessary. [Actually, large inventories are counterproductive for Zagg since the cellphone/mobile-device market is evolving so rapidly that models come and go, often in little more than a year, leaving older shield models virtually worthless. Moreover, polyurethane film is hardly a rare commodity, so storing a ton of it makes little sense.]

The firm also just acquired a maker of earbuds and other similar cell phone/mp3 player accessories, for a whopping $110 million, whopping considering prior to a recent run-up in the stock, ZAGG itself was not worth much more than that (and still isn’t by reasonable comparison).  This acquisition was in no small part financed by a $45 million term loan from notoriously investment firm Cerberus Capital Management and PNC (a $45mm revolving credit facility was also arranged concurrently).

While not unparalleled, firms that are growing revenues 200% and net income 300% per quarter generally don’t 1. (need to) make transformative/material acquisitions, and 2. need significant debt financing (cost of capital discussions aside for the time being).  This is unless, of course, they are hemorraging cash (usually from operations), as ZAGG appears to be doing, specifically in that inventory balance.  In fact a cursory look at their last 10-q indicates had the firm not monetized its receivables, it would have lost significantly more cash than it did.  

3. The company filed a statement of an offering of exempt securities (form D), stock issued to help finance the aforementioned acquisition.  Again, while not unheard of, this filing is sufficiently vague to raise an eyebrow, after all, they disclosed neither the amount of (proceeds from) securities sold nor the investors who bought them, only mentioning that there were 5 investors.  Perhaps there’s some fair explanation in other filings I missed in my cursory read, but considering the warnings raised by Citron Research and Roddy Boyd, I wouldn’t be so quick to just ignore it.

There are possible explanations for these flags, however I don’t think any prudent investor should give the firm (and its management) the benefit of the doubt, quite the contrary you should take a deeper look into the firm’s SEC filings and ask a few questions.

Why, for example, is a firm with such huge revenue and income growth also growing inventories so fast (+19% in q1), while fixed assets (Property, plant & equipment) bare budged (+3%)?  They say they outsource high-volume precision cutting and even some packaging of their products, which makes me wonder what exactly the firm does in its “manufacturing” facilities (which are leased), and what equipment (computer and otherwise) it really needs, short of a few dozen PCs and some relatively affordable warehouse equipment.  $500,000 in computer equipment & software and another $930,000 in “Equipment” at year-end seems a bit high for a firm that doesn’t actually do any real manufacturing or even assembly, no?  Did the firm buy five dozen licenses for every product made by Autodesk (CAD, etc software) instead of the 1 or 2 programs and 5-10 licenses – at most – it needs?  (Perhaps this is how they have – allegedly – products for >5,000 different mobile devices, an absolutely stupid number if true)  Maybe they told their IT guy to go wild and order servers & network equipment capable of supporting a firm 10x this size?

The firm also acquired PP&E of $175,000 in the first quarter of 2011, >30% annualized increase over their gross 2010 year-end balance.  The firm does not provide any further explanation as to what assets it actually acquired.

As Roddy mentioned, their raw materials (primarily polyurethane) aren’t exactly scarce last I checked, and their relationship with what appears to be their sole supplier (repeated use of supplier, singular, in their 10-k) is “on excellent terms,” neither of which necessitate the firm’s raw materials account increasing almost 25% in the first quarter. 

All things considered, I spent about 15 minutes perusing a few of the firm’s recent SEC filings and found more orange and red flags than I’ve seen from any firm I’ve looked at since China MediaExpress Holdings.

Curiously, the stock is up over 1% on the day after being down around 10% earlier.  I’m chalking this up to much of the daily volume being from technical/momentum traders, and not fundamental/value investors.  If I’m one of the institutional investors with millions of dollars in this stock though, you bet your ass I’m scouring over my previous work and seriously considering hedging my long exposure by buying some puts (if I haven’t already).  Maybe the company is legit, but there’s more than enough anomalies in the financial statements – combined with the Boyd and Citron reports – to warrant a much more skeptical look.

Caveat Emptor

Project YOKU-zuna: Failure to Execute

15 Jun

While his legacy is still being written, YouKu CEO Victor Koo has achieved success seen only by a very select group of revered business leaders, visionary CEOs with an ability to not just dream it, but do it.  His previous effort, Sohu, is one of the most successful internet firms in China, and if the past few years are any indication, he’s well on the road to a repeat performance with YOKU.

