Deloitte abruptly resigns as auditor of former billion dollar HK apparel maker Boshiwa — stock plunges, remains halted

  Before you think this can't happen to you … better think twice.

Deloitte's Boshiwa exit a precursor to more China auditor resignations (Reuters)

Trading in Boshiwa, the Hong Kong listed (1698.HK), Chinese apparel maker that owns a license for the Harry Potter brand, was halted yesterday following a 42% price plunge upon the abrupt resignation of its auditor Deloitte. 

http://www.forbes.com/sites/forbesasia/2012/03/15/shares-in-boshiwa-suspended-as-auditor-resigns/

Some information requested by Deloitte is “outstanding or explanations provided by the company’s management are not to their satisfaction,” read the company's statement.  Details were quite a bit more specific here:

http://hk.todayir.com/en/fileview.php?file=/todayirattachment_hk/boshiwa/attachment/20120315123201001370466_en.pdf&lang=0&code=1698

Citron notes that the largest investor in Boshiwa is Trustridge Partners, whose co-founder and Senior Partner Shujun Li is a director of Boshiwa and he is also an "independent" director and heads Qihoo 360's audit committee.  Trustbridge, Boshiwa's largest investor, holds nearly 5.8% of Qihoo's stock as of its most recent SC 13G filing with the SEC, signed by Shujun Li himself.

We believe Boshiwa is a precursor for Qihoo as Citron has just realized that CEO Zhou Hongyi has been accused in the past of falsifying financials by numerous entities…including an agency of the Chinese Government.

History of Financial Information Falsified by Qihoo 360's Founder Hongyi Zhou

 

The balance of this post will not rehash the exhaustive work published by Citron on Qihoo 360's nonsensical financial reports for the year 2011.  This report focuses on the history of its CEO's flagrant financial misdeeds.  

Exposed material misstatements while being sued by China Ministry of Information Agency

In this well-publicized case, Zhou was sued by the China Internet Network Information Center  (http://www1.cnnic.cn/en/index/index.htm) , the state network information center of China.  But did anyone read the details?  This is not a Citron allegation.  The CNNIC takes orders directly from China's Ministry of Information.

The lawsuit claimed that Zhou and his company 3721.com misused the media to claim CNNIC was a privately owned monopoly, and was interfering with its lawful duties.  But when CNNIC went to research 3721's capacity to pay damages, it uncovered that Zhou had been falsely claiming his company attracted investments from Japan's JAFCO and IDG, as well as CIV and MassMutual.  Meanwhile SAIC business filings stated he owned 60% of the company's stock, and his wife the other 40%.  

Even worse, the "About Us" section of 3721.com's company website claimed that the business had achieved "monthly income growth in excess of 20% since October 2001."  However, its annual business inspection records stated its retained earnings were negative. 

The article states that the representative of the CNNIC, Mr. Liu, suggested that there were only two possibilities.  Either 3721.com had falsely disseminated information to investors or they had lied to the Chinese government.

http://home.donews.com/donews/article/4/47444.html

http://www.eweb.cn/news/newsshow.php?Id=63

Zhou lost the case in 2005, and had to pay CNNIC and issue a public apology.  http://tech.qq.com/a/20050624/000140.htm

What happened then?

Zhou went on to sell 3721.com to Yahoo, with a contract tied to financial performance.  But Zhou was rapidly forced out of Yahoo China when it became clear that his software product was essentially malware.  More importantly Zhou was accused of embezzling and defrauding Yahoo.

http://archive.webpronews.com//topnews/topnews/wpn-60-20061103YahooChinaWagesWarOnQihoo.html

Citron has now obtained credible evidence about the triggering event that caused Zhou to be fired from Yahoo.  He falsified the financial results of his division, upon which his own compensation was being based!!!  Citron invites the opportunity to prove this statement with its unimpeachable evidence in a California court – the sooner the better. 

Note-:  In addition to Zhou, most of the Qihoo 360 management was taken out of 3721 and into Qihoo 360 by Zhou. 

He's So Sorry

It occurs to Citron that Hongyi Zhou has been required by the misdeeds that landed him in court to have to issue no less than 4 public apologies in the last 4 years.

To CNNIC:

http://ccnso.icann.org/mailing-lists/archives/registrars/msg00915.html

To Kingsoft:

http://www.menafn.com/qn_news_story.asp?storyid=%7Bceec62aa-566d-44c6-906e-a4c687679b0e%7D

To: Tencent

http://en.21cbh.com/HTML/2010-11-22/tencent-369-qihoo-qq.html

To Yahoo:

http://www.iresearchchina.com/views/2862.html

Citron has been publishing this blog for 11 years — more years than 3721.com and Qihoo 360 have been in business combined.  During that time Citron has been sued four times, and has lost none, and has never had to issue a single apology.

   Auditor Note

 

Character is an acknowledged predictor of fraud, so much so that the PCAOB, audit standards-setting board established by the US Congress, states:

" …  the auditor who becomes aware of the existence of such information should consider it in identifying the risks of material misstatement arising from fraudulent financial reporting. For example, auditors may become aware of the following information that may indicate a risk factor: ''        … Known history of violations of securities laws or other laws and regulations, or claims against the entity, its senior management, or board members alleging fraud or violations of laws and regulations." http://pcaobus.org/Standards/Auditing/Pages/AU316.aspx

Why should you care?

Just last year, Deloitte was forced to re-examine its audit of Longtop Financial after Citron reported on the CEO's former financial misdeeds:

http://www.citronresearch.com/index.php/2011/04/26/citron-reports-on-longtop-financial-nyselft/   

Before shareholders dismiss this note with "it can never happen to us", consider that Longtop had passed 4 prior audits before Deloitte was prodded to look deeper by disclosure of management's seamy track record and financial metrics that nobody else in the industry could match.

The outcome is now history, and a disaster for investors, including numerous top-tier Wall Street analysts who rallied to the company's defense.

In light of yesterday's news with Boshiwa, Citron thinks shareholders ought to consider whether Deloitte is willing to stake the goodwill of its 165-year reputation on this company, all of whose statements about its business operations contradict every major player in the industry, including numerous other Deloitte clients.

It is Citron's opinion that Qihoo 360's stock is being managed by a powerful group of insiders, but the net is closing around that conspiracy.   

Today Boshiwa – Tomorrow Qihoo

A copy of this report has been forwarded to Deloitte and the SEC.   

Cautious investing to all.

stock ticker: SOHU

  YOKU acquires TUDO:  Why isn't SOHU worth $90?

 

YOKU's acquisition of competitor TUDO yesterday represents a strong move to consolidate online video in China.  Considering the current market, there were just three impact players:  YOKU, TUDO and SOHU …. and now there are two.  The market reaction to the transaction, including today's substantial follow-through up-bid in both the acquirer and the acquired, means that the market is valuing video in China as "the next big thing".   If the market was saying "YOKU overpaid", YOKU would have sold off, but instead it is rallying further. 

Looking at December's figures, which are representative of trends in the second half of 2011, we see:

December 2011	Video Websites,  Total Minutes, millions	Total Page Views, millions
YOKU TV	1,801	2,142
TUDO Sites	1,405	2,097
SOHU TV	2,445	2,155
Next 5 competitors combined	1,738	2,256

Data source JP Morgan

These numbers validate the attractiveness of SOHU's content, demonstrating stickiness by attracting viewers to view more minutes per page view than its competitors.

Yesterday's purchase of TUDO for appx $40 a share in YOKU stock sent both YOKU and TUDO soaring, validating a purchase price north of 1.5 Billion USD.  The case for SOHU Video being worth more is obvious.  

SOHU TV is not an afterthought.   It has been carefully assembled, and streams some of China's highest quality content from Sony, Disney and MGM amongst others.  As the CEO stated on their last conference call, they stream 21 of China's top 30 prime time dramas.  All this has caused their viewer metrics to have grown 250% to 300% since Q1 2011. 

SOHU is an integrated internet operator, with strong positions in games, streaming video, search, and a leading portal.  Its games business comes via its 63% ownership of publicly traded Changyou, a leading online games vendor in China.  Sogou's Pinyin search has demonstrated genuine popularity with users, and is steadily gaining market share in a sector written off to domination by "winner take all" dynamics.

We rate SOHU's business development strategies as coherent and credible.   

Taking a "sum of the parts look" at SOHU's enterprise value,  JP Morgan does a conservative and credible job of valuing search, portal and games components.  But given what we now know about the enterprise value of video, we see SOHU north of $90 a share.   

 

Segment	Value (mil USD)	Comment
SOGU	200	Search, gaining market share, in a sector written off as impossible
Games — CYOU	1,000	Leading player in the space, DD Tank
Portal	700	Conservative in relation to SINA and others
Video	1,200	Pegged by YOKU TUDO transaction
Cash	500	In addition to CYOU cash position
Sum of parts	3,600	Conservative Valuation estimate
Shares o/s	38.76	Million shares
Valuation p/s	$93.00

 

We couldn't help noticing that even iResearch, in a recent report, measures Sohu's weekly unique visitors 50% higher than Qihoo 360.  If SOHU carried the same market cap as Qihoo, its portal would be valued at $3 billion, and SOHU's per share valuation would be $145.00. 

 

Company Category Weekly UVs(M) %Change Tencent Portal 276.43 + 4.47% Baidu Search 266.81 + 4.64% Sina Portal 188.46 + 4.16% Sohu Portal 181.83 + 3.84% NetEase Portal 129.20 + 10.24% Qihoo 360 Navigation 116.25 - 2.83% Youku Online Video 131.27 - 0.11% Company Category Weekly UVs(M) %Change Renren SNS 61.31 + 9.96% Dangdang E-commerce 4.40 + 6.42% Ctrip Travel 37.80 + 8.40% 58.com Classified Ads 20.98 + 4.37% 360buy E-commerce 16.67 + 6.64% Lashou Group Buying 7.38 + 3.43% Vancl E-commerce 8.15 + 0.53% Source: iUserTracker, professional user behavior monitor software with more than 200,000 Internet users in China

 

No, we don't think SOHU is worth 145, but it demonstrates how ludicrous Qihoo's valuation is at a $23 share price.

Cautious Investing to All.  

stock ticker: QIHU

Today Citron publishes a framework for investors to assess the revenue and growth claims of Qihoo 360 (NYSE:QIHU), directly from the most objective market metrics presented to date.   

   DO NOT BELIEVE CITRON!

Instead, believe every major internet company worldwide, along with the statistics from Chinese Government Ministry of Information, and research from China's State-owned banks to prove the gross misrepresentation of the financials at Qihoo.   

As Qihoo nears its audit date we remind investors that  “A half a truth is a full lie”.

Cautious Investing To All.

stock ticker: QIHU

When Citron began to write on Qihoo we had questions but we did not identify Qihoo as an outright fraud.  We understand the liability that exists in calling a publicly traded company a fraud if it is not one, especially one that trades on the New York Stock Exchange.  Until now, we have always left ourselves an out … that has now come to an end.

