Muddy Waters Seen Right on NQ Mobile Payments, Wrong on Cash

Research firm Muddy Waters LLC was correct to focus on NQ Mobile Inc.’s delays in collecting customers’ payments as part of an 81-page report that labeled the Beijing-based mobile service provider a “massive fraud,” according to three accounting experts.

At the same time, accountants, professors and a lawyer interviewed by Bloomberg News said the report’s criticism of NQ’s cash accounting and the way the Chinese company got funds from its U.S. public offering may be unfounded. On other points Muddy Waters raised in its Oct. 24 report, it’s still hard for observers to gauge their validity.

That mixed scorecard helps explain why the stock declined more than 60 percent three days after the report, then pared the loss to 44 percent by the Nov. 1 close in New York. It fell 6.6 percent to $11.94 in New York today. Muddy Waters, run by Carson Block and best known for exposing fraud at Sino-Forest Corp. in 2011, gave NQ a strong sell rating and called it “a zero.”

“I am on the fence,” said Rocky Lee, Asia managing partner and head of Greater China corporate practice at Cadwalader, Wickersham & Taft LLP in Beijing. “When I see a short seller report, I expect it to be indisputably convincing and this one, unlike some of Block’s other, better reports, does not do it for me.”

NQ has defended itself vigorously, in a conference call, presentations, press releases and interviews.

Uncollected Payments

The report criticized NQ’s delays in collecting payments from customers, evidenced in a measure called daily sales outstanding. At the second quarter’s end, the company’s DSO measure was 198 days, according to Muddy Waters, which made the calculation based on NQ’s revenue for the 12 months to June 30. That would mean the company’s customers are taking more than six months to pay, on average.

NQ calculated a DSO figure of 145 days for the second quarter of 2013, based on the average of accounts receivable for the first and second quarters, according to Michelle Ma, the company’s head of investor relations. The company is working to shorten the time it takes to get paid, Matt Mathison, vice president of capital markets, said on a conference call on Oct. 25, particularly in the Middle East and Southeast Asia where delays are the longest.

Data compiled and calculated by Bloomberg show NQ’s DSO for the second quarter at 144 days. That’s almost five months.

‘Red Flag’

A high DSO “to me sounds like a red flag with a siren going off,” said James Angel, a finance professor at Georgetown University. “This is one of the classic signs of a fraud. You can easily manufacture sales with the stroke of a pen, but if you don’t have cash, what you have is a receivable.”

NQ’s public filings say the company offers customers credit terms ranging from 60 to 210 days in international markets and 30 to 90 days in China. The Muddy Waters report also alleged that it took the company 167 days on average in 2012 to collect payments from Tianjin Yidatong Technology Development Co. despite a contract requiring settlement within 30 days. Tianjin Yidatong is a payment processor through which NQ collects 22 percent of its revenue in China, according to NQ filings.

Xu Rong, Yidatong’s owner, said in an e-mail that his company pays NQ within 30 days of collecting from users. Still, it can take 90 days or more for Yidatong to collect from corporate customers, which pushes its payments to NQ to 120 days or longer, Xu said -- “a common thing” in the industry.

Carriers’ Delays

During the Oct. 25 conference call, NQ’s Mathison also cited the time it takes to collect from mobile carriers as the reason his company’s DSO within China, excluding international markets, is in the range of 90 to 100 days.

“Accounts-receivable balances that dwarf the stated payment terms, that’s always a red flag, it always increases the risk of fraud or misstatement,” said David Bassett, an analyst covering Asia at CFRA, a New York-based forensic accounting and analytics company.

Qihoo 360 Technology Co., operator of China’s second-largest search engine and maker of a competing mobile security application, had daily sales outstanding of 22.4 days in fiscal 2012. Tencent Holdings Ltd. measured 18.2 in fiscal 2012.

Longer Terms

It takes larger customers longer to make payments, according to Drew Bernstein, co-managing partner of Marcum Bernstein & Pinchuk LLP, a New York-based accounting firm focused on Chinese companies, who said he’s seen companies with collection periods of as long as two years in China. AsiaInfo-Linkage Inc., a Beijing-based telecom software developer whose main customers are the biggest phone carriers in China, measured 189.5 days for sales outstanding in 2012.

