Friday, August 19, 2016

The Theory of Financial Relativity

The best thing about being a blogger is that I have the latitude to write about whatever piques my curiosity, without concern that some ham-handed editor might ban my musings or worse try to distill them to 140 characters or less, in a misguided effort to maximize "eyeballs" or advertising revenue.  Many of the topics I like to explore are simply too complex to discuss in a few paragraphs.  For example, for this post, to really understand this topic, it's important to take a trip back in time to revisit the work of French Chemist and Physicist, Antoine Laurent Lavoisier, circa 1785.

I'm hopeful I didn't lose too many of you with that introduction, but I believe it's an important preamble to set the stage for what we're going to talk about today.  For those of you unfamiliar, Lavoisier developed/discovered what is now commonly known as the Law of Conservation of Mass (i.e. Matter can neither be created nor destroyed.) This was groundbreaking work and his experiments and methods became a road map for for the modern science to follow.  Unfortunately, for his unique perspective and conflicting political views during the French Revolution, Lavoisier was eventually guillotined in 1794, presumably without recognition, understanding or appreciation of the historic importance of his work.  I'm of course hopeful that my work re: the Theory of Financial Relativity will result is a much less brutal consequence for my efforts.  I've never been one to contemplate giving my life, literally, to science. Thankfully, I need not frame my work to deal with the politics of an impending revolution, nor do I have a guillotine-wielding Robespierre to consider, at least that I'm aware of.

As Lavoisier's theory generally states, in a closed system, Matter/mass can neither be created nor destroyed. It simply changes form.  Mass/Matter is fungible, flowing seamlessly from one state to another when energy is applied.  Matter is Matter.  For example, in economic terms an iPhone and the proverbial "steaming turd on a hot August sidewalk" have roughly the same mass, yet the perceived economic value is vastly different.

This post explores the human experience re: the mechanics of how our global economic systems place a value on various forms of Matter.   Here's a silly little chart to get us started.



Let's say for example, hypothetically of course, that there are only two things on this planet, "Matter" and "money".  Matter is defined as "everything" and "money" is defined as our perceived value of same.  Since Matter is a constant (it can't be created nor destroyed), simple math tells us that the relationship between the price people are willing to pay for Matter (at least on this planet....a closed system) and the amount of money available, is linear.  As our singular, omnipotent, all powerful imaginary central bank increases/decreases the money supply, the price that people are willing to pay for Matter increases/decreases proportionately.

So...Why does the Price of Matter actually matter?

Let's think this through.  If our imaginary money supply stays constant, the aggregate value of all global Matter also remains the constant.   There's a certain level of stability.  There's an expectation of equilibrium.  If the price of one type of matter goes up....another must go down.   People, who ironically are also made of Matter, have an easier time making rational decisions, determining value and allocating their money.

In an economic system, people convert matter to other types of matter through production, construction, marketing, hype, fraud and any conceivable method to create a higher perceived value, and hopefully, create some personal wealth for their efforts along the way. Perhaps they take wood, land, plastic and cement and create luxury real estate, or maybe throw together some aluminum, steel and engineering talent and Eureka! we have a jumbo jet!  In any case the perceived value of the end product should be much higher than the aggregate value of the components, providing of course, in this example, that there is enough "money" available, and people can afford the luxury Real Estate and/or the jumbo jets can actually stay in the air. As all of this activity takes place, it would be prudent for our singular, omnipotent, all powerful imaginary Central Bank to gradually increase the money supply to match the perceived value of what's being created.  Unless there's  a reasonable expansion of the money supply, as people perceive more value in a jumbo jet and they are willing to pay more for travel, compared to say, food or clothes, the relative perceived value (and price) of food and clothing would have to decline without said monetary expansion.  i.e.) There's only enough money to go around.

Here's where it gets complicated 

The above simple example describes the price/value relationship between one (1) currency and one (1) constant, universal economic good/service (Matter).  Today, our wonderful, big blue marble has more than seven billion people engaged in some sort of economic activity (production or consumption).  There are millions of businesses, all attempting to manage a perceived value of tens of billions of SKUs, barters, trades, goods and services. There are hundreds of governments trying to regulate the aforementioned activities for various, and usually conflicting political reasons.  There are 200+ Central Banks and currencies out there, thousands of financial institutions, and hundreds of trillions of dollars worth of "money", financial assets, stocks, bonds, derivatives, off the books IOU's, guarantees and god knows what else, all having their "perceived values" adjusted by Mr. Market nearly every millisecond.

All of this complexity and speed, of course, creates the possibility for mistakes and errors in judgment.  Dr. Richard Thaler, if you are familiar with his work on Choice Architecture, often cites the difference between humans and "Econs".  Humans, of course, are you and I. We make choices based on our own personal biases and limited knowledge, often failing to make the best choices. Econs, as Thaler describes, are people who have no biases, perfect knowledge and an aptitude to always make the best decision in any scenario.  Econ's, of course don't exist....so it looks like you and I (and seven billion of our neighbors) are relegated to the life of a human, muddling through with limited or incorrect information, inappropriate biases and an insufficient ability to analyze most of our daily conundrums.

Central Bank Coordination

Financial globalization has lead us to an unprecedented time in Central Bank history.  Like never before, the FED, PBOC, ECB, and the BOJ (the combined monetary engine for roughly 75% of the planet's economic activity) seem to be operating in a carefully choreographed stimulus dance, with each trying to take the lead and pick up the tempo at the expense of the others.  This waltz began with the BOJ's movement toward  Near-ZIRP in the late 1990's and was further validated by the FED's rate cuts, TARP and stimulus during the financial crisis.  Once the FED opened the door, albeit necessarily, to recapitalize the US Banking system, Central Bankers around the globe had an epiphany....they were born again,  They began implementing policy, which, under the guise of economic stimulus, did little more than support and inflate already bubble-ized asset prices.  It stands to reason that the Central Bankers will reach (if they haven't already) the point of no return.  It would appear that we are on an inevitable, accelerating pace to negative interest rates in every corner of the globe.  (Sweden, Denmark, Japan, Switzerland, etc. are already paving the way)  There is always some "crisis" on the horizon preventing the Central Bankers from "going up" that pesky quarter-point. This phenomenon was unthinkable a decade ago.

The FED Charts below illustrate the odd behavior of US Broad Money (M2) over the last few years.  M2 has nearly doubled in the last decade yet the velocity (defined as the ratio of the number of times one dollar is spent per quarter) continues to decline.




One would think that this relationship would be unlikely, if not, impossible.  Logically, circulation should increase (rather than decline) as the money supply increases.  For an answer to this paradox we need to look to Dr. Thaler's work in Behavioral Economics.  Since the financial crisis, all of this liquidity has been poured into the banking system.  Since the bankers are the gate keepers, deciding who gets a piece of all of this stimulus, we can only conclude that the lions share of this money has been "stuck" in the banking system and financial assets, i.e.) the often discussed "decoupling" of the financial system from the "real" economy. Simply put, the money isn't actually making its way to individuals and businesses which hire workers, spend money, increase consumption and therefore, velocity.  The money is being used to bid up the price of financial assets.  If we think about it for a minute, it makes perfect sense.  Most of us (bankers included) make the best choices available.  If we don't believe that we can expand our businesses profitably, we don't do it.  The folks at the top of the food chain would rather keep the money in financial assets, retirement accounts and savings.  (because they are generating a heck of a return)  They/we/us have no need to consume. Our consumption habits don't change all that much when we have a good year.  On the other hand, working folks, scrimping by on two part time jobs would most likely consume/spend every nickle they could if the money ever made it down to them.  Unfortunately for all of us, it doesn't.   So consumption, prices and wages don't increase....and we can't grow our businesses comfortably/profitably.  So we all hunker down.



