Auditor Drops Huafang, Dealing New Blow To China's 'Internet Bad Boy'

Key Takeaways:

• KPMG has abruptly resigned as Huafang’s auditor, dealing a major setback as the company seeks to end a four-month trading suspension of its shares
• The livestreaming entertainment platform’s secretary and vice president Jiao Yang resigned a month after trading of Huafang’s shares was suspended in April

By Yi Xi

The bad news keeps coming for Zhou Hongyi, founder of security software company 360 Group and one of China’s leading tech entrepreneurs. First, the man, whose outspokenness has earned him a reputation as China’s “internet bad boy,” split with his wife Hu Huan, handing her 6.25% of his company’s shares worth about 9 billion yuan ($1.26 billion) as part of their divorce settlement.

More recently, Huafang Group Inc. (3611.HK), which counts Zhou as a major backer, lost its auditor with the sudden resignation of KPMG last week, in a blow to the company as it fights to resume trading after its shares were suspended in April.

Zhou is one of China’s best-known high-tech entrepreneurs. He worked for Founder Group, an early big name in the computer industry, in 1995 and was quickly promoted to general manager of the business department. But his ambition didn’t end there, and he set up his 3721 Web Assistant, one of China’s first search engines, in 1998. That led to his first shot of fame – and wealth – in 2003 when he sold the company to Yahoo for $120 million, and went on to serve as president of Yahoo China.

But Zhou isn’t without controversy. He often clashes with other big names in China’s scientific and technology circles, and is no stranger to lawsuits – both on the giving and receiving ends. A dispute with Yahoo co-founder Jerry Yang ended with Zhou’s stormy departure from the U.S. search giant. After setting up Qihoo 360, Zhou would frequently exchange insults with Yahoo’s China CEO Tian Jian.

Other famous clashes followed, targeting a wide range of big names from China’s internet and software communities, often resulting in high-profile defamation and other lawsuits and countersuits. More recently, however, Zhou has maintained a lower profile in publicly expressing his views.

Huafang is his fourth listed company, with Zhou holding 36.46% of its shares. Shenzhen-listed Songcheng Performance Development (300114.SZ) is its second largest shareholder with 35.35%. Huafang operates a livestreaming entertainment social platform, and had 415 million registered users at the end of May last year. More than 61 million of those were monthly active users at the end of last year, with 1.55 million of those as paying monthly users.

The company’s flagship Huajiao app was China’s highest-ranked entertainment livestreaming platform last year in terms of mobile users, with its focus on attractive show hosts who chat and interact with users in real time. The platform’s average monthly paying users exceeded 1 million at the end of May last year, with the average user forking over 293 yuan ($41) per month.

Post-debut Slide

Last November, another Zhou-backed company, Qifu Technology QFIN, was listed in Hong Kong, complementing its existing New York listing. Huafang was listed a month later in a separate IPO for HK$2.80 per share, and quickly spiked as high as HK$4.56. But the surge was brief, and just three months later the price was down to HK$1.71, a drop of nearly 40% from the listing price.

Despite its weak stock performance, Huafang’s first full-year financial report, released in late March, was quite solid. The company’s annual revenue rose nearly 11% to 5.1 billion yuan, and its net profit increased by nearly 20% to 390 million yuan. The company’s finances are also quite healthy, with more than 1.6 billion yuan in cash and no short- or long-term bank liabilities.

Frozen Accounts, Trading Suspension

But then things took a turn for the worse. Just days after releasing its first annual results, the company suddenly announced its shares were being suspended and the publication of its final annual results delayed. It revealed that one of its bank accounts was frozen, involving an amount of 136 million yuan. It added that a company in which Huafang owned 25% was under a government investigation, without providing more specifics.

Those matters continued to shadow the company. At the end of May, Huafang’s company secretary and vice president Jiao Yang resigned for personal reasons. Such a top-level departure less than half a year after the listing inevitably raised eyebrows during such a period of turmoil.

As Huafang’s shares remained suspended, the Hong Kong Stock Exchange in mid-June gave the company a series of steps needed to resume trading. First, it needed to publish its audited financial results, and then publish results of an independent investigation and take necessary remedial action. Third, the company needed to conduct an independent internal review and show that it had sufficient controls and procedures to comply with Hong Kong listing rules.

Faced with those requirements, Huafang went to work and said it expected to appoint an independent investigator and internal control consultant by the end of July.

After some hard work, things were starting to look up for Huafang. At the end of last month, the company said it was fully cooperating with the government investigation, and ponied up 155 million yuan to resolve the case of the frozen bank account, leading to the unfreezing of the account on July 25 and resumption of its use for daily business.

But just when it appeared the path was clear for a trading resumption, KPMG unexpectedly said it was unable to evaluate and investigate Huafang’s financial performance and the impact of earlier events on the company’s business, leading it to resign as the company’s auditor on Aug. 3.

KPMG pointed out that most importantly, Huafang failed to issue an independent consultant’s report on the freezing of the bank account before July 30. It also failed to hand over results of the government investigation and legal opinions from external lawyers on the ramifications of the account freezing before the deadline.

Questions To Be Answered

Without the auditor’s report, Huafang clearly can’t meet the stock exchange’s requirements for a trading resumption, killing its chances to quickly resolve its issues.

For minority shareholders and investors, Huafang represents a potential can of worms. After all, the company was only listed for three months before the trading suspension, one of its bank accounts was frozen, and one of its invested companies came under investigation, which are hardly reasons for confidence.

So, what exactly are the company’s problems? Huafang has yet to provide a detailed explanation, instead giving only vagaries. How did the company’s auditors and underwriters conduct their reviews before the listing? Huafang’s 2022 financials have yet to be finalized, so are the attractive financials released in March credible? And at this point, a timetable for trading to resume is even less clear, since the company currently has no auditor.