Thursday, June 09, 2011

Can You Profit By Betting Against RenRen?

RenRen (NYSE: RENN), a Chinese social network, is down 42% since its early May 2011 Initial Public Offering (IPO). The day it went public, May 4, the stock peaked at $18.01 -- and since then it has tumbled to $10.51. Can you profit from a short bet?

You have to get nervous when a young company changes its name. After all, RenRen, registered in the famous tax haven, the Cayman Islands, used to be known as Oak Pacific Interactive. RenRen describes itself as "a social networking Internet platform in China." Its revenues come from advertising and "Internet value-added services (IVAS)." In the last year, $4.1 billion market capitalization RenRen generated $77 million in revenues, up 64%, and lost $63 million, 7% less than the year before.

In thinking about whether to sell this stock short -- a bet that involves borrowing the shares from a broker, selling them at the market price, and then repaying the share loan by buying them back in the open market, it is important to consider whether the company has a good chance of going bankrupt. And since RenRen has no long-term debt, the answer is probably not.

One area worth looking for problems is in RenRen's accounting. A Stanford researcher I spoke with this week told me half tongue-in-cheek that Chinese companies have three sets of books -- one that reflects their real results, another to keep from paying taxes, and a third for U.S. investors. And that third set of books often inflates the actual results of the company.

Research into so-called reverse mergers with Chinese companies reveals that this is not always a joke. In such a reverse merger, a moribund, but publicly traded U.S. company buys a Chinese company and changes its name to the acquired company. The purpose is for the Chinese company to get access to U.S. investors without going through the process of getting its shares registered with U.S. regulatory authorities.

There are plenty of such reverse mergers. As BusinessWeek found in January, such reverse mergers were 94 companies with market capitalizations of between $50 million and $1 billion that trade an average of at least 50,000 shares daily, with a total stock market value of more than $20 billion.

And there are plenty of such reverse mergers where the U.S. financial results are much better than the actual ones. An example, according to BusinessWeek, is China Sky One Medical (NASDAQ: CSKI), a maker of products such as "magnetizing" hemorrhoid ointments and patches that would "dispel fat." Sky One, according to its annual report filed just a few days earlier, was selling out of its inventory every seven days -- much faster than one investigator, John Bird, thought possible.

But Bird found that Sky One's report on its financials to the Chinese regulatory authorities, SAIC, was much different than what it reported to the SEC. Specifically, Sky One reported to SAIC that its operating unit, Harbin Tian Di Ren, had 2008 sales of about $1 million while reporting $59.7 million in 2008 sales to the SEC. Bird made a huge profit selling Sky One's shares short.

Although RenRen has not done a reverse merger, its U.S. prospectus raises important questions about its accounting. For example, its auditor pointed out that RenRen had material weaknesses in its internal controls -- including a lack of personnel with adequate U.S. GAAP accounting expertise and inadequate procedures for control of the investing of its surplus cash. The upshot is that there is no certainty that RenRen's financial statements are accurate.

Among the curious parts of RenRen's financial reporting -- one sticks out. Thanks to a $73 million "change in the fair value of warrants" -- a warrant is similar to an option that gives the holder the right, but not the obligation, to buy shares -- in 2010 RenRen went from burning through cash to reporting in increase in cash. RenRen issued these warrants to SOFTBANK CORP. in April 2008 and amended in July 2009 in connection with its sales of series D preferred shares.

As it turns out, this $73 million is based on management's very convenient set of assumptions plugged into a financial model for the valuation of its so-called ordinary shares. If you have the stomach for it, these calculations are mentioned in its prospectus -- but despite a plethora of details about the assumptions -- there is still not enough detail to decide whether these assumptions are accurate.

The prospectus also highlights some enormous regulatory risks. The Chinese government could shut down RenRen's business if it finds that it is not complying with a law regarding its corporate structure (operating in China while being registered in the Cayman Islands); the U.S. government may decide that it should pay U.S. taxes, the Chinese government could penalize it for causing gaming fatigue for RenRen users who play its games for more than three hours.

Can you profit from selling RenRen shares short? I cannot find a smoking gun although, according to Cody Willard, "Renren has already had to correct numbers in their IPO prospectus and has had a board member resign already because of accounting issues at another company where he was on the board.”

If you're willing to bet that RenRen has sufficiently poor accounting that its value is overstated, then you should considering shorting its shares. Otherwise, I would suggest avoiding the stock.


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