Description

Short Sale:  Focus Media  (all amounts in U.S. Dollars)

ADS Outstanding: 129 million * $56.50 = $7.3 billion market cap

Net debt: $0

Focus Media (“FMCN”) is a fast growing Chinese “multi-platform” media company run by a charismatic 34-year-old salesman named Jason Jiang.  The company was founded in 2003 and went public two years later.  Focus Media owns networks of display LCD screens and billboards around major Chinese cities and in high-rise office buildings and has recently branched into delivering ads via mobile phones and the Internet.  Their customers are the advertisers, like Toyota, Motorola, and P&G that wish to use the Focus network to reach Chinese consumers.  The bull story on Focus Media is simplistic:  they are a large, dominant company and a pure-play on the rapidly growing Chinese advertising industry.  Since the growth potential is so high, the bulls say that FMCN certainly deserves a nice premium multiple when compared to slow growth mature companies such as Lamar Advertising, Clear Channel Outdoor, and JC Decaux.  The current 2008 EBITDA projections are approximately $300 million, so the implied multiple is 24x compared to 12x for Lamar, etc. 

Presented herein is a contrarian view of Focus Media as seen through the skeptical eye of a short-seller.  This alternative view attempts to transcend the superficiality of hot Chinese fundamentals and pieces together a bear story from an analysis of accounting footnote flags, related party dealings, and allegations of fraud by a related party of which Jason Jiang’s father is a financial officer, and other events that have transpired since the IPO. 

Summary of the Major Flags:

1. Alleged fraud that was not properly dismissed by an internal investigation, in my opinion.
2. Accounting flags – poor cash flow and balance sheet.  Massive issuance of stock for purchase accounting acquisitions at high prices.
3. Massive insider and company sales of stock ($2.2 billion USD since and including the IPO versus a current market cap of $7.3 billion)
4. Other possible undisclosed related party transactions
5. Potential erosion of fundamentals in core elevator lobby business, and arguably weak position in new and expanding businesses such as mobile phone advertising

1.  Alleged fraud

Let’s begin with the most interesting first.  Focus Media has been accused by an anonymous short seller (not me) of fraudulently inflating the financial performance of the public company by shifting expenses that should be borne by the public company to a related third-party.  Read the following disclosed risk-factor discussion carefully.  In fact, read it twice and you will see the central issue and the potential inadequacy of the investigation:

Our failure to timely file the 2006 annual report on Form 20-F as a result of allegations raised by an anonymous investor holding a short position in our ADSs may subject us to shareholder litigation and delisting review, either of which may materially and adversely affect our business.

     As a result of the Audit Committee investigation of allegations raised by attorneys representing an anonymous investor, we failed to timely file our 2006 annual report on Form 20-F. The unnamed investor, described as currently holding a short position in our ADSs, alleged that: (a) Everease, a company previously run by Focus Media’s founder and CEO, Jason Jiang, is a related party as a result of ongoing ties between Everease and Mr. Jiang and members of Mr. Jiang’s family; and (b) Focus Media was making undisclosed rebate payments to a third-party advertising agency through Everease in order to inflate Focus Media’s reported financial performance.

     The Audit Committee commenced its investigation of the allegations on June 28, 2007. It hired independent U.S. legal counsel and independent forensic accountants, who reviewed documents and interviewed witnesses. Everease and the third-party advertising agency declined investigators’ request to provide access to specified witnesses and documents. (Emphasis added)

     On September 25, 2007, the Audit Committee completed its previously disclosed investigation into allegations made by U.S. Counsel to an investor described as holding a short position in our stock. The results of the investigation have been discussed with our independent Registered Public Accounting firm. Based upon its review of the evidence, the Audit Committee concluded that nothing had come to its attention - apart from the initial allegations that gave rise to the investigation - that would cause the Audit Committee to believe that we made undisclosed rebate payments to a third party advertising agency through another advertising agency, namely, Everease. (Emphasis added) We have informed the investigators that we have concluded that Everease is a related party based upon information developed during the investigation. Based upon its review of the evidence, the Audit Committee concurs with our conclusion that Everease should be deemed a related party. For detailed descriptions of our related party transactions with Everease, see “Item 7 — Major Shareholders and Related Party Transactions — B. Related Party Transactions-Transactions with Everease; “ — Other Related Party Transactions-Loan from Relative of Jason Nanchun Jiang.”

