Carson Block Followers Bet on 46% Rout in NQ Mobile on Probe

May 14, 2014 10:23 am ET

(Updates with today’s trading in fifth paragraph.)

May 14 (Bloomberg) -- For investors in NQ Mobile Inc., the Chinese mobile-service provider accused by short seller Carson Block of overstating revenue, this could be a make-or-break week.

About two-thirds of the record 345,000 bearish options that investors hold will expire by May 17, two days after the deadline the company set to conclude an investigation into Block’s allegations. The most popular options contracts, known as puts, will make money if the shares drop 46 percent from yesterday’s close. Stock borrowed for short selling amounts to 26 percent of shares outstanding, the highest among the most- traded Chinese companies listed in the U.S.

The result from the investigation led by law firm Shearman & Sterling LLP and auditor Deloitte & Touche Financial Advisory Services Ltd. will be the most definitive judgment so far on whether Block’s assertion that NQ Mobile misrepresented its financials has merit. Shares of NQ Mobile, which counts wireless carriers such as Sprint Corp. among its partners, have sunk 51 percent since Block, founder of Muddy Waters LLC, issued his report in October.

“A clean bill of health will resolve this issue and will allow the company to move forward,” Timothy Ghriskey, chief investment officer at New York-based Solaris Asset Management LLC, which helps manage about $1.5 billion in assets, said by phone yesterday. “On the other hand, short sellers are very confident that there are some issues here. Either way, something significant is going to happen this week, resulting in sharp moves of the stock one way or the other.”

No Evidence

American depositary receipts of NQ Mobile declined 7.8 percent to $11.17 yesterday. They fell 0.2 percent at 10:17 a.m. in New York today as the Bloomberg index of the most-traded Chinese shares in the U.S. added 0.2 percent to 101.09.

The Beijing-based company said in an April 30 statement that its investigation team, comprised of Shearman and Deloitte, thus far found no evidence that it was engaged in the “fraudulent conduct” alleged by Muddy Waters as the six-month probe draws to an end.

NQ Mobile at the same time delayed the filing of its audited annual report by 15 days as it waits for the final results of the investigation. The company said it doesn’t anticipate any changes to its previously reported financial results.

The statement came three weeks after NQ Mobile reported negative cash flow from operations in the fourth quarter and adjusted profit 31 percent below analysts’ estimates, renewing concerns that the company may have manipulated accounting. The stock is down 30 percent since the earnings report.

Sino-Forest, Enron

Kim Titus, a spokesman for NQ Mobile, referred to the company’s April 30 statement when asked about the likely outcome for the investigation and its publication date.

Block, who shot to fame over the past years for exposing illicit practices in Chinese companies, said yesterday these kind of probes often lack credibility and reiterated his assertion that NQ Mobile is a fraud.

“The delay makes clear that if NQ manages to receive an unqualified audit opinion, it will have been by the skin of its teeth,” he said by e-mail. “If that turns out to be the case, going forward, China management will be under a lot of pressure as it tries to up its fraud game. As we’ve seen with Sino- Forest, Enron and other companies that commit fraud, so-called independent board investigations are rarely worth the paper they’re printed on.”

Sino-Forest Corp., once the largest Chinese forestry company with more than $6 billion in market value at its peak, filed for bankruptcy in March 2012, two months after an independent committee said it may not be able to disprove some allegations made by Block.

Bearish Bets

Bearish options expiring this week amount to about 226,000 contracts, three times the number of the bullish ones, according to data compiled by Bloomberg. Put options are used by investors to protect against or bet on declines in stock prices, while calls gain in value when share prices increase.

Puts with a strike price of $6, about 46 percent below the yesterday’s close, have the biggest open interest with more than 97,000 contracts. The stock hasn’t traded at that level since the beginning of 2013.

Short interest, or shares borrowed and sold to profit from a decline, rose to a record 15 million on April 15 before decreasing to 13.1 million at the end of last month, according to data from U.S. exchanges. It accounts for 26 percent of shares outstanding, the highest ratio among Chinese ADRs with a market valuation of $300 million or more, Bloomberg data show.

Block wrote in an Oct. 24 report that NQ Mobile’s shares were worth less than $1 because the company misrepresented its cash balances and sales. The report triggered a 47 percent drop in the shares that day.

’Biggest Overhang’

“If the report comes out clean, it’s going to be very positive,” Calvin Zhang, a portfolio manager at PNC Capital Advisors which holds NQ Mobile shares, said in an e-mailed response on May 12. “This is the biggest overhang to the share price. People would then begin to look at the underlying business more closely, which is growing and evolving nicely.”

NQ Mobile will report $75.2 million in first-quarter sales, up 126 percent from a year earlier, according to the average forecast of three analysts surveyed by Bloomberg. Cash from operations will reach $15.3 million, from negative $13.4 million in the previous quarter, according to the survey.

“It has already been a prolonged war,” Taek-Geun Kwon, chief investment officer of Toro Investment Partners LP, a San Francisco-based hedge fund that held 3.5 percent of NQ Mobile shares outstanding as of January, said by e-mail on May 12. “I’d expect a positive outcome this week to be more than enough” to put Block’s allegations behind us, he said.

--With assistance from Eugene Miculet in New York.