China Growth Stocks

[Shengli]

Why CCME Fraud Claims Don't Hold Up

http://seekingalpha.com/article/251653-why-ccme-fraud-claims-don-t-hold-up?source=yahoo

I'm currently long China MediaExpress Holdings (CCME). But before I was, I heard the whispers of fraud, which have now become flat out screams. As a result, I spent several hundred hours combing through documents, message boards, reading articles and building my own model of the company which I ultimately put on line at investorshub.com for other potential investors to review.

I knew there was a community of bears that were casting doubt on this company's financials. I read the bullish articles by Chimin Sang that were posted here and here on SA last summer. I also talked to a hedge fund manager who mentioned during our chat that Chimin had changed his investment thesis on the company and was ready to publish a negative article. That was 2 months ago. Again to put it in context, I was not yet invested in the company, still doing my own research to determine whether to put any money to work in the name. This period of research led to my conclusion that the accusations of the short community were unfounded, so I started building my position in the stock.

Looking back now it's hard to come up with a complete list of all the claims that have been made. Muddy Waters and Citron in their reports, and shorts on various message boards have thrown out quite a few, so I won't claim this is a complete list. However, identifying some is helpful in framing (bad choice of words I know) the rest of this blog. Here's a few that come to mind:

Revenue in 2009 was less than 20% of the $95m in the audited 10k.

There is an underground organization that infuses cash on a short term basis into companies looking to intentionally overstate cash balances to support reported revenues.

Buses under contract and bus operators are dramatically less than claimed by the company.

The SAT and SAIC filings don't match the reported revenues of the company.

Customers listed by the company as top advertisers have never heard of them.

Insiders are not shareholder friendly because they either own too many shares (never too much for me), have an incentive in the form of earnout shares (for a 6 fold increase in net income), are buying shares with borrowed money (no evidence) or selling shares at distressed prices (one owner decided to liquidate for personal liquidity purposes).

They must be a house of cards because they don't own the buses where the screens display the advertising.

There are dozens more but I particularly like #6, so I'll stop there for purposes of this article.

The perspective of this article is to reflect on who would have to be in on this for the claims of fraud to be believable. I can determine only two scenarios where this degree of fraud could exist: 1) The management team and Deloitte became conspirators in late 2009 when hired to audit the 10k, or 2) There are many co-conspirators that have to be in on the fraud and so coordinated that they fooled Deloitte during the 2009 audit process as well as during the quarterly reviews of 10Q's. I'll take a quick look at each alternative next.

Could Deloitte be involved in a blatant fraud of this magnitude? Before anyone routinely dismisses this premise you have to admit that historically, fraud has been found to exist in capital markets. Auditors are human and as such they are subject to the same greed/temptation as anyone else. However as I reflect back on the history of fraud where a top notch audit firm was complicit, I have not found an example that fits the fact pattern of CCME. This is a company that was small in 2009 with less than $30 million in net income. The service fees for Deloitte are miniscule relative to the firm so the motivation of the partner and office to participate seems improbable.

I know that many posters have attempted to discredit the firm Deloitte Touche Tohmatsu as not being part of Deloitte so I might as well address that up front.

"Deloitte” is the brand under which tens of thousands of dedicated professionals in independent firms throughout the world collaborate to provide audit, consulting, financial advisory, risk management and tax services to selected clients. These firms are members of Deloitte Touche Tohmatsu Limited ((DTTL)), a U.K. private company limited by guarantee. Each member firm provides services in a particular geographic area and is subject to the laws and professional regulations of the particular country or countries in which it operates. DTTL does not itself provide services to clients. DTTL and each DTTL member firm are separate and distinct legal entities, which cannot obligate each other. DTTL and each DTTL member firm are liable only for their own acts or omissions and not those of each other. Each DTTL member firm is structured differently in accordance with national laws, regulations, customary practice, and other factors, and may secure the provision of professional services in its territory through subsidiaries, affiliates, and/or other entities.

This description comes from Deloitte's website.

Just like CCME has different subsidiaries that are set up for various legal and tax reasons, so does Deloitte with separate partnerships. That doesn't make the audit standards any less strict.

For those that don't understand the audit standards of the Big Four or the process that occurs once claims of fraud are heard, it goes something like this: The SEC has undoubtedly been in contact with the Liaison office of Deloitte's U.S. National Office. The national office is now likely overseeing the local office of Deloitte Tohmatsu. This is standard procedure for all the Big 4 audit firms that have clients listed on U.S. exchanges. Therefore, any fraud being perpetrated would not only have to include the local engagement partner and staff of Deloitte Tohmatsu, but that group would either have to be sophisticated enough to fool professionals trained to deal with fraud at the highest level of the firm, or these National Office partners are in on it too. Starts to get pretty so unbelievable that it's not really worth even addressing. If any reader wants to seriously consider that possibility just look at the annual billings of Deloitte and Deloitte Tohmatsu consider what would possibly cause them to take that risk for a company with CCME's billing potential.

Could CCME have fooled Deloitte by forging documents and setting up a network of outsiders that are complicit in the fraud? Seems far fetched but auditors have been fooled before so let's look at what would be required. Again realize that with the fraud publicity this is currently under a microscope with partners in the National Office overseeing the level of testing and documentation that is being scrutinized. This was not the case during the 2009 audit or the quarterly 10Q reviews so I'm only assuming normal audit standards. For this level of fraud to have occurred it would take the following players to be coordinated:

All the management team and board of CCME.

Banks, who are submitting directly to the audit team, statements that include balances, deposits and withdrawal details.

Virtually all customers, as the degree of claimed overstatement of revenues is so extreme it couldn't be focused on a limited number. These customers or individuals would have to represent themselves as customers with fake addresses, phone numbers, stationary and the like to fool a team of professional auditors. Remember the audit function doesn't rely on company documents but rather direct confirmation from customers responding directly to the audit team.

A large percentage of bus operators who would be receiving significant checks that are cashed to fool the auditors, and who then surreptitiously funnel the cash back to the company or this supposed underground organization.

A significant number of advertising agencies who are acting the part of an outside sales team selling the ad minutes on behalf of the company.

The advertising association that lists the company on their list of top advertisers (despite attempts to claim this isn't the case).

I could go on but it seems pointless. I'm not saying the company is pristine. It is relatively small and still learning the requirements of being a U.S.-listed company. CCME is a microcap and should be considered in that light. I'm just saying that a fraud, to the extent others are claiming, requires a set of assumptions that I for one can't envision.

For any potential investors that are judiciously sitting on the sidelines due to the tug of war going on in the stock let me add a final point. Once the 2010 audit is finalized, CCME will have been vetted by the best practices that Deloitte at the National headquarters has laid out. It will also be to a degree beyond any normal sampling methodology that is commonly used. That's the standard whenever a client being audited raises the risk profile due to an external perception that fraud could exist. At that point I would hope that fundamental analysis would start carrying some weight.

Disclosure: I am long CCME.