Description
AsiaInfo-Linkage (“ASIA”) is a low quality business with deteriorating fundamentals and aggressive accounting. With the stock up nearly 50% from its January lows thanks to the company actively promoting the idea of a low-likelihood “going private” transaction, now is an excellent time to consider ASIA as a short sale candidate.
Brief Business Description:
ASIA is a Beijing-based provider of software and business processing service to telecommunications companies. The three large Chinese telecom companies China Mobile, China Unicom, and China Telecom, represent 80% ofASIA’s total billings. Much like the services provided by outsourced IT companies that focus on the financial services industry inChina(VIT, LFT, HSFT, etc.), ASIA essentially provides the big three telecom companies with manpower and some expertise in building, changing and updating software and systems that are part of their billing process and analysis of customer usage. WhileChinarepresents the company’s main market, management has recently begun expanding outside ofChinain an effort to win new clients and diversify away from the big three telecom companies in their home country.
In July 2010, the legacy AsiaInfo purchased Nanjing Linkage, and the two operations were merged. This was a somewhat strange marriage, as our sources inChinaindicate ASIA CEO Steve Zhang was opposed to the merger. There appear to have been political motivations behind the merger (i.e. legacy AsiaInfo may have been “encouraged” by the Chinese government to purchase Linkage.) While a good conspiracy theorist could have a field day with the initial AsiaInfo/Linkage tie-up, it happened nearly two years ago and I am going to focus on the here-and-now of the situation. Suffice it to say, however, that AsiaInfo + Linkage was not a great merger, and it helps to keep that in mind in understanding the combined company’s current challenges.
Deteriorating Fundamentals
ASIAreported impressive topline growth for 3 quarters following the Linkage acquisition, with revenue growth close to 100% in Q1 and Q2 2011. Since lapping the acquisition last year, growth has been far more pedestrian at 8%, 15% and 8% for each of the last 3 quarters. While high-single-digits may not pass for a good growth rate inChina, it is not terrible and not a cause for alarm on its own. The truly troubling part ofASIA’s results are their operating margins. In Q12012 alone, gross margins fell 650bps YOY (from 45.6% to 39.2%) and operating margins fell a whopping 1,260bps, from 14.8% to 2.2%, largely as a result of stubbornly high S&M and G&A expenses, as well as and R&D expense that nearly doubled on YOY basis.
Cash flow has been anemic for the last 3 years, largely as a result of ballooning A/R balances that have taken DSOs up to over 200 days. The company offers an explanation of the elevated DSO count that amounts to “large Chinese companies just pay slowly, you shouldn’t worry about it” as well as an “adjusted” DSO count that they put closer to 150. When evaluating the quality of a business, I like to judge how long it takes them to collect cash, regardless of the customer, and there is no question that their cash conversion cycle has only lengthened over the course of the last 3 years.
Aggressive Accounting
ASIAutilizes percentage-of-completion (POC) accounting for the majority of its service revenue. Under this system, revenue is recognized based on the ratio of cots incurred to the total estimated cost of the project. I am always suspect of companies that utilize POC accounting because its inherent subjectivity makes it an easy place to fudge numbers. InASIA’s case, unbilled receivables have remained persistently and troublingly high. In concert with elevated R&D costs and a less than fully utilized labor force, it seems highly likely thatASIAmay have allocated unabsorbed costs to an existing project, pulling forward future revenue to make margins look better. This would certainly help explain the company’s poor net income to cash conversion ratio – and mean that actual margins are even lower than the paltry ones they reported in Q1 2012.
It is worth noting thatASIA’s auditor is Deloitte Touche Tomahatsu, one of the lowest quality of all the Chinese auditors (never mind the Big 4.) Actually, a friend of mine who works in private equity inShanghaitold me last year that there is no “Big 4” inChina– it’s the “Big 3” accounting firms, because Deloitte is so bad they don’t carry any weight.
Going Private?
On January 20, 2012, ASIA put out one of the odder press releases I’ve ever seen in relation to a potential takeover, in announcing that private equity firm Power Joy (Cayman) Limited, a wholly owned-subsidiary of CITIC Capital China Partners II, LP (Power Joy, for simplicity and because it sounds cool) had offered to acquire all of the company’s outstanding shares.ASIAallowed that it was an all cash offer and the bid price was “a premium over the current stock price.” The company later said Power Joy’s offer had contained a specific price, but they weren’t going to disclose it. I can understand announcing that you got a bid (out of fiduciary responsibility); I can understand not announcing that you got a bid (and running a process to sell the company and discovering the best price before disclosing it); but I don’t think I have ever seen a company announce that they had a bid…but not say for how much!
The Board announced the formation of a special committee to consider the proposal and any alternative transactions. Oddly, the special committee is made up of the three people on the audit committee. It is also worth noting that one of the investment professionals at Power Joy is a former board member atASIA. Perhaps he knows the company so well that he just wants to own the whole thing. Or perhaps he is doing his old friends a favor in lending his name to a scheme that got the stock up 50% (and has more or less held it there) in a few days time.
Fast-forward to March 26, 2012, andASIAput out a press release saying the special committee would solicit bids from other interested parties and had engaged Goldman Sachs to assist in the process. I take this to mean that the Power Joy bid isn’t really progressing and that no other bids had been forthcoming, as it certainly should not take two months to begin a sales process.
When all is said and done, I think the press releases, the bid for “a premium over the current stock price,” the invocation of Goldman’s name, are all just an attempt by management to distract from the deteriorating fundamentals of their business. While HRBN did close, the likes of CISG never have. I do not know that they ever formally tell us the bid has been withdrawn, but I think the going private idea will fade away. The deterioration in their business, however, will not.
Valuation
Given the deteriorating margins, decelerating revenues, and accounting gimmickry, I thinkASIAwill be lucky to report $0.75 in EPS this year. I suspect cash flow per share will be well below that level. At a rather generous 10x multiple, the stock would be worth $7.50, or 35% below the current share price.
Catalyst
- Lack of further bids
- Deteriorating fundamentals
- Potential action against Deloitte's Chinese operation