Bernstein said his firm, which provides services to companies’ audit committees and management teams as well as to investors, has met with NQ’s management since the Muddy Waters report was published. NQ hasn’t retained his firm, he said.

Bernstein and Block have squared off previously. In 2010, Muddy Waters accused Orient Paper Inc., a paper maker based in Baoding, of overstating revenue in 2008 and 2009. Bernstein was the chairman of the company’s audit committee.

“I believe we ran a very thorough and credible process to address his claims,” Bernstein said in an e-mail.

Accounting Criticized

After Muddy Waters labeled Orient a fraud, the company appointed Loeb & Loeb LLP, Deloitte & Touche Financial Advisory Services and TransAsia Layers to probe the allegations. That four-month investigation found no evidence to support the short-seller’s claims, the company said. Orient paper’s share price, which was $8.33 on June 28, 2010, the day the report was published, fell by more than 50 percent in the two months afterward. Though it recovered to $7.28 by November 2010, it closed at $2.37 on Nov. 1. Muddy Waters hasn’t covered the company since 2010.

The Muddy Waters report on NQ also lambasted its accounting treatment of its cash, cash equivalents and term deposits, which the company reclassified as so-called Level 2 inputs, from Level 1, in 2011. Companies use three levels to classify assets, with 1 being the easiest to value and 3 the most difficult.

Level 2 assets are those that don’t necessarily have public quotes, like a stock price, but which can be valued using data from public markets.

Treating cash and term deposits that way constitutes “significant red flags,” Muddy Waters’s report said. “This raises questions about how NQ is claiming to hold its cash, and how NQ’s auditor confirmed the balances.”

Rules Change

NQ appears to have changed the classification to meet a change in accounting rules, according to Paul Gillis, a professor and co-director of the International Master’s of Business Administration program at Peking University’s Guanghua School of Management in Beijing. The company is following proper accounting procedures and all U.S.-listed Chinese companies should follow its example on this, Gillis wrote on his China Accounting blog on Oct. 27.

While the Muddy Waters report says the change was suspicious, the change alone doesn’t suggest any issues, said CFRA’s Bassett.

“I don’t think you can conclude that the cash is nonexistent because it’s classified Level 2,” he said. “Cash is a hard thing for us as outsiders to really audit, but it’s not a conclusion that I would go with.”

NQ’s accounting for its cash is in line with U.S. accounting rules, the company said in a presentation responding to the Muddy Waters’s report on Oct. 25.

Possible Clue

NQ is alone in having all cash classified as Level 2, Block said in a telephone interview on Nov. 1, including the ones cited by NQ’s management in their response to Muddy Waters. Classifying all of the company’s cash as level 2 may also be a clue that NQ’s auditor hadn’t done the cash verification the way they would have liked to do it, he said.

Web portal Inc. and its listed online games unit Ltd. have more than 30 percent of their cash classified as Level 2 according to calculations based on their 2012 annual reports. Perfect World Co., another Chinese online gaming company, had 17 percent of its cash balances classified as Level 2. NQ cited the three companies during its conference call.

A related allegation -- that NQ reported moving cash from its U.S. public offering into its China operations “in a way that almost certainly would not have been permitted” -- may also be more red herring than red flag.

Complex Structure

NQ uses a complex corporate structure designed to get around Chinese government restrictions on direct investment by foreigners in sectors including the Internet and telecommunications. The listed company doesn’t technically own the main business or assets in China, but has a right to profits from them based on contracts with a “variable interest entity” -- a domestic Chinese company that owns and operates the main business. The structure is used by many Chinese companies listed in the U.S.

Even under the VIE arrangement, transferring cash from abroad into China is complicated by the country’s controls on its foreign exchange. NQ’s disclosures show that its U.S.-listed company transferred $47 million in IPO proceeds directly to its VIE, according to Muddy Waters. Such a loan from offshore into a VIE would require permission from one of two Chinese government agencies and is almost impossible for a private company to get, according to Muddy Waters.