In writing this column for over 10 years, Citron has learned that any time a “fraud” has an opportunity to explain their business, it is a good thing for a short position.  Yesterday’s conference call was no different, as now the company has stated positions that they cannot take back.

   In the Company's Own Words

Yesterday, in a hastily called phone conference to respond to Citron's last posting, CFO Alex Xu fielded questions in an attempt to quell fears of shareholders and concerns of analysts.  Judge for yourself.  Below are some the highlights of the call in the words of Mr. Xu as he attempted to justify the number advertisers and their claimed rates on their homepage ( hao.360.cn)  Here he explains why so many of the links on Qihoo's home page do not contain tracking links.

Alex Xu statement #1:

Non transaction customers do not need to see the tracking patterns.

Citron Response:

Any customer of Qihoo is presumably buying web traffic, period.  Why would a non-transaction customer buy a link anyway?  Any company seeking branding buys banner or dynamic ads.  As Qihoo stated in their Q2 conference call:

“We are the best at really in Chinese Internet market in terms of advertising results for those e-commerce companies and because we don't do any branding ads or anything like that…”

 

So he is claiming that his customers are buying links because the generated traffic is so great, but have no interest in knowing where the traffic comes from?

 

Alex Xu statement #2:

In China users who scroll over a URL with their mouse and become suspicious of a long link and may decide not to click. So some customers decide not to put it up (eg not to click).  (We swear he said this)

Citron Response:

Every website throughout the world tracks ads and paid links with tracking id's in the links …..duh.  Do you know something Google, Yahoo,  Sina, Sohu, and Baidu don’t know?  Not to mention the tracking id can add as few as 7 or 8 characters (several examples of which are on Qihoo's own site) and Qihoo's user is the most novice of all internet users.

Alex Xu statement #3:

Companies don’t put tracking id into their URL’s in order to enhance the user experience.

Citron Response: 

Does this gentleman, the CFO of a company claiming to be China's 3^rd largest internet firm, know how the internet works?  Having a URL with 8 more characters does NOTHING to the “user experience.”  I cannot believe Citron actually had to respond to that statement.

Alex Xu statement #4:

There is confusion in the marketplace because we run such a differentiated business model — either in China or globally.

Citron Response: 

To the contrary, Qihoo's might be the most undifferentiated business model on the internet.   As Citron has shown in previous reports there are literally hundreds if not thousands of web directories in China.  If you just type HAO360.cn or HAO360.com (instead of HAO.360) you will see two examples of hundreds (more than a dozen of which we published URL's for in our prior report) of directories not belonging to Qihoo.  As for globally, there used to be many companies in the US with this business model…..until they all went out of business.

Alex Xu statement #5:

Customers with 2 links pay for both links and Citron only gave them credit for one link. 

Citron Response: 

We are supposed to believe that customers are paying double the rate to have two of the same links on the same exact page….really?  Or triple the rate for 3 links?  Hmmm…..

Alex Xu statement #6:

Qihu 360 has largest and most sticky internet sites in China.

Citron Response: 

How…why?  Qihoo has zero unique content.  Why would your sites be sticky?  In our opinion, just more internet jargon.

   More Qihoo Lies

On the last conference call we are told that their hao.360 website is now more popular than Baidu’s hao123.  The exact quote was:

 “regarding the question on market share. First of all, compared to hao123, both from our internal data as well as from third party data, we already surpassed hao123 in terms of UV as well as the clicks." 

Citron has the Comscore ratings on both sites. 

Comscore compares hao.360 and hao123

For those of you unaware, Comscore is the gold standard of internet ratings.  Its Media Metrix product generates the metrics  upon which all major brand internet advertising globally is priced from… including China.

http://www.comscore.com/Products_Services/Product_Index/Media_Metrix_Suite/Media_Metrix_Core_Reports

From this we see that as of October 2011, Baidu's hao123 directory site is generating 300% — 400% the traffic and reach of Qihoo's.  And for those who say that is not a fair measure, just read Comscore’s methodology from their site where they explain:

“comScore’s UDM is unique to the industry and provides a superior solution by overcoming common methodological shortcomings, such as the inability to measure the actual person not just machine, over- or under-counting usage based on cookie deletion habits and misrepresentation based on a multiple usage devices or the same person using multiple browsers.”

http://www.comscore.com/About_comScore/Methodology

So let's get this straight.  We are supposed to believe that companies call Qihoo directly and give them $50,000 USD a month on average (and in many cases multiples of that for multiple links) , all of such customers dealing direct — without an agency,  and without tracking identification?  And furthermore, these customers are accepting ad rate cost increases of 25% each quarter because of a blind auction, again without any verification? … Really?

   "Trust, but Verify" — Ronald Reagan

Someone has to teach the Qihu CFO how to lie better.  Much of the call was that whether it be the traffic or the auction model, QIHU advertisers do not require any verification from the company because they trust them.

That would make QIHU the largest and the only internet company in the world based on trust rather than analytics.

In the real world, the internet is based on analytics.  Unlike advertising on an outdoor billboard, what makes internet advertising so effective for the advertiser is you can actually see what people click on and how to make more effective ad spends.  Google does not provide analytics because people do not trust them, they provide it because THAT IS HOW BUSINESS IS CONDUCTED, ANALYZED, AND EVALUATED IN THE DIGITAL WORLD.

The analysts on this name have it wrong.  They can stand by it just like the many analysts did on Longtop Financial.  We can start highlighting commentaries in the analysts reports, but it is nothing more than a sideshow.  Furthermore, even though Qihoo's gaming revenue reflects ARPU's way out of comparables of their competition, we will make the point on another day.  To stay focused, we are just discussing the largest part of Qihoo's revenue which is the HAO.360 website directory and the advertising revenue it generates.

For those of you who keep saying that Citron does not understand because we live in the United States and not China we offer this link.  Two weeks ago QIHU CFO Alex Xu was on CNBC Asia with Bernie Lo.  After hearing his pitch and apparently being unaware of Qihoo's  market cap, Bernie Lo makes the comment:

“You're not going to be a SOHU — they have way too long of a lead time and diversification in their business that makes you a minnow in their ocean”

http://video.cnbc.com/gallery/?video=3000057575

What Mr. Lo didn’t realize is that even though Qihoo is the minnow, Qihoo's enterprise market cap is already 70% larger than SOHU!  Ridiculous is not the word here. 

If Qihoo had the same market cap as SOHU, the stock would be 11. 

If it traded at the same multiple to revenue, it would be at $4. 

And if it is a fraud, it will trade at 0….you choose your poison.

BTW…we just have to mention that QIHU CFO Alex Xu used to be the CFO of China Finance Online (Nasdaq: JRJC) – a Chinese stock picking and touting site.  When Citron wrote about the company in 2007 as it was trading $30 a share….and today it is $1.85.

For those of you who believe 25% qtr over qtr ad revenue growth (eg 144% year-over-year) is not only credible but sustainable, SINA ad revenue has gone up just 26% year over year, despite owning the hottest web property on the China internet, which is Weibo.   And their ad revenue guidance for 2012 is "cautious".

   Conclusion:

This is fraud plain and simple.   Every component of Qihoo's parabolic revenue growth story is based on company assertions that can't be verified in the public domain, do not align to comparisons with industry competitors, and defy common sense.

When you find such a company in the US or China, especially one with a market capitalization over 2 billion dollars, watch out. 

Cautious Investing to All.

 

 

stock ticker: QIHU

   Can Qihoo's Topline Revenue Withstand any Analytical Scrutiny?

 

QIHU reported 47.5 million USD in topline revenues and guides next quarter to 55 million USD.  What do we know about these revenues?

The company states that 75% of its advertising revenue is generated on its homepage hao.360.cn.  It further states that appx $4 million was generated from referring search to Google.  

Qihoo Revenue Analysis for its Most Recent Quarter 

Qihoo Topline Revenue All figures USD in millions for Most Recent Quarter	47.5	Comments
Search Referral	7.3	Net search revenue was 4.6m, (plus 2.7m back payment from Baidu after settlement of 2010 dispute and claims)
IVAS (mostly games)	12.1	Includes Games and other internet services
Third party antivirus	0.2	Business being phased out
Advertising Revenue	27.9
Home Page	75%	"Last quarter, we were at like, I think, 75%." – conf call by Zuoli Xu, CFO.
Advertising from home page	20.9	Revenue generated by home page (if these numbers are to be relied upon).

 

   $20.9 million and the missing number

What we know:  Homepage advertising link revenue is the largest component of Qihoo's revenue.  The Company sells links on this page on a fixed fee per month basis.  The company states that the fees vary based on the customer's business type.  Yet it was extremely challenging to find the single most important metric :  The average advertising revenue per paid link.

We read everytning we could find on Qihu, to no avail.  But finally, in a single analyst report by Macquarie (the only one that seems to reflect any detailed knowledge of the company's actual business model)  we read:

“The average advertising price for a link on Hao.360.cn’s front page is RMB 200-250 K per month.”

This was published on August 29th, and notes it was after "the company raised its ad prices by 20% – 25% sequentially in Q1 2011".  Of course an average is an average — some links will be be priced higher, and others lower.  To make the math easy we will run the estimates on $225,000 RMB per month, a little more than $100,000 USD per paid advertiser per quarter. 

It is easy to see what sites are paid because they have tracking URL's attached to them; thereby the advertiser can judge the effectiveness of the campaign.  Links such as Hotmail, Vogue, CNTV sports, are displayed, as in all the Chinese directory home pages, for free, for user convenience.  Citron has made a heat map so investors can see how many links on the HAO.360.CN page are tracked, untracked, or lead to another 360 company page.  Here is the current hao.360.cn homepage, which generates for 75% of Qihoo's ad revenue. 

GREEN:  Tracked Link to a 3^rd party website.
RED:  Link to another 360.cn or qihoo.com page – a Qihoo company page
YELLOW:  Untracked link, presumed free.

With this key, lets look again at QIHU's homepage again:

 

There are appx 92 green links on this page; however many are duplicates and dispatch clicks to the same domain.  Eliminating links to Google (paid separately) and Baidu, there remain appx 60 – 65 links with tracking IDs to the websites of 3^rd party entities.  (There are appx 9 links to Taobao.com, which Qihoo claims is now appx 10% of Qihoo's revenue; presumably these are at the high end of the scale of revenue per link.)

This is what we assume are the paid links.  UBS verifies this by publishing a list of Qihoo's paid links in its Nov 17^th note, totaling about 65.  UBS includes several untracked links in their list, but for now let's not quibble about details.  UBS's list very closely matches the spreadsheet we compiled with all the links from the hao.360.cn homepage here:

List of Tracked and Untracked Links on hao.360.cn homepage

An interview with competitor 2345.com confirmed that around 60 links on their homepage are sold and they believe the same to be with their competition.

