Netflix, Inc. (NFLX) - Potential Red Flags in Financial Statements and Business Risks

Since I initiated coverage of NFLX, several investors have given me good feedbacks and inputs (most of them are positive to my analysis, and I appreciate it). Some investors mentioned some red flags in the company’s financial statements that I think are worth some discussions here. There are indeed numbers in their financial statements that may be indications of poor earning quality and/or manipulation on recording of accounting transactions and/or preparation of financial statements by the company in order to hide the deterioration of operational results/outlook from the attention of the public. All my analysis and estimates of course were based on an assumption that reported accounting statements so far are reliable and certain areas that require management’s assessments such as depreciation schedule, intangible impairments, timing of revenue recognition were prepared in an objective and unbiased way. If not, all analysts’ estimates of future financial results may be totally off.

One area of potential concern is the amortization amount that you mentioned. The radio of “Amortization of content library” to “Current content library” stayed at 62% - 63% in the first two quarters. So, the numbers were consistent in Q1 and Q2 reports. However, what many analysts have overlooked (or have noticed but not brought to investors’ attention) is that the value of current content library swelled 47% in Q1 and 88% in Q2 this year, and there is no stop of the bloating trend in sight. Meanwhile, revenue only increased by 9.7% from Q1 to Q2. So, going forward the company’s gross margin is going to be squeezed hard in the remaining of the year and beyond. As we know average per capita income and purchasing power in Latin America is a fraction of that in the U.S., but I don’t think movie studios will give Netflix, or any streaming provider, large discount on per subscriber or video view charge. So, I really doubt if the company can even break-even in their south America venture. For U.S. and Europe, tons of people are still unemployed and struggling to pay their debts, while inflation rates are high for commodities and staples but low for discretionary items (well, it is economy 101 – many people’s pockets are shrinking, and most people choose to cut vitamins fist before cutting life-saving medicines). So, overall I am just not feeling too good about the outlook of the company revenue growth and am very pessimistic about its margin.

Another area of particular concern from the standpoint of trustworthiness of the accounting reports is accounts payable. This line bloated by 35% in Q1 and 77% in Q2. The increase so far seems to be still in line with the increase in purchase of content library each quarter. However, the radio of AP to cash + short term investments has grown from 0.63 on 12/31/2010 to 1.42 on 6/30/2011. In other words, the company’s quick ratio has deteriorated significantly from AA to BB- in credit rating terms in my opinion. If some suppliers decide to tighten the invoice term to the company for whatever reason such as seeing better term from the company’s major competitors, the company can quickly run into liquidity trouble. What is even more alarming and suspicious to me is that the company suddenly erased the showing of change in accounts payable in its last quarterly report. In the statements of cash flows for Q1 (http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0001193125%2D11%2D112061%2Etxt&FilePath=%5C2011%5C04%5C27%5C&CoName=NETFLIX+INC&FormType=10%2DQ&RcvdDate=4%2F27%2F2011&pdf=) this year and earlier periods, “Accounts Payable” is clearly shown as a line item under “Changes in operating assets and liabilities” in cash flows from operating activities section. However, in the statements of cash flows for Q2, (http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0001193125%2D11%2D198669%2Etxt&FilePath=%5C2011%5C07%5C27%5C&CoName=NETFLIX+INC&FormType=10%2DQ&RcvdDate=7%2F27%2F2011&pdf=), the line for accounts payable was gone, evaporated! Of course the liability account does not stay flat QOQ. In fact it increased by a whopping $311K from $222.8K to $533.4K within the last quarter. I think its accounting team probably buried the change in AP into “Additions to streaming content library” line or “Change in streaming content liabilities” line. Either way, it is a very misleading way of presenting operating cash flows because AP has very different meaning from these other two accounts. AP is part of liability, which tells a company’s extension of borrowing capacity to its vendors and the danger of running into insolvency in the future. On the other hand, “Additions to streaming content library” and “Change in streaming content liabilities” are cost of revenues account that show how much new inventory was purchased and how much inventory was consumed or written down. The fact that the company decreased visibility of change in AP in its financial statement (sure people with enough accounting knowledge will still figure it out by doing the calculation I showed, but many investors have limited accounting knowledge or simply do not pay attention to the QOQ changes in balance sheet lines) tells me clearly that the management team themselves agree that the huge increase of AP was a negative to many investors.