Connections Count

“NQ’s purported implausible movement of funds makes it easier to divert funds without detection,” the report says. “This claim is reminiscent of Sino-Forest, which also purported to have moved cash in ways that contravened China’s exchange controls.”

A well-connected company can work around such rules, said Bernstein of Marcum Bernstein. “I would certainly classify NQ as a company that is well connected,” Bernstein said. The issue may be poor disclosure rather than fraud, he said.

“Our lawyer’s take on it is, first of all these people don’t have that kind of political clout,” Block said.

There’s more than one way to transfer money directly into a VIE, said Cadwalader’s Lee, who’s an expert on the corporate structure. For example, a company might make a directed loan to an offshore bank and then the same bank, onshore in China, lends to an individual shareholder of the VIE. That borrower injects the money into the VIE, he said.

Security Concerns

“It’s not illegal,” Lee said. “I might want to disclose it, but that’s the company’s decision. The key question is whether the actual money arrived in the VIE entity.”

Moving beyond accounting questions, the Muddy Waters report also attacks NQ’s products, calling its antivirus application “spyware” that’s “unsafe for sale to consumers,” based on analysis of the code and its functioning by software engineers that the report doesn’t name.

The application creates vulnerabilities in users’ phones that make them less secure, sends far more data than necessary to servers in China, doesn’t use basic industry standards to secure the data and creates fake alerts for viruses, according to the report.

An analysis obtained by Bloomberg news of NQ’s Mobile Security & Antivirus application by ViaForensics, a mobile security app and testing company, found that the application has poor security leading to leaked sensitive data. The app does appear to generate fake virus alerts, according to ViaForensics’ analysis, which also found indications that it sends contacts and contents of text messages back to the company, “a serious privacy concern.”

Virus Database

“In terms of the data it collects and sends back to the vendor, that’s not atypical, because antivirus apps need to collect a lot of data to protect the phone,” said Thomas Cannon, director of research and development at Oak Park, Illinois-based ViaForensics. “The concern is the security is very poor. You wouldn’t expect that in a security application.”

NQ Chief Product Officer Gavin Kim denied that NQ sends sensitive private data to China in the Oct. 25 conference call with investors. He also said that the virus alerts mentioned by Muddy Waters are simply a notice to new users of the company’s virus database about the latest virus discoveries.

Some of the issues Muddy Waters raised remain difficult to parse. The report alleged that Yidatong, the payment processor, is secretly controlled by NQ, calling that revenue into question. Muddy Waters reported visiting 10 addresses pulled from China filings, Yidatong’s website and NQ filings, and finding that five did not exist at all.

‘Virtual Addresses’

Bloomberg News visited the address that NQ said on Oct. 25 was Yidatong’s “main operating facility,” in a business park 21 kilometers (13 miles) southwest of Beijing. There, about 15 of its workers share space with another company -- both of them owned by Xu Rong. The 10 addresses that Muddy Waters visited were “virtual addresses” set up to comply with regulations that the company have a registered address in each region where it processes payments, Xu said.

While Muddy Waters may be correct that Yidatong is a related party, that alone doesn’t suggest fraud, Cadwalader’s Lee said.

“In principle I have no problem with that,” he said. “So long as the customer is a captive company of theirs under NQ’s control and the money is real, I am then less worried.”

Block expressed confidence that time will prove Muddy Waters’s portrait of the company as a “massive fraud.”

“Our goal is to get this thing delisted and I think it’s a very good candidate for that,” he said. “It’s not a close one.”

‘Higher Bar’

Omar Khan, NQ’s co-chief executive officer continued the company’s campaign of defense in an interview on Bloomberg Television on Nov. 1.

“We just hold ourselves to a higher bar, frankly,” he said. “You’ve seen our responses in the last week after these false and malicious accusations. We did nothing but completely open up and be very transparent.”

Determining who’s right may take time. For NQ, “there are probably some issues that the company at the very least has to address, and there are aspects in Carson’s report that are correct,” said Bernstein. “There’s a big leap between a company that commits fraudulent acts and, perhaps, very bad management positions.”

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