 

This is a very similar pattern to Baidu's directory page hao123.com:

 

So now we try to construct a picture of Qihu's homepage revenue:

	Min	Max
Paid Links	60	70
Average Revenue per paid link in RMB	200,000 RMB/mo	240,000 RMB/mo
Average Revenue per paid link in USD	30,769 USD/Mo	36,923 USD/Mo
Estimated monthly advertising revenue USD	1,846,154 USD/Mo	2,584,615 USD/Mo
Estimated quarterly advertising revenue USD	5,538,462 USD/Qtr	7,753,846 USD/Qtr

Exactly where is the $20 million in advertising revenue from the home page, or anything even close to it??

We expect the company will now claim that many of the non-tracked links are paid.  This would be very challenging to believe, as anyone paying real money for a link would want to track the traffic generated.  And we would need an additional 130 paid advertisers on the home page.  WHO ARE THEY?  (We wanted to ask this pivotal question on the conference call but the company would only take questions from their “cheerleading” analysts.)

Or calculating in the reverse direction:

Homepage Advertising	Min	Max
Revenue in millions USD for most recent quarter	20.9	20.9
Paid Links	60	70
Average Revenue per link per qtr in USD	348,333	298,571
Average Revenue per link per month in USD	116,111	99,523
Average Revenue per link per month in RMB	736,144	630,981

 

Neither the company nor any of its analysts, nor any of the numerous mainline ad agencies in China nor any of Qihoo's competitors have have EVER quoted an advertising rate for a web traffic link in China within an order of magnitude of this astronomical number. 

   And now the 7 million in ad revenue that doesn't come from the homepage

 

 

Now we try to construct a picture of Qihu's non-homepage and non-game revenue (the other 25% of advertising revenue ):   Citron was able to procure a contract for a non-home page link.  We were quoted a rate of $20,000 RMB per month, which seemed reasonably within expectations, as rates fall off rapidly because traffic is much lower by any measure on pages only linked from the home page.  

Non-homepage advertising revenue per qtr in USD		7,000,000
Non-homepage advertising revenue per month in USD	/ 3	2,333,333
Non-homepage advertising revenue per month in RMB	x 6.34 RMB/USD	14,793,331
Cost per link per month, avg in RMB (from company source)	Est per contract	20,000
Number of customers required to generate this much revenue		740

 

Who are these customers???  Citron has searched all pages on 360.cn and QIHOO.com and cannot come anywhere close to a number approaching 700.  Some of the 360.cn linked pages have only one customer…or none.

    But the "Games" Do Not Stop There!

Qihoo runs a game directory page, which is extremely similar in appearance to those run by many major competitors, for example Sohu and RenRen: 

RenRen  http://wan.renren.com/  

Sogou: http://wan.sogou.com/

Qihoo:  http://wan.360.cn/

What isn't similar is the astonishing revenue per customer Qihoo claims in their last quarterly report.

"Within IVAS, web games revenue were $9.7 million, up 187% from same period last year and 47% from the prior quarter. The strong performance was driven by a large user base on our web game platform."

"At the end of the second quarter, we have about 62,000 paid game players. At the end of the third quarter, we have about 87,000 paid game users."

 

Qihoo Games Revenue 2011	Games Gross Revenue	Qtr over qtr increase	Paid Game Players	Qtr over qtr increase	Revenue per paying player per qtr USD	Revenue per paying player per month USD	Gross Revenue paid per paying customer per month in USD– (Qihoo and /developers split 70:30)
Qtr 3	9,700,000	47%	87,000	40%	111.49	37.16	53.09 USD
Qtr 2	6,600,000		62,000		84.48	28.16	40.23 USD

 

These revenue numbers are simply absurd.   Nobody in the games business, in China or the US or anywhere, generates $53.00 per month per paying customer – not NTES, not CYOU and not SNDA.  Other Chinese games vendors report ARPU's appx $3 to $8 per month USD.  Zynga generates about $1.00 to $4.00 per month per paying customer, depending on which number you compute.  Even the "gold standard" Blizzard International, whose World of Warcraft is in a league of its own for online gaming, charges US and European gamers, who typically pay far more than Chinese gamers, $15/month for subscription.

And nobody in China is growing games revenues at 47% quarter over quarter.  For comparison, RenRen, one of the hottest properties on the internet, grew games revenue at 26.3% year over year, and Shanda, one of China's largest game companies, increased revenue just 3.7% quarter over quarter. 

Like the advertising revenue numbers, these numbers are simply not believable either.  Yet the analysts simply nod and offer the perfunctory "great quarter, guys!"

Citron has no idea how the company will even attempt to explain this glaringly unbelieveable revenue per player number.  Too bad not one analyst on the call even asked about it!

Why does Qihoo make it impossible to verify their web traffic claims?

 

Citron has presented a compelling case as to why the current business of QIHU can be questioned.  Yet, the multiples afforded to the stock by analysts are obviously not based on their current business but rather their future business, which is all predicated on the web traffic generated from their homepage — both in its generic and "personalized" forms. 

Even though the analysts don't agree on how Qihoo will generate money in the future, the one thing they all agree on is that its current revenue depends solely on internet traffic generated through its website.  Therefore the company should be taking extra steps to clarify and make transparent 3rd party verification of the reach, penetration, and page views they claim. But instead, the company does the opposite.

Citron first challenged Qihoo's hao.360.cn homepage traffic claims because the industry standard measurements of internet traffic – including Alexa, Google, CNZZ,  and Comscore — all report ranges of lower penetration, reach and traffic rankings than the company's paid-for statistics from iResearch.  The company's defense was that "Citron doesn't understand" the internet –  because the company's anti-virus software prevents all analytic tools from being installed on a users computer.

All tools except of course those from iResearch and their 200,000 sample size.

Wait a minute!  What kind of excuse is this?  How is it that Qihoo's software coexists with iResearch's monitoring tool, but can't coexist with Alexa?   Does anyone seriously consider Alexa's voluntarily installed toolbar to be malware?  Like all anti-virus software, Qihoo's anti-virus updates the desktop without user intervention, so the company could easily change its software to make it Alexa compatible any time it wanted.  The fact that the company actively prevents any independent verification of web traffic metrics remains a huge red flag for this company.  This is not Citron's issue, it is Qihoo's issue.  In the real world, this limitation would impose a huge obstacle for a coompany trying to sell web advertising.

This should make any interested investor question the depth of the relationship between iResearch and Qihoo. 

   What business is Qihoo in?….a terminal one.

Each of the analysts covering Qihoo seems to present a different idea of what business Qihoo is in and where the company is headed.  One says its "mobile" (which won't be monetized before 2014), one says it's "search" as though they operate in a fantasy world where they could turn on a switch and compete with Baidu.  Another says it's going to operate an app-store with an interface copied from iPhone.  The only thing these three strategies have in common is that all of them currently generate zero revenue for Qihoo.

Citron will not address search, mobile, or desktop platform because the company has generated no revenues nor presented any notable proprietary technology.  The analysts involved in the name do not even have a cohesive story as to where this company will be in 3 years — every analyst describes the company's future differently. 

The truth is Qihoo's revenues come nearly 100% from what can only be called "Web Directory Services".  They devised a clever low-cost strategy to give away anti-virus software as an indirect method to entice internet users to their home page.  But they generate no revenue from the anti-virus software, and no revenue from their browser. 

But this model — "get in front of the eyeballs"  — is hardly new.  We can observe the same in the early days of the internet in the US, where the gold rush was on for eyeballs and clicks, and of course Wall Street's dollars. 

AltaVista, Lycos, Excite, anyone?  Does anyone even remember these web directory businesses? 

http://web.archive.org/web/19990125093146/http://www.altavista.com/ http://web.archive.org/web/19990224192939/http://www.infospace.com/ http://web.archive.org/web/19980212232333/http://www06.excite.com/

Billions of investors' dollars went into them, all of which was vaporized.  Why?

Because they provided neither durable content nor services, they quickly ebbed into the background.  They were mostly a short-run and shallow land rush to "get in front" of the user's internet experience.  Look at what happened to the US Web Directories — they are a virtual internet graveyard.  Even Qihoo's biggest cheerleader Mirae says:

“Our assumption is that PSP will run out of momentum by the end of 2012.” 

So where does that leave Qihoo?

   Analyst Malpractice

 

Citron has commented on the incredibly shoddy analyst work on this stock, but in our opinion, the work of Mirae goes even farther, to professional malpractice.   For a firm that writes glossies on QIHU nearly every week, we find the most disturbing pattern of promotional claims without foundation that we have ever seen from an investment banking firm. 

Mirae will probably want to comment on this piece as well, so we thought we'd offer them some topics to address.   Mirae has raised its 2013 topline revenue estimates for Qihu twice just in November. 

This topline number which includes no breakdown or financial basis looks like this:

Mirae report date	Oct 13 2011	Nov 15 2011	Nov 18 2011	% over QIHU's 2011 rev est
2011 Revenue Est	148.1	153.0	167.0
2012 Revenue Est	307.4	324.9	330.8	105.5%
2013 Revenue Est	472.7	563.3	573.3	355.4%
Target	37.50	40.00	40.00
Current Mkt cap at date of report	2.1 Billion	2.4 Billion	2.2 Billion
Mkt cap at this target	4.4 Billion	4.7 Billion	4.7 Billion

 

The Mirae analyst's work reveals the following gross deficiencies:

• Provides no breakdown or foundation of the prediction of massive revenue gains for Qihoo in 2012 or 2013.
• Completely ignores the red flag inconsistencies in Qihoo's current reported revenue, the lack of transparency in how the revenue is generated, the gross discrepancies in Qihoo's claims of reach and penetration vs industry standard metrics from Comscore, Alexa, Doubleclick and CNZZ, and ignores the crazy ARPU in Qihoo's games revenue
• Completely ignores that China e-commerce was grossly disappointing in 2011; investments have collapsed due to gross revenue shortfalls, massive losses, lack of fulfillment infrastructure, low demand of Chinese consumers wary of poorly made counterfeit products that they feel the need to inspect before buying, and other obstacles.  See the charts of DANG and MCOX – both down 80% year to date. 
• Displays a clear and fundamental misunderstanding of Qihoo's business.    Unfathomably, in the November conference call, despite management having made perfectly clear that their revenue is derived from selling links on its homepage on a negotiated fixed-fee-per-month basis, Ms. Nancy Yang, Mirae's internet / media analyst, asks:

"Firstly, can you help us get a sense how much of your fourth quarter revenue guidance will come from growth in users and growth in per click per user? It seems that growth in per click per user is much faster than growth in monthly active users, should we expect this trend to continue? "   (She got her answer in Chinese)

Instead of analysis, Mirae publishes screen shots of a mockup of a yet-unreleased Google product and claim that because Qihoo has hired an unidentified former senior Google employee, that Qihoo will be able to monetize this unreleased technology in 2012.   Note that the product sketch simply clutters up the user's screen with more ads – exactly the opposite strategy of Qihoo's homepage.  The mockup's main feature is a product price comparison, which would itself be an anathema to Qihoo's main e-commerce advertising customers.