There are a lot of other legitimate questions to ask for data to verify such as if the increase in subscriber number real? How do they count subscribers? Are inactive members (members who are suspending their accounts and not paying) counted as subscribers? Among all people around me – people in my office, my relatives, and my friends range from 17 to 70 years old – the total number of subscribers to Netflix have been roughly unchanged over the past two years. Few people newly subscribed to it, and few people dropped their subscription. I am really wondering where are the populations in the U.S. that the company claimed to have just discovered and loved the service so much that so many of them jumped on board in the past two years? I personally feel that the movie rental and viewing population is pretty much like the PC usage population and should already been pretty saturated in North America?

I did not go into details of financial statements and challenged the numbers because, unlike Muddy Water Citron Report, and many “professional shorts”, I normally give the benefit of doubts to the management team unless some numbers fall into the range of absurdness. Even if there is some chance that the values of certain lines in the financial statements might hold water, I’d leave the whistle blowing obligation to their internal accountants and auditor. In addition, I do not have as much resource and capital as Muddy Water and Citron to dig out some hard to get documents in order to expose a company’s accounting manipulations (yet I need to stress again that in my view not all their accusations are correct). This is a good example of what I meant by Wall Street’s discriminative treatment of American firms vs foreign firms in several posts including this one: http://www.staranalystonline.com/2011/02/special-discussion-reliability-and.html. If this is a Chinese company, all these shorting specialty groups will rush to jump on board to expose all potential accounting irregularities on company at this lofty level of valuation. I guess everybody assumes that everything is fine simply because it is an American company and the CEO looks so righteous. This is exactly how we get American scams with manipulated financial bubble bloated to such a big size such as Enron, Worldcom, Movie Gallery, Bear Stearns, Lehman Brothers, and Madoff before being exposed. Then again, who knows? Many of these famous short houses have expressed opinions lately that it is now very hard to profit from shorting Chinese companies because the valuations of even legitimate ones have been depressed to underground levels. Muddy Water in particular might be turning their attention to American mid to big caps because their appetitive seems to be becoming bigger and bigger - from RINO to CCME  to SNOFF. Sino Forest (SNOFF) in particular is a company with substantial business activities in North America and traded at multi-billion capitalization after several years of high-flying and being pumped hard by several big hedge funds including Paulson & Co before being attacked by Muddy Water. For readers not familiar with the story of how these quite powerful shorting groups have destroyed many high flying Chinese stocks (some of them have more believable financial reports than NFLX in my opinion) this year, I encourage you to search online and read how RINO, CCME, and lately SNOFF stocks were destroyed by them in matter of days after they published negative reports on these stocks. Netflix of course has bigger market capital and supports from more I-banks and funds than SNOFF. However, on the other hand it has much higher P/E multiple then SNOFF before struck down and has brewed a bigger bubble. So, I think these two factors are pretty much a wash in terms of potential effects from Muddy Water / Citron Research attacks. Even if Muddy Water or Citron Research just publish an informal inquiry to NFLX management with a list of suspicions like they did to SPRD in June (blogs.barrons.com/tech...), I think the stock will fall to 200 or lower in a couple of days. If Muddy Water or Citron publishes a full report declaring seriously accounting misstatements in NFLX, the stock may plunge to 50 within a couple of days.

I have sent emails to Muddy Water Research analysts (http://www.muddywatersresearch.com), its founder Carson Block, and Citron Research analysts (http://www.citronresearch.com/) telling what I have discovered so far on NFLX and asking them if they have taken a look at Netflix and if so what’s their view on its and whether they are working on anything regarding the stock. Right now I think it will help to have some very reputable whistling blowing and fraud detection specialists research on this stock for all investors.

Now, let’s leave concerns on accounting and financial side along and turn our attention back to business and economics. Basically there are two segments of Netflix’s business – physical DVD rental and online streaming. One the physical delivery side, I think there is no argument even from the pumpers that the outlook is pretty dire. Again, like PC industry, the market is completely saturated. Even assume what the subscriber number the company reported in the past two years did not hold any water, going forward new subscriber gain is likely to be small and will be offset by customer attrition. This is only the revenue side; the danger on the cost side is even greater. Inflation has been rising over the past year or so and is almost certain to be running high going forward. Gas price in particular has risen almost 50% in a year and almost doubled over the past two years. Meanwhile, USPS has kept the lowest mail delivery rate, the one that Netflix uses to transfer DVDs, at 44 cents for a very long time - more than two years since May 2009 (http://en.wikipedia.org/wiki/History_of_United_States_postage_rates), pretty much like China government rules retail gas price and always try to cap it at early stage of inflation in order to stabilize “social cost”. However, once the cost increase reaches certain limit the regulator will have no choice but to start raising the rates, often by quite huge extent in a series of raises. China government’s series of raises of retail gas and diesel price from Q4 2010 to Q1 2011 and USPS’ series of hikes on standard rates from 37 cents to 44 cents from 2006 to 2009 were good examples. In other words, the company has been taking advantage of this unusual generosity from US government and painting a false impression of artificially low and stable delivery cost for its DVD service over the past two years. Now, we all know that government subsidy to a lot of things including to USPS going forward will inevitably shrink due to current budget and national debt crises. What if USPS raises the rates to 47 cents next month, 50 cents in the end of the year, and 54 cents again at mid 2012? The impact to Netflix’ cost of goods sold will be quite material.

