|Shares Out. (in M):||57||P/E||19.1x||15.4x|
|Market Cap (in $M):||1,895||P/FCF||27.6x||20.0x|
|Net Debt (in $M):||-413||EBIT||113||137|
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I believe Longtop (LFT) could be a Chinese version of Satyam, the Indian IT services company that declined more than 90% in 2008-09 after the founder admitted to falsifying the accounts. I have strong doubts about the accuracy of LFT's reported financials. Revenues from top customers cannot be verified and the company's industry leading margins do not seem possible. Therefore the earnings and the cash on the balance sheet could be vastly overstated. Other red flags include an unconventional staffing model, questionable acquisitions, and management stock sales and gift of stock. Additionally, there is evidence that management has committed fraud in the past. Management was found guilty in a Chinese court for defrauding their ex-employer while they were establishing Longtop. A number of US-listed Chinese frauds have been exposed recently and I think this could be the next one to fall.
Brief Business Description
LFT is an IT services and software provider to Chinese financial institutions. According to the company, 85% of revenue is from software development and 15% is from other services including ATM maintenance, hardware distribution, systems integration, and professional services. Of the software revenue, ~31% is from standardized software and 69% is from customized software development.
Revenues from Top Customers Appear Overstated
LFT started out mainly servicing the Big Four state-owned Chinese banks. Two of those banks, China Construction Bank (CCB) and Agricultural Bank of China (ABC), accounted for 90% of software revenues in 2004 according to the prospectus. LFT added a third Big Four bank, Bank of China (BOC), through an acquisition in 2006. Customer concentration has declined over time and in the year ending March 2010, LFT generated 43% of software revenue from three of the Big Four banks. LFT still has virtually no revenue from the final Big Four bank, ICBC, because of that bank's strategy to handle most IT functions in-house.
I have conducted channel checks with top customers and these checks highlight several issues that I believe cast significant doubt on LFT's reported revenues. I will focus the discussion on CCB, LFT's largest customer which accounted for 22% of revenue in the March 2010 year.
First, LFT claims to generate revenue from CCB that equates to an unbelievably high vendor market share within CCB. CCB uses dozens of external software vendors and while LFT is cited as a top 10 vendor, it is not the largest. LFT reported $37m of revenue from CCB in the March 2010 year. CCB's total budget for outsourced software development is approximately $100m-$150m. Therefore, this would imply that LFT is capturing from one quarter to more than one third of CCB's external software development budget. Based on conversations with the customer, this does not seem possible.
Second, LFT has reported growing revenues with CCB at a time when CCB's spending on external software developers has declined significantly. At the beginning of 2010, CCB changed the head of its IT department. The new IT head decided to reevaluate the outsourcing strategy. As a result, many projects were put on hold or cancelled and the IT budget for outsourced vendors declined by 30% in 2010. This visibly affected some of LFT's public competitors including Yucheng. However, LFT said that its CCB revenue has continued to grow 20% y/y in CY10. Based on conversations with CCB, it seems very unlikely that any major vendors could have avoided being impacted by this development.
Finally, when asked how much business they have historically given to LFT, CCB cites a number that is a mere fraction of what LFT reports. I have triangulated this through several sources and the answer is consistent. I also find a similar revenue discrepancy when conducting channel checks at ABC, LFT's second largest customer.
LFT's management rebuts these concerns by claiming that the Big Four banks' IT spending is very decentralized making it impossible for anybody in the organization to know how much is being spent with each vendor. However this explanation seems unlikely to me. CCB indicates that historically > 70% of spending is through headquarters and < 30% is through branches. Additionally, the visibility on spending with vendors at headquarters is very high and the amount spent on branches is declining as the budget becomes increasingly centralized. CCB branch spending was impacted even more than headquarter spending in 2010 and dropped to <15% of the total IT budget. LFT management told me that ~70% of their CCB revenue is from headquarters, so even if you add 30% to the LFT revenue number from the channel checks it still is dramatically lower than the amount claimed by LFT.
So how then could LFT be reporting substantially higher revenue? I don't know for sure but it's possible that they are simply forging contracts. Before you dismiss this as unlikely, please read the background below on how LFT was founded. Additionally, keep in mind this is China where this type of thing is not unheard of.
Margins are Inexplicably High
LFT reports spectacularly high margins which are much higher than any peer company. In the fiscal year March 2010 LFT reported gross margins of 69% and non-GAAP operating margins of 49%. GAAP margins including share-based compensation were 42%. Peers report gross margins between 15-50% and operating margins of 10-25% or even lower. LFT's margins are comparable or superior to software industry heavyweights like Microsoft and Oracle. When comparing LFT's revenue and cost per employee to domestic peers, the higher margin appears to be attributable mainly to much higher revenue per employee. LFT generates about $66k per professional compared to peers at $20k-35k. Some analysts have attributed LFT's superior margins to lower employee costs because of the low-cost Xiamen headquarters but LFT's cost per employee is similar to its peers.
