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

 

 

stock ticker: HRBN

   Introduction

In 2010, the Chinese RTO space was thrown on its head when once high flying Rino International was exposed as a fraud and its customer/contractee list was shown to be fraudulent.  At the same time the CEO was taking money out of the company, the company was misrepresenting its stature in its industry to US investors.  All of this transpired under the eyes of their trouble-plagued auditor Frazer Frost. 

It was only a month earlier that Harbin Electric (NASDAQ:HRBN) prevented itself from becoming another RINO by announcing a takeover bid by its Chairman/CEO Tianfu Yang.  But that time has now come.  Citron will prove that Harbin is just as bad as RINO:  fabricated customers, management taking money from the company, undisclosed insider dealings, and the worst accounting disclosures that either Citron or any forensic accountant has ever seen.

As for a buyout?   Not happening!   This report, if printed in its entirety, would span over 100 pages.  A team of attorneys and investigators has been gathering this data for months. 

Overview

This report examines in significant depth Harbin’s purported operations and the deal documents to explore the following questions:

2. Harbin has grossly overstated revenues from its three disclosed (largest) customers.
3. Harbin has grossly overstated its export revenue. 
4. Harbin is guilty of multiple securities violations
5. Harbin's largest division has disclosed material control weaknesses in every principal aspect of its business. 

Note:  Throughout the report we will refer to a thorough investigation into Harbin conducted by a private investigative firm in China.  In order to protect our sources, Citron redacts the name of the firm,  replacing it with “X” in appropriate documents.  The executive who headed the report is a Certified Fraud Examiner with a specialty in China who has curriculum vitae more extensive than any investigator we have ever worked with.  The full report, including the redacted names, will be available to the SEC or through legal due process with Citron Research.

   Grossly Overstated "Largest Customer" Revenues

Harbin’s current 10-K (fiscal yr 2010, filed March 16, 2011) states:

“No customer accounted for more than 10% of the total revenues for the fiscal year ended December 31, 2010. Two major customers accounted for approximately 22% of the net revenue for the fiscal year ended December 31, 2009, individually accounting for 12% (DXT) and 10% (Jiangsu Liyang Car Seat Adjuster Factory), respectively. Three major customers accounted for 43% of the net revenue for the fiscal year ended December 31, 2008, with each customer individually accounting for 16% (Jiangsu Liyang Car Seat Adjuster Factory), 15% (DXT) and 12% (Guiyang Putian Logistic Co., Ltd.), respectively.”

It is the opinion of Citron that Harbin is materially misrepresenting its revenue to the investing public and thereby committing fraud on the marketplace.  Here we will review the 3 stated major customers of Harbin and the results of our investigation.

Customer #1: Jiangsu Liyang Car Seat Adjuster

The clearest sign of fraud at HRBN is seen in the interview with the purchasing agent at Jiangsu Liyang.  Jiangsu Liyang (JLA) was reported to be Harbin's 2nd largest customer in 2009 (10% of revenues), and its largest in 2008 (16% of revenues).
The customer's Vice General Manager states unequivocally that not only has his firm not ordered a fraction of what Harbin has reported, worse, their customers predominantly order manual seat adjustors, not motorized ones.

This interview is definitive and draws a clear path to fraud – more than sufficient to trigger the Material Adverse Effect clause of the bank's loan document draft. 

[  Liyang Car Seat Adjuster Manager Interview  ]

Analysis of JLA revenues per HRBN disclosures:

Year	HRBN Reported Revenues (USD mil)	% from JLA	Revenues attrib to JLA (USD mil)	Avg RMB / USD conversion rate FY	Revenues attrib to JLA (RMB mil)	Revenues as reported by JLA (RMB mil)	Revenue % over-stated
2009	223.23	10%	22.32	6.8311	152.49	0.32	98 %
2008	120.82	16%	19.33	6.9483	134.32	0.32	98 %

 

According to JLA's SAIC filings and presentation, which are consistent with its published business model, HRBN’s claimed sales to JLA were 114% of JLA’s total 2009 revenues, and 148% of JLA’s 2009 operating costs.  See the documents linked below for verification. 

[ JIANGSU LIYANG AUTOMOBILE SEAT ANGLE-CONTROLLER Credit Report and SAIC filing ]

[ Liyang 2011 Business Plan ] 

**  Interesting note:  JLA has no difficulty making public statements consistent with its SAIC documents – which is not the case with HRBN … or many other of the Chinese RTO’s.

Customer #2:  Daqing Xinchengtai Technology  (DXT)

The reported largest customer of Harbin in 2009 (and #2 in 2008) was challenging to obtain financial information from.  That is because they are not a manufacturer themselves, but rather a middleman, supplying pumps to the government funded Daqing Oilfield.  While the SAIC docs retrieved were light on information because of the “Intermediary” nature of DXT's business, the interviews were conclusive.

All of Citron’s research, including interviews, confirmed that Harbin grossly overstated revenues recognized from DXT.  It is Citron’s assessment that HRBN overstated its 2009 and 2008 sales to DXT at least by 365% and 247% respectively. 

Below is the supporting documentation:

[ Daqing Interviews ]

[ DXT SAIC ]

Customer #3:  Guiyang Putian Logistic

The last of HRBN’s “top 3” customers is Guiyang Putian Logistic (GPL), responsible for 12% of Harbin’s revenues for 2008.  ( The Chinese character name for GPL is:

贵阳普天物流技术股份有限公司 ) 

It is the opinion of Citron Research that Harbin has greatly exaggerated its sales to GPL.  As stated in the 10-K,  GPL was 12% of 2008 Net Revenue of $120,802,302. Obtaining these records was more burdensome because Guiynag is located in the Guizhou Province, a third level province in China with inferior corporate record keeping.

HRBN reported sales to GPL that would be 85% of GPL’s total revenues.  This is obviously unrealistic as validated by the purchaser for GPL.  Our source documents appear below:

[ GPL_Interview ]

[  GPL SAIC English  ]

This is what our research revealed for the only three customers ever identified in Harbin's SEC filings.  We can only imagine what the rest of the revenue book looks like.

   Grossly Overstated Exports

From 2010 10-K:

“Our automobile specialty micro-motors are purchased by customers who are first-tier suppliers to the automobile industry. We supply these products to domestic customers and also export them to OEM suppliers in North America.”