Debt continues to grow.  As we can see by the chart below, Non-Financial (Core) and Public (Government) debt has increased significantly (US$ 23 Trillion) since 2010 with no appreciable accretion in GDP. Simply put, businesses and governments are borrowing to spur growth with comparatively little to show for it. Moreover, with China's NBS continuing to report dubious GDP/Growth/Production, and nearly all of the below described debt increase ($20 Billion) is attributable to the Chinese economy, the proliferation of non-productive, low quality (non-performing) debt may be accelerating at a much quicker rate than the traditional ratios might indicate. In other words, despite all of this stimulus, global GDP might actually be declining.      



Here's another chart (below) showing US GDP growth.......bumping along at a half -% or so per quarter.  It looks kind of pathetic when we think about the amount of money that's been deployed to generate this paltry growth.  You'd think that the GDP would be skyrocketing.  Again, the value of Matter that really matters... Matter that's "transformed" and "consumed" (GDP)..... has been flat. 



The FED is starting to rethink what's happening in this "New Economic Era".  Presumably they'll be working toward an increased focus on fiscal policy (which unfortunately is out of the FEDs control) in an effort to get more of the money they print into the hands of people who will actually spend it.   (see Williams - New Orthodoxy)

So What's the Problem?

Central banks can continue to ease, provide credit, roll over bad loans, absorb and recapitalize businesses, and keep money losing, zombie enterprises afloat indefinitely.  With a coordinated effort Central Bankers can support the price of bad Matter, continually breathing new life into an an economy chocked full of steaming financial turds.  So as the Central Banker's dance continues, the global money supply and related debt levels spiral upward.  As an economist, you might ask: Where is the inflation going?  Well, of course the disposition of inflation is government/economy specific.  The perceived value of Matter everywhere is being re-evaluated.  In the US we know inflation isn't going into wages or raw materials.  We've learned long ago that trickle down economics doesn't always trickle.  Sometimes the trickle gets diverted by Mr. Market.  I've postulated for a while now that we shouldn't be seeing a doubling in US equity prices (since 2009) with an anemic (2% +/-) annual growth in GDP, but that's where the inflation is hiding.  The US Stock Indexes just keep busting through record high after record high.  In China the inflation is "stuck" in vacant real estate and excess capacity.  I'm sure we can look at every economy participating in the global money supply expansion and make a "Where's Waldo" guess as to where they are storing their inflation.  As an aside, for those of us who work for a living, there doesn't seem to be much inflation showing up in our paychecks anywhere on the planet.  Yet, the retirement (income) assets we're hoping to buy with our savings are continually priced higher. The yield declines, until we will all eventually pay a fee  to save (negative rates).  This math, for a Central Banker, is apparently a fair trade for the avoidance of a systemic default

The Theory of Financial Relativity:

The cornerstone of the theory is:

"Central Bankers, acting in concert, expanding the money supply, funding, guaranteeing and recapitalizing debt, regardless of quality, can prevent the decline of the perceived value of the planet's aggregate Matter."

Everything is indeed..."Relative".  The proposed Theory, to be tested over time (Like most Macro-Economic Experiments there is unfortunately no test-lab available) is comprised of Five Underlying Banking/Accounting Rules (FUBAR):

  1. The aggregate value of Matter has a linear relationship with the supply of money.
  2. Prices of individual components of Matter(assets) will fluctuate based on their perceived value.
  3. Central Banks, acting in concert, can manage the perceived value of classes of Matter (assets) within a relative range through open market operations. i.e.) Purchasing anything their hearts desire with money hot off the press.
  4. Nominal prices are irrelevant as long as perceived value relationships remain constant within a relative range. 
  5. If classes of Matter (assets) never decline in value or default, Economic stability is guaranteed.

Of course, the key question is:  Does the world really have a theoretical debt ceiling?....if so...what is it?  The Theory of Financial Relativity would conclude that there is none.

It's a given that individual businesses, economies and governments all have a theoretical "debt limit". They borrow money and  reach their debt ceiling when their creditors believe, through complex analysis, there is a possibility that they might not be paid back.  At that point, lenders have their lawyers draft a carefully worded letter that says.  (Dick Fuld Banker-Speak-Translator "BST" Translation:):  "NO MORE %$&#!! MONEY FOR YOU!....YOU LOSER!....GIVE ME MY MONEY BACK NOW!".   These letters are of course, generally ineffective (the money is gone/spent), but they feel good to write and legally absolve the author from any responsibility to shareholders or regulators for making the bad loans in the first place. As a nugget of trivia, I believe the Mafia coined the term "debt ceiling"....or was that "cement overshoes".....but I digress.

Let's consider the possibility (and it seems to be happening), that if all of the Central Banks on the planet are on the same page and collude to prevent any and all defaults, they will all keep printing money at a coordinated rate, maintain stable currency relationships and allow borrowers to keep paying debt service with cheaper and cheaper currency.  If Central Bankers continually increase the outstanding global debt and money supply (i.e. nobody demands their money back, similar to how the PBOC is operating today) the cycle could conceivably continue on forever.  Central Bankers, when they work as a team, can simply keep printing money, preventing anyone from having to send out those nasty "GIVE ME MY MONEY BACK!" letters.  Like in China today, everyone gets a participation trophy.  The world is sunshine lollipops and rainbows in perpetuity.

Carlo Reiter, an analyst at JCAP estimates that the Chinese Central Bank (PBOC) spends RMB 570 to 600 Billion (US$ 85 to 90 Billion) per month rolling over bad loans that would otherwise be considered non-performing (NPLs).  One series of actions which might indicate that the FED, ECB and BOJ are acting in concert with the PBOC would be a continued, coordinated easing to assist the PBOC in an orderly depreciation of the RMB.  Carlo expects this roll-over-funding to continue and the RMB could decline by up to 15% within the year.  If Carlo is correct, for this to be a truly orderly adjustment, the PBOC will absolutely need a little help from their friends.  If the Theory of Financial Relativity is genuinely being implemented, we can expect this stealth refunding and expansion of Open Market Operations to accelerate, softening the blow when perceived value shifts, if and when Central Banks around the globe deem it necessary to step in.

Naturally, Central Bank Balance sheets continue to expand. (Yardeni)  Combined assets (FED, PBOC, BOJ & ECB) have increased nearly US$ 2 Trillion, to roughly US$ 17.3 Trillion this year. This increase would most likely be even greater had the PBOC not been required to spend "a few hundred billion" of its FOREX reserves defending an over-valued RMB.  (Remember my post a year and half ago.....China's Dream?)  Of note, this increase, of course wasn't a liquidity driven TARP-like-free-for-all yard sale where the Central Banks were forced to buy every orphan, unwanted security on the street in order to keep financial markets from freezing up.  The bulk of this expansion, as far as we can tell, has been voluntary.  Global, pre-crisis balance sheet levels were roughly US$ 6 Trillion and rose to about US$9 Trillion once liquidity was safely restored.  Today, Central Bank Assets have nearly doubled from that level.  As you might suspect, it's apparently lots of fun to print money and buy stuff!    


Moreover, the "Theory of Financial Relativity" provides that, as long as the perceived value relationships remain constant, the nominal value of assets (Matter) is irrelevant.  Asset prices might be increasing at the speed of light but it feels like we are standing still.  There is no debt ceiling and there can never be an actual default.  The deck chairs are simply reshuffled.  Sadly, there is also no real economic growth.  Like Major League Baseball during the steroid era, all of the historic ratios become meaningless. Wages and commodity prices will always decline in real terms since new money must be used to roll-over bad debt, stave off defaults and pay the negligible debt service due to BZIRP.  (Below-Zero-Interest-Rate-Policy....like the Frozen theme song....just "let it go"...) Interest rates must remain negative forever. Yet, the world remains in equilibrium.

So, you might ask, what happens if one of the major players won't/can't participate in the choreography? What happens if  some political shock appears on the horizon that a coordinated Central Bank effort can't handle?  What if the currency/valuation relationships are disrupted?  What if Central Bankers just can't seem to get along, or god forbid, disagree?  Isn't there a good chance that the rogue economy/Central Bank might be sucked into a financial black hole, taking anything near its' perimeter (counter-party) with it?  Well, yes, of course, that probability exists, just as it always has, but I might suggest that there is also a point where, once the giant ball of global debt reaches a critical mass, the consequences for not playing along would be so severe that no banker or politician would dare tempt fate.  The safe political path would always be to continue pumping stimulus into zombie banks, paying paltry debt service on loans that will never be paid back in a mad scramble to an undefinable, infinite bottom.