     Our failure to timely file the 2006 annual report on Form 20-F has subjected us to delisting review by the Nasdaq Listing Qualifications Panel. We received a Nasdaq Staff Determination letter on July 10, 2007 that we are not in compliance with the filing requirement for continued listing as set forth in Nasdaq Marketplace Rule 4320(e)(12). If the Nasdaq Listing Qualifications Panel decides to delist our ADSs from the Nasdaq Global Market, our share price and business will be materially and adversely affected.

     In addition, as a result of these allegations, we may be subject to shareholder litigation, which may divert the attention of our management and force us to expend resources to defend against such claims. Any litigation may have a material and adverse effect on our business and future results of operations.   (source:  Focus Media 20-F for year 2006)

I am not a lawyer and never went to law school, but I suppose this is how they think.  Here’s the fact pattern:

a.       a fraud is alleged

b.      an Audit Committee investigation is commenced

c.       the alleged perpetrator entity declines to provide documents and witnesses to the investigation (including the accounting books and records according to FMCN)

d.      the Audit Committee “Based upon its review of the evidence…concluded that nothing had come to its attention…that would cause the Audit Committee to believe that [Focus] made undisclosed rebate payments.”

To me, it sounds like the lawyers wrote this and there was nothing substantial concluded because there was insufficient availability of evidence to aid the “investigation.”  The committee never concluded that there was an absence of wrongdoing; it concluded that “nothing had come to its attention that would cause them to believe there was wrongdoing.” 

The sell side was even more generous in their interpretation of the wording.  For example, the next day the headline of the Citigroup research report proclaimed “Buy: Audit Committee Finds Allegation Without Merit” 

I hate to be such a nitpicky critic of semantics, but it is not clear that this major allegation of fraud was ever resolved.  In the advertising world, rebates to advertisers and agencies are common.  To the extent FMCN is booking higher net revenues and/or lower expenses as a result of shifting rebate expenses/contrarevenues to a third-party, their earnings are overstated.  Embedded in the bulls simplistic EBITDA multiple valuation is an implicit assumption that the EBITDA is actually a correct number.

2. & 3.   Accounting cash flow and balance sheet flags, stock issuance

This is a summary of the statement of cash flows for FMCN:

It is certainly possible that this company is growing rapidly and thus consuming cash, and one can point to the positive Cash From Operations.  However, the lack of overall cash generation is indeed an accounting red-flag in my opinion.  In addition, there is a weird category of “Deposit Paid to Acquire Subsidiary”.  I do not know exactly what this means, but it appears to be a deposit in conjunction with a non-binding acquisition agreement.  This is potentially a way (though I cannot prove this) to get money out of FMCN to “roundtrip” back into FMCN.  If insiders or affiliates reaped proceeds from the sale of FMCN stock as well, these cash proceeds could also be used to perpetrate a fraud, if such a fraud existed, and if it required cash to pay expenses that should be borne by the public company, Focus Media. 

Additionally, FMCN’s balance sheet is weak (9/30/2007) in the sense of limited hard asset support.  While it is 100% equity and 0% debt, there isn’t much in the way of asset value.

$mm

Cash                                          190.2

Equity Securities                           52.0

A/R                                            169.8

Prepaid Expenses                         20.1

Equipment                                    83.6

Other Assets                               120.8

Intangibles/Goodwill                 1,002.0

Total Assets                             1,638.5

The Bulls will say that this is a cash-flow business and thus, the hard assets aren’t as important as the cash generated.  This is true, but unlike Lamar, or a TV network, or newspaper, etc., FMCN has limited “locked in duration” to its cash flows, because their contracts with the building owners or store owners or mobile network operators are usually short.  For example, 2 or 3 year contracts are in place with the major office building owners, but these have to be renewed.  This stands in stark contrast to Lamar, which owns “dirt” under a lot of its billboards or has signed long term leases securing an easement, or a TV station, etc. with the right to a broadcast license that is usually long-lived.  Remember, this company started in 2003 and it is “asset light.”