The other side of business – streaming video – isn’t fairing much better either. I just don’t know why some stock commentators and I-banks keeps on hyping the prospect of this chunk of business. Again, it is a pretty standard, low tech, stuff by now. Even I myself wrote a web application that provided online video viewing and video conference in three months when I did some system developments about 10 years ago. Today I can hire a team of five computer science graduates, purchase several high-end servers and racks of disk-storages and created a pretty professional Netflix, Youtube, or Hulu like video viewing web application in three to six months. There is a reason why we see online streaming service offerings suddenly sprouted over the past two years. It is not that this business is so lucrative or what, it is simply because this business has low level of entry. In fact, for many services the traditional brick-and-mortar model has higher barrier to entry than new online model because capital requirements and system development time are more stringent when companies are doing physical business. For example, in physical mail delivery several big players – UPS, Fedex, DHL – dominate the market and earn quite good margins, but in online form of mail delivery, e.g. emails, the situation is totally opposite. There are countless of email service providers online, nobody really dominate the market, and the worst thing is that nobody really earn any meaningful profits from the business because, well, most email services are free, and even big companies with huge base of customers in other service segments – Microsoft, Google, Yahoo, etc. – cannot do anything about it because if you don’t offer it free, nobody will sign up to your service since there are abundant free lunches out there. Same thing apply to web hosting, messaging (including “video” conferencing), image sharing, and even network connections (dial up, DSL, cable, wireless, whatever). Streaming video might fare a little bit better as least for now, but it pricing power for Netflix or anybody else is still very weak. That’s why we see free movies, TV, and other videos flooding everywhere on the web – Hulu, Youtube, Youku.com, Sohu.com, ppstream.com, BitTorrent sharing network, and more. If you think the number of new online video viewing portals over the past two years was large, wait until you see how many more will pops up over the next two years. I won’t be surprised at all if 20 more new or existing websites start putting movies online for people to view over the next two years. Why so many? Because as I said putting streaming videos on websites is not a high tech but a low tech for programmers now. However, something can be easily done doesn’t mean that companies can make a lot of money out of it. Actually, it is quite the opposite. When there are 30 online movie viewing sites out there, none of these sites, including Neflix will have any bargaining power with the upstream of the supply chain – the movie studios. People will be reminded again that the majority of value creation and critical point of the video entertainment business is the movie making, not distribution. The “concentration of value” and “imbalance of power” will become even more obvious when movies are distributed over the web rather than through physical means. I don’t understand why some people are selling the story that Netflix’ fate in this new business realm will be better than in traditional DVD mailing realm. What if most of its then remaining subscribers are using its streaming business paying $4 per month, and the company only owns 20% or less of market share in the U.S. two years down the road and has to spend a lot more on a much bigger content library to keep its customers satisfied? Honestly, I think Netflix right now is Yahoo in year 2000 at best and more probably AOL or Blockbuster in late 1990s.

I see that many speculators and momentum traders are still blindly jumping into the stock simply because a few TV commentators and I-banks are saying that nothing serious can go wrong to the company and there are still lots of potentials (in other words dreams). We’ll I won’t bet my fortune basing on their advice because most of them are not promoting the stock for the good of general public; most of them are pumping the stock for their own good because many of them and/or their friends have tons of shares on the stock to unload. I mentioned one CNBC commentator in my last post. How about Goldman Sachs? Well, the firm told investors that crude price would go to $200 (http://www.marketwatch.com/story/goldman-sachs-raises-possibility-of-200-a-barrel-oil) in 2008 when the commodity was already over $100 and close to $150 at its peak and when all economic signs strongly suggested drop in consumption, credit tightening, deteriorating financial system, and bubbling commodity prices fueled mostly by speculations. When crude pulled back from $150 to $130, just like NFLX has pulled back from $300 to $260 right now, GS and a couple other I-banks told investors that it was probably only a temporary pull back and that it was “healthy” for a run up to higher ground, like $200. Guess what? Woops, nope, their predictions were dead wrong. Crude plunged all the way to $30 before the bleeding stopped. It is only in the U.S. that most financial professional and firms producing this kind of damaging advice are not sent to jail, and hundreds of billions of tax payers’ money were spent to rescue them and went into their bonus pockets. I wonder how they can face themselves in the mirror if Netflix drops all the way to $60.

