Bloomberg News

Muddy Waters Target Spreadtrum Says No Concern on Inventory

June 29, 2011

(Closes today’s trading in third paragraph.)

June 29 (Bloomberg) -- Spreadtrum Communications Inc., the Chinese chip designer whose accounting was questioned by Muddy Waters LLC, responded to the short seller’s report today by saying inventory surged last year because of new products.

Muddy Waters, the investment firm run by Carson Block whose research has preceded almost $5 billion in share losses among Chinese companies trading in North America, cited a fivefold increase in inventory in a letter to Spreadtrum’s management. Block’s firm said the company’s deferred costs may have climbed too fast in explaining why it was betting the stock will fall.

Spreadtrum is so far the only company out of six analyzed by Block that isn’t trading below its price the day his report was published. The shares rose 10 percent to $13.76 as of 4 p.m. in New York, advancing 6.3 percent from their June 27 close. Sino-Forest Corp., the Hong Kong-based tree-plantation operator, has tumbled 85 percent since Muddy Waters said June 2 it was overstating timber holdings.

“The allegations made against Spreadtrum were not nearly as damning nor as well diligenced as the allegations made against Sino-Forest,” Kevin Pollack, a fund manager at New York-based Paragon Capital LP who invests in U.S.-listed Chinese stocks, wrote in an e-mail. “There was no real evidence of management wrongdoing presented, it was more about displeasure about the company strategy and management changes.”

Erasing Losses

Spreadtrum tumbled as much as 34 percent yesterday before paring declines, closing down 3.5 percent after Needham Group Inc. and Chardan Capital Markets LLC said the Muddy Waters assertions were overblown. The shares fell 32 percent in 2011 through yesterday after rallying 452 percent in 2009 and 236 percent in 2010, data compiled by Bloomberg show.

Muddy Waters highlighted five financial-statement items in its report: inventories, advances from customers, prepayments, accounts payable and accrued expenses. The short seller said it’s most concerned about the jump in the first two.

“Can you explain why the size (in absolute value terms) of each of these accounts is much larger than in the past?” the short seller wrote in the report, which appeared on its website. “What processes did the auditors undertake to confirm the sizes of each of these accounts?”

Spreadtrum doesn’t expect to record any write-offs on inventory and its auditor has completed its review of the way it accounts for merchandise, said Leo Li, the company’s chairman, chief executive officer and president. He spoke today during a conference call with investors and analysts.

Tracking Revenue

“The inventory level increased due to new product introductions and also the need to maintain the current product line,” Li said on the call. “Also, the inventory level tracks to the level of revenue increases,” he said. “We provide full access to accounting records to auditors.”

The value of Spreadtrum’s inventories rose more than fivefold to $133.1 million in 2010 from $25.5 million in 2009 as revenue more than tripled to $346.3 million, data compiled by Bloomberg from company statements show.

“Building inventories can be a way to lower your costs,” said Bill Fleckenstein, president of Fleckenstein Capital Inc. in Seattle. “It allows a company to report lower costs for the products that it has sold because you’re moving a chunk of your cost onto the balance sheet. It may be a warning sign, but it can also be completely legitimate.”

Revealing His Process

Block said in an e-mail yesterday that the report achieved its goals.

“We get a lot of requests from investors wanting to know how they can protect themselves against getting blindsided by a major expose on a company,” he said. “We therefore wanted to give investors a look at our internal process, and let them see how we approach the earlier stages of our research,” Block wrote. “It brought important issues to investors’ attention, and helped investors better understand how to spot red flags. We hope the company will make a sincere attempt to answer our questions candidly.”

Short selling, or the sale of borrowed stock to profit from a decline, rose to a record 15 percent of Spreadtrum’s outstanding shares as of June 27, up from 6.7 percent at the beginning of the month and 1.5 percent at the end of 2010, according to Data Explorers, a New York-based research firm.

Quinn Bolton, an analyst at Needham with a “buy” recommendation on the stock, wrote that the “conference call reiterates our belief that SPRD is a real and rapidly growing company,” according to a note to clients, in which the analyst referred to the company by its stock symbol.

‘Most Positive’

“We are incrementally more positive given the company’s efforts to return cash to shareholders through the dividend and repurchase program,” New York-based Bolton said.

Spreadtrum said today that it will pay a dividend on its American depositary shares of 5 cents and that it will continue buybacks it announced this month. The company can repurchase as much as $100 million of its American depositary receipts under the program. It has purchased 1.44 million shares, or about 3 percent of outstanding stock, through today, according to an investor presentation.

“We think our stock is undervalued,” Li said. “This repurchase program will be a benefit for shareholders.”

--Editors: Chris Nagi, Nick Baker

To contact the reporter on this story: Nikolaj Gammeltoft in New York at ngammeltoft@bloomberg.net

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net


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