In the same 10-K they state that international sales are $20,410,902 for the year ending 2010.  Noting all of the subsidiaries of Harbin as presented in this corporate structure on their website:

 

Citron has completed an exhaustive analysis of product imports as published in Datamyne, and finds a mere fraction of the amount of imports to North America Harbin claims to be exporting. 

It is the opinion of Citron that Harbin has exaggerated their export data by a factor of multiples.  Linked here is a worksheet with our findings.   Our research shows HRBN exports of less than $4 million in 2010, compared to their reported $20+ million.

[ Harbin Exports from Datamyne ]

For all those who think that Harbin is immune to criticism because of its purported pending buyout, be advised that this company is under the scrutiny of the SEC until the moment the deal is completed.  The company is at risk of being forced to announce non-reliance on its filed financial statements at any time.  The Material Adverse Events clauses of the various deal agreements therefore hang in the balance. 

   Material Adverse Events

Even though Citron has provided strong evidence that HRBN has been fabricating revenues in its SEC filings, we are sure that many investors will say, “Who cares if the company is being bought?” 

Besides the obvious regulatory risk involved, there are critical contingencies defined in the loan docs that give the bank an out for material misstatements by the company in its reported financials.  In particular, the loan documents state:

18.12   Original Financial Statements

(a) The Original Financial Statements were prepared in accordance with the Applicable GAAP consistently applied unless expressly disclosed to the Lender in writing to the contrary before the date of this Agreement.

(b) The Original Financial Statements give a true and fair view of the Target’s consolidated financial condition and results of operations during the relevant financial year.

(c) There has been no material adverse change in the Target’s assets, business or financial condition since the date of Original Financial Statements.

(d) The Group’s most recent financial statements delivered pursuant to Clause 19.1 (Financial Statements):

(i) have been prepared in accordance with the Applicable GAAP as applied to the Original Financial Statements; and

(ii) give a true and fair view of (if audited) or fairly present (if unaudited) its financial condition as at the end of, and results of operations for, the period to which they relate (consolidated where applicable).

(e) Since the date of the most recent financial statements delivered pursuant to Clause 19.1 (Financial Statements) there has been no material adverse change in the business, assets or financial condition of the Group.

 

Securities Law Violation/Conflict of Interest 
– Part 1: Tianfu Yang’s personal loan from Harbin

 

In the 10-K we read an interesting disclosure: 

"On December 28, 2010, the Company made an advance of $1,517,000 to Tai Fu Industrial Co., Ltd., an entity owned by Tianfu Yang, the Company’s Chairman. The purpose of the advance was to accommodate an urgent cash need of a transaction for this related entity under a guarantee to repay the Company within a few days.  As of December 31, 2010, the money was repaid in full."

This disclosure brings up several issues that should be troubling to all investors:

• Why does another entity belonging to the CEO have an “urgent cash need”?
• Why does Tianfu Yang not have $1.5 million in cash to give to the other entity?  Isn’t that odd for someone proposing to sign personally for a $400 million loan?
• This transaction appears to be a clear violation of Sarbanes Oxley.  As clearly stated in section 402 from Sarbanes Oxley:

SEC. 402. ENHANCED CONFLICT OF INTEREST PROVISIONS. (a) PROHIBITION ON PERSONAL LOANS TO EXECUTIVES.—Section 13 of the Securities Exchange Act of 1934 (15 U.S.C. 78m), as amended by this Act, is amended by adding at the end the following: ‘‘(k) PROHIBITION ON PERSONAL LOANS TO EXECUTIVES.— ‘‘(1) IN GENERAL.—It shall be unlawful for any issuer (as defined in section 2 of the Sarbanes-Oxley Act of 2002),  directly or indirectly, including through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer.

.

Was the loan actually repaid?  Is it odd to take an "urgent cash need" loan out on Tuesday, only to pay it back on a Friday?  Who accounted for the reconciliation of the loan?  Was it paid back in full in cash on that stated date?  Or was this a postdated transaction that involved an “in kind” repayment at a later date so the company did not have to take the charge before the quarter ended ?  Or are we supposed to believe the repayment just coincidentally fell on the last day of the quarter?

Additionally, it was previously reported on by Citron that in the past that CEO Tianfu Yan and his brother Harbin Vice President Tianli Yang were previously obligated to make a civil settlement of a charge of misappropriation of funds and falsification of a bank loan document at a prior company.  While these facts do not prove fraud in Harbin, it does go to character.    

Harbin responded to this finding, not by disproving or even denying their legal wrongdoings, but rather by claiming that Tianli Yang is not a director of Harbin as Citron stated.  Just to prove the thoroughness of the work, here is a document that proves in fact that Tianli Yang is on record as a director of Harbin.

[ SAIC Filing with Tianli Yang Director ]

 Securities Law Violation/Conflict of Interest – Part 2: 
Boyd Plowman’s role in Abax and the Harbin Special Committee

 

 

Aside from Harbin’s CEO, the most important man in this process has become Boyd Plowman.  Mr. Plowman is both head of the audit committee of Harbin, as well as the appointed head of the special committee to take the company private.  This committee is at the center of the requirement that the interests of shareholders be defended.  It is under his watch that we are to trust both Harbin’s financials, and the fairness of the process by which the “takeover” transaction proceeds. 

However, the July 13, 2011 proxy statement filing is the first time investors are informed of the following :

“Shortly after Abax filed a Schedule 13G with the SEC on December 9, 2010 announcing its greater than 5% ownership of the Company common stock, Mr. Plowman, the Special Committee Chair, brought to the attention of the other members of Special Committee, as well as to Gibson Dunn, the fact that he was then serving as a director of several Abax-controlled entities including Abax Global Opportunities Fund, Abax Arhat Fund, Abax Claremont Ltd., Abax Jade Ltd., Abax Emerald Ltd., Abax Lotus Ltd., Abax Nai Xin A Ltd., and Abax Nai Xin B Ltd. (the “Abax Companies”).”

This relationship presents many conflicts of interest among shareholders / Harbin / Boyd Plowman that the SEC cannot ignore. 