Disclaimer

I am a completely independent analyst and am not paid by any company of which the stock I cover or write articles about. However, I may have long or short position on a stock I cover or write about at any time.

My ratings and/or analyses of a stock only represent my personal view on the stock and/or my assessment on the probable movement of the stock price in the next 12 months. They are by no means a guarantee of performance on any long or short trades on a stock and should not be relied upon solely for buying or selling a stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences and needs when making an investment or a trading decision. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.

Netflix, Inc. (NFLX) - Coverage Initiation

Stock Covered: Netflix, Inc. (NFLX)

Current Stock Price: $272

Target Stock Price: $165

Rating: Strong Sell

Date of Analysis: 07/27/2011

Most my readers and followers know that I am a fundamentally and long-term focused investor, rather than speculator, manipulator, or gambler. As an investor, naturally I am heavily poised to take long positions in stocks and rarely take short positions partly because I am more enthusiastic to see companies succeed than fail and partly because most shorting ideas are more short-term oriented due to the nature of shorting. Occasionally, I do see situations when a stock has been hyped to an unthinkably inflated level and the assumptions that need to stand and events that need to unfold in order to future revenue and earnings to grow at the rates needed to support the lofty price level are dauntingly unattainable in statistical sense that shorting of the stock is at least an intriguing idea to me. One such example right now is Netflix (NFLX).

To begin with, Netflix already ranks at the bottom of industry list from my top-down selection. First, it is in a traditional, low tech business. Yes, not only its DVD service is old dog, but I consider even the streaming business is not any hot or new technology now. Secondly, the industry does not have any resource constraints or regulatory license requirements (unlike coal and oil industries LLEN and LPH are in). These two key characteristics of the industry mean that barrier to entry is low and competitors and imitators can get into the business and eat Neflix’ market share IF THEY ARE DETERMINED TO. Finally, it selling discretionary, leisure products, of which the sales are volatile and are usually cut relentless by consumers at economic down turn or when their pockets are tight (like right now when inflation eats into their income). Statistics show that just these three characteristics along almost ensure that a company’s ability to sustain above average revenue or profit growth rate (especially on the profit side because companies can expand revenue with the sacrifice of profit or even at a loss). As such, a company with these characteristics should be placed at a valuation multiple lower than those of other companies with similar short-term profit margins and growth rates. The valuation level and price trend of Netflix stock from 2006 to 2008 were generally in line with this principal. However, starting from the beginning of 2009 the stock suddenly roared out of gate and has kept on gravity-defying rise for about 2.5 years under the continuous gang blockbuster, herd flocking pumping by the CEO and whole bunch of hedge funds and bankers, sending the stock to a rightly money-robbing level of almost 80 times TTM EPS and 60 times FTM EPS basing on average first call analyst estimate (http://finance.yahoo.com/q/ae?s=NFLX+Analyst+Estimates), which is at the high end of the estimate of $4.20 to $4.50 from my statistical quant model.

Backing up this super long stretch of jaw-dropping price inflation were a series of actually not so jaw-dropping compounded annual revenue growth rate of only 26% from 2008 to 2010 and 33% from 2008 to 2011 (basing on average estimate of $3.27 billion revenue for 2011). In comparison, LLEN grew its revenue by 55% annually from fiscal year 2008 to 2010, LPH grew its revenue also by about 55% annually from fiscal year 2008 to 2010. Ok, ok, I know they are Chinese companies and small caps, but how about Apple? Even Apple grew its revenue by 42% annually from 2008 to 2008 and 49% annually from 2008 to 2011(basing on average estimate of $107.90 billion revenue for 2011). Why should I give Apple, a company with much more technology sophistications, a premium brand image that is untouchable by its competitors, and as a result much more solid advantages and secured revenue and profit growth rates, at only 16 times TTM earning while paying multi-fold price for a Netflix stock at  80 times TTM earning? I cannot think any reason from asset valuation stand point to give Netflix such a fat bonus in pricing.