I’ve been analyzing this company (stock) for the past two weeks or so trying desperately to essentially over- value the firm.  When I started, the stock was trading around $43/share, and even with aggressive assumptions for revenue growth, margin expansion, and other measures of management effectiveness, I couldn’t figure out how the company could be worth more than mid $20’s/share (for whatever its worth, the stock closed yesterday at $29).  Investors should make no mistake: Just because a firm operates in a major growth sector in a major growth market, profits are far from guaranteed.  Running a several billion dollar company is NOT an easy task, and while some have been able to handle it (and then some), the path to sustainable success is littered with the carcases of corporate failure.  Many and myriad are the chances to slip-up, while those to achieve lasting prosperity are fewer and farther between.

That being the case (like it or not), this week I’m playing around with my original assumptions to see how the valuation changes if the company – led by Victor Koo – fails to attain the lofty goals I set with my assumptions.  I’ve made some relatively small changes/fixes/improvements to my model and its assumptions too nuanced and numerous to mention here (those with financial modeling experience should understand, model is now more consistent/accurate/flexible, formulas less clunky, etc), but the cumulative result is that the DCF value is now higher –  17% higher in fact or $27.77 – than the $23.76 from my initial effort.  Using this new, higher value and the assumptions driving it, let’s see what happens when we make some changes.

Here is the income statement along with growth rates and margins:

As you can see, that $27.77 valuation is predicated on some serious revenue growth – 58.1% CAGR – and gross margin expansion – 75.5% CAGR –  over the next decade.  It is these two assumptions that I want to address today, to see what happens if YOKU fails to grow as fast as projected.  We should be publishing more in-depth report on YOKU’s operating costs soon.

I use comps (SOHU, Tudou, etc) and industry reports (e.g. the iResearch data cited by both YOKU & Tudou) to help generate my assumptions for revenue growth and gross margin expansion/contraction, which is what I’ve done here (see my last post on revenue growth assumptions).  I then use a multi-step approach – to reflect the business (growth) cycle – et voila, an oversimplified explanation of where these numbers come from.  For YOKU’s top-line growth and gross margins, though, I focused primarily on the rates for the next year or two and assumed those rates degrade constantly over time, i.e. for 2011, I assumed a 110% growth rate, which decreases 10% each year, and cost of goods (services) of 75%, which similarly declines 10%/year.  While this is not very likely to reflect the firm’s actual performance over time, it makes it far easier to sensitize the valuation to changes in growth rates.

I think using 10% decay for both of these figures is fairly generous; I’d be surprised if YOKU management can get costs in line that well, even as the business scales and matures, considering significant wage growth and inflation in China.  If we adjust the decay rate for cogs to -7.5%/year from -10%/year, all else being equal, the valuation drops from $27.77 all the way down to $19.37!

If we assume cost of goods decreases 10%/year, but that revenue growth will come up a little short of my initial estimates, say this year will still be 110% growth, but that will decay by 12.5%/year thereafter, the value drops all the way down to $19.02!

If we assume that both revenue growth and gross margins will be strong this year, but will be increasingly less so going forward, lower than my initial assumptions (of -10% sequential decay), say -12.5% for revenue growth and -7.5% for cost of goods, the value goes all the way down to $13.14!

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Project YOKU-zuna: Deconstructing Questionable Revenue Growth Assumptions

6 Jun

I don’t like stating the obvious, except when it seems many if not most are seemingly oblivious to it.  Such, I believe, is the case with the stock price of Youku.com (YOKU).  As I shared last week, I believe the firm is grossly over-valued even when assuming amazing revenue growth and margin expansion over the next decade.  We’re talking 70% average revenue growth for the next 10 years.  Off the top of my head, I’m not sure any firm of this size has achieved a decade-long run that impressive in the history of the corporation!

This should be obvious, but firms can only grow so much, so fast.  YOKU makes substantially all of its money from online advertising, which means its revenue growth is bounded by two factors: the growth rate of the Chinese internet advertising market, and its share of said market.  The very-same “independent” research firm YOKU cites in its regulatory filings – iResearch – says the market only (yes, only) grew 54% last year, yet YOKU’s revenues grow three times as fast (152%)!

The only way for this to happen (and continue to happen) is for the market to grow faster than estimated, the sub-market in which YOKU operates – online video advertising – grew (and will continue to grow) faster than the broader internet advertising market as a whole, and/or YOKU made (and will continue to make) HUGE market share gains last year.  (YOKU could also expand into new markets, but for our purposes, we’ll assume the company invests most of its capital in the internet video space.)  Of course there is another way – falsifying revenue – but as I have done in my financial analysis, I’m working on the (very possibly unrealistic) assumption that YOKU’s financials are fraud-free.

In order to rationalize YOKU’s current (at the time of my analysis last week, around $42/share) price, not only did YOKU’s revenue growth rate have to significantly outpace that of the industry rate, but going forward, it will have to continue to do so for years to come!  Even if Victor Koo is the most brilliant CEO the World has ever seen, he is still (using our no fraud assumption) faces real-world constraints in how fast he can grow the company.