Central Bankers behavior would resemble a financial arms race reminiscent of the cold war. Remember MAD? "Mutually Assured Destruction"?.  (Authors Note: When I typed that phrase I had a chilling flashback of the days when my classmates and I would huddle under our kindergarten desks when the Nuclear drill alarm went off.)   The deterrent of MAD relied on the belief that the consequences of launching a missile were so dire that it was thought no rational leader would ever consider doing it.  Central Bankers may be nearing a monetary MAD, but instead of ICBM's, today we use junk bonds, derivatives, "dog-shit-wrapped-in-cat-shit"CDO's and the discount rate.  Today, no rational Central Banker would dare tighten unilaterally.  When they press the button they would risk destroying the global financial equilibrium and their own country's economy....along with everyone elses.  What Central Banker worth his/her salt would want his/her picture to pop up after a Wikipedia search entitled: "Dude responsible for the Global Financial Armageddon"?

Interestingly, there may also be, in this author's opinion, a moral hazard attached to all of this acceleration.  The money we've earned and managed to save from back in the 80's & 90's, when treated like any other commodity, declines in value rapidly.   When the supply of dollars/currency increases geometrically, every one of those original '80's & '90's dollars is now worth a fraction of what it was worth when we earned/saved it, in terms of purchasing power.  The value of our savings is destroyed.  As a "saver" choices become limited.  Our life savings is the validation of our hard work and good decisions over the last few decades.  Today, as Investors, we can either 1.) "Invest" in risk assets that should either increase dramatically in nominal terms if the Central Bankers stay the course..... or could go away overnight if the choreography of the Central Bankers is somehow violently disrupted; or 2.) hold cash and watch its purchasing power silently devalue over time.  Risk averse savers on fixed incomes (our Mom's & Dad's and eventually you and I) will slowly go broke.  Sadly, those are really our only two (2) options today.

Therefore, if the Theory of Financial Relativity is correct, and Central Bankers will never permit risk asset prices (in aggregate) to decline, we should all throw caution to the wind and trust our Central Bankers.  We should pile our savings into risk assets (stocks & derivatives tied to stock performance) forever. Jeremy Siegel was right!  We're all going to be filthy rich (in nominal terms) without doing a blessed thing!  Participation trophies all around!


The Only (Painless) Way Out.....

Now, let's say that, perhaps, just for the sake of argument, that the Theory of Financial Relativity (what's happening now) might be.....well.....and I shudder to think it......dead wrong.   I'm not talking about an Ooops...I bounced a check or forgot to renew my license plates kind of "wrong".  I'm talking about something more like a "the world is flat...this ship is unsinkable.....those O-rings should work just fine... and I'm positive Saddam has Weapons of Mass Destruction" fire and brimstone kind of "wrong".  As a scientist (particularly an Economist), I feel it's my duty, and only prudent, to speculate about the ramifications of being catastrophically wrong.  It's just part of the job.

The first way out, of course, is the aforementioned valuation reset and a Global Financial Armageddon, which hopefully no Central Banker would be in favor of.

The second path, and perhaps, the only painless way out of this spiral might be a carefully choreographed, cooperative, global Central Bank tightening? Central Banks would/could/should meticulously coordinate a slow march back up to "normal" interest rates, hopefully in a cooperative, joint effort, limiting market disruption, restoring the perceived value of savings and salvaging the future for the generations to come. Or, in the nearly immortal words of the globally respected economist, Dr. Tom Petty:  "Hey ....Baby....there ain't no easy way out.....You can stand me up at the gates of hell....but I won't back down..."

Success, of course would demand that Central Bankers lay all of their cards on the table and come clean, describing, in great detail, all of the skeletons in their collective closets and own up to all of the politically motivated misrepresentations and accounting gimmicks they've cooked up over the last decade.  Agendas, ideologies and self-interest would be put aside.  Peace and harmony would flood the streets.  Central Bankers would march arm in arm, shoulder to shoulder on Washington, Frankfurt, Beijing and Tokyo, armed with the truth, demanding monetary responsibility and a new, cooperative world order.  No Banker left behind....No Justice!....No Peace!.....Power to the People!.....They would rise up in stalwart unity, forever Facebook friends, dedicated to the proposition that they will no longer facilitate financial weapons of mass destruction fueled by cheap money and irresponsible, steaming financial turd proliferation.   As has been aptly demonstrated on the interest rate spiral down, Central Bankers are a brilliant, cooperative, benevolent, politically savvy group, deeply concerned about the common good and the welfare of all mankind.. and.....hey stop laughing!....it could happen!.....

Armageddon here we come.....


Additional Reading:

April 21st Yahoo! Finance Interview
http://finance.yahoo.com/news/ecbs-draghi-havent-talked-helicopter-124843859.html

Negative Interest Rates
http://www.bloomberg.com/quicktake/negative-interest-rates

People are starting to look.....Anne Stevenson Yang at Grant's re: RMB
http://www.valuewalk.com/2016/04/alibaba-group-holding-ltd-baba-jcap/

Gordon Chang - China's Credit growing 4x GDP
http://www.forbes.com/sites/gordonchang/2016/04/17/china-credit-growing-four-times-faster-than-gdp/#190b9108256c

Interest Rates
http://www.global-rates.com/interest-rates/central-banks/central-bank-america/fed-interest-rate.aspx
http://www.global-rates.com/interest-rates/central-banks/central-bank-china/pbc-interest-rate.aspx
http://www.global-rates.com/interest-rates/central-banks/european-central-bank/ecb-interest-rate.aspx
http://www.global-rates.com/interest-rates/central-banks/central-bank-japan/boj-interest-rate.aspx

CIA Factbook - Total Stock of Domestic Credit
https://www.cia.gov/library/publications/resources/the-world-factbook/rankorder/2211rank.html

World Bank - Domestic Credit
http://data.worldbank.org/indicator/FS.AST.PRVT.GD.ZS?locations=US
http://data.worldbank.org/indicator/FS.AST.PRVT.GD.ZS?locations=CN

BIS - Debt Statistics
http://www.bis.org/statistics/totcredit/tables_f.pdf

Trading Economics - US, EU, China, JPN Stats
http://www.tradingeconomics.com/country-list/government-debt-to-gdp

MAD Flashback
https://www.youtube.com/watch?v=sTJ0GB1ltAQ

John Williams - SF Fed President - Take on ZIRP
http://www.bloomberg.com/news/articles/2016-08-15/williams-calls-for-rethink-of-fed-orthodoxy-in-new-economic-era

Bloomberg - Monetary Policy
http://www.bloomberg.com/news/videos/2016-08-17/trennert-monetary-policy-has-become-actually-harmful?cmpid=yhoo.headline&yptr=yahoo

Yardini - Central Bank Balance Sheets
http://www.yardeni.com/pub/PEACOCKFEDECBASSETS.pdf




Thursday, August 11, 2016

Really?.....how silly can these numbers get?

Well, I just finished listening to the Alibaba Investor Call and reviewing the press release & 6K.

What can I say.....It just keeps getting better and better.

Here are the links:

Webcast
http://edge.media-server.com/m/p/wnauw9sh/r/1
Press Release
http://www.alibabagroup.com/en/news/press_pdf/p160811.pdf
Presentation:
http://www.alibabagroup.com/en/ir/presentations/pre160811.pdf
SEC Filing:
https://www.sec.gov/Archives/edgar/data/1577552/000110465916138896/a16-16621_1ex99d1.htm


My history of the Alibaba growth phenomenon is chronicled in "It's Like Deja Vu ....all over Again..."  I won't bother rehashing how we got here, but this Investor Call was even more entertaining than the last.....here are the bullets:.