1. #1.  On July 29, 2010, just before all the buyout drama began, Abax Emerald loaned Harbin $15 million at a 10% interest rate.  This would be a related party transaction, since the head of the audit committee is a director of Abax Emerald.  Worse, you would think the head of the audit committee would know better than to fail to  disclose this relationship.  The above-market interest rate alone gives rise to the question of whether preference was granted to a related party.
2. #2.  Reading the language in the filing, we are to believe that no one on the special committee ever knew that Plowman was associated with Abax?   Does this pass the smell test?
3. #3.   It has never been disclosed how much financial interest Plowman has in Abax.  Nor have been disclosed other relationships with directors of Abax, such as this investment company we found called Kilometre Growth, where Plowman is a director along with other Abax directors.  Why are these matters undisclosed in HRBN's SEC filings?

http://www.formds.com/issuers/kilometre-growth-asia-fund

Citron is amazed that Gibson Dunn did not find conflict in this relationship and that the SEC can authorize this deal without greater transparency of the Abax/Plowman relationship.  This might be the first time in the history of takeovers that the head of the special committee formed to oversee the sale of a company is actually a director of the acquiring entity.

Citron also notes the numerous times Plowman’s bio appears in Harbin’s filings; yet not once does it mention his directorship in Abax funds; this despite Abax’s high profile in the China investment scene following Morgan Stanley’s major stake in the fund in 2007. 

   Disclosures that the SEC Cannot Ignore

While the Special Committee was busy talking to the white shoe lawyers and bankers about a deal, the most reprehensible disclosures we have even seen in a public company were filed in the HRBN 10-K.  The disclosures are regarding Simo Motor, the largest subsidiary of HRBN, purchased in 2009 and "restructured" in 2010, at a cost of over $25 million, to integrate it into Harbin just last year.  We note that these disclosures did not exist when HRBN purchased Simo. 

“We and our independent registered public accounting firm, in connection with management's assessment of and the audit of our internal control over financial reporting as of December 31, 2010, identified five material weaknesses in our internal control over financial reporting…

Control activities related to bank reconciliation – At Xi’an Simo, the bank reconciliation for various bank accounts were not prepared accurately, which impacted the valuation and existence of the cash in bank as of December 31, 2010.

Control activities related to the reconciliation and classification of notes receivable – At Xi’an Simo, notes receivables endorsed as payment to third parties were not properly recorded, resulting in a discrepancy between the physical notes receivables on hand and the general ledger. Additionally, the improper classifications of transactions has impacted the completeness, and valuation of accounts payable / advance to suppliers and notes receivable balances at the year ended December 31, 2010 at Xi’an Simo

Control activities related to the calculation of provision of income tax – At Xi’an Simo, due to ambiguities in the PRC tax rules, the temporary and permanent differences in tax amounts were not properly identified

Control activities related to valuation of inventory allowance – At Xi’an Simo, slow moving inventories that had not been used over a year were not properly evaluated for inventory allowance.

Control activities related to inventory recording –– At Xi’an Simo, inventory movement between manufacturing facilities and sales entities were not timely and properly recorded on the general ledger.

It is especially astonishing how Simo Motors, Harbin's largest and highest visibility acquisition, has severe management control problems in every single verifiable part of this business:  cash reconciliation, tax filings, payables, receivables, and inventory valuation.  And as has been previously documented in text and video ( view here if you haven't seen it already), Simo Motors main physical plant is an antiquated 50 year old facility, with severe lack of automation of its manufacturing capabilities, requiring tens of millions of dollars in retooling and capital improvements required to to be competitive in its space.

With all the money being spent on consultants, why wouldn’t Goldman Sachs, Morgan Stanley, or Lazard recommend a new, independent forensic accountant to run these material weaknesses to ground before any deal closes? 

   Forensic Analysis

Because we knew that HRBN directors would not hire a forensic accountant to go through their current operations, we hired one ourselves to present a financial analysis of HRBN.  As noted, every potential financial acquirer walked away from this deal…maybe they saw what our forensic accountant projected.

[ HRBN Independent Forensic Acounting Report ]

   Cannot be Said Too Many Times:  Frazer Frost

Anyone following the China RTO drama is well aware of the notorious audit firm Frazer Frost, which occupies a unique spot in the history of this sector.  After all, Frazer Frost is the only auditor sued by the SEC during this entire China RTO fiasco.  Citron is actually in competition with Frazer Frost — they have as many halts as we do over the past 7 months.

http://www.theprogressiveaccountant.com/news/sec-suspends-california-audit-partner.html

“Moore Stephens Wurth Frazer Torbet, LLP and Frost, PLLC are moving to resume operations as separate entities, as existed prior to their combination in January 2010. The combined firm, Frazer Frost, LLP, will continue to exist as a legal entity until the separation has been completed. It continues to be the policy of both firms not to comment publicly on client, personnel, or other internal matters.”

“Frazer Frost”, the auditor of record for Harbin’s 10-K, doesn’t actually exist any more. (Citron especially appreciates this website.  http://www.frazerfrost.com/ )  This is what investors will see if anyone ever tries to hold the auditor accountable for the annual financial report on which this purported 3/4ths of a billion dollar transaction is based. 

Formed of a merger in early 2010, Frazer Frost was dissolved in the wake of the SEC suit for having accepted management’s assurances in lieu of its own verification in the case of China Energy Savings Technology.  Then came the exposure and delisting of RINO, whose management admitted it had fabricated revenues based on non-existent contractual relationships with large customers, again assumed valid by the same audit firm.  

With all the firepower of assembled consultants for this deal :  Goldman Sachs, Morgan Stanley, Ernst & Young, Lazard, Skadden Arps, Gibson Dunn,  and White & Case, all with their hand in the till for the deal, nobody has demanded the hiring of a forensic auditor to finally lay out a full and fair accounting of the entire company for all investors to see what’s going on.  The only numbers available are Frazer Frost’s.

   A 500 Page Proxy Statement, but
Nobody Has Done Their Homework

 

Lets see what all these high-priced consultants didn’t do.

Morgan Stanley:

“In arriving at its opinion, Morgan Stanley assumed and relied upon, without independent verification, the accuracy and completeness of the information that was publicly available or supplied or otherwise made available to Morgan Stanley by the Company, and formed a substantial basis for its opinion. With respect to the April 2011 Case, Morgan Stanley assumed that they had been reasonably prepared on bases reflecting the best currently available estimates and judgments of the management of the Company of the future financial performance of the Company.”