Management's explanation for the high margins is that they have more standardized software sales then peers and standardized software has very high gross margins of around 90%. The company claims that these solutions and modules can be deployed to new customers with few man-hours and expenses. Surprisingly, though, LFT only spends about 4% of revenue on R&D annually. This seems very low for a company that is building software with 90% gross margins. LFT management says that they are able to co-develop products with their customers and then sell the same product to other customers.
When I speak to LFT's customers, however, they say they do not buy any standardized or pre-packaged software from domestic vendors including LFT. They claim that they use LFT for software customization, IT integration, and ATM services. They also say that project tenders are very competitive and they usually pay similar prices for LFT services as they do for competitors.
LFT management says that they often co-develop software with Big Four customers and then sell it as standardized software to smaller banks, which could explain why the Big Four say they aren't buying standardized products from LFT. However, back in 2005-07 when the Big Four accounted for a much higher share of total revenue, standardized software was also a higher share of revenue. This would imply that LFT was selling a lot of standardized product to the Big Four banks, yet those same banks say they aren't buying this type of product from LFT.
Furthermore, even if you believe the standardized software gross margin is 90% then this implies that LFT is generating 60-65% gross margins on customized software development which is still much higher than peers. When something seems too good to be true, it probably is.
Unconventional Staffing Model
The majority of LFT's employees are not directly employed by the company. As of March 31, 2010 LFT had 4,258 employees of which 3,413 (80%) were employed by third-party HR staffing companies. Of the employees at staffing companies, 95% (3,235) were from a single firm called Xiamen Longtop Human Resources Services Co (XLHRS). This firm is supposedly not a related-party despite the name and that it only transacts with LFT. No competitors or firms in other industries I've come across use third-party contractors to this extent.
Coincidentally XLHRS was formed on May 10, 2007, just months before LFT's IPO. There was no mention of XLHRS in the prospectus. It's not until the March 2008 annual report that we learn that 90% of LFT's employees are actually employed through XLHRS.
Management's explanation for this is that they use XLHRS to 1) focus on their core competency because XLHRS performs human resource functions more efficiently and 2) to limit liabilities related to employees from acquired firms. They say they are worried that acquired companies may not have paid all the past social welfare benefits for employees and this is a major potential liability. These arguments both appear weak. How is human resources not a critical function for an IT services company? And how would the business be any different if XLHRS were made a fully-owned subsidiary of LFT, since XLHRS only deals with LFT? Also there are many acquisitive companies in China that don't use this staffing model and it seems implausible that they are all just missing this large potential legal liability.
There might be a benign explanation for the existence of XLHRS but at the very least it is a major red flag. XLHRS allows LFT to transfer the majority of its cost structure off-balance sheet which could create opportunities for accounting gimmicks.
In January 2010, Longtop acquired Giantstone, another Chinese IT services company. They paid $50.4m plus earnout payments of up to an additional $45m over the following two years. Giantstone is a single client, single project company. The company is implementing an SAP core banking system for Minsheng Bank. According to LFT, Giantstone had 2009 revenue of $12m and earnings of $3m and they are guiding for $18m of revenue and about $4.5m of earnings in fiscal year March 2011. This implies a trailing P/E multiple of 16.8x ex-earnouts and a Mar-11 multiple of 21x assuming full earnout payments.
The deal seems risky in light of Giantstone's customer concentration and the potentially finite life of the company if more customers are not obtained. This is particularly relevant because SAP's core banking solution does not have a good track-record in China and many banks are reluctant to consider it. A recent sell-side note (Wedge Partners, Jan 25) claims that Minsheng Bank is not happy with the new core banking system and the project has been delayed. The bank may also be considering switching to another vendor. I have not been able to independently verify this and cannot comment on its veracity. But this claim is in direct contrast to LFT's version of the project's smooth progression.
So why did LFT make this acquisition? The official reason is to diversify into the important core banking solution market. There were rumors circling that LFT management owned a direct stake in Giantstone prior to the acquisition. LFT categorically denied this on a conference call. I don't have any insight into that but I was told that LFT's CEO is close friends with the owner of Giantstone. Could there have been an under-the-table deal made? It would certainly be a convenient way to get cash out of the company. At the very least, this acquisition seems like a very questionable use of cash.