If we take a deeper look at the industry and YOKU’s position within it, I think it will become even more crystal clear that YOKU’s share price – driven largely by unrealistic revenue growth assumptions – is grossly over-valued.

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Project YOKU-zuna: The Good, The Bad, and The Very Ugly

1 Jun

As many of you know, I’ve spent the past two weeks analyzing “the Netflix/YouTube of China,” Youku.com.  From the first second I looked at the Yahoo! Finance summary page for the stock, I was EXTREMELY skeptical that a firm hemorrhaging money had a ~$5bn valuation.  When I looked at the competitive landscape, I became even more skeptical.  Sure, the company has experienced massive triple-digit revenue growth in the past few years (assuming, of course, you trust the financial statements, which may or may not be made-up) and appears to be one of the top two firms in the Chinese internet video space, but with incumbent sites like BIDU, SINA, and SOHU developing and rolling-out their own web-based video services, I find it hard to believe growth is going to continue for much longer at anything even close to those lofty rates.

I’ve encountered a number of hurdles in attempting to value this company, for instance, the lack of any half-decent comps, public or private.  I checked out as-yet-to-go-public competitor TUDU, but for all I know and care, their financial statements are just as uncertain (read: made-up) as YOKU’s, so in establishing my assumptions for the model, I tended to rely more on larger, more established firms’ financial statements, even if their businesses don’t really line-up very well with YOKU’s.  Think BIDU, SOHU, etc.

Thus, I developed 5 separate cases for P&L (income statement) and capex growth rates (% sales, % cogs, etc) none of which are really THAT conservative.  All assume the company’s financial statements are not only free of material misstatement, but will continue to be so over the course of the forecast period.  Personally, considering the ridiculous amount of (apparently) fraudulent Chinese companies we’ve seen over the past 6-12 months, I find this assumption hard to make, but I’m giving the firm the benefit of the doubt, deserved or otherwise, for the purposes of this exercise.*  Here are my assumptions for the income statement and capex:

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Project YOKU-zuna Update: 10-Year Projected Income Statement

31 May

I’m still not done modeling YOKU‘s projected financial performance, but so-far I think I’ve done enough research to put together a preliminary (set of) income statement(s).  The image below shows an income statement which combines generous revenue growth and margin assumptions, each semi-possible – although by no means probable – if we look at those of YOKU’s “comps” over the past 5-10 years.

I haven’t finished the model yet so I don’t have accurate cash flows, but even using these very bullish assumptions I’m extremely skeptical I can get to the current valuation (~$4.5 BILLION).  The stock price has dropped significantly following the (announcement of) the secondary offering, but it looks like its still over-valued by about 15-20%, at the very least…

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Explaining the Lack of Posts This Week: Project YOKUzuna

26 May

If you read the site but don’t follow me on Twitter, you’re very likely wondering why I’ve gone from at least one post/day to zero over the past week.  The simple reason is because I’ve decided to undertake a much larger, more time-consuming project of attempting to value Chinese “internet television” high-flyer Youku, in response to challengers who think $4.5 billion is an entirely reasonable valuation for a company with increasingly tough competition from new and incumbent services that’s bleeding cash and losing money every year for the foreseeable future.  Did I mention its a high-flying Chinese internet company, susceptible to what readers should immediately recognize is a non-zero probability of being an accounting and/or other type of fraud?

Preliminary results (read: NON CONCLUSIVE) indicate that if we assume the Youku’s financial statements are accurate – which I consider to be a bit of a leap of faith – the firm would have to grow revenues about 50% per year for the next decade while driving their costs down by about the same % to rationalize its current valuation.  Is this possible?  Sure, but is it likely?  Most certainly not.  Again, this is to say nothing of the (not unsubstantial in my opinion) discount we should apply considering the legal structure and financial/etc opacity involved.

If you want to see some of my preliminary thoughts, you can check out the Stocktwits stream and/or follow it on Market Pulse.

If you’ve been following this company and/or cover it, feel free to get in touch and we can discuss the assumptions/inputs.

What Chinese Company is Worth 60% More Than Sohu With 1/10th the Revenue?

23 May

The company is actually worth ~57% more than Sohu with 1/9th the revenue, but rounding made for a better title.  Know what company I’m thinking of?

Here’s a few more hints:

  • It’s currently trading at about 60x annualized 2011 sales (4x as rich as Linkedin’s valuation)
  • Has about 1/10th as many employees as Sohu
  • Claims to be engaged in significant research & development, but only spends 8.2% of revenue on R&D while Sohu spends 12.6%

Any guesses?

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