1.) Astounding Revenue Growth (59% year over year for the quarter ended).  No other (real) large business or economy on the planet is experiencing this type of growth. Businesses all over the world are generally treading water right now, looking for direction and sanctuary,  Global growth, even though supported by extraordinary levels of Central Bank stimulus can best be described as stagnant, yet Alibaba's reported growth story is somehow immune to macro-economic factors.

2.) Even though Alibaba's GMV growth has slowed to just 24% YOY, if we have some fun with ratios, we can extrapolate that Alibaba's GMV this year, with a "conservative" 24% annual growth rate will be just short of US$ 600 Billion (Using this quarter's slowing 24% GMV growth rate applied to the 3/31/16 YE numbers).  This extrapolated number now becomes 125% of Walmart's annual sales.   If Alibaba's projected GMV were GDP, Alibaba would then be the 34th largest Economy on the planet, right behind the United Arab Emirates.  They've somehow accomplished this economic miracle with 35,000 employees, a few computers and an "ecosystem" of undisclosed, odd partnerships that somehow get these goods from point A to point B.  Truly amazing.

3.) Share-Based Compensation (Stock Grants & Options) slowed a bit to $556 million for the quarter, but continue through the roof at 11% of FQR (i.e. Fake Quarterly Revenue ).  Since FQR increased 59% this naturally drives the SBC ratio lower.  Math is a wonderful thing.

4.) The creation of "Questionable Assets" also accelerated dramatically during the quarter.  Questionable Assets (as defined in prior posts) increased by US$ 8.4 Billion during the quarter and now comprise 2/3rds of the Balance Sheet.





















As an aside, did they really convert US$ 8.4 Billion in cash to financial vapor in just three months? Again, there is no discussion re: the details/components of this gigantic write up/purchase in the Investor Call, Press Release, Presentation or 6K filing.  They've increased these same "Questionable Assets" a whopping $30 Billion in just two short years (since the IPO), fueled primarily by increased bank debt, bond issues and the IPO money.  How is this even possible?  At some point, these investments (aka  boondoggles) will have to be written down/off.  This is indeed a milestone quarter for Alibaba.  It's the the first quarter where "Questionable Assets" have exceeded Shareholder Equity. If I'm indeed directionally correct about the "real" value of all of this intangible fluff, Alibaba is un-officially insolvent as I type.

5.) For the first time the Group has reported Segment data.  (pg 7 of the Press release).  All of the acquisitions generally since the IPO, described as Cloud Computing, Digital Media & Entertainment and Innovation Initiatives contributed operating losses of US$ 581 million.  BABA's share of losses for its' "Equity Investees" (Koubei, Youku Tudou, Cainiao, et al.) came in at US$ 221 Million, more than doubling the loss for the prior quarter.  (pg 15 of the 6K)  From a purely cash flow perspective, these businesses are providing about as much utility as a steaming turd on a hot August sidewalk.

6.) Costs are skyrocketing.  Quarterly Expenses excluding Share Based Compensation (SBC) increased by US$1.29 Billion on an absolute basis, or an additional 7% of Revenue YOY. (pg 11 of the 6K)

7.) Borrowing has also, of course, increased significantly in the quarter.  Liabilities are up by US$5 Billion, of which US$ 3 Billion is Non-Current Bank borrowing. (pg 22 of the 6K)

8.) They are burning through cash like drunken sailors.  Despite all of that additional borrowing, Cash & Equivalents declined US$ 3.7 Billion.  (pg 24 of the 6K).  US$ 2 Billion was used to Repurchase (support) BABA shares from Softbank at US$74.00 per share, ostensibly to help Mr. Son, an Alibaba director, out of his own self-inflicted mess.

9.) Again, there is no detail provided for the required Alipay/Ant Financial profit sharing accrual and "processing fee" offset.  Presumably, since there is no discussion of the net profit-sharing amount, it stands to reason that there must continue to be no significant profits in Alipay/Ant.  Perhaps they have adopted the Lending Club (NYSE:LC) model. (i.e.) Make under-priced loans to un-bankable businesses and hope for the best.  It might look good for a while, but as we learn repeatedly, it's hardly sustainable.

10.) Finally, in my mind the most important figure, the FNI (Fake Net Income)  decreased Q over Q from US$ 4.6 Billion in 2015 to US$ 1.1 Billion in the quarter just ended (pg. 26 of the Press Release).  It's actually relatively flat after the elimination of the absurd prior year US$ 4 Billion  "Gain on deemed disposals/disposals/ revaluation of investments and others" (Authors note: That description still cracks me up whenever I read it.  You just can't make this stuff up.)  This Net Income number (albeit fake) is shockingly small for a business which purportedly has cornered the e-Commerce market in China, (US$125 Billion GMV in the quarter) shares profits with the preferred payment method of every Chinese Consumer (900 million registered Alipay users) and holds estimates of up to US$ 200 Billion of the Hard-Working-Chinese People's money in related, off the books investment funds.  Moreover, Alibaba's demonstrated, unquenchable thirst for cash is far from typical of a business that, by Alibaba's own account has a virtual monopoly on eCommerce, and all that is on-line in the "World's Second Biggest Economy".  With reported dominance like this, one would think that Alibaba treasury personnel should be driving to the bank daily with dump trucks full of cash to deposit, rather than scouring the globe for more sucker capital lurking under any remote off-shore rock they are fortunate enough to overturn.

Sarbanes-Oxley

All that said, to jump off on a tangent, some of my readers have been opining that, for some reason, Sarbox doesn't apply to Alibaba since it's an off-shore ADR.  I'm not sure where this is coming from and I've addressed it privately via email.  Sarbox absolutely applies to Alibaba management.  I've also attached a link to the Alibaba Audit Committee Charter spelling out the committee's Sarbox Responsibilities as they apply to the signors, Daniel and Maggie. Again, even though the Sarbox sanctions, penalties and fines apply to them, my assertions that they are "safe in China"would seem reasonable.  Like the financial equivalent of the Nuremberg trials, they could only be prosecuted in absentia, as I doubt their lawyers would advise them to get on a plane and defend themselves in an American court room.  If you are reading this and have any additional insight, or work in the world of Sarbox, please fill me in, I'd enjoy hearing your thoughts. Fascinating stuff.

Last Words....

Moreover, and again I need to emphasize this, Alibaba's audit work-papers and supporting data for their bizarre, incomplete, fragmented financial statements have never been available for regulatory review.   Regulators continue to clamor for access, but oddly, are stymied every step of the way.  When domestic businesses refuse to comply, regulators have lots of hammers available and never hesitate to swing them. For whatever reason, with Alibaba, regulators are either reluctant or unable to do their job. Which, of course begs the question, how could a business like this have ever been allowed to list on a US Exchange in the first place?

On the other hand, Mr. Market seems to think all is peachy, driving the Alibaba stock price up another 5% after they reported today.

Finally, given all of the convoluted discussion above, I have to hand it to them.  Just when I think Alibaba management couldn't possibly report anything sillier than they already have, they go ahead and do something like what we've seen today.........and totally redeem themselves!


More Relevant Reading

Alibaba Audit Comittee Charter -  SARBOX Responsibilities
http://docs.alibabagroup.com/assets2/pdf/Audit_Committee_en.pdf

CIA - World Fact Book
https://www.cia.gov/library/publications/the-world-factbook/rankorder/2001rank.html

Alibaba WSJ Comments prior to the Earnings Call
http://www.wsj.com/articles/analysts-seek-clarity-on-alibabas-accounting-practices-1470774166

Alibaba - WSJ - Auditor Limitations
http://www.wsj.com/articles/u-s-regulator-expected-to-get-access-to-alibaba-baidu-financials-1470377222

Friday, July 29, 2016

Well...that didn't take long....