Management Selling and Gifting Shares
The Chairman and CEO have been steadily monetizing their stakes in the company since as early as 2004. They have taken money out of the company at each major round of financing and have collectively pocketed at least $60m including share sales made since the IPO. During this time their stake has been diluted from ~100% to approximately 17.9% today. There is not necessarily anything nefarious about this but it does show that they have been handsomely benefiting from the strong reported results and rising market valuation of the enterprise.
Another red flag worth mentioning is that the Chairman has gifted 9.0m of his shares to beneficial trusts in BVI for employees. 37% of the trust shares have already been sold but the trusts still own 9.9% of the shares outstanding, which is almost as large as the Chairman's remaining stake. These shares are apparently designated to more than 100 employees including the Chairman's driver. The value of all the gifted shares based on today's stock price is approximately $300m so that's about $3m per designated employee. Again there is nothing necessarily shady about this but it is strange and not something I've ever seen before. Perhaps he is just a very altruistic person.
Background on the Founding of Longtop
Some common rebuttals to this thesis are that "Management seems trustworthy" or "How could they fabricate such egregious lies?" It's worth examining the circumstances surrounding the founding of the company to get a better understanding of top management's character. Leading up to mid-1996, Jia Xiaogong (LFT Chairman) and Lian Weizhou (LFT CEO) were working as managers at Xiamen Dongnan Computer Co (XDCC) and its parent company. On July 15, 1996, Jia, Lian, and two others set up a company called Xiamen Dongnan Rongtong Electronic Co (XDREC) unbeknownst to their employer. XDREC was later renamed Longtop Inc. On October 15, Lian signed a contract with one of XDCC's major clients, but he inscribed on the contract that he was working for XDREC instead of XDCC. The two company names sound very similar in both Chinese and English so it is likely that the client thought he was signing a contract with XDCC. Then on November 26 Jia and Lian sent a letter to the Xiamen Postal Office saying that the address of XDCC had moved to a new location which happened to be the address of the office they had rented for XDREC. So basically they confused the client into thinking he was continuing business with XDCC and then began to intercept XDCC's mail. Court evidence suggests that Jia and Lian probably used a similar strategy to steal away other clients from XDCC. XDCC also alleges that Jia and Lian spread rumors among the employees of XDCC in order to hire them away to their new company. In November 1996, the four Longtop founders and 39 employees from XDCC quit in succession to join XDREC. In January 1997 Longtop published an opening advertisement in the local newspaper with 32 customers signed. At that point their former employer XDCC was all but done. Revenues of XDCC plunged from RMB 77.8m in 1996 down to RMB 250k in Jan-May 1997. The court subsequently ruled against Jia and Lian for breaking Anti-Unfair Competition Law and Company Law and they were forced to pay damages to their previous employer.
So is this management team capable of perpetrating a fraud? It certainly wouldn't be out of character based on past behavior. This court case also reveals an inaccuracy in the LFT prospectus and subsequent 20-F fillings. The bios of the Chairman and CEO say that prior to founding Longtop in 1996, they worked as managers at Xiamen Longtop Electric Computer Co. This appears to be a lie, possibly in order to deflect attention away from the name of their previous employer and the court case where this story is chronicled. I've included a link to a translated version of the court document below.
The timeline is unclear and it is difficult to determine the catalyst that will fully expose the issues discussed above. However the market's concerns seem to be growing as evidenced by the stock's underperformance and declining multiple. I view this as a positive sign.
Management very consistently beats estimates and raises guidance. Of course this would be easy to do if they are making up the numbers.
The IT services industry in China is growing. This is a secular tailwind that could support growth and the valuation multiple.
LFT was underwritten by Goldman Sachs, Deutsche Bank, and Jeffries. This was not a reverse merger which has been a red flag for other Chinese companies with accounting issues.
LFT is audited by Deloitte Touche Tohmatsu, the mainland China arm of Deloitte & Touche. Using a Big Four auditor is clearly more reputable than some of the smaller auditors which have been involved in recent Chinese frauds like Frazer Frost. However we all know that Big Four auditors have been involved in some of the biggest accounting frauds of all-time in western markets so I don't think that should provide too much comfort. Furthermore China MediaExpress (CCME) also uses Deloitte Touch Tohmatsu. I think many would agree CCME has a reasonably high probability of being a fraud and Deloitte approved their accounts.
There are a number of well respected hedge funds on the register. They apparently don't think LFT is a fraud. From what I understand they are generally positive on the sector including other listed names in the Chinese IT services space. I don't disagree with the general attractiveness of the space, although I don't understand why you would choose to play the theme by investing in a company with unverifiable revenue, inexplicable margins, numerous red flags, and a management team that has defrauded before.
Disclaimer: We have a position in LFT and we may buy or sell shares at any time. This should not be considered investment advice and is not a recommendation to buy or sell shares.
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