Don't believe us?  Have a look here:  Mirae Nov 15th

The US Securities and Exchange Commission has a long history of regulatory enforcement actions against analysts and other 3^rd party enablers of stock promotion who issue "baseless or unfounded revenue projections".  Literally dozens of regulatory links against firms and individuals for this practice have been filed over the years.  Here are just a few examples:

http://www.sec.gov/litigation/litreleases/2008/lr20644.htm

http://www.sec.gov/litigation/complaints/comp17674.htm

http://www.sec.gov/litigation/complaints/2007/comp20375.pdf

http://www.sec.gov/litigation/litreleases/lr16456.htm

http://www.sec.gov/litigation/litreleases/lr17050.htm

http://www.sec.gov/litigation/litreleases/2010/lr21565.htm

http://www.sec.gov/litigation/complaints/complr17300.htm

http://www.sec.gov/litigation/litreleases/2009/lr20940.htm

http://www.sec.gov/litigation/litreleases/lr16924.htm

http://www.sec.gov/litigation/complaints/comp18652.htm

Citron believes Mirae Research is publishing thinly disguised reports on Qihoo that are in fact promotional materials masquerading behind the appearance of "analyst coverage", and is worthy of immediate SEC enforcement scrutiny for stock promotion activities.

   Conclusion

Based on the data presented above, and the interviews we conducted to gather it, it is Citron's belief that Qihoo's current web directory business is generating far less in revenue than the company is reporting. 

Its presence in China's web market is, by the company's own choice, opaque to third party metrics.  Its advertising links are sold only by a small sales staff, not any of China's many agencies that would represent major advertisers.  There is no pricing transparency.   There is no media kit, typical of major online advertising providers.  We are told that their rates are soaring, but e-commerce revenue and investment in China is currently being crushed due to brutal price competition and logistics pressures.  We are told there is an "auction process" driving ad rates higher, but there is no auction functionality.  In short, nothing about Qihoo's main line of revenue is independently verifiable.  That was a common problem among several dozen US-traded China stocks halted and delisted in the last year. 

But even if Qihoo's revenues were reported accurate to the penny, the company is still overvalued by a factor of 4 or 5 x. 

Analyst claims that Qihoo could be in search, or could be in mobile, or could be a leading app store, are patently ridiculous.  Qihoo has no more claims on those highly competitive spaces than Citron.  It is pure fiction.  Qihoo is no more likely to be able to compete with Baidu in search than Microsoft's money-losing attempt to compete with Google. 

What Qihoo does have is a web directory, which competes with other web directories for advertising dollars.  The company's topline would have to double and double again just to grow into its current valuation.

You could say that the last standing monetizable "directory" in the US is Yahoo.  Of course Yahoo offers a lot more than a menu to web services, it has tons more content than Qihoo.  But even so, when you strip out its other equity positions, the multiple afforded by the market for its advertising revenue is about 1:1.  For Qihoo, we're talking 14:1 or higher (even if you believe their highly questionable numbers).

If Qihoo makes sufficient metrics available to allow independent verification of its claimed web penetration and reach, and if Qihoo were to provide transparency to its advertising revenue sources so that a credible revenue model could be built, Citron would generously afford a 2:1 multiple on its current revenue run rate to the company.  This plus the company's cash yields a price target of appx $5.00 per ADR.

Cautious Investing to All.

Note to all readers :  This report is not to be misunderstood as Citron holding any antipathy toward China or China investments.  Citron believes the China investing space (especially China-domiciled companies trading in US markets) are subject to extreme risks due to the absence of independent 3rd party verification and regulatory remedies for corporate misbehavior at all levels.  This condition is similar to the US market before the Securities Acts of 1933 and 1934, which set the standard for investor protection that underpins the US equity market.  There will be successes and failures in this space, and as the market matures, the worst ones will tend to be washed out. 

Disclaimer:  As of the date of publication, the editor of this report is short QIHU for the reasons stated above, and long SINA and SOHU.

stock ticker: QIHU

For those of you who read part 1 of Citron’s analysis on Qihoo, (NASDAQ:QIHU), we compared the company to MOBI as operating a web 1.0 business that is presently misunderstood by the marketplace.  From the company's rebuttal, we conclude Qihoo is not so much like MOBI…. it might be a lot more like China MediaExpress (CCME). 

Our intended part 2 on QIHU was planned to focus on the naïve analyst commentary and the dubious history of management.  But all that has become a sideshow to what our research found, so hold on to your seat and call your class action attorney.

While Qihoo does in fact have penetration in the free anti-virus software business — that we do not question — the rest of the business seems to be nothing more than an illusion that defies validation by any third party source.  Either Qihoo has some magic pill that neither Citron nor the major players in the China internet space knows about, or this is a FRAUD.

There are a number of chilling parallels to CCME in QIHU's current business model.   Citron suggests that investors and analysts — especially those who are quick to proclaim "Citron doesn't get it" — read this report with an open mind.

   Foundation

The main criticism of the initial Citron report was that we did not understand  Qihoo's business model and therefore we could not draw a comparative valuation to any other business.  The analysts describe Qihoo as a "master aggregator".  We get that.  They say they generate a lot of web traffic. 

Business – n. dealings or transactions especially of an economic nature.

 

Giving away free software is not a business…lets call that a hobby.  A business generates revenue.  If you don’t believe us, just read QIHU's prospectus:

"In 2008 and 2009, we generated a substantial portion of our revenues from sales of third-party anti-virus software. In the second half of 2009, we started offering 360 Anti-Virus to users free of charge as we adopted the business model of offering free Internet and mobile security products to build up a large and loyal user base and generating revenues through providing Internet services, including online advertising and Internet value-added services."

So advertising is how they generate their revenues, and that is consistent with their revenue mix disclosure last quarter. 
 

Revenues June 2011 Qtr
Total	$35.1 million  USD
Online advertising	$26.8 million
Internet value add services (mostly    games authored by 3rd parties)	$  8.1 million

 

The company states that they generate this advertising revenue by posting links through their portal site. 

   Undifferentiated Business Model

Qihu's homepage, shown below, resembles dozens or hundreds of other web directory / navigation sites which are very popular in China.   Here are just a few:

http://www.2345.com/

http://www.265.com/

http://www.1616.net/?www2

http://www.tao123.com/  (taobao)

http://www.wu123.com/

http://www.0460.com/

http://www.91913.cn/

http://www.44244.com/default.html

http://www.9991.com/

http://www.537.com/

http://www.5566.net/

http://www.zgwdq.com/

http://www.46.com/

http://www.176176.com/

http://www.155.com/

http://www.haokan123.com/

http://www.129139.com/

http://www.wndhw.com/

 

You can see they're all very similar, (English speakers can get a pretty good sense of these using Google translate)    In fact there's a fierce battle for domain-brand identity.  In Qihoo's case, their portal is hao.360.cn.  It is not hao360.com or hao360.cn, which appear to belong to others. 

These sites typically focus on link traffic, not brand (display) advertising.  Companies that pay for links on these are paying out of their advertising budgets … their online advertising budgets.  Qihoo classifies this as "advertising revenue".   Citron gets that … do you?

   Comparing to Baidu

Some analysts and commentators have been comparing Qihoo to Baidu.  This is fatally flawed logic.  Baidu also operates a directory / portal (hao123.com), but it is such a small part of the business that they don't break out its revenues or costs separately.  Baidu's primary business is search, which is proven to be a highly profitable business model — at least for the winner in a winner-take-all category. 

   Breaking Down The Top Line

Qihoo's pre-eminent revenue generator is their flagship portal and within that domain, their PSP's (users can personalize their own start page).   Linked to that are their vertical niche portal pages.   Together, these sites generate 100% of Qihoo's current revenue. 

Below is a screen shot of Qihoo's flagship revenue driver HAO.360.CN :

 

 

There are appx 200 links on this page.   But how much revenue is generated from this site, and who is paying what?  We are supposed to believe that this site is generating over $40 million revenues this quarter, and further, is growing at a rate that outstrips all the major players in the China internet space, raising serious questions about its credibility. 

Below is a screenshot of the same site 21 months ago when it was generating less than $10 million per qtr in revenues: 

Feb 12, 2010 (QIHU revs of $9 million in that quarter) - http://web.archive.org/web/20100212202913/http://hao.360.cn/

 

 

 

And lastly the same page from early 2009, when it was generating only $3 mil a quarter in online revenues.   http://web.archive.org/web/20090210050039/http://hao.360.cn/

 

 

A few less links, but essentially identical in structure and function.  So exactly how did revenues increase 400% from last year and 1200% from two years ago?  The quantity of links certainly hasn’t increased 400%.  We have no verification that the traffic has increased anything near 400%.  Have the ad rates gone up 400%? 

   Or is this just a fraud??

For that matter, are there even verifiable ad rates for this page?   Below is a list of advertisers on the front page of HAO.360 that we believe do not pay QIHOO one dime.

• Yahoo Mail
• NBA
• Hotmail (Microsoft)
• Amazon
• Vogue (Conde Nast magazine)
• Self  (Conde Nast magazine)

Further, of these well-known Chinese brands, some of whom directly compete with Qihoo for games or traffic, isn't there a serious business issue requiring disclosure as to how much they are paying for links?    

• Ctrip
• QQ Mail
• Baidu
• China Mobile
• Sina (8 links)
• Sohu  (6 links)
• Todou
• Netease
• Taobao  (2 links)
• Youku (2 links)
• Tencent
• CNTV
• Dangdang

Our favorite of the "advertisers" is West Point Military Academy ( Look in the "Military academies" section, left column, 4^th row …  http://translate.google.com/translate?hl=en&ie=UTF8&prev=_t&rurl=translate.google.com&sl=zh-CN&tl=en&twu=1&u=http://hao.360.cn/junshiguofang.html

… Yep, that's it, … right next to the link to the "U. S. National Defense University".

   E-commerce aggregator

Qihoo recently launched an "e-commerce aggregator page" which sounds exciting. 

OK, so let's look under the hood at this page :  http://mall.360.cn/

It is filled with logos of global companies you will recognize :

Nokia, Samsung, Motorola, Sony, Sharp, Giordano, Reebok, Converse, Puma, Nike, Lee and many others.   Ask on the conference call how much revenue this page generates for the company.   We did.

Despite the lack of revenue, here's a selection of logos displayed on Qihoo's "mall" page: 

The creepy thing is this is exactly what CCME's strategy was.  In order to convince investors that it was a huge advertising channel, it produced a small number of copies of a very glossy catalog filled with logos from top-name brands like Coach, Lexus, and Coca-Cola. 

 

Here are some screen shots from Citron's 3 favorite pages out of CCME's "Investor Presentation, October 2010":

 

 

  

 

Qihoo’s other sites are the following 4 vertical portals, for group buying, video, games, mini games, and literature.  They are merely aggregators and the company has told us that none of them except games represents more than 3% of revenues:

Wan.360.cn -  Games

Tuan.360.cn -  Group Buying

Xiaoyouxi.360.cn – Minigames

Xiaoshou.360.cn – Literature

   Competition

An early sign to Citron that China Media Express was a fraud was simply the incredible pace that they were growing revenues and profits compared to their well-known competition.