Lazard:

“Lazard assumed and relied upon the accuracy and completeness of the foregoing information, without independent verification of such information. Lazard did not conduct any independent valuation or appraisal of any of the assets or liabilities (contingent or otherwise) of the Company, or concerning the solvency or fair value of the Company, and Lazard was not furnished with any such valuation or appraisal.”

Goldman:

Mr. Tianfu Yang did not request, and Goldman Sachs did not provide, at any time, any opinion to the parties as to the fairness of the $24.00 offer price or as to any valuation of the Company for the purpose of assessing the fairness of such offer price. Goldman Sachs was not requested to, and did not, recommend at any time the specific consideration payable in the proposed merger, which $24.00 consideration was communicated by Mr. Tianfu Yang to Goldman Sachs and subsequently was determined by negotiations between the Special Committee and Mr. Tianfu Yang and Abax, and as a result, the Company’s decision to enter into the merger agreement was solely that of the Special Committee and the Company’s board of directors.

(Goldman apparently did not assist Tianfu Yang in the negotiations for a $400 million dollar bank loan either.) 

Audit Committee:

“Members of the Audit Committee rely without independent verification on the information provided to them and on the representations made by management and the independent accountants. Accordingly, the Audit Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal control and procedures designed to assure compliance with accounting standards and applicable laws and regulations. Furthermore, the Audit Committee’s consideration and discussions referred to above do not assure that the audit of the Company’s financial statements has been carried out in accordance with generally accepted accounting principles or that the Company’s auditors are in fact “independent”.”

And finally, Citron notes that all the negotiations with China Development Bank were conducted personally by Tianfu Yang, despite his having retained the world's pre-eminent investment banker as his personal advisor. 

    The Silence of the Buyers is Overwhelming

This company was left at the altar by Barings.  Worse, they were left at the altar by 73 potential strategic and financial bidders, who were offered a look at this company.   Only 3 bothered to execute an NDA, and not one offered a competing bid.

The industry has spoken.  The lack of enthusiasm for this deal speaks volumes. Initially the deal was to be funded by Goldman Sachs and Barings.  After they walked away, Morgan Stanley shopped for buyers.  Of the 73 potential bidders they bought to the table (41were strategic), only 3 strategic ones even asked for an NDA. 

For a company who is supposed to be a leader in the Chinese motor industry it is obvious that their industry does not even find them significant enough to sign an NDA.  The complete lack of interest in the deal from all parties that were brought to the table by Goldman Sachs and Morgan Stanley affirms to ridiculous nature of this alleged buyout.  This demonstrates that not only does Citron view Harbin with skepticism, but it has no credibility with any serious competitor in the space.

   Breaking Up Is Hard to Do

Deals of this size typically have breakup fees attached.  These are intended to provide a measure of assurance to investors, who have the most to lose if it fails, or the spurned buyer, for all their wasted expense and effort if a better suitor comes along. 

But like every aspect of this proposed deal, the breakup fees are a story of their own. 

Consider:

• If the company breaks up the merger, it owes the buyer group, 90% of which is Chairman Tianfu Yang $22.5 million.
• If the buyers group fails to conclude the merger, the buyer group jointly (but not jointly and severally) is obligated to pay the company a $30 million breakup fee.

Since, in neither of these cases, is any cash pledged to back these guarantees, these failsafe provisions, customarily structured to protect the unaffiliated security holders from a broken deal, result only in scenarios where the Chairman has to sue his company or the company has to sue its Chairman, for enforcement of the "guarantee". 

   The Significance of the SEC in this process

The entire proxy and Form 13E-3 is now submitted and under review by the SEC for comments and questions.  At a time when both US officials and Chinese officials are working towards the goal of reliable and transparent disclosures from Chinese listed companies, this filing is a major step in the wrong direction. 

The next step in this process is an anticipated set of questions and comments from the SEC, due within 30 days of the SC 13E3 filing date, July 13, 2011.  This report will shed light on numerous issues that should be of substantial concern to the SEC, as noted in the next section.

Where the market has done an efficient job in flushing out Chinese RTOs and other equities with unreliable accounting, the notion of hiring a team of lawyers to prop of a company with questionable financials, reconciled by non existent auditing firm is a dangerous blueprint for other Chinese companies to inflate their stock while management could possibly be selling stock into a bidding market.  Chinese nationals in management positions, insulated as they are from any enforcement of US securities law can easily orchestrate the whole process.  Therefore the SEC is a gatekeeper on a set of market integrity concerns which stretch far beyond the current Harbin drama.

   Proof that Tianfu Yang has NO INTENTION of Concluding the Proposed $24 Buyout of Harbin Electric

 

It's really quite simple.  If Tianfu Yang wanted to buy Harbin Electric he would have taken a different path.  He knew Simo's cash couldn't be reconciled.  He knew his gross margins from his antiquated factories couldn't possibly be double or triple any of his competitors.  He knew the sales to disclosed major customers were false.  More than anyone, he knows that the company keeps consuming cash, despite the profitable financial statements and projections.

ALL he had to do was declare non-reliance on the filed audited financial reports.  He would have disclosed all the internal weaknesses in the company, and gone through restatements.  He would have hired a forensic auditor, and would be able to buy the entire company for possibly under $5.00 a share.  He knew all of this and knows it today.  

For less than 25% of the pricetag of the financing he's purportedly arranged, he and a group of colleagues could have bought 100% control of the business completely legally and swiftly.  In fact, as his advisors, Goldman Sachs would have been remiss to the point of negligence had they not so advised.  Why has nobody advised calling in a forensic accountant? 

Caveat emptor.

   Conclusion

In reviewing the preponderance of evidence presented in this and previous Citron reports on Harbin, it is the unequivocal opinion of this writer that CEO Tianfu Yang does not want this deal to go through.  He alone knows what his company is truly worth, and he knows about the overstatement of revenues.  The last thing he wants is to be on the hook for a $400 million loan for a company that only made .16 cents last quarter, even considering its highly suspect accounting.  Mr. Yang was able to procure a boilerplate loan doc; Citron believes it was competently prepared, but it will never be executed.

 

stock ticker: ZAGG

Next month, August 2011, marks the 10^th anniversary of Citron Research researching and publishing on the topic of stock fraud.  China aside, Citron has uncovered and published more actionable stories of stock fraud in the US markets among domestic companies than any other research journal or column online. 