Earlier this week,Verizon announced an agreement in-principle to acquire the "core" non-Asian assets of Yahoo! for a piddling $4.8 Billion. A far, sad cry from the $45 Billion Microsoft was willing to pay back in 2008.  The deal excludes Yahoo!'s Alibaba (BABA) and Yahoo! Japan (TYO:4689) holdings.   These excluded assets have current (inflated/fake) values based on the publicly traded pro-rata Market Caps of $32 Billion & $8 Billion respectively (approximately $4 Billion over the current Market Cap of Yahoo!) The asset sale leaves a $45 Billion "Investment Company" shell in the deal's wake.

Here's a line from my 11/20/2014 post on Laura Logan's CBS News page (and this blog re-posted on 12/13/2105).

When this scheme is discovered, the results will be devastating. BABA stock will be worthless. Yahoo will be out of business. 

I'm projecting that Marissa Mayer, and any other executives or board members with first hand knowledge of this mess will resign relatively soon. It's the only logical choice for them to make.

One down (Yahoo! asset sale).....and two (BABA crash & Ms. Mayer's departure) predictions to go.

Not to toot my own horn or anything, but I don't recall any of the main-stream financial media (with the sole exception of Deep Throat IPO) predicting that Yahoo! would be groveling for a buyer and eventually absorbed for a pittance, right after the "Greatest IPO in History" back in the fall of 2014.

Looking forward, Yahoo! assets included in the deal will be combined with AOL content to form a presumably nostalgia-driven portal that we baby boomers will continue to relentlessly visit, much the same way we've clung to our land-lines and fax machines.  Or to paraphrase the late Charlton Heston, you'll have to "pry my Yahoo! News from my cold dead hand."

Presumably, in yet another effort for the Yahoo! board to distance themselves from the insider trading issues  (17 CFR 240.10b5-1as discussed previously in this blogMs. Mayer has also, most likely, been "sold" along with the Yahoo! assets.  Her resignation from the remaining Yahoo! "Investment Company" should be forthcoming.  The only remaining question is how large her departure package will be.  The aforementioned is most likely part of the "dot the i's & cross the t's" negotiations.  As  shareholders routinely re-learn, silence can be expensive.

So there you have it.....the first shoe (Yahoo! going "out of business") has just hit the floor.  The second shoe (Ms. Mayer's resignation), at least from the remaining Yahoo! Investment Company will follow as the Verizon deal nears completion by Q1 2017.

Of course, the third shoe (Alibaba collapse) has been discussed at length throughout the bowels of this blog.  It will be interesting to see what impact the collapse of the Alibaba (BABA) stock price might have on the Verizon deal if it occurs prior to the completion of the asset sale.  In any case, the clock is ticking for current Yahoo Shareholders to be able to escape unscathed.  With the departure of Ms. Mayer and other insiders, along with the expiration of their insider liability, Yahoo! shareholders will finally be free to "unlock their Alibaba value" (i.e. get out) sometime after Q1 2017.  They'll be allowed to sell their shares in the remaining "Investment Company" and finally reap the rewards of the Alibaba IPO.  For their sake (and the sake of the global financial markets) let's hope that Jack and company can figure out how to keep the stock price propped up long enough for the loyal Yahoos!s, Jeff Smith and other leveraged activist investors to get out.  Jack and company will have to spend lots of shape-shifting money somehow laundered/borrowed from Ant Financial, the hard working Chinese people and the related web of offshore shells to do it, but the way I see it, their success in maintaining the current (fake) Alibaba stock price is the only chance Yahoo! shareholders will have to get out.  In this particular case, the relentless flow of monopoly money pouring into US assets from China is oddly, at least in the near term, a good thing for Yahoo! shareholders.

Switching topics, I'd like to take a paragraph to thank you, my loyal readers for your support.  In June our little blog exceeded 30,000 page views and it looks like it's going to come close to 35,000 page views in July.  I'm truly gratified that, by definition, since we do NO advertising (Note the conspicuous absence of "Viagra Pop-Ups", "Buy Gold", "Matchmaking", "Troubled Credit Loans" and "Click Here for a Free Trial" ads.) that we've generated so much interest and enthusiasm for these topics.  The people who read my content (aka: you), again by definition, are smart, inquisitive, open-minded people who are curious about the topics I enjoy exploring. Consequently, they/you've found it worthwhile to share my work with other like-minded folks.

I thank you from the bottom of my heart!


Other Reading:

DT Post - December 2015
http://deep-throat-ipo.blogspot.com/2015/12/breaking-news-yahoo-ceo-marissa-mayer.html

The Last Days....
http://www.forbes.com/sites/miguelhelft/2015/11/19/the-last-days-of-marissa-mayer/#669903fd6bff

Marissa Meyer Final Letter to Employees
http://www.forbes.com/sites/briansolomon/2016/07/25/here-is-marissa-mayers-final-letter-to-yahoo-employees/#5900cb3975ba

The Economist - Yahoo!/Verizon Deal Analysis
http://www.economist.com/news/business/21702779-telecoms-giant-has-made-bold-risky-bet-future-advertising-does-it-ad-up?cid1=cust/ednew/n/bl/n/20160728n/owned/n/n/nwl/n/n/NA/n

Marissa Meyer - SEC Form 4
http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0001550608&type=&dateb=&owner=include&start=0&count=40

Tuesday, July 19, 2016

More on price support for the Greatest IPO in history

Good to be back from a wonderful July 4th Holiday, spending time with family and friends.   Our Cavaliers are the NBA Champs, the town was pretty much shut down for the celebration and the Indians are leading the division.  Fireworks over Cleveland were a little foggy, but lots of fun as always.

July 4th fireworks from our boat....BOOM!

Even though our town is pretty much on lock-down because of the RNC, we're all looking forward to an action packed, fun-filled Convention!  I haven't seen a police presence like this since the Walter Cronkite news reels of post-war Checkpoint Charlie at the Berlin Wall.  Fortunately, thanks to our Ohio open carry law, everyone is heavily armed.

What could possibly go wrong?

Anyway, let's get back to work.

I've received a number of e-mails and inquiries from readers asserting that there's a possibility that I could indeed be "full of beans" regarding my suppositions that the Alibaba stock price is artificially supported because of insider intervention.  The arguments generally centered around the premise that the market cap is simply too large to be manipulated.

On its face I'd suggest that this would be quite true if it wasn't for one incredible economic force that I'll present for your consideration.  That force, of course is:

The hard working, industrious, conscientious, trusting and unfortunately, naive Chinese people.

Alibaba.....The The World's Largest Shadow Bank

In January of 2015 I published a blog post describing how Alibaba was actually a financial firm that ran a dubious "eCommerce" business on the side.  I won't recount all of the details in this post, but feel free to reference it for a bit of background.

Let's take a look at some of the Alibaba websites to illustrate the "Worlds Largest Shadow Bank" Thesis.

§  Antsdaq: Crowd-funding site for media and software projects. Roughly 18 million users. 
§  Ant Check Later: Short-term lending for online purchases, similar to PayPal credit. 
§  MyBank:  Small loans to corporations. RMB 613.2 Billion extended to 3 million borrowers, Average loan RMB 2,000, with a 2% NPL rate. 
§  Zhima (“Sesame”) Credit: Loans to individuals and “credit” scores for individuals. 
§  Ant Fortune: (Includes "Ant Treasure" , "Trick Treasure" , "AntGroup" and "Ant Microfinance" )Sales platform for investment products. 
§  Zhaocaibao: Sales platform for investment products. 
§  Yuebao: A tool for transferring money to the Tianhong fund. 
§  Alipay: Online and mobile wallet. 
§  Ant Financial Cloud: Cloud computing platform for financial institutions.

Since all of these businesses are reputed to be controlled by Alibaba and privately held, i.e.) outside the reporting envelope of the Alibaba ADR and NOT included in any of the 300+ related consolidated or equity method entities, there's very little publicly verifiable information on exactly how large these businesses are.

One thing we can be sure of, is that the amount of float these businesses provide is absolutely enormous. Various sources estimate that these funding/banking/investing/P2P & B2B Lending sites provide between US$150 Billion and US$200 Billion of total funding on hand at any point in time.

So what is the most important element of a successful Ponzi Scheme?