During the trailing twelve months, both SINA and SOHU have grown their top line revenue around 23%.  Both companies have diversified revenue streams and a PROVEN internet footprint.  During the same trailing twelve months we are supposed to believe that Qihoo has grown their revenue 400%?

Yet, just like China Media Express… none of their pre-eminent competitors even consider them competition.  Qihoo fancies themselves as competition for BIDU.  Yet in its own filings, BIDU describes their competition as:

" Google and Microsoft, and China-based Internet companies, such as Netease, Sohu, Tencent and Alibaba"

SOHU, who recently launched a popular browser and who also sells games and lists their competition this way.

“not limited to Sina Corporation (or Sina), Tencent Holdings Ltd. (or Tencent) and NetEase.com, Inc. (or NetEase), and vertical sites, such as YouKu.com Inc. (or Youku), Tudou, Inc. (or Tudou), Ku6 Media CO., Ltd (or Ku6), Pacific Online Limited (or PConline), SouFun.com Limited (or SouFun), China Real Estate Information Corporation (or CRIC), and Bitauto Holdings Limited (or BitAuto).  In addition, we compete with operators of leading global websites and Internet service providers, including Yahoo! Inc. (or Yahoo!), Microsoft Corporation (or Microsoft) and AOL Inc. "

SINA, who describes themselves AS AN INTERNET PORTAL and fights for ad dollars as well, voluminously defines their competition as:

Our competitors include existing or emerging PRC Internet portals as well as vertical websites competing in a specific niche such as automobile, finance and IT information. Our competitors in these areas include Baidu.com, Inc. (“Baidu”), Tencent Holdings Limited (“Tencent”), Netease.com, Inc. (“Netease”), TOM Online, Inc. (“TOM Online”), Sohu.com Inc. (“Sohu”), ifeng.com, Hexun, East Money, China Finance Online, PCAuto, Auto Home and PCOnline.      outdoor media, more directly compete with traditional media, such as television, they ultimately compete with us to convert advertisers from traditional media to new media. These competitors include Focus Media Holding Limited (“Focus”), Air Media Group Inc., Vision China Media Inc. and other China-based private or public new media advertising companies…There issignificant competition among MVAS providers. A large number of independent MVAS providers, such as Kongzhong Corporation (“Kongzhong”), Tencent, TOM Online, Hurray! Holding Co., Ltd. (“Hurray”), Sohu and Linktone Ltd. (“Linktone”), compete against us. We may be unable to continue to grow our revenues from these services in this competitive environment. In addition, the major operators in China, including China Mobile and China Unicom, have entered the business of content development. Any of our present or future competitors may offer MVAS that provide significant technology, performance, price, creativity or other advantages over those offered by us, and therefore achieve greater market acceptance than us.

     Our other areas of focus for future growth include WAP portal, search, online video and Web 2.0 services. We also face intense competition from domestic and international companies in these areas. The main competitors for our WAP portal include Tencent, Kongzhong and WAP portals operated by mobile telecom operators such as China Mobile’s Monternet. The main competitors for our search service include Baidu, Yahoo!/Alibaba, Google, Microsoft (Bing), Tencent (Soso) and Netease (Youdao). The main competitors for our instant messaging service include Tencent (QQ), Microsoft (MSN Messenger) and Yahoo! China (Yahoo Messenger)/Alibaba. Web 2.0 companies are defined as those that offer tools to: companies such as Baidu, Tencent, Netease, Sohu, Youku, Renren.com Microsoft (MSN), Shanda (Shanda Literature), and Giant (51.com) as well as private companies such as 56.com, Tudou, Ku6, PP Live, PP Stream, Bokee, Blogbus, Poco, Blogcn, Hexun, Kaixin001.com and hainei.com in China and international players such as YouTube, MySpace, Twitter and Facebook."

What sticks out like a sore thumb is that Qihoo says they are the #3 internet company in China by active user base, the #1 provider of internet and mobile security solutions by active user base, and sport a user penetration rate of 92% … yet the aforementioned companies list everyone as their competition except … Qihoo, of course.

So we are supposed to believe that the 3rd largest internet company in China with revenues growing at 400% a year has just been forgotten about by their competition?   Sounds very CCME- like to us.

    Mainstream Media Attention:

Exposing CCME was difficult because nowhere online was there ever a compilation or ranking of their competitive sector (video advertisers on intercity buses in China).   

In the case of Qihoo, there are plenty. 

Citron scoured the internet to try to find just one list that would have hao.360.cn or any Qihoo site in their top rankings of internet traffic. …. to no avail.  Here look for yourself.

http://www.chinarank.org.cn/

http://www.edu.cn/20010101/22272.shtml

http://371.li/cn/

http://top.chinaz.com/

In Qihoo's rebuttal, we learn that we cannot use Alexa or Google Doubleclick to judge Qihoo's traffic, because their toolbar is incompatible with Alexa …  Then who are we supposed to use?   We challenge anyone to find one independent piece of research that would rank HAO.360 as a significant player.  Citron cannot, and neither can their “competition”.  Besides the commissioned iResearch report, prepared for Qihoo's IPO, are there any other lists that rank Qihoo's sites in the top 5 in China in terms of traffic?

What makes all of this even more ludicrous is just like CCME, Qihoo doesn’t even have an online media kit.  Sina and Sohu both have online media kits to be explored by potential advertisers, but Qihoo’s link tells potentials to just “send them an email”  … Very CCME like.

SOHU's:  http://ad.sohu.com/adprice/

SINA's:  http://emarketing.sina.com.cn/

But QIHU's is only this:  http://hao.360.cn/mkt.html   (eg.  "Send us an email")

   Meanwhile, Who is Counting The Beans??

Citron has made a strong case why the advertising revenue volume at Qihoo just does not add up – either to their competitors or us.  Yet, it is in an SEC filing so it has to be true … no?  In our last but most telling comparison to CCME we have the auditor.  

Qihoo is audited by none other than Deloitte Touche in China.  Deloitte was also the auditor of CCME and most notably, Citron exposed fraud Longtop Financial.  Anyone who follows the saga of Chinese stocks knows that Deloitte China recently refused to cooperate in an investigation by the SEC of Longtop and is being taken to federal court by the SEC.

http://www.reuters.com/article/2011/09/09/us-sec-deloitte-idUSTRE78768R20110909

Citron will follow through with Deloitte Touche and make sure their auditors are aware of the many "holes" in Qihoo's story.  

   What will happen when QIHU reports earnings??

Tomorrow, QIHU reports earnings.  We are confident that, despite the warnings and cautious guidance from the pre-eminent Chinese internet companies, whose revenues are largely dependent on advertising, they will put up a topline number that will beat analyst estimates.  This is reminiscent of CCME’s last Q in 2010 when they put up record numbers and raised guidance. 

http://www.businesswire.com/news/home/20101108006165/en/China-MediaExpress-Holdings-Announces-Quarter-Financial-Results

All this will be oblivious to the strong headwinds in the online advertising space in China.  No one questions that SINA's Weibo is among the “Hottest” internet properties in China.  But last week SINA CEO Charles Chao, was cautious on online ad spending as he said on a conference call, "Overall, the sentiment is good but not great based on our assessment … There may be some increase (in advertising spending), but not significant.”

http://www.reuters.com/article/2011/11/09/us-sina-idUSTRE7A81O120111109

So we are supposed to believe that SINA is not seeing significant increases in online ad spend yet Qihoo is able to grow their top line 30% per quarter….but no one in China seems to know about it….which leads us to our next point.

   Questions for the Conference Call

As investors, we are fortunate that QIHU will host a conference call tomorrow.  Here are some questions that must be addressed as the company needs to give more transparency to their “business model”:

 

• Please explain what verifiable metrics besides revenue have increased 400% in the last year (as revenue has to be tied to another verifiable metric
• Besides the commissioned iResearch report, what independent third party verification of Qihoo's reach and exposure can the investing public actually rely on?
• Who are your five largest advertisers?  Where do they appear on your site, and what percentage of their revenue do they generate in aggregate and individually?
• How many of the links on the HAO.360 site are free links?  What percentage of the total number of links on the site are free vs paid ?
• What metrics does an advertiser use to evaluate how much to pay for a link?  Why would an advertiser pay for a static link if the party they compete with, or the party whose product they sell, receives a link for free ?
• Please walk investors through your site and identify the specific links and the revenue generated by the ones that substantiate $40 million in quarterly revenue.
• What is the catalyst for the next 300% increase in your revenues from here?   What barrier to entry prevents others from copying your model and topping your growth? 

In order to justify its current market cap, Qihoo must both make transparent its revenue growth to date, but also justify 300% — 400% revenue growth over the next year. 

  Conclusion

Citron acknowledges that Qihoo found a niche when it offered anti-virus software for free in China.  Its product was downloaded by a remarkable number of China's internet population.  But to become a business, it had to establish true cash flow out of something it gave away for free.  Qihoo's current efforts resemble more a hall of mirrors than a roadmap to the future.   Investors should be extremely wary of investing in a multi-billion dollar valuation to a story as thin as this one.  

Cautious investing to all.

Disclosure:  As of the date of publication, Citron is short QIHU, long SINA and SOHU.   Its positions can and do change at any time without further disclosure.

 

stock ticker: QIHU

 

The most overvalued and misunderstood

Chinese Internet Stock:  

Target Price-$5

 

Recent Market Cap:   $ 2.5 Billion USD      Last Quarter Revenue:  $35.1 million      Management: Disturbing Record of Deceit      Outlook:  Destined for Single Digits

 

 

 

 

 

 

 

On May 2, 2011, Citron reported on Sky-Mobi (NASDAQ:MOBI) when the stock was $18.  Citron placed a price target of $3 on the stock, pointing out the company's outdated business model and documenting its gross representations of itself to Wall St.   Well, Sky-Mobi kicked and screamed.  They held a conference call to refute our critique, and multiple analysts upgraded their stock ratings and raised targets.  Not more than 4 months later, despite the protests, the MOBI traded at $3 — not because of Citron, but rather the inevitable fate of their business model's value.

Citron explores today a company with many similarities, Qihoo 360 (NASDAQ:QIHU).  We estimate that it is headed to $5 per share, more than 75% below its current trading range.  Sky-Mobi and Qihoo have both intentionally misrepresented their businesses to Wall St in the hope of sustaining exaggeratedly high market capitalizations, but in both cases Citron's analysis points decisively to the conclusion that their best days are behind them, not in front of them. 

Qihoo went public at the right time.  In the spring of 2011, all Chinese internet stocks were entering bubble territory.  SINA was approaching $150 per share and YOKU was over $50.  With scant revenues, Qihoo claimed some bold benchmarks in their prospectus and their most recent quarterly statement.  Once you have read our findings, you will see those claims in a different light. 