Now, most investors, including the CEO and those hedge funds and promoters of the stock, would agree that the stock definitely should not deserve such a valuation basing on the revenue and earning trends over the past 3 years. So, what other selling points have they put in their marketing campaign to successfully fooled investors into giving them such a high price for each share of stock? A dream of worry-free growth for years to come mostly, a dream that is largely unrealistic and unlikely to come true.

Many investors, especially retail inventors, have amazingly short memory and forget lessons learned quickly. No stocks, especially stocks in traditional business (DVD rental certainly is, and in my view even streaming is not a hot new tech stuff anymore either), can defy gravity and shoot to the moon. People forgot what happened to Blockbuster, Hollywood Video, Movie Gallery (MOVI), and AOL. Like Netflix, Blockbuster and AOL, two names no less dominating and powerful in their respective businesses in 1990s than Netflix is today, fought hard to thwart off a demise of stagnating and thinking businesses replaced by similar, but improved, products or ways of service delivery. Let’s not forget how strikingly similar the situation of Blockbuster’s in 1990’s was to the situation Netflix is facing today. Blockbuster was a super Wall-street darling for a decade before start seeing real market erosion to new form or movie delivery by Netflix, pretty much like Netflix is facing competition from yet a newer form of movie delivery – streaming video – today. The CEO and most his “pumper alliances” – some hedge funds, I-Banks, and manipulators (including a notorious CNBC entertainer who told all viewers of his show: “Bear Stearn is fine! Do not sell the stock” two days before the collapse of the stock) kept on dismissing the power of Netflix’ competition even when the signs of Blockbuster’s revenue and profit growth slow-down manifests in the first couple quarterly reports (pretty much like Netflix’s last quarterly report). After a couple years of late into the game (pretty much like Netflix is to streaming video today), Blockbuster finally started adopting into the new form of business to try to transfer its revenue from old business to new business. Not surprisingly, the CEO told the public that the company would be able to dual with the product offerings from its major competitors including Netflix and Redbox and use its brand name to be the market leader in the new form of business. Sounds to me similar to what I have been heard repetitively from Reed Hasting and some analysts that that Netflix can trump online streaming offerings by all other competitors – Redbox, Hulu, Amazon, Walmart, Lovefilm, Youtube, Blockbuster, Zediva, cable service providers (e.g. Time Warner Cable), etc. Well, guess what? It’s the 100+ year old economics and statistics doctrine, not the CEO’s and hyping analysts’ optimisms, that stood at the end: Blockbuster did experienced major problems replacing all its revenue from then existing business model to a new business model and did lost quite an huge chunk of market to new competitors.

A more alarming, and maybe more similar comparison to Netflix from the aspects of logic-defying revenue/income growth and stock inflation, is MOVI. Like Netflix, MOVI was hyped to the core by hedge funds and speculators from cents to almost $40 a share when the company kept on beating analysts’ estimates for several years amid abundant skeptisms and warnings from several whistle-blowing fundamental focused analysts and the CEO kept on selling the fantasy growth story that the company could keep on multiplying even when it was forced to go out of its comfort zone and tread into an unfamiliar (and proven lethal) territory (see http://seekingalpha.com/article/315-movie-gallery-movi-meets-consensus-revenues-increase-15-in-quarter, http://seekingalpha.com/article/189-movie-gallery-movi-hits-consensus-blames-same-store-sales-decline-on-the-calendar-the-box-office-and-the-weather) until all of sudden all kinds of problems including revenue and earning shortfalls foretold by several insightful analysts sprouted altogether in a swift. After the first pull back from $37+, the truths of the company’s ugly margin squeeze and revenue contraction (a reversal from eye-popping growth like Netflix has been dishing out for several years) were quickly discovered, sending the stock to an almost free-fall to single digits within a couple months (http://www.businessweek.com/magazine/content/06_19/b3983073.htm, http://en.wikipedia.org/wiki/Movie_Gallery).