Now lets go back to my discussion re: Bernie Madoff, Frank Gruttadauria, WorldCom, Enron, etc. Although ineffective, incompetent or even complicit Public Accountants, Regulators and Bankers (as discussed throughout this blog) can all play a major part in the metamorphosis of a tiny little fraud into a gigantic, systemic risk, a successful Ponzi scheme can only continue (Sometimes for years or even decades) if the perpetrators have access to adequate funding.  Simply put, lots of money (whether it's yours or not) can cover up a lot of malfeasance, silliness and accounting shenanigans. (Note: Jack, before you call your lawyers, I'm not accusing Alibaba management of running a Ponzi Scheme here, I'm just talking about Ponzi schemes in general and exploring possibilities re: the Alibaba capital structure.)

So let's say, hypothetically of course, that Alibaba's financial statements might be, shall we say, suspect? Even with Alibaba's vast amount of capital, mis-deployed on dozens of odd, money-sucking businesses of dubious strategic value, there seems to be minimal imminent risk that the stock price could collapse. The hard working, industrious, conscientious, trusting and unfortunately, naive Chinese people won't let it.  They are willing to continue to pour money into these sites/funds, regardless of any formal government guarantee, oblivious to the possibility that they may lose principal.

Moreover, there seems to be little distinction between earnings (company money) and funding (someone else's money) in the Alibaba ecosystem.  Funds are funds to be invested (aka "spent"), no matter what the source, with no consideration as to repayment.. All of the above described funds/tools/float (US$150 Billion +) can be deployed or "invested" without limitation to any of the 300+ Alibaba businesses or perhaps even used to buy Alibaba common stock or bonds, as was discussed, in the last couple of posts.  US$150 Billion is more than enough to prop up a stock where the daily volume is under a billion dollars a day.   If this mess really is a Ponzi scheme (hypothetically), until the hard working, industrious, conscientious, trusting and unfortunately, naive Chinese people stop funding it and/or actually want their principal back, this charade could continue for a long time.

A Seemingly Unrelated Topic.....

Yesterday Softbank announced that it was acquiring ARM, a computer chip designer located in the UK. The $32 Billion deal, at a 40% premium over the company's closing price on Friday is the biggest ever deal involving a European tech company.  Masayoshi Son is indeed, one of a kind.

ARM is up +40% since the announcement, so apparently Mr. Son is paying 40% more than the market thinks ARM is worth. The purchase price calculation would yield a P/E of 70x last years earnings.  Of course Mr. Son understands things that Mr. Market doesn't. He knows that under his leadership, direction and vision, ARM will morph into something many multiples greater than what it is today.  Just like he's done with "Buy.com" and Sprint.  He may have to personally take the reins of course, a job he can easily do while also personally redesigning Sprint's networks, in between his bi-annual rounds of effortless, 2-under-par golf.....Henrick & Phil should take note.

Here's a Summary of what I thought of Softbank back in September 2015, as a refresher, complete with citations re: Mr. Son's efforts to "alleviate sadness and increase everyone's happiness to the greatest extent possible".

Apparently Tokyo shareholders think a bit less of the "all cash" deal than Mr. Son, sending Softbank shares down 10% overnight.  Shareholders have been clamoring for Mr. Son to clean up his balance sheet and he's responded by committing the $17 Billion tranche from the sale of BABA and Supercell shares, presumably along with an additional $15 Billion he'll scrape together somehow.  Interestingly, Softbank only had cash & equivalents of $24 Billion as of 3/31/16 so Mr. Son is seemingly betting the farm on this acquisition. We all recall how Mr. Son fared when the dot.com bubble burst (destroying $70 billion of his personal net worth) with a hubris reminiscent of a Fourth of July skyrocket "oooohhhh", and a very public explosion "ahhhhh". Like Melania Trump's speech last night, this episode seems strangely familiar.  Mr. Son's modus operandi hasn't changed.

So how is this mess related to Alibaba and the the hard working, industrious, conscientious, trusting and unfortunately, naive Chinese people?

It's becoming clearer by the day that the the hard working, industrious, conscientious, trusting and unfortunately, naive Chinese people are funding this (alleged) Ponzi scheme.  Their good faith IOU's were and will continue to be happily extended to Messrs. Ma and Son, through their spider web of related shadow-bank enterprises. This money, absent of regulatory oversight is available to use for any and every imaginable boondoggle, without restriction, fueled by the trust that these legendary financiers would work their absurd financial alchemy and continue to turn lead into gold.  The deeper we get into this, the closer we get to reality being painfully exposed. The Chinese people believe that their money is safe and they are achieving risk-free, out-sized returns through this magic.  Like Bernie Madoff, Frank Gruttadauria, WorldCom and Enron, this charade can continue for a long time, but when the end eventually comes, it will be shockingly swift, and investors all over the globe will be hurt by it.




Sunday, June 12, 2016

Follow up thoughts on "I would never say...(Part Deux)....."

I've received a number of excellent questions regarding my thoughts on the Alibaba SEC investigation.

Announcement of the Investigation in contained in the SEC filing below (Ref. pg 30 &187):
http://www.sec.gov/Archives/edgar/data/1577552/000104746916013400/a2228766z20-f.htm

Rather than try to address my readers questions individually, I thought I'd take some time within this post to discuss the general themes contained therein.  The following are common threads of my readers inquiries.

1.) How long do you think the investigation will take and how significant will the findings be?
2.) Why has the stock price held up so well?
3.) Should I short it?

I'll address these questions in reverse order:

"Should I short it?"

Let me be clear, I do not give Investment advice within this blog.  I accept no compensation from anyone re: any of my commentary.  My observations are mine and mine alone.  I have no "inside contacts" at any of the businesses discussed herein, although I do have friends in the Peoples Republic of China (PRC) off whom I bounce my ideas off of from time to time.  My modus operandi is simply to read the filings and SEC correspondence and interpret them based on sound judgment and reasoning developed over my years of accounting and investing experience.  If I have any positions in any of the investments discussed, I'll disclose the position.  Moreover, I have neither current nor had past positions in any of the individual stocks discussed within this blog.   In any case, whatever you decide to do with my input, I wish you the best of luck!

"Why has the stock price held up?"

Oddly, in this business, you can be absolutely "right" about a stock, but Mr. Market might not agree with you for ten years.  Unfortunately, again, in this business, being "right" in ten years has the same financial repercussion as being "wrong" for a decade.  On the other hand, it's worth pointing out that when fraud is discovered, stocks can tumble very, very quickly, Enron or Valeant style.  It's not like the stock slides neatly 3% per month for 36 months.  Investors who are waiting for the "perfect" time to short the stock may find that when the whiff of fraud becomes unmistakable, many of the long investors will get out very quickly and not wait for the full post-mortems.  For investors who short a stock, "no one rings a bell at the top".

First, Specifically with Alibaba,  based solely on some of the un-publishable comments I've received since I've started posting, Alibaba seems, for whatever reason, to have developed an almost cult-like following. I'll reiterate, I'm happy to post any comment re: whatever I say as long as it's free of profanity and includes some sort of actual thought process:

For example, the following would be acceptable for publication:

A: "DT, you are a complete moron and here's why......(insert well thought out commentary here.)"

Moreover, if I happen make a mistake in my analysis, math or documentation, I'd like to know about it.  You'd have my gratitude for pointing out my error(s).

The following will NOT be deemed acceptable nor will it be published:

B: "DT, you are a F-ing moron....(with no explanation as to your thought process)"

I seem to be getting more correspondence similar to B than A lately.