   Corporate History

QIHU publishes a browser that has gained considerable market share in China over the years because it is bundled with anti-virus software (In reality, this was simply a customized version of Google's Chrome, bundled with anti-virus technology mostly licensed from 3^rd party providers, Qihoo's R&D has been historically minimal).  In fact, 2008-2009 the company had generated the bulk of their revenues selling anti-virus protection, a revenue stream that rapidly dwindled to zero.  After realizing that this was a dead-end business model, in the Q4 2009, QIHU began to give away its software, selling ads on its default home page and referring search requests to Google for a revenue share, as do thousands of other websites.

So this is where they are today, a web 1.0 brand with a web 1.0 business model that is hoping (and claiming) to be moving into mobile, cloud computing, and search — all businesses in which they are years behind and have zero present-day market share.

Before going into their revenues and business model, let's address those big market share numbers that are thrown in the face of the investment community on page 1 of their prospectus.  Those numbers are greatly exaggerated or misleading to say the best.   According to their prospectus and recent filings they claim : 

 

 

It sounds impressive, but the problem is that it is so far from the truth.

   The Numbers That Really Count

 

The company boasts they have "over 300 million active users", "80% penetration", and are "the 3rd largest Chinese internet company by active user base".  We find that, based on independent metrics, the truth shows no resemblance to that.

What does their biggest customer think?

More than 21% of QIHU's revenues are derived from Google, primarily be referring search queries.  According to Doubleclick ad planner as powered by Google, 360.cn is the 21st most visited site in China with a reach of only 10%.   http://www.google.com/adplanner/static/top100countries/cn.html

(Note:  There are many companies with higher rankings and dramatically lower valuations on this list. )
 

For the sake of comparison in this report, we will compare Qihoo to SOHU and FENG.  Two publically traded Chinese Internet Companies who have ad based models similar to Qihoo.

This 10% reach estimate would take 360.cn into only 30 to 40 million Chinese homes, not anywhere near the 300+ million they claim.

But Google's AdSense ranking for QIHU's site is actually high next to Alexa, which shows 360.cn as the as the 35th ranked site in China.   

http://www.alexa.com/topsites/countries/CN

( FYI…for those of you who might be confused, 360buy.com is not related to QIHU, they just have similar names. )

Alexa traffic statistics	SOHU  SOHU.com	QIHU   360.cn	FENG.com
Rank in China	9th	35th	12th
Average time spent	53 seconds	36 seconds	Not stated
Pct of worldwide pageviews	.12%	.012%	.2%

Further, SOHU also owns SOGOU.com (search dog), a site that also outranks QIHU's 360.cn on its own.  (13th on Doubleclick ad planner, ranked 25th on Alexa).  

   Valuation Comparison QIHU and SOHU

 

Now look at the comparative valuations of SOHU and QIHU.  SOHU is widely acknowledged as direct competition to QIHU.  The below chart shows how ridiculous their comparative valuations are.   We'll also look at FENG, which outranks QIHU on every metric, but in the same ballpark. 

	QIHU	FENG	SOHU *	Kingsoft
Shares Outstanding (m)	117	65.4	38.4	1167
Stock Price (USD)	20.5	5.14	61	0.45
Market Capitalization	2,398.5	336.2	2,342.4	525.2
Cash Balance	309	178	811	221
Enterprise Value	2089.5	158.2	1531.4	304.2
Value of Spun off Holdings	0	0	607.9	0
Enterprise Value ex Subs	2089.5	158.2	923.5	304.2
2011E Revenue ex Subs	146	141	408	138
2012E Revenue ex Subs	257	217	521	165
2011E Revenue Multiple	14.3x	1.1x	2.3x	2.2x
2012E Revenue Multiple	8.1x	0.7x	1.8x	1.8x
Revenue per $1000 invested	69.87	891.52	441.81	453.72

 

*  When comparing to SOHU, we have to credit SOHU's 67.1% ownership of CYOU, worth $600 to $885 million (enterprise value / market value times SOHU's percentage owned) in addition to SOHU's enterprise value for the balance of its business. 

CYOU's value to SOHU

Recent Stock Price	25
Market Valuation (m)	1,320
Cash (m)	414
Sohu's Stake	67.10%
Enterprise Value (m)	906
Market % Ownership (m)	885.72
Enterprise % Ownership (m)	607.93

 

*   What makes comparing these 2 companies even more ridiculous is the mindshare perspective.  SOHU is number 7 on the Google Doubleclick ranking and number 9 on Alexa respectively.  From point of few of internet ranking, the gap from #7 to #21 is massive – about 3 to 7-fold in terms of overall web presence.  And in addition, SOHU owns 65% of SOGOU.com, a search site which on its own outranks QIHU in both Alexa and Doubleclick. 

Even the Mirae analyst admits when it comes to 360.cn growth:

The share is still growing but it is not growing as fast as SOGOU  (SOHU)

So when these numbers are reduced to a bottom line, here's what you get when you invest $1000 in each of these companies' stock:

 

For those of you who want to bang the table and say that QIHU should be given premium because it is not just an ad seller but rather they have security products, we included their arch nemesis Kingsoft. 

http://investing.businessweek.com/research/stocks/snapshot/snapshot.asp?ticker=9274438

When comparing these companies, QIHU should be trading at $5 a share, if we are being generous .. very generous.

    In Management’s Own Words!

I am sure many of you are saying, "OK, Citron, that is the bear case, but what does management have to say about this?"  

Here is a link to an interview given by Zuoli Xu, CFO of QIHU along with Yu Yao, their VP, in which management admits their lack of a current compelling business model and describes their hopes for the future.  When Citron reads this interview, it seems more like the banter of an internet startup company knocking on doors to raise money  – not that of an established $2.5 billion dollar internet standard bearer.

http://news.ichinastock.com/2011/08/interview-with-qihoo-cfo-and-vp-big-potential-for-360-browser-homepage/

    Can you Trust Top Leadership ?  MUST READ

QIHU's CEO is a gentleman named Zhou Hongyi. 

http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20101222000107&cid=1102

As QIHU was preparing for its IPO, there corporate actions resembled those of a company fighting for its survival.  The browser was losing market share and they were becoming insignificant in the rapidly changing face of the Chinese internet market.  QIHU's choice of action was to try to muscle competitors off the desktop.  Its installations forced users to uninstall competitor’s products, sometimes with misleading prompts.   This led to a very ugly public squabble, with accusations of spying and leaking users private information, as well as deliberately releasing malware.  As the attached link shows, QIHU went to war with leading instant message platform QQ (Tencent), a major anti-virus competitor Kingsoft, and search leader BIDU.

Despite all of their public complaints, they wound up on the losing side of all three battles.

http://english.caixin.cn/2011-04-20/100250564.html

The one lawsuit that foretells the desperation of management is one in which the QIHU CEO was sanctioned by China's courts for defaming Kingsoft's CEO on his personal blog in over 45 entries.  The court ruling required him to pay damages and publish a letter apologizing and recanting his libelous claims.  

http://www.yiliaobk.com/first-case-of-microblogging-zhou-jinshan-public-apology-to-the-court-of-final-appeal-judgment-claims.htm

If these had been the actions of a US company, it would NEVER have been allowed to IPO! 

RE Management — The bottom line is this:  Given the utter lack of reach for US regulatory agency protection of shareholders interests against malicious and deceptive corporate actions in China, can this person be trusted as the basis of an investment at all ?

  Qihoo's “mobile” business

The only thing more disturbing than skewed numbers are boldfaced lies.  In both the prospectus and quarterly filing from the company refers to themselves as "the leading mobile security provider in China". 

Does anyone believe this?.  Qihoo is not even a current participant in the mobile security space, aside from a claim last month to have launched mobile internet browsers.  The fact is to date it has generated 0 revenue from mobile services.  This fact is indisputable from the company's most recent 10-Q. 

http://gs.statcounter.com/#mobile_browser-CN-monthly-201006-201106

We see no less than nine marketshare combatants in June 2011, with Qihoo nowhere to be seen.  Is this a picture of "leading China's nascent mobile device security market?

    So what is left here?

Once you get past all the rhetoric and “netspeak”, you are left with a web 1.0 company that publishes a browser that at one time was getting a lot of installs, but is now hustling to try and find its place in a brutally competitive and fast changing internet landscape, out-invested and out-gunned by larger competitors. 

With no disruptive technology and no fast growing properties (such as Weibo,  Yoku, or Q+)  Qihoo has …. a browser….that is it…plain and simple. 

For those of you who need a history lesson, a browser is not a business, it is a tool.  The grandfather of all browsers Netscape is now shut down, and a non-profit company now owns its browser. 

A browser is not a business in the US and it is not a business in China.  Dong Xu, a researcher with Analysys International, states:

"With the move from the wide-open web to semi-closed platforms in the digital world, web browsers, which don't tend to make money, are regarded by vendors largely as a means of making their main products available."

http://www.china.org.cn/business/2011-08/08/content_23164056.htm

Qihoo's problem is that it doesn't have "main products".  It simply tries to hustle sales of games and other links from its web traffic.   And 3^rd party statistics cast substantial doubt on Qihoo's claims of anywhere near as much browser penetration as they claim.

And even for their one standing business being the browser, the bad news is that competition has come to town.  Baidu, a company with over 75% of the search market has recently launched their own browser that has a focus on internet security. 

http://www.pcworld.com/businesscenter/article/223453/chinas_baidu_testing_new_web_browser.html

BIDU's new browser is being released to cement its position as the unquestioned leader in search, much as Google developed Chrome to make sure it had a foothold with web surfers, not to generate a revenue stream, but to assure Google's hold on the search business.

    Conclusion

Citron plans to follow up this QIHU story with a part 2 that will focus on the plethora of misinformation presented to the pubic from the many investment banking firms covering QIHU.  Much like MOBI, we were amazed to read the many analysts reports that have simply repeated management's hopes for the future as though it were independent analysis. 

We look forward to their strident defense of this name, and hope they present some data more substantive than management's hopeful narrative.   We suggest independent investors seek out and give more weight to independent data points especially those that would verify the range of Qihu's real revenues, and less to company stated "future plans", expecially where those plans have generated no revenues. 

Cautious investing to all.

stock ticker: HRBN

Citron believes it is time to offer its final comments on the long drama leading up to Harbin Electric's purported going-private transaction (NASDAQ:HRBN). 