Even if Netflix CEO is indeed so superior in leading a company in a slow-growing industry to fight all competitions and cost pressures, I don't think he is a super man and don't think the stock can be worth even $200, a price level for a forward P/E of no less than 40. As one of the most famous sentences from Warren Buffett says: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”  Now, I am not saying that there is a 90+% chance that Netflix will certainly lost most of its business in the next couple years. However, to believe and promote the opposite – that there is a 90+% chance that Neflix will thwart off almost all competitions, not experience any problems in revenue transformation and margin pressures, only be affected minimally by equally or even more technologically advanced rivals, and keep on enjoying 30+% YOY top line and bottom line growth every quarter going forward – criteria that need to be met in order to even marginally justify the stock at current valuation level – is an unconscionable and completely irresponsible thing for me to do as an analyst. Of course, there have been a lot of talks about international expansions – Canada, Europe, Latin America, etc., but really, how successful the company can be in competing in Europe, a place where people heavily favor local brands and American products are not particularly successful and where most people are struggling to even make ends meet at heavy debt crisis right now? Will Latin Americans be willing to pay high enough even to pay for Neflix costs in these countries? Canada? Forget about it. It is a country with combined buying power roughly half of California. It will not save Neflix in any way. China or India in the future? Ah I won’t count on those either. People there don’t pay for copyrighted materials. In fact, Netflix should thank god that most American consumers haven’t realized that they can watch a lot of movies free on Youku.com, Sohu.com, and many other web portals in China (many people from China living in the U.S. do and thus never use Netflix).

As said I think the company will deliver full year EPS of $4.20 - $4.52, below or match current analysts’ consensus EPS estimate of 4.52 in the best case scenario with noticeable revenue/earning miss against existing street forecasts for Q3 and Q4 (sure these forecasts are likely to be slashed by some first call analysts in the next a couple weeks). For 2012, currently probability weighted mean EPS is somewhere $4.20 to $5.00 by my calculation, meaning that YOY earning growth will be single digit if the company only experiences moderate slowdown in its growth and possibly negative if domestic subscriber attrition deteriorates. At current a price of $272, the stock is trading at 55 - 65 times two-year out earning. Under universal methodologies and principals for valuing assets and earning streams, I cannot see why I as an investor should buy an asset that give me less than 2% return on invested capital (inverse of the P/E of 50), with returns growing at only single digit, and facing all kinds of downfall risks. From purely intrinsic valuation stand point I would only pay $100 top for the company’s $4.52 EPS this year and low growth rate going forward. Understanding that in stock market an overly hyped stock can take some time to re-align to its intrinsic fair value, I’d say $150 - $180 might be a reasonable equilibrium price for the stock to adjust to by the end of the year.

Another telling sign that has been sneaking under most investors’ attention radar is the staggeringly lopsided insider sells versus buys over the past 12 months: http://www.nasdaq.com/asp/holdings.asp?symbol=NFLX&selected=NFLX&FormType=form4

Sure, insiders can sell occasionally for need of cash rather than being bearish on the business outlook, but unloading 7 million shares (about 14% of shares outstanding) in 12 months and 1.66 million shares (over 3% of all shares outstanding) in 3 months while only buying only tiny 52K shares in 3 months is never a kind of normal, measured selling. Even if most of the sells are conducted under pre-arranged automatic periodic option exercising and simultaneous stock sales, the pace of the program as a whole is still a rush sale and a vote of pessimism on future stock movement in the minds of the management team and board of directors. If the outlook of the company is really so bright as some analysts have been painting and the stock should be able to be justified at higher prices within a year, while don’t the management team and board of directors accumulate more shares or at least slow down selling of their shares? The answer: because they know likely pretty soon the game of “I am buying the stuff regardless of how ridiculous the price is as long as I can sell to the next fool willing to pay even higher prices”, the game that so many irresponsible people played in housing bubble, will be over.

Disclaimer

I am a completely independent analyst and am not paid by any company of which the stock I cover or write articles about. However, I may have long or short position on a stock I cover or write about at any time.

My ratings and/or analyses of a stock only represent my personal view on the stock and/or my assessment on the probable movement of the stock price in the next 12 months. They are by no means a guarantee of performance on any long or short trades on a stock and should not be relied upon solely for buying or selling a stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences and needs when making an investment or a trading decision. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.

My Conundrums for Harbin Electric Inc. (HRBN) Buy Out Deal

All my readers and followers know that I am generally bullish on Chinese economy and companies and a strong believer of the values the assets and operations in China can bring to the investors and to all people in the world. I have used several recent examples of drastic price appreciations on several beaten down Chinese stocks from various direct intervention maneuvers (mostly institutional purchases or buyout offers), including the buyout offer on HRBN, to illustrate how imminent price correction by arbitrations on LPH, LLEN, and even ACTS can happen any day.