If you've read Thaler's "Nudge" or "Misbehaving" (I recommend both books.  Each is an easy, informative read.  Note that Rich is fully capable of delivering higher levels of math that would make your head spin and put you to sleep, but thankfully, for the sake of book sales, he's spared us the exercise, although the citations are fully available in the footnotes.) you've been armed with the knowledge that people/investors tend to develop all sorts of irrational, emotional "biases" toward a particular stock or investment.  Moreover, they tend not to sell it nor listen to reasonable arguments as to why their initial assessment (which was a hot tip from their commission-only broker) might be dead wrong.  They cling to their original thought process, like a dog to a bone, defending it and inevitably riding the stock all the way to the bottom.  "Buy the dip baby!" They become emotionally invested.  Their hubris, success and prior experience tells them that they can't possibly be wrong.  They are smarter than everyone else.   (See Thaler's survey describing how every respondent stated they were well above the average intelligence of their classmates.) In short, they've made up their minds and don't want to be "confused by the facts".

Second, because Alibaba is so closely held and thinly traded (I'll explain why I say that in a moment), with a significant proportion of the shares owned by insiders and "related" Caribbean Shell Corps, we really can't tell exactly where the price support in the public market is coming from.  See the full list as of the IPO at:
http://deep-throat-ipo.blogspot.com/2015/02/the-chinese-laundry.html


Given the above 80% insider holdings, lets take a look at the top twenty shareholders who've presumably purchased their shares on the open market.  Here's a list of non-insiders per Yahoo! Finance.



























So today, an additional 14% of the company is owned by the above 20 funds/investors.  Note that these funds are generally not considered to be quants or day-traders.  These are longer term, buy-and-hold investors.  So that leaves roughly 5% of the outstanding shares (125 million shares give or take) available for trading by "little-guy" investors on any given day.  Not much in the grand scheme of things.

Now, lets take a look at volume trend for Alibaba.  The chart below represents the average daily volume, calculated in three month periods for Yahoo!, BABA and AAPL as a percentage of their issued and outstanding shares.  The NYSE "index" is simply the quarterly volume divided by a constant to show the change in trading volume for the entire market over the same period of time.



We observe the following from the above:
  • BABA volume has dropped off substantially since the IPO, Average Daily Volume has decreased from 1.75% (45 million shares) to 0.50% (12 million shares) in that time..
  • This decrease in "enthusiasm" has persisted even though NYSE average daily volume has consistently increased over the same period.
  • Yahoo! average daily share volume has generally mirrored  BABA's, but at about three times the relative percent of shares outstanding.
  • The value of BABA is being determined by a relatively few number of shares changing hands. There are about 2.5 Billion shares outstanding and only a few million shares are exchanged in arms length transactions daily.
Don't get me wrong, I'm not a conspiracy theorist by nature. I'm not wearing an aluminum foil hat or looking over my shoulder right now.  I'm just pointing out that with daily volume that low, in relative terms, with tremendous wealth spread out over a number of insider controlled businesses, and the insider necessity to keep the collateral value as high as possible, it wouldn't be that difficult to manipulate or support the share price if you were properly financed and so inclined.  This might also explain the phenomenon that there is usually significant support for the stock even after negative news breaks. The stock usually takes a bit of a hit on the announcement and moves up a bit on lower volume days, irrespective as to what the market does.

Remember, you're not paranoid if they really are out to get you.

How long will it take and what will happen? 

To state the obvious, these things are complex.  If there is indeed a fraud brewing, it's almost impossible to catch.  Rating Agencies, Public Accountants and the SEC are nearly powerless to challenge management representations without a whistle-blower or insider-witnesses participation in the investigation.  Allow me to meander around for a few paragraphs to illustrate how difficult it is for really smart, trained, hard working people to catch these things.

There's a reason that PWC HK has the following disclaimer on Alibaba's Auditor's Opinion.  (Every Auditor's report has a similar Disclaimer)

"Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate."

What this means in "accountant speak" is that, if management colludes to produce fraudulent financial statements there's a good chance that a public accountant won't catch it,

Moody's Research

Interestingly, the day after Alibaba announced the SEC investigation, Moody's issued the obligatory press release stating that, in summary banker-speak ,everything is probably just fine.

https://www.moodys.com/research/Moodys-comments-on-SEC-Investigation-of-Alibaba--PR_349768?WT.mc_id=AM~WWFob29fRmluYW5jZTQyX1NCX1JhdGluZyBOZXdzX0FsbF9Fbmc%3d~20160527_PR_349768

"If the SEC determines certain reporting requirements were violated, this would likely result in a restatement of Alibaba's financials, as well as in fines and shareholder lawsuits. In addition, any significant restatement would bring reputational damage to the company.  The rating could come under pressure if Moody's concludes Alibaba's financial performance and credit strength are significantly weaker than previously believed.  However, at present Moody's views this scenario as unlikely in the absence of substantial restatement implications that there has been material misrepresentation."

Putting this in perspective, in just one day, with presumably no actual knowledge of what the SEC is actually looking at, Moody's fully reviewed more than two years of their own research and immediately concluded that everything they've done so far is absolutely error free.  It's amazing how much work they accomplished in just one day, don't you think?

With that preamble, here are my two favorite Moody's posts of all time:

March 23rd, 2000 - MOODY'S UPGRADES ALL ENRON CORP LONG TERM DEBT RATINGS
https://www.moodys.com/research/MOODYS-UPGRADES-ALL-ENRON-CORP-LONG-TERM-DEBT-RATINGS--PR_35633

And a year and a half later......

December 3rd, 2001 - MOODY'S DOWNGRADES ENRON CORP'S LONG-TERM DEBT RATINGS (SENIOR UNSECURED TO Ca); COMMERCIAL PAPER CONFIRMED AT NOT-PRIME
https://www.moodys.com/research/MOODYS-DOWNGRADES-ENRON-CORPS-LONG-TERM-DEBT-RATINGS-SENIOR-UNSECURED--PR_51015

The downgrade came the day after the bankruptcy filings of a number of Enron's subsidiaries.  As usual....the rating agencies were right on top of it.....Ooooppsss.

Another of my Favorite "Investigations"

The only reason I bring this one up is that it's "close to home" and I have some personal recollection of the details.  It's another great example of how a really smart, charismatic person can fool other really smart people for a long time.  Frank Gruttadauria was a "man about town" in Cleveland, Ohio, everyone knew him, he was connected......until the following (per the SEC Report):

On or about January 11, 2002, Gruttadauria sent a letter to the Federal Bureau of Investigation in which he stated: "During the course of the past 15 years I have caused misappropriation through various methods which resulted in other violations. It has occurred at Lehman Brothers, SG Cowen Securities Corp. Cowen & Co., Hambrecht & Quist, Inc. and LF Rothschild Inc." He continued: "It is a complicated and substantial interwoven fabric of digressions [, which] . . . . began as an attempt to make up lost monies for customers and mushroomed over the course of time." After he sent his letter, Gruttadauria disappeared. On January 25, 2002, the Office of the U.S. Attorney for the Northern District of Ohio obtained an arrest warrant against Gruttadauria. On February 9, 2002, Gruttadauria surrendered and is in federal custody.

https://www.sec.gov/litigation/complaints/complr17369.htm

It's a long story and an interesting read if you have the time .  When the dust cleared, it turned out that Frank was perhaps the worst investor in history and a really bad crook to boot.  His scheme was simple, confiscate client money for his own personal use, "invest it" in leveraged, high risk bets and issue fake statements to his clients showing out-sized gains.  At the time Frank wrote the letter to the FBI, total assets available to clients were $1.8 million and the fake statements showed more than $278 million in nonexistent assets.  The "who's who" of Cleveland Investors were bamboozled.  Frank was ahead of his time.  He was a mini-Madoff in training.

As you might suspect, after only fifteen years, the SEC was all over this fraud.  The investigation commenced as soon as the FBI forwarded Frank's confession letter along to them.

As I may have mentioned before, the SEC, Public Accountants, Bankers and Rating Agencies Investigative prowess seems to be at their best immediately after the voluntary confession hits the media.