 

   Lie with Dogs, Get Fleas

What really drew Citron's attention to ZAGG was the 10-K of 3/25/2011, in which Randall Hales is appointed head of ZAGG's audit committee.  This is a move so egregious it absolutely made our eyes pop out.

Indeed, Mr. Hales is well known to Citron… 

 

Introducing Randall Hales, audit committee chairman of ZAGG

Mr. Hales is the former CEO, President, and Chairman of the board of First Scientific.  The claim to fame of First Scientific is that after the post-September 11 anthrax scare, (FSFI) claimed to be in the middle of testing “an anti-anthrax bacterial crème”. 

http://www.stockpatrol.com/article/key/anthrax2

What makes the anti-anthrax scam even crazier is that according to the SEC the company’s principal operating subsidiary was sold at foreclosure just six months before they even pulled the anthrax stunt…. and it was never disclosed.

This is the chosen new head of ZAGG's audit committee? 

In uncovering fraud, one of our key indicators has always been the pedigree and credibility of management.   It is our study of management that leads us to believe that ZAGG is committing fraud on the investing public.  Go ahead and sue, ZAGG, you will lose.   We continue our discussion of management credibility below…but its not off to a very promising start…

 

ZAGG is presenting an intentionally distorted financial picture of its current business, playing word games while flirting with outright fraud.  Citron predicts that ZAGG will not experience the explosive growth that management and the analysts project for the future, and the retail investors piling in now as its enterprise value approaches $500 million will take huge losses as a consequence. 

 

In the first Citron report on ZAGG, we focused on cash flows, pointing out how real cash flow has been declining while inventory has been growing disproportionately to reported revenues.   These metrics come from ZAGG’s reported financials to date, revealing the company is not generating cash, but rather burning it in increasing amounts.  Their investment premise, parroted uncritically by analysts, projects a glowing picture of the future.  But this picture is directly contradicted by the competitive factors inherent in ZAGG’s core business.   

 

The heart of the issue therefore goes to management credibility.   Therefore this report covers three main points:

 

• Reliability of reported revenues in ZAGG’s core business, in light of adverse competitive factors
• Analyst track record, and whether they are worthy of investors’ trust in their recommendations
• Management credibility

   ZAGG’s revenues:  Can you take them to the bank ?

ZAGG’s protective covers for cell phones and iPads are sold through a variety of channels, but the largest one by far is Best Buy.   Any Citron reader can in fact wander into their local Best Buy and observe a whole rack of SKU’s for ZAGG’s covers for dozens of cell phone models.  These include hot selling models as well as dozens of “last year’s models” that have gone dormant, which is simply the nature of the business.

 

If you ask a sales rep, you’ll find out, unsurprisingly, that ZAGG sells some products for the current “hot models”, and the rest are dead. 

 

Analysts and skeptics have focused on the status of ZAGG’s revenues because of the huge number of “dead” SKU’s on display at Best Buy.  Big box retailers are notorious for highly one-sided, vendor adverse return policies for inventory they carry.  For example, Staples has an “open return” policy on ZAGG’s products.  Yet ZAGG has steadfastly insisted that Best Buy purchases are final and cannot be returned.  This would imply vendor market power for ZAGG which is available only to Apple, and would be highly unusual for a gadget accessory vendor. 

 

Speaking of Apple, Citron has no doubt that ZAGG is selling some amount of covers for the currently hot model: iPhone 2, plus accessories for the iPad.   But it is clear from industry commentary about Apple that it is selling huge quantities of its own cover, and there are literally hundreds of competitors for iPhone covers.

http://blogs.barrons.com/techtraderdaily/2011/07/11/apple-bachman-ups-ipad-estimates-those-covers-make-money-too/?mod=BOLBlog

 

Comparative data points keep popping up to increase the concern.   For example, just last week, on 7/6, Skullcandy filed their S-1 to go public.  As most ZAGG investors know, Skullcandy is “the brand” in the headphone and phone case market.   (Recent ZAGG acquisition Ifrogz can be considered a generic competitor to Skullcandy.)  In Skullcandy’s S-1, we read an interesting disclosure:

 

"……….We have executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded as a reduction of revenue at the time of recognition or when circumstances change resulting in a change in estimated returns."

 

It is the opinion of Citron that Skullcandy sells its products subject to an open return policy because it is simply required to do business with the big box stores.

 

This relationship description is consistent with the experience of numerous product vendors’ when dealing with major chain retailers.   Yet ZAGG claimed it could sell the same category of products to Best Buy without any return contingency….until they were forced to insert some more wiggle words. 

 

Has ZAGG really orchestrated a better deal at the major retailers than Skullcandy, a deal unique in all the world of big box retail?  Or is management not being forthright about its terms?  Remember, this issue is large enough to trigger an accounting restatement, and/or to wipe out all of ZAGG’s reported profits.

 

Citron advises that investors assess the risks here based on the company’s own words (from their 11/10/2010 conf call) :

 

http://www.sec.gov/Archives/edgar/data/1296205/000101376210002774/ex993.htm

 

“Q:  Okay and then just one last question and I don’t want to be rude here or anything but would you please address one more time your contract with Best Buy and what their opportunity is to return product to you or not.  Could you lay that out on the table one more time?

 

Brandon O’Brien – ZAGG Incorporated – CFO

Sure, as we have reiterated in the past.  Our contract with Best Buy does not allow for any type of return.  We do not have the ability to send products to Best Buy more than they order.  So there is no way for us to stuff that channel.  We are fulfilling the orders that Best Buy sends to us on a weekly basis.  They get that product.  That product is theirs then and there’s no return rights on that.”

 

Just three weeks later, the company was obliged to issue an 8-K, backpedaling on that claim, having gotten so much flak that the claim simply wasn’t credible.

 

http://www.sec.gov/Archives/edgar/data/1296205/000101376210002947/form8k.htm

 

On November 9, 2010, the Company conducted its Third Quarter Earnings conference call.  Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company’s Chief Financial Officer, participated in the call on behalf of the Company.  During the question and answer portion of the conference call, Mr. O’Brien was asked questions about Best Buy’s right to return products sold by the Company to Best Buy.  In response, Mr. O’Brien stated that the Best Buy contract did not allow Best Buy to return products to the Company.  As clarification to Mr. O’Brien’s statement, the Company notes that Best Buy can return products to the Company under limited circumstances, including where products are defective or for other similar customary reasons.