Finally, one must look at what FMCN is getting when they issue all their stock to acquire companies.  In addition to all the secondary offerings, limited value received would suggest they are desirous of utilizing a temporarily inflated stock.   Here are some recent examples of high priced acquisitions:

CGEN Digital Media was announced in December 2007.  The amount is $170mm + earnout of another $180mm.  CGEN filed to go public, and thus we know that during their last full reported year, 2006, they did $21mm of revenue and broke even.  Granted, they are growing, but one can see the high price here.  In addition, I note that purchase acquisitions in large scale, and continued payments of earn-outs are another accounting flag, as it is possible they shifted expense into the purchase accounting (e.g. the managers could get paid out on the stock purchase, and agree to a low recurring compensation expense level that hits the P&L in the future).

Infoachieve Ltd. was acquired on January 1, 2006 for $332mm.  In 2005, the year prior to their acquisition by FMCN, Infoachieve did $11.8mm of revenues and lost money on an operating basis. 

Allyes, an Internet ad company was acquired in March 2007 for $224.7mm plus an earnout of approximately $100mm more if they achieve certain targets.  In 2006, the last full year for which financials were disclosed, Allyes did $49mm of revenues and broke even on an operating basis.

So, one can see that Focus Media isn’t exactly hesitant to give up their stock as they have acquired a lot of early stage companies (albeit growing) for around $1.0bn of stock and they have also sold in the market (the underwriters love them) another $2.4bn of stock.

4.  Other related party transactions

While it cannot be proven, I believe that there are millions of dollars of commissions being paid to Jason Jiang, the CEO, for selling ad space on FMCN’s network.  In the United States, most CEOs don’t also receive compensation as salesmen in addition to their CEO salary and stock incentives.  In addition, I believe that Jason Jiang and/or his family members and friends may be indirect minority owners in the companies that FMCN is acquiring for stock.  I understand that this may be a common practice in China, but nevertheless, I add a lot of related party transactions to my list of flags.

5.  Fundamentals

Finally, I include a brief discussion of possible fundamental problems, although as I have stated previously, this is a short based on circumstantial evidence and rampant red-flags more so than a repudiation of the fundamentals. 

Focus’s best business is providing ads in the elevator lobby in major office buildings (outside the elevator while people wait to get on the elevator).  The building owners in Shanghai and Beijing are very fragmented.  It is quite possible that they will get smarter about negotiating contracts and/or consolidate.  Remember that FMCN only has contracts of 2-3 years and thus is vulnerable to a change in the economics.  The in-store network they own provides screen advertising in hypermarkets.  This business is much lower margin because their top five customers in this business (the retail chains) demand much better cuts of the economics.  In the U.S. billboard business, the metro contracts negotiated with cities or airports, etc. have lower margins than the plain old billboard business.  Whoever owns the “dirt” is the one that can arguably extract most of the economic rents.  Remember that FMCN is an “asset light” company and they were just formed a few years back, so they don’t have a legacy asset base that can command economic rents.  Another example is the mobile phone ad business.  The network operators (China Mobile, etc.) should arguably receive the bulk of the economic rents, if not all of them.

I think that in addition to an attempt to use a high priced currency to make acquisitions, the rapid acquisition strategy also is recognition of the potential future deterioration in the economics of the existing businesses.

Finally, to finish on a cute note, I note that the Focus Media logo as it appears on the cover of their prospectus (but is only used presumably in China for business) is a knock-off of the CBS “eye” logo.  I have found that companies that try to gain credibility by associating themselves with good companies, or by having a board stacked full of big name politicians and quarterbacks are frequently decent shorts. 

Catalyst