Additional (Possibly) Unbiased Alibaba Research

One of my readers, and a correspondent at the South China Morning Post (an Alibaba Company) also sent me an "all is well" email.citing "independent" opinions from Morgan Stanley, Suntrust and Deutsche Bank (and to borrow a phrase from the Alibaba disclosure "and others"), whose logos, by pure coincidence, were prominently splattered all over the front page of the Alibaba IPO.  Again, like Moody's, these underwriters, with significant skin in the game, reputation risk and presumably no knowledge of the specifics of the investigation, have completely reviewed all of their work in just a few days and predictably determined, in Kevin-Bacon-esque style, that "all is well".   I'm extremely flattered that the South China Morning Post would take the time send me these "independent" opinions of the financial condition of their parent company and their assessment of the outcome of an investigation that, by its' nature, they can know absolutely nothing about.






SEC Process

These investigations, again, by their very nature are private matters.  Both the SEC and the subject of the investigation normally make no public disclosures, nor do they have anything to gain by doing so. However, we might be able to shed some light on the process by combing through the correspondence leading up to the IPO.  I've attached a few of the documents below for your review if you choose to take the time:

Example - 60 page SEC document Q&A 6/16/14 Response to 5/6/14 F1 fiing.
https://www.sec.gov/Archives/edgar/data/1577552/000119312514237452/filename1.htm

Example - 35 page SEC document Q&A 7/11/14 response to 7/3/14 Amended F1
https://www.sec.gov/Archives/edgar/data/1577552/000119312514266474/filename1.htm

Correspondence - 8/6/14
https://www.sec.gov/Archives/edgar/data/1577552/000119312514298625/filename1.htm

Correspondence - 8/12/16
https://www.sec.gov/Archives/edgar/data/1577552/000119312514306858/filename1.htm

Correspondence 8/22/14
https://www.sec.gov/Archives/edgar/data/1577552/000119312514318466/filename1.htm

Without getting into the gory details, I'll discuss the general format of the Q&A and then interpret some of my favorite interrogatories through the magic of my Dick Fuld Banker Speak Translator (BST) (patent pending):

Q&A Format:

SEC: "Dear Alibaba Management & Counsel, we see you've disclosed/described (Insert odd, unsupported metric here) which may or may not have a bearing on (Insert odd, unsupported additional metrics here).


BABA Respondent: "Thank you for the wonderful, insightful question"  From this point the response takes one (or more) of the following three possible directions:

  1. "I'm sorry, it appears that you just don't understand what we are doing in our business model.  You must understand, in China, eCommerce, financial reporting, mathematics perhaps even the laws of physics are totally different than they are in the US.  Let us try to help you get past your ignorance.  After all, the Chinese people invented mathematics well before Capitalism even existed.  Don't worry, we'll get you through this.  Please see the attached additional odd, unsupported, made-up, metrics."
  2. "I'm sorry, what you are asking us for is impossible.  Because of our laws in China we simply can't comply with your request.  Selling fake tchotchkes on the Internet is a highly guarded State Secret and the politburo will not allow us to discuss the matter.  Let's just move on and call it a day.  Once again, we'd love to help out, but our hands are tied, our deepest regrets.  I'm sure you understand."
  3. "I'm sorry, we've been advised by our Public Accountants, Investment Bankers and our Legal Counsel that we don't have to give that to you.  We don't think it's necessary and you don't need it.  You wouldn't know what to do with the information, or understand it anyway.  So that's that. Next question please."

Now, as promised, lets run a few of my favorite interrogatories through the BST and see what we get:

This one addresses a US$1 Billion dollar "loan" of Alibaba funds to be made directly to Simon Xie, Jack's buddy for "strategic investment purposes".  (Page 3 of the August 12th, 2014 Correspondence cited above)

SEC: We note the disclosure on page 226 regarding the RMB6.5 billion loan arrangement with Simon Xie. We also note that a company controlled by Jack Ma will serve as a general partner of the PRC partnership that will receive indirectly the proceeds of such loan. Please provide us with a detailed analysis of the nature of the loan and the extent to which the provisions of Section 13(k) of the Exchange Act are applicable to the loan. Your analysis should address both Mr. Xie and Mr. Ma.

SEC - BST - WTF??.....you are taking $1 Billion of Shareholder money and giving it to Jack's buddy?  Is this thing Jack Ma's own personal piggy bank?  

I'm not going to bother posting the entire Alibaba response.  It's long winded and barely understandable.  You can certainly muddle through the filing if you are so inclined. However, to keep things moving, here's the BST version of what they said:

Alibaba Respondent: - BST    "Ohhhh!.....I see what you are getting at.  You've got it all wrong. Here's what's really going on.  The loan to Simon isn't a 13(k) 'personal' loan....it's a 'business' loan!  See, even though the money is going to him, Simon is going to take the money and contribute it to a partnership that he and Jack have cooked up, and once the money is sufficiently laundered, the partnership is going to 'invest' it in Wasu Media, since Wasu media has a strategic relationship with Alibaba.  Jack isn't getting the money (It's going to a partnership) so he's not in violation of 13(k) either!  That's why we did it this way!....That way, Jack and Simon get a billion dollar loan, they can do whatever they want with the proceeds, maybe invest in Wasu, maybe not.   Moreover Simon isn't a qualifying executive under 13(k)...he's not a director or 'senior' manager.....we just want to give him a BILLION DOLLARS since he's a good guy.....he's just one of five 'strategic' vice presidents!   Who knows, if this works we might give all five of them a BILLION DOLLARS each!  US Shareholders are really generous that way.  That way all of the VP's can get access to Billions of US Shareholder Dollars, for 'strategic purposes', pay the interest from loan principal until the investments pay off (or not) and nobody is the wiser!   Isn't this an AWESOME IDEA! If you guys sign off on this one we will be actively looking for homeless people to start partnerships with Jack.  We understand that in America you can go to jail for things like this, but in China it's SOP.  We're sure glad you understand how this works now.  Thanks for asking about it."


Here's a follow up on pg 7 of the same August 12th, 2014 Document.

SEC: Please address in this risk factor any potential material conflicts of interest between you and Simon Xie and expand this risk factor to discuss any potential material conflicts of interest resulting from the manner in which you plan to invest in Wasu Media Holdings Co., Ltd.  It appears that the disclosure required by Item 6.A of Form 20-F is applicable to Simon Xie. In this regard, we note your apparent dependence upon Mr. Xie based on his role as one of your founders and as a member of your management, as well as his equity interests in Alipay, your material VIEs, and the partnership through which you plan to invest in Wasu Media Holdings Co. Please provide the disclosure required by Item 6.A of Form 20-F and in doing so disclose Mr. Xie’s roles and responsibilities in your company and where Mr. Xie falls within your management structure.

SEC - BST: "So you are making the loan to the partnership owned by Simon, Jack and Yuzhu Shi?  The partnership is going to buy the stock of Wasu media?  That's the same Yuzhu Shi, the guy who went bust trying to build the tallest skyscraper in China (that was never actually built) and then took a video game company, Giant Interactive public on the NYSE, raised $1 Billion on the IPO, milked it for all it was worth and took it private in China at a deep discount with US Shareholders left holding the bag? .......is that the same Yuzhu Shi that you are jumping into bed with on both Wasu and Yunfeng Capital??   And you don't see any conflict of interest here?  Really?" 

Here's the BST version of the Alibaba Response:

Alibaba Respondent: - BST  "Wowww....you guys are really sharp!  You've actually read through the whole filing and you know your securities law to boot!  Ok, here's what's really going on.  You think that Simon actually works here and that his employment would make him an employee 'upon whose work the company is dependent' as defined in Item 6.A of Form 20-F.   Again, you've got it all wrong.  Simon, is a peon, a nobody, he pushes a broom around and occasionally opens the mail....that's it!  In fact, if you don't let us structure this deal this way we're going to fire his sorry ass so that there is absolutely no conflict under 13(k).  Of course, we're still going to give him a Billion dollars,  just 'cuz we want to and you can't stop us. Moreover,  Yuzhu Shi is a wealthy visionary and great man.  He was able to amass a tremendous fortune by creating fake businesses out of nothing, pulling all of the cash out of them and selling the decaying shells to suckers....uh....I mean fortunate investors.  Anyway, all of these people are safe in China and you have no jurisdiction over them.  So mind your own beeswax."

The May 26th