Another week… another fraud allegation leveled against a Chinese company.
On Monday, Muddy Waters Research released evidence, which showed that Hong Kong-based, Focus Media Holding (Nasdaq: FMCN), may have duped shareholders. The news resulted in a 40% one-day plunge for the stock.
While we don’t yet know if Muddy Waters’ accusations are true, such fraud stories from China are unfortunately becoming all too common for investors. It’s a trend we’ve covered all year, in our tireless pursuit to expose the truth behind the headlines and alert investors to the dangers of this market.
So to avoid the next scam, it’s crucial that we know how to spot the warning signs.
One tip is to look at suspicious acquisitions – ones that seem too good to be true, as is the case for Focus Media…
It Starts With a Simple Exaggeration
Focus Media has a pretty simple business. It installs television screens in Chinese office lobbies, checkout lines and street corners. Anywhere with a few square feet of space, really. It then sells commercial time on those TVs to advertisers.
According to Muddy Waters, Focus Media claimed it operated 172,382 screens when it actually had less than 120,000. The company also claimed to have more screens in premium locations when many were in places with lower foot traffic.
However, the real fraud emanated from a pattern of acquisitions that hid losses and funneled cash to insiders.
Focus Media Sells Shareholders Down the River
In case you’re unaware, when one company buys another, it lists the acquisition as an asset at the cost it paid. If the buyer later finds that the asset is overvalued, it can “write-down” those assets, making them worth less and taking the loss.
In Focus Media’s case, it appears to have acquired a number of companies at inflated prices and then wrote-down the assets.
For example, Focus Media paid $24.2 million for a riverboat company, which has large advertising screens on its vessel. It separately bought the boat for $12.4 million (a total of $36.6 million).
However, just three months earlier, a different company had agreed to acquire the same riverboat company for a mere $3.7 million (the deal fell through). In addition, Muddy Waters calculates that the boat’s value was actually closer to $3.9 million, not $12.4 million!
Sure enough, 14 months after the acquisition, Focus Media wrote-down the holdings and declared a $36.9 million loss.
A closer look reveals that Focus Media’s total losses from write-downs like this one totaled $1.1 billion. That equated to nearly one-third of the company’s entire value (before the stock tanked on Monday).
Muddy Waters also found 21 other instances where Focus Media bought a company, then wrote-off the acquisitions as losses and gave away the companies for nothing.
So why the heck would Focus Media want to intentionally rack up losses from acquisitions?
Losses for Investors… But Profits for Insiders
There are at least two possible reasons:
1. The acquisitions were a smokescreen, used to hide losses from the false number of advertising screens that Focus Media claimed it had.
2. The acquisitions were used to somehow funnel cash to Focus Media’s insiders. This is what Muddy Waters claims. And while the allegations haven’t been proven yet, the record shows that Focus Media insiders have cashed out on $1.7 billion in stock since 2005.
I should note, though, that Muddy Waters openly states that it shorted Focus Media shares before it released its negative research report.
However, the firm does boast a decent track record of uncovering deception. So far, it’s released fraud accusations against five Chinese companies. Two of them – Rino International (OTC: RINO) and China Media Express (PK: CCME) – appear to have stopped operating and their stocks have gone to zero.
Another report sent shares of Sino-Forest (OTC: SNOFF) down 73%, with trading halted since August. The company continues to deny the allegations. Meanwhile, two other companies that Muddy Waters highlighted – Duoyuan Global Water (NYSE: DGW) and Orient Paper (AMEX: ONP) – continue to operate.
It will take time for Focus Media to respond to Muddy Waters’ allegations and prove its innocence. But that’s meaningless for investors who lost 40% overnight.
For us, however, the lesson from the Focus Media story is clear: Dubious acquisitions – and subsequent write-offs – can provide vital clues to potential fraud.
Ahead of the tape,
P.S. The Focus Media scandal outlines the difficulty of investing in rogue foreign stocks – especially in China. You must be extremely careful, and conducting due diligence becomes more important than ever.