 

That wasn’t the only forced “clarification” either.  In the same release, they were forced to “clarify” statements made at the Merriman Investor Summit Conference, reducing the claim of “millions of dollars” of orders to just $1.5 million.

Merriman Investor Summit Comments

On November 15, 2010, Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company Chief Financial Officer, participated in the Merriman Investor Summit 2010 in New York, New York.  Mr. Pedersen gave a presentation regarding the Company and its prospects.  In the course of the presentation, Mr. Pedersen discussed the introduction of a new product, the ZAGGmate, for protection of the iPad device.  Mr. Pedersen described the ZAGGmate product and its features, its anticipated introduction date and pricing.  Mr. Pedersen further stated that the Company had received orders for “tens of thousands” of the ZAGGmate product and that companies “like a Best Buy” had ordered “millions of dollars” of the ZAGGmate product.  It has now come to the attention of the Company that some participants at the Merriman Investor Summit 2010 and others who have listened to a recording of the conference might have understood Mr. Pedersen to say that Best Buy had ordered “millions of dollars” of the ZAGGmate product.  As clarification to Mr. Pedersen’s remarks, the Company notes that as of November 15, 2010 it had received initial stocking orders for $1,500,000 of the ZAGGmate product from large, national indirect channel partners.  In addition, as of November 15, 2010 the Company had also received ZAGGmate product orders from other retail outlets, including on-line retailers.

 

The company has been very evasive about the details of their relationship with Best Buy.  The funny thing is that Citron does not fundamentally disagree with the company, we believe that Best Buy only has the right to return product under “certain conditions”.   So whether its a matter of credits against future orders, expense deferred forward, or whatever, there is a shell game being played in here with loose language.  If ZAGG really wanted to clarify this question, they should have made their entire sales relationship with Best Buy transparent.  It is Citron’s belief that they can’t – it would force them into a financial restatement.

 

These restatements should be red-flag concerns all investors.  It is Citron’s opinion that they inevitably foreshadow another kind of restatement – the bad kind.

 

   Analysts or Puppets?  Uncritical Analysts Just Parroting Management Claims

 

Two analysts cover ZAGG:  Northland Securities and the new kid on the block, Jon Hickman, at Ladenberg Thalmann. 

 

Northland, whose now notorious anointment of CCME (now delisted) as its “Top Pick of 2011”, has been very vocal about ZAGG, feeling the need to issue a note and a reiteration every time anything critical is stated in public about ZAGG.  But their justification is just a hollow echo of management’s claims.   They don’t say a word or provide any independent assessment of the risk factors and the troubling red flags surrounding management’s actions and statements.  

 

It would be no surprise that Citron places zero credibility in the work product that comes out of Northland.  Recommending that investors buy ZAGG at these levels, without even acknowledging the major risk factors in the details of their sales contracts or the quality and credibility of their management, is malpractice.

 

Hickman just came over from a small firm MDB Capital Group.  His 15 minutes of fame came in an interview just 7 months ago, in which he delivered more dogs than the Humane Society.  http://finance.yahoo.com/news/Semiconductor-Company-Rated-1-twst-556849794.html?mod=pf-real-estate&x=0

 

Let’s review the quality of his thought:

 

Ticker	Nov 4, 2010 Price	Current Price	Pct Change	Comments
SATC	4.00	2.00	- 50%	His top pick
HEV	3.75	.80	- 75%	Citron covered this stock in 2008l stock was 7.00 at the time
QTWW	9.50	5.43	- 40%
VLNC	1.30	1.08	- 20%
ALTI	2.00	1.02	- 50%

 

Honestly, these outcomes are exactly representative of what Citron’s expects from ZAGG.

At its core, the ZAGG pro-and-con argument breaks down like this:  The bullish analysts take their projections straight from the company’s guidance.  The optimistic view is that revenues will rocket higher — and all of the paper profits plowed into inventory stockpiles so far have been built up to prepare for this future.  The bull case also stands on the premise that all sales to Best Buy (by far their largest single customer) are final sales with no refund or credit overhang.  Therefore its posted revenues are clean, and its revenue growth projects into a future which can be relied upon. 

 

The bear case, as reflected in the opinion of Citron, is that the company is operating a terminal business model and has not been forthright with Wall St. on either revenues, inventory accounting, or future business prospects. 

 

If you’re going to buy this stock, you are banking on the bright future story, not its current assets or current cash flows.  Therefore, the safety of your capital will be entrusted to ZAGG’s management team. 

 

   Introducing the ZAGG team

 

Top Dog

Let’s start from the top down.  The CEO of the ZAGG is Robert Pedersen. As mentioned in the widely read Worthless Pennies report, CEO Pedersen was involved in many penny stocks over the years.  Yet, Citron wants it noted that he was not just passively involved, but while the CEO of ZAGG was supposed completely fully dedicated to his position with the company, he was moonlighting orchestrating dodgy reverse merger deals.  Below are the list of stocks and the relevant dates he appears at the center of reverse merger deals while he was the acting CEO of ZAGG. 

 

         

Ticker	Company	Merger Filing   Date	Recent price
AMBS	Amarantus Biosciences	6/3/2011	1.05
ADSYQ	Ad Systems Communications	2/12/2010	.0014
PMOZ	PrismOne	6/22/2009	.0027
BESN	Blue Earth Solutions	5/20/2008	.0011
GNAU	General Automotive	2/28/2008	.05
WSGF	World Series of Golf	2/1/2008	.01
ZNOM	Znomics	11/08/2007	.0255

 

The Face of Fraud

The public’s last line of protection in the soundness of companies it invests in is the auditor.  It is the audit committee that is responsible for all aspects of the audit relationship.  Because of the red flags regarding ZAGG’s inventory and sales policies, the auditor and the integrity of audited financials going forward is the fulcrum of the investment’s safety and soundness. 

 

As mentioned in the previous report but cannot be understated, late last year ZAGG committed blatant securities fraud by not disclosing the dismissal of the former head of its audit committee Lorence Harmer until four months after the event.  Clearly there were shenanigans involved; ZAGG appears to have eaten a substantial loss after having advanced $4 million in a related party deal with the Chairman of its own audit committee.  