Even though I am a strong supporter for Chinese economy and stocks, I am proud of my ability to give unbiased valuations and analysis of these undervalued stocks basing on solid information and data and am not afraid of taking bearish stance on some Chinese stocks at certain moment when I feel something is not right. This is why I was bearish on CCME right from the very early stage of the fraud discovery of the stock (http://www.staranalystonline.com/2011/02/special-discussion-reliability-and.html). Today, I am going to share my thoughts on the buyout offer of HRBN, which might surprise some Chinese small cap investors and anger some. Note that this is only a casual article and is not a full coverage of the stock I do not intent to cover the stock any time soon because I am not bullish or bearish on the electric machinery industry.

I have been watching the tape play on HRBN over the last month or so and paid special attention on the violent debates between shorts and longs everywhere. There are too many things can be discussed from too many angles on this thing; I don’t have time to go into details on all of them and don’t believe the most topics will really help in settling the issue. For one thing, the proposed buyout offer of $24 per share is roughly 10 times of TTM EPS and 8 times FTM EPS assuming that the reported and estimated results are accurate and reliable. So, from purely static valuation standpoint it can certainly be argued that the $24 price tag is not a bad deal considering that electric machinery makers with similar growth rate are trading at P/E multiples of 12 - 15 in Hong Kong and China, although some may argue the other way that compare to current valuations of most Chinese small/mid caps the valuation is above average, which brings up the point below that keeps me wary of the situation. At a P/E of 8 to 10, there surely can still have some room for the buyer of the company to gain if the buyer later lists the stock in Hong Kong or mainland China. However, for the effort and fees a buyer needs to go through to list a stock in another exchange, a 50% arbitrage gain before fees is not too exciting for most arbitragers of this kind, at least not for me. That’s why when in my argument for a LBO of LPH and LLEN, I targeted a forward P/E of 4 – 6 because I believe at these multiples the potential arbitrage gain of 100% or higher is more satisfactory for most arbitragers (note that average P/E multiple for energy companies are higher than the average P/E multiple for machinery companies in China because revenue and profit for energy companies are more stable and the industry is in hot demand). Nonetheless, it is not to say that the buyer of HRBN cannot be content with this lower rate of return. Investors can have different return objectives.

The single, critical, unsolvable puzzle in my mind that keeps me from buying into the authenticity of the CEO’s buyout story is this: from the perspective of the buyer, $24 is almost THE WORST PRICE that a buyout suitor needs to spend on the deal. Here are several key facts: (1) the average trading volume was about 2 million shares per day for several weeks before the announcement of the deal, (2) the stock was trading at $6+ before the announcement of the deal, (3) the stock has fallen over 60% within about a period of 2 months before the announcement of the deal, breaking almost all technical supports along the way and making a lot of people desperately lining up to sell at the moment due to margin calls and stop loss, and (4) the group already owns about 40% of the shares outstanding and need to buy the remaining 60%, or about 18.5 million shares, or roughly 8 times daily trading volume.

I am not the best trader in the world, but my 15 years of trading experience tells me that if I had been a buyout suitor of the stock I could have easily accumulated at least 12 million shares for an average cost of $12 - $15 per share within a month considering all of the factors listed above under the situation of supply overwhelming demand on the stock at that time. I think most I-Banks, funds, and other experienced traders will agree with my assessment. In other words, the CEO and his fellows can easily save 40% (assuming average purchase price of $14) on 2/3 of their target shares, or roughly $120M, by buying these 2/3 of shares on open market and then offer to buy the rest at $24. In fact, in my opinion this is only an average execution and average outcome for a buyout suitor at that time. A good execution would have been like this: (1) being even more patient and accumulating 6M shares of the stock in two weeks from $8 to $5 for an average price of $7 as the stock likely would have kept on drifting down further from $7 under Citron’s ruthless attack at that time, (2) accumulating additional 6M shares on the way up from $8 to $15 for an average price of $12 in the next two weeks (by this time the CEO had have to file a couple form 4s and many investors would have been aware of his intention), (3) offering to buy 6.5M remaining shares at $22, 38% - 45% premium over the then stock price after open accumulation. The average cost under this scenario would have been about $14 per share, a $10 per share or $185M saving!!