If Harbin's private buyout falls apart at the last minute, consistent with the many other “fraud calls” we have made, Citron will not be taking a "victory lap".  Likewise, if this deal ultimately closes, we will not issue a mea culpa or comments full of sour grapes, as we are convinced that our research on the fraud committed at Harbin Electric was always honest and thorough.  Not one analyst, US or China-based journalist, stock commentator, or even the company has been able to rebut any of the voluminous data points presented by Citron documenting the many indicators of malfeasance Harbin's operating results, including:

 

• The sole audit on which the buyout is based, from a firm that no longer exists, after being sanctioned by the SEC for improper audits on other China stocks.  This is the single most important document in the entire transaction.
• An "independent director", the audit committee and "special committee" chairperson, is also on record as a director of Harbin's private equity funder Abax – a glaring conflict of interest. 
• A multi-year track record of operations funded by a crazy-quilt of one-pocket-to-another band-aid financings
• Consistent track record of cashless profits
• Crazy fake asset purchases consistent with the behavior of other Chinese fraud stocks

One point on which longs and shorts agree is that the fulcrum of this deal is a massive multi-year, low interest term loan commitment from China Development Bank, upon which the deal depends for its core funding.  Longs' position is : "It’s a done deal, so just deal with it.", while skeptical shorts have pondered "Why would the bank make such an un-economic, high-risk loan?"

Harbin Electric is no longer a stock; it has become a leading indicator for a debate about business corruption in China.  Those who are long the stock have committed their capital, not to investing in the company, but to go long on the corruption that exists in China. The premise of this deal closing is that corruption has no boundaries in China and has moved beyond rogue CEO's all the way to the policy making bank of China. 

China has become a country whose economic stability has been plagued by fraud.  These are not allegations; these are facts that have played out over the past year.  Beyond the collapse of many Chinese RTO's, we have also seen two multi-billion dollar market cap companies delisted from US and Canadian exchanges for fraud (Sino-Forest and Longtop).  This has also been the year of the fake Apple Stores in China.  And now we are left to ponder the implications of a massive regulatory black hole created by the complete breakdown of a working relationship between the PCAOB and Chinese accountants, as well as between the SEC and its Chinese counterparts.

http://www.forbes.com/sites/francinemckenna/2011/10/21/auditors-in-china-a-whole-lot-of-posturing-going-on/

http://dealbook.nytimes.com/2011/10/20/deloittes-quandary-defy-the-s-e-c-or-china/

Talk of a Chinese banking crisis dominates the financial media while world markets perch on the edge of their seats wondering if the China bubble is about to burst.  In the midst of this uncertainty, the riddle of Harbin has not helped anyone.  Can someone really get a loan in China for $400 million with no business basis, knowing the only outcome is default, just because of political connections?  The market has handicapped "Yes", but Citron still thinks the real answer might be "No".

Citron looks forward to moving beyond Harbin.  We have been publishing this column for 10 years and have no plans on slowing down.  We are proud of the work we have done, and stand behind the research, analysis, and writing on Harbin Electric.  Readers are encouraged to reference  the "Citron Knows China" tab on this site for a summary of research on China companies.

As Citron waits like every other investor to learn the eventual fate of Harbin, we only hope for sake of the country of China that fraud and lack of transparency is just one of the temporary growing pains in their economy and society; and in the future, US investors will not have to rely on hope and faith as the principal factors in their investment decisions.

PS. For a little lighthearted humor, this news story just came out about the level of fraud in Harbin Province.  We couldn’t make this up if we wanted to.

http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20111023000081&cid=1103

Cautious investing to all. 

 

 

 

stock ticker: HRBN

This past week, a new film documentary premiered entitled “Chasing Madoff”. 

http://movies.yahoo.com/movie/1810207107/video/26380206

It chronicles now famed whistleblower Harry Markopolos, whose longstanding battle to get the SEC to take action against the massive Ponzi scheme perpetrated by Madoff & Co. had been documented for years. 

To this day, Markopolos’s letter to the SEC in 2005 (which wasn’t his first, his first formal complaint to the SEC was made in early 2000), remains a classic in common sense insight for investors.  Citron believes it should be required reading for every market participant, legislator and regulator.

http://online.wsj.com/documents/Madoff_SECdocs_20081217.pdf

After recently re-reading “No One Would Listen”, this writer couldn’t help but see the similarities between Madoff and Harbin Electric.  Before you dismiss this as a stretch … consider a few points.

   Similarities between Madoff and Harbin: 

 

1)  Off-the-charts financial results that defy independent verification

Madoff reported earning 12% or more almost every year, while never disclosing how he did it.

Harbin has doubled revenue each of the last two years, to a run rate of over $500 million per year, meanwhile claiming net margins besting peer competitors by orders of magnitude.  Yet it does not disclose a single verifiable large customer or large scale order with a verifiable counterparty. Its major customers from prior years’ filings state little or no business conducted with Harbin.

2)  Investors who know something fishy is going on, but stay involved

Many of Madoff’s investors suspected he was doing something “wrong” (i.e. frontrunning orders), but invested anyway, because they figured he was on their side — as long as they could profit from his cheating, then cheating was OK.

Harbin investors have submitted hundreds of emails to Citron.  But not a single one has ever credibly defended the company’s business.  Instead, they all assert the theme of “who cares if there is a business or not….we are getting taken over.”

3)  Investors focus on credentials and not business

Madoff derived credibility because he was Chairman of the Board of Directors and a member of Board of Governors of the NASD.

Harbin’s Chairman Tianfu Yang derives credibility because he is a Deputy in the National People’s Congress.

4)  Professional Industry counterparties keep their distance

Many qualified market participants concluded Madoff was a fraud.  But while Madoff's wealth management business grew into a multi-billion-dollar operation, none of the major derivatives firms would trade with him because they concluded his numbers and his strategy were fictional.

Even though Harbin Electric has engaged numerous experts in its going-private process, the major firm analysts are all mute, large firm arb desks aren’t taking the “easy money” bait, and short-sellers can’t even short the stock because the borrow is so tight, all while the stock trades at 2/3rds of the takeout price. 

5)  Family members in key positions of trust

Madoff’s right hand man was his brother Peter Madoff who served as Chief Compliance Officer for 20 years.

Tianfu Yang’s right hand man is his brother Tianli Yang, who is Vice President of Harbin Electric and a director of subsidiaries.

6)  The low credibility auditor

Despite being surrounded by white shoe pedigree peers, Madoff’s auditor was Friehling & Horowitz, a little known accounting firm that has since been sued and put out of business.

Despite its going private documents festooned with pedigree white shoe names (every one of which explicitly disclaims any actual due diligence), Harbin’s auditors are Frazer Frost, a now disbanded and disgraced auditing firm which has been sued by the SEC and whose client list is the poster child for China stock fraud.

7)  Constantly raising expensive money despite claiming wildly profitable operations

Madoff continued to pay large acquisition fees to feeder funds, despite a business that purported to be massively profitable. 

Harbin’s Chairman Yang had to pledge the majority of his stock for an expensive $50 million loan.  The company also is indebted to a patchwork of banks, pledging various assets, while the company claims nearly $100 million in cash on the balance sheet, and hugely profitable operations, that never relieves its insatiable needs for cash.

   …But … One Major Difference

 

When Madoff’s fraud was finally exposed, there were consequences … serious consequences, as in a 150 year jail term, and asset seizure.

Citron believes the Harbin Electric deal is likely to “fall apart” at the last minute due to unexplained circumstances, which will likely be conveniently blamed on “regulators” and “short sellers”. 

But when it goes south, nobody at Harbin will be accountable, either legally or financially.  The utter lack of civil or criminal jurisdiction over the principals in China assures that shareholders will have zero recourse. 

Although there have been dozens of China RTO frauds exposed, not one penny has been recovered for shareholders by legal action, and not a single indictment of a culpable party has been executed.

    Conclusion

Citron alerts investors that, as currently structured, and absent regulatory intervention, this purported buyout can proceed all the way to the altar with not a single dollar escrowed to protect investors from being jilted at the last minute. 

The impressive-sounding white shoe names on the documents have all indemnified themselves with broad disclaimers.

For those following the case of CHBT, a China RTO fraud stock tracked by Citron for nearly a year, the real liquidity only poured into the stock in the final weeks immediately prior to the deadline for its audited annual report.

The entire Harbin take-private transaction depends on massive bank financing from one of China’s state financing agencies, an entity which customarily underwrites massive infrastructure development projects for widespread social benefit, not leveraged private equity deals to profit selected Hong Kong fund operators.  It remains utterly unclear how far this bank will deviate from their clearly stated policies of state and social interest to underwrite this dubious transaction.

Investors need look no further than the recent cases of Sino Forest and Longtop, whose stocks had no floor when the music stopped.  Billions in investor assets simply disappeared into the mists.

 

Cautious investing to all.

 

stock ticker: HRBN

Whether a company’s stock trades in the US, Shanghai, Hong Kong or Shenzen, all investors want the same thing:  transparency.  The problem with Harbin (NASDAQ:HRBN) is not the short-sellers, as the company so vehemently stated on its last conference call.  The problem is the company has been violating every principle of transparency over recent years, which only intensifies as the company ramps up its claims of an upcoming $24 a share private takeover.

Investors have nothing to judge an actual business, absent a buyout offer, except a 2010 audit by defunct auditor Frazer Frost, which was has become the poster child for auditor negligence in the Chinese RTO space.  Meanwhile, Harbin Electric’s stock is being propped on the promise of a going-private transaction at $24 per share, a make-good for any possible operational problem the company has or any inconsistency in its financial reporting.  The story has not wavered in the face of:

• industrial slowdowns both worldwide and in China
• increasing gross margin pressure on the entire Chinese industrial sector — in both labor and materials
• wave after wave of exposures of fraud among China RTO’s
• the specific corruption being investigated among China’s rail industry after the recent fatal crash
• bank / state credit tightening in China

… just to name a few headwinds.

The operations of the company, as well as the going-private promises, are perched to an extraordinary degree, on the representations and obfuscations of just one man, Chairman Tianfu Yang.

The going private transaction filings are already replete with Chairman Yang’s refusal to provide transparency into his company.  Thwarting Morgan Stanley's buyer search, Chairman Yang’s was unwilling to share sufficient information with any parties trying to value the company.  Its language we've never seen before in a public company document.  (See link below to "no disclosure to suitors". )  

Further, despite having hired the world’s pre-eminent investment bank, Goldman Sachs to advise him personally, the bank financing essential to the company’s going-private transaction has been negotiated by just one man, Tianfu Yang.  Outside confirmation of the “bankability” of this loan commitment has been reduced to just one single disclosed conference call among the parties.  All of the nameplate advisors have explicitly disclaimed any independent verification of material company information, or the responsibility to acquire any, beyond what the company has disclosed to them.

And still the financials for this company are no better than those provided by the disgraced audit firm Frazer Frost, which is actually not in business any longer, its own merger-formed company torn apart by SEC sanctions for shoddy work practices ( http://www.sec.gov/litigation/admin/2010/33-9166.pdf ) and failure to detect fraud at RINO.

   Where is Harbin’s Real Business?

 

Here is a glaringly simple question, yet one which shareholders are willing to overlook in the hopes of a buyout.  Who are Harbin’s customers?  The linear and micro motor division creates custom motor solutions.  Therefore the company should have a portfolio  of customers with large-scale production orders.   Harbin’s revenue growth claims are enormous – it claims it is now doing more business in its most recent quarter than it did in the entire year 2008 — a 400% increase in just over 2 years — and at very high margins.   But not a single customer of significant size can be independently confirmed.  With a $500 million a year run rate, it should be possible to find at least a few customers doing $25, or $15 or even $10 million a year in verifiable revenues with Harbin.  But there simply are not.