 

On November 5, 2010, he resigned from ZAGG but the company never filed a required 8-K announcing the event.  To make maters worse, the company then issued a 10-Q just four days later, but made no mention of the resignation or a replacement.

 

What were they hiding?  Why did they not want the investing public, or their new auditors to know the new head of the audit committee?  Here is why.

That all becomes a little more clear once you realize his replacement is the abovementioned Randall Hales.  This choice is unspeakable from a corporate governance standpoint.  And note that is he works hand-in-hand with CFO Brandon O’Brien, whose last public company went into liquidation while he was CFO, with annual revenues barely more than $1 million.

So these are the horses you are betting on when you bet on ZAGG. 

 

   Hello Skullcandy, and a comment on valuation.

 

Once public, Skullcandy will have 27.5 million shares outstanding with management selling half of their equity at IPO.  With a brand that is growing over 100% a year and ttm revs of 160 mil and strong management, Skullcandy would have the same enterprise valuation as cash strapped ZAGG…but who cares about valuation when your business will eventually implode?

   Conclusion

Buyer beware.

 

Cautious investing to all.

stock ticker: ZAGG

Citron comments on ZAGG, Inc.  (NASDAQ:ZAGG)

Price target:

One month — $8.00

24 months — $2.00

 

Outstanding Shares: 

• 26.2 million fully diluted per Q1 10-Q
• + 4.4 million shares for iFrogz acquisition
• New Share count:  30.6 million shares

Debt:

• 4.2 million
• $5 million assumption from iFrogz
• $50 million new debt financing:

Enterprise value  $450 million +

   Overview

 

Citron notes the insightful writings of others on this red-flagged company, in particular Roddy Boyd at  http://www.thefinancialinvestigator.com/ and Worthless Pennies,  http://www.scribd.com/doc/45466615/ZAGG-Presentation-12-14-10-Final-2 , who have both carefully documented the personal backgrounds of a number of dodgy players in gadget protector company ZAGG. 

However, Citron advises that to get to the heart of ZAGG’s current problem, investors need to follow the money.  If ZAGG’s current financial reporting were as clear as its gadget protectors, we would be inclined to withhold judgment on management’s history.

But while the company is battling scarce cash, it is perilously dependent on a single concentrated retail relationship that in Citron’s opinion puts it at huge risk of restatement.  Meanwhile there’s a very troubling track record of insider transactions among management that are adverse to shareholder interests, an 11^th hour auditor switcheroo last year, and a long record of abject failure at executing on “the next big thing”.

For its readers, Citron notes these data points and connects the dots.   For reasons we will document below, it is Citron’s opinion that the company is in desperate need of additional financing, and the coming dilution will be at the hands of existing investors to fund a business model that has bankruptcy written all over it.

   Please Define “Execute”

Let’s evaluate this company from another perspective:  What management says vs what has really happened.

Last week the CEO of ZAGG came on CNBC and, while dodging the real questions of the company’s lack of cash flow, stated  “We are proud that the company has ‘executed’ its business plan.”  When Citron heard this, we didn’t know if he meant executed (to carry out fully) or executed (to put to death).  It seems that EVERY new business ZAGG has entered over the past few years has been a colossal failure.  Here is a sample of their press releases and results.

 

August 14, 2007  “RockStic”  Portable speaker system for iPod (one of thousands) — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=259618

 

May 2, 2008:  Finance animated and live-action feature films — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=307948

 

March 31, 2009  New design for Zbuds — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=374064

 

June 8, 2009  Mobile App marketplace — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=388591

 

Sept 29, 2009  Waterproofing technology — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=412063

 

October 29, 2009  Zagg box – big failure

http://investors.zagg.com/releasedetail.cfm?ReleaseID=419590

http://www.zaggbox.com/wheretobuy.php

 

Dec 22, 2009  “Zaggsparq” portable lithium battery system  – failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=432001

 

April 6, 2010  iPad Photo App — failed

http://investors.zagg.com/releasedetail.cfm?ReleaseID=456981

To make matters worse, on the deal for the ZAGG box, they had their own head of the audit committee hoodwink them for over $4 million.  When the head of your audit committee pulls a fast one on the company, it is like your own mother telling you “you’re ugly”.

   The Whole ZAGG Story in one graph

Beneath the constant stream of cheerful sounding PR’s, the company’s actual financial condition as reported in its filings is appalling. There are numerous disturbing trends that can be observed in ZAGG’s reported numbers, including increasing SG&A as a percent of revenues, declining inventory turns, and that glaringly small cash balance.  But all you need to know is the little chart here from Google finance that shows the cash flows of the company

http://www.google.com/finance?q=NASDAQ:ZAGG&fstype=ii  (Click the “Cash Flow” tab)

So the business was generating zero cash a year ago.  Since then, operations have burned an increasing amount of cash, which loans and equity issuance have shored up until now.   

 

Cash was so scarce at the end of last quarter ($1.7m), that the question could legitimately be asked whether the company could make payroll this month.  (SGA alone was $8.78m last quarter)   And that is before considering how iFrogz’s current burn rate will be funded. 

 

Just a couple of the metrics that indicate the severe problems underneath the covers here:

 

	Mar-11	Dec-10	Sep-10	Jun-10
Revenues	26.976	29.253	23.06	15.047
CASH (millions)	1.767	2.373	5.886	6.402
SGA	8.782	7.251	5.427	4.294
SGA % of revenues	32.55%	24.79%	23.53%	28.54%
Recievables (millions)	18.65	23.76	14.40	9.48
Inventory (millions)	21.19	17.95	10.39	6.20
Inventory turns per year at current run rate	5.09	6.52	8.88	9.70

 

   Kissing a Frog Doesn’t Make it a Prince

ZAGG’s stock got a big boost when it acquired competitor iFrogz for about $100 million in stock and cash.

Why has the company has not filed the required 8-K disclosing the financials of the acquired company?  Are we to believe that this acquisition was done without benefit of an audit?  If not, how could it be accurately valued?  If so, why haven’t the audited numbers been shared with the market?  iFrogz is itself just a wannabe competitor for Skullcandy, and also competes directly with ZAGG SKU’s, Citron wonders why this acquisition is a justification to bid up the stock ?   ZAGG mentioned that iFrogz has operating margins in the 20% range, but we find that hard to believe — that is the range of the established brand Skullcandy line.