Instead, the CEO rushed in dishing out an outright offer with a price tag at almost high of 3-year price range of the stock without even trying to the least effort to save for him and his group. Why? There is a terrible thought in my mind that I hope is not true: can it be that the CEO know that the deal won’t go through at the end (and know that he does not have to spend any money at the end) and thus chose to give a very high offer to push the stock to a higher ground in order for himself to unload his shares, like a player in a Texas Hold’m game suddenly going all in on a total bluff and trying to scare opponents with superior hands away? The rebuff to this is that the CEO is not allowed to sell shares now under the buyout agreement and even if he dumps shares he will not be able to sell much at high price because the public will see what he is doing once they see the form-4s filed for these selling. However, all these are assuming that the CEO is integral and still following the rules. If he has been deceiving the public for years (and thus will be convicted at the end with his stock becoming worthless), what can stop him from fooling the public one last time? Again I am not saying this is really happening; it is only a hypothesized scenario. What I am saying that the assumption that the CEO was not honest before can be consistent with the assumption that he is not honest right now. On the other hand, assuming the CEO is an average or above average honest and good-hearted rational business decision maker like the CEO of LLEN, LPH, and many other Chinese companies I believe, the way he handled this buyout seems to be inconsistent with this assumption. To make his behaviors logical we have to go to the other extreme of the spectrum – assuming that he is an extremely integral and nice business man with extreme sense of justice and passion to defending his stock and company. So, in my opinion either he is a pure devil or great saint. It is black or white, all or none; there is nothing in-between that can be logically explained at this moment. For the good of numerous die-hard shareholders loyally holding the stock right now at almost $20 per share, very close to the buyout price, I certainly hope he is indeed a saint.

Two “technical” arguments supporting the legitimacy of the buyout offer are: (1) the CEO simply had no other choice because it is impossible for him to buy several million shares and increase his stake to 70% of the company without pushing the stock to over $20 or higher, and (2) it is impossible for the buyer group to pull out of the deal this late into the process. While these two arguments do have some merits, they are not convincing in my opinion.

First of all, a company can certainly have 70% or more of its outstanding shares owned by one person or a group of people yet still having its stock trading a super low valuation level. The situation is especially easy to happen on any Chinese small cap this year. LPH is a perfect example now and more so in 2010 and 2009 (when the two biggest shareholders owned over 80% of the company). Similarly, many Chinese stocks accused of fraud saw their shares staying at low valuation level even after the company or its CEO offered to by millions of shares. Look no further than CCME or an example. As such, I believe the CEO definitely had a good shot to buy millions of shares under $15.

Secondly, I agree that it would will take the buyer or the board of director quite some effort to abort the deal right now and that an abortion of the deal at this moment would probably shock the market, but I think the process is far from being at a point when the chance of the deal falling apart is next to nil or negligible. Take the fall-off of XING’s proposed acquisition of QXM after almost one year of progress as a perfect example: http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0000950123%2D11%2D033769%2Etxt&FilePath=%5C2011%5C04%5C07%5C&CoName=QIAO+XING+UNIVERSAL+RESOURCES%2C+INC&FormType=6%2DK&RcvdDate=4%2F7%2F2011&pdf=.

Of course no two cases are the same, but I am just saying that from purely probability and procedure standpoints, there are still many reasons that the deal can be withdrawn by a party or by court, especially considering the number of parties involved, the complex deal structure, the abundant of covenants, provisions, and conditions (subject to part xxx’s due diligence, subject to xxx’s review, etc.) in the agreement, and the nature of the agreement as a “merger” agreement rather than a more standard purchase agreement in a LBO deal. I especially do not like this part of the termination provisions that “If the Merger Agreement is terminated under certain circumstances, the Company will be required to pay Parent a termination fee of $22,500,000” and the “Limited Guarantee” by the CEO (Parent) to the Company, which pretty much reads to me that there is in essence no guarantee because the CEO can easily walk away under the reason that just one of the numerous “terms” and “conditions” is not met at the end.

It would be great to all Chinese companies, investors, and the nation if the CEO is an example of such a generous, honest, and good-hearted business man that is 100% selfless and put the interest of all shareholders before himself without reservation. For the good of Chinese stocks, investors, and analysts’ community I sincerely hope that he is such a nice business man. Let’s hope that the deal will indeed go through and do give Chinese small cap group another blow.

Disclaimer

I am a completely independent analyst and am not paid by any company of which the stock I cover or write articles about. However, I may have long or short position on a stock I cover or write about at any time.

My ratings and/or analyses of a stock only represent my personal view on the stock and/or my assessment on the probable movement of the stock price in the next 12 months. They are by no means a guarantee of performance on any long or short trades on a stock and should not be relied upon solely for buying or selling a stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences and needs when making an investment or a trading decision. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.