This is why Citron’s findings published two weeks ago here  http://www.citronresearch.com/index.php/2011/08/03/harbin-electric-completely-exposed/   are so disturbing.  Harbin stopped disclosing customer concentration identities and percentages in 2010.  But its claimed 2009 and 2008 large customers do not check out, and are easily disproven.  Harbin’s largest purported customer in 2008 (and #2 in 2009), Jiangsu Liyang Car Seat Adjuster, simply does not manufacture or offer for sale electric seat adjusters (after a brief attempt to expand into that product line), and states it buys no electric motors. 

So who are the customers?  To make matters worse, the company was not willing to disclose or discuss customers even with a possible suitor, who was brought to the table by Morgan Stanley, as evidenced by comments in the fairness opinion. 

See page 2:  no disclosure to suitors

Instead of issuing Press Releases attacking short sellers, if Chairman Yang were interested in building the value of his company, rather than manipulating the price of his company’s stock, he simply needs to make his company transparent to investors.  With millions spent on “advisors”, not one dime has been spent to remedy the lack of a reliable audit.  Why has Harbin published at least 5 PR’s in the last year attacking shortsellers, and 7 others about the going-private transaction, yet only one identifying a single design win leading to a new piece of business with a disclosed party.  Citron has made a simple chart that shows the communications from Harbin to Wall Street.  In the past 2 years, Harbin has only disclosed one customer order (and we do not even know the value of the order) in December in 2010.  Besides that….nothing.

HRBN PR survey

 

   How do you explain this land transaction?

It has been a common tactic of China fraud stocks to announce fraudulent asset purchases to offset claims of fraudulent revenue.  The problem is, if you announce huge fictitious gross and net revenues, how do you account for the fact that your cash never goes up?  You have to offset the fake profits with fake asset purchases.  PUDA, YONG and BORN are just a few of the firms that have gone this route.

So it raised a few eyebrows when Harbin abruptly announced with its most recent “record” quarter, that it was putting down a $23 million deposit on land rights for a new factory.   This transaction was never disclosed in a press release, nor was the need for these 80 acres was ever previosuly disclosed in a conference call or investor presentation.  It just suddenly appeared in a filing last quarter’s 10-Q.  (It is just a coincidence that the purchase price is almost exactly Harbin’s pretax net income reported for the quarter?)

 

"On June 10, 2011, Simo Motor entered into a land use agreement (the “Simo Land Use Agreement”) with Xi’an Lintong Tourism and Business Development Management Commission (“Xi’an Lintong”) with respect to Simo Motor’s use of 500 Chinese Mu of land (approximately 82.4 acres or 333,500 square meters) located at Daixin Industrial Development Zone in Xi’an Lintong (the “New Site”). Pursuant to the Simo Land Use Agreement, the New Site will be used for construction of a new manufacturing facility that will produce electric equipment and machinery and related products as part of a capacity expansion project at Xi’an Simo. The term of the Simo Land Use Agreement is 50 years and the aggregate amount that Simo Motor shall pay to Xi’an Lintong is approximately $38.8 million (RMB 250 million). The Company made a pre-payment of $23.0 million (RMB 150 million) as of June 30, 2011 and will pay in full upon receipt of the land use license to be issued by the government."

 

The price Harbin paid for the most recent land transaction comes out to be 500 thousand RMB per Mu.  This price appears seriously inflated after some online research and review of corresponding land bureau records. 

1. http://studio.e696.com/stock/InvestContent.aspx?stockid=600302&reviewid=254914173250

The link above shows the purchase of 242.85 Mu of industrial use land in the exact same industrial park, dated 2008.  The purchase price then was a mere 70 thousand RMB per Mu, 14% of what Harbin is paying. While Chinese land price appreciation has been steep since 2008, a 700% appreciation is not credible.

2. http://www.dc88.com.cn/gyyq/police.asp?id=709

The link above is a policy document that shows the purchase price of the industrial park. While the date of the info is unclear, the purchase price comes to between 30 thousand to 60 thousand per Mu, roughly in line with the 2008 purchase record.

3. http://www.xainvest.gov.cn/baozhang/tzbz.asp

The link above contains information about industrial land purchase prices during 2009 and 2010, in the city of Lintong, where Harbin’s land purchase is located.  We see prices of 112 thousand per Mu, less than 1/4^th the 500 thousand per Mu Harbin paid for its land.

4. http://maps.google.com/maps/ms?msa=0&ie=UTF8&ll=34.250406,108.998108&spn=0.503433,0.891953&z=11&msid=212302640873797248115.0004aa40c7b347d4bd0cc

The link above shows transactions and comparable land purchase data pulled from Xi’an land bureau. Harbin’s land purchase price simply doesn’t make sense when benchmarked against the recent transaction data and it most likely grossly overstated the price it paid for the land acquisition.  Further, this price would amount to more than double the entire land use rights the entire company shows on its balance sheet! 

Yet, not only did the company not state its intention to commit to this size land rights purchase, it didn't even put out a PR when it closed the deal.  Can this transaction stand independent scrutiny?  

   Xi’an 

Citron thought the following article, on the wild-west state of stock peddling in China, with epicenter in Xi’an, which happens to be where Harbin Ximo Motor is domiciled and where the “funky” land transaction occurred.  What makes this article interesting is it shows that even local Chinese are not immune to RTO scams and the epicenter of the problems is in the backyard of Harbin.

http://www.bloomberg.com/news/2011-08-18/chinese-protest-5-billion-losses-tied-to-u-s-reverse-mergers.html

 

   Is This the Price of a Payoff??

In Harbin’s most recent filings, we read an interesting disclosure, which management was recently asked to explain.  

“In February 2011, the Company entered into a consulting service agreement with a third party which agreed to provide advisory and consulting services to obtain financing in Chinese Capital Market for a period of 5 years from 2011 to 2015. The service fee is non-refundable and amounted to $3 million.”  

Of the $3 million, over 2.9 million has already been paid to this undisclosed party … in cash.  Now while Citron does not believe that $3 million is enough to secure a $450 million loan that cannot get paid back, we do believe that it is more than enough to secure loan documents.  Why we believe this to be true is twofold.

1. If there is one thing Harbin can do without consultants is raise money.  The company has multiple bank loans, relationships with the largest investment bankers in the world, and a purported deep-rooted relationship with one of the largest banks in China. 
2. In normal fundraising situations, companies pay investment bankers a percentage after the money has been raised.  The upfront money to this undisclosed entity that was given the same month that all parties walked away from a possible takeover transaction is the type of business done by companies on the brink of bankruptcy, not ones about to be taken over.
3. Most importantly, what makes this relevant now is that management had an opportunity to respond to the question of to whom and why they gave this money.  But management chose doubletalk and subterfuge, offering us this response:

$3 million consultant explanation

   The Black Swan

 

Citron, like many other investors, has taken a position that the lack of transparency about this company, and its operating history, create a significant risk that this deal is just a charade and can never close on the terms disclosed.  Investors will have to take their chances on a binary event – either the going private deal is funded and closes, or it does not, and the stock falls to low single digits.  There is really no other outcome.

This has nothing whatsoever to do with the fiction of "forcing down the company's stock price" the fiction management keeps trumpeting.   Based on mountains of due diligence, only the summary of which can be effectively reported in a blog, it is Citron’s belief that Harbin Electric cannot possibly pass an audit with a real accounting firm, or justify an enterprise value of $750+ million.  Further, without the going-private deal, its stock is worth no more than $2 or $3 on the Nasdaq market.   Meanwhile, Harbin has never responded to any of the substantive disclosure failures raised by Citron with verifiable  answers about the business, rather just more defense of the buyout.  Their story, and their stock, is propped by hope – the light at the end of the tunnel — without ever disclosing the dangers lurking for investors if that light is not reached.

However, what Citron cannot control is whether the political and economic situation in China is so corrupt that a bank can be influenced to make a low interest $400 million dollar loan that makes no business or economic sense, and that has no chance of ever being repaid.   If Tianfu Yang is able to use his influence and power to effect lending of a state owned bank on a stack of material misrepresentations, then the shorts are dealt a black swan situation. That is a question that no independent research or investment banking firm can handicap.

If this is the case, however, the current price of Harbin’s stock should be of no consequence whatsoever to Chairman Yang.  In fact, the lower it trades, the more “easy money” can be earned by his minions by simply waiting for this "sure thing" deal to close.  His preoccupation with the short positions and the option positions is all just noise.  The shareholder vote is a foregone conclusion; every shareholder wants the “easy profit” of the $24 payout.  The only question is whether this deal is real or not, period. 

   Conclusion

Citron expects that there will be private buyouts of a few Chinese companies in the next year.  But these will be at very modest prices, after the fraudulent inflated claims wash out.  The transparency risks of companies operating in China have been made very very clear to the market, and are now increasingly being priced in.

Meanwhile, Citron has published ample evidence that Harbin Electric closely resembles the raft of other China RTO’s that have collapsed under the weight of their material misstatements to the US market.  Consider:

• Extreme revenue growth, but an absence of verifiable customers
• 50-year old main manufacturing facility
• Its unlikely cash position inconsistent with its patchwork of loans and financings
• Quarter after quarter of purported “record profits”, but keeps needing financing
• Hasty and apparently fabricated land rights transaction
• Unnecessary cash-up-front “Fees” to undisclosed parties
• No legal or financial accountability from the many paid advisors and consultants to the deal

If this buyout deal should hit a “last minute snag”, in Q1, 2012, China Development Bank’s financing commitment is set to expire, just days before the company faces its March 15, 2012 audited 10-K filing date with no “plan B”.  Without audited financials, Harbin then faces delisting proceedings. 

It is Citron’s belief that the company cannot pass a real audit, and the only way an unaffiliated banking entity would finance a $400 million dollar loan for this company is with the application of substantial “guanxi”, which is not a balance sheet item.

Meanwhile, the regulatory risk remains very high.  Harbin trades despite its obviously deficient 2010 audit, and its failure to satisfy Nasdaq independent audit committee requirements, which it was notified about in 2009.  It is obvious from prior Citron reports that Audit Committee Chair Boyd Plowman is not and was never "independent", due to his undisclosed director's role at various Abax entities. 

Meanwhile, if unchallenged by regulators, the proliferation of other “Chairman led” buyouts flying in the face of due diligence, (latest example PUDA) is an obvious consequence for the US markets.

 

PS   If the deal doesn’t close, don’t expect the deal terms to provide consequences that protect shareholders.  No purchase money is escrowed in this deal structure.  90% of the termination fee would be due from Chairman Yang himself.  And as Chairman, it would be his responsibility to collect it …. from himself.  Now that’s a payment that would take some “guanxi”…! 

 

Cautious Investing to All