For stock market history buffs, Citron believes ZAGG has “Forward Industries (NASDAQ:FORD) written all over it.    http://www.google.com//finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1309464000000&chddm=909458&chls=IntervalBasedLine&q=NASDAQ:FORD&ntsp=0

The problem is that accessories for electronic gadgets is fundamentally a brutally bad business.  The Financial Investigator and Worthless Pennies did a fine job in describing the competitiveness and razor thin margins of the screen protector business.   The huge proliferation of SKU’s for each new model of gadget is a big problem under the best of circumstances.  Then there’s colors and styling.  For runaway models such as iPad2, there’s no barrier to entry.  The competitiveness and non-differentiation in the iPad case business is so bad, that even the New York Times ran a feature article on the space just yesterday:    http://www.nytimes.com/2011/07/07/technology/personaltech/a-closetful-of-options-for-protecting-the-ipad.html?_r=2&ref=business

 

   The #1 Question Management Will Not Answer

Ask anyone who works for Best Buy corporate about Best Buy’s policies for returns of unsold accessories (not to mention why they don’t private label their own).   We have.   Also, if any of Citron’s readers visited Consumer Electronics Show over the past two years, you would note that there are halls and halls dedicated to low price cell phone covers that can be imported from China for pennies.  It has become the ultimate commoditized product in the accessory market.

Because of ZAGG’s concentration of sales to Best Buy, investors are desperately in need of transparency with regard to its rapidly rising inventory.  How much of this “inventory” is good inventory and how much is required to be bought back from Best Buy?  Is this number accounted for in write-downs?  It is a VERY simple question, but management provides only circular answers.  They have always maintained that Best Buy cannot return product to them.  To this we say Bullshit.

On November 9, 2010, the Company conducted its Third Quarter Earnings conference call.  Robert G. Pedersen II, the Company’s Chief Executive Officer, and Brandon T. O’Brien, the Company’s Chief Financial Officer, participated in the call on behalf of the Company.  During the question and answer portion of the conference call, Mr. O’Brien was asked questions about Best Buy’s right to return products sold by the Company to Best Buy.  In response, Mr. O’Brien stated that the Best Buy contract did not allow Best Buy to return products to the Company.  As clarification to Mr. O’Brien’s statement, the Company notes that Best Buy can return products to the Company under limited circumstances, including where products are defective or for other similar customary reasons. 

What defines a “customary reason”?  Are you recognizing revenue on these “customary reason” returns?  Would any of your sales terms to Best Buy qualify as consignment basis ?   Do you pay cash incentives to Best Buy?  How are inventory levels determined?

The language employed by ZAGG to define this relationship is extremely unusual; we could find only a handful of companies in recent years that used it … most have since ceased filing. 

   Is Management Worthy of Investors’ Trust ?

To illustrate just how untrustworthy management is, from the 10-K filed March 25, 2011, we learn of the resignation of director Lorence Harmer.  But magically, we learn that he resigned as Audit Committee Chair back on November 5, 2010, over four months prior!  Now that would have been an event for which a definitive 8-K should have been filed.

“On March 14, 2011, Lorence A. Harmer resigned as a director of the Company.  Mr. Harmer had served on several of our Committees through November 5, 2010 including serving as the Chairman of the Company’s Audit Committee; as a member of our Compensation and Stock Option Committee; and as a member of our Nominating and Corporate Governance Committee.  Effective November 5, 2010, Randall Hales was appointed as the chairman of our Audit Committee.”

 

 http://www.faqs.org/sec-filings/110325/Zagg-INC_10-K/#ixzz1RQMFlYt6

 

We wouldn’t quibble if this was just one of those “for personal reasons” resignations.  But it seems Mr. Harmer had entered into a major related party transaction with ZAGG over the “ZaggBox”, which resulted in ZAGG having paid out deposits of over $4 million dollars, for which it got nothing.  This has now been papered over by a promissory note from Harmer, secured by real estate with collateral value insufficient to cover the principal.  And this blatant related party transaction was conducted by the Audit Committee Chair!

The larger problem here is ZAGG’s corporate transactions are laced with inexplicable and indefensible related party transactions similar to this one.  

   Beware the PIPE

The absence of an 8-K with accurate financials for iFrogz, along with Northlands constant table-pounding begs us to ask the question … what will come first:  the 8-K or the PIPE offering?

 

It has been a long time since we’ve seen an analyst with the conviction of Northland’s – 4 upgrades and reiterations in the last week!   

Too bad Northland can’t anoint ZAGG as its “Pick of the Year 2011”, that choice having already been reserved for CCME.

http://www.scribd.com/doc/47598147/CCME-Top-Pick-of-2011-Northland-Securities

Do you think Northland might possibly have an interest in getting a piece of the action in ZAGG’s financing ?    

   Note to management: 

Don’t bother responding to this report.  ZAGG is now a company with an enterprise value approaching half a billion dollars … act like one. 

The problems in this stock are not the shorts.  It is Citron’s opinion that this is what the market demands of ZAGG: 

• File an 8-K with the audited financials of iFrogz
• Give Wall Street fully transparent disclosure on your entire relationship with Best Buy, and
• Start turning a cash profit 

   Conclusion

ZAGG’s stock is priced not for its current business, but in anticipation of a highly profitable future.  However, it is Citron’s opinion that ZAGG management is simply not credible, and its track record is not worthy of investors trust.   Management’s track record is laced with blatant self-dealing, execution failures, and disclosure omissions.  The lack of transparency in its most concentrated retail channel relationship puts it at severe risk of a devastating earnings restatement.

Meanwhile, ZAGG simply has to raise cash.  It is Citron’s opinion that a PIPE could come any day, and a secondary would follow an 8-K on the iFrogz acquisition.  It is Citron’s opinion that absent their ability to raise cash from investors, ZAGG is a likely candidate for bankruptcy inside of 24 months.

Citron disagrees with The Financial Investigator on only one point:  the one where Roddy Boyd states there is no barrier to entry to ZAGG business.  NOT TRUE.   It is Citron’s opinion that the barrier is that very few companies want to enter into a low margin, money losing business. 

 

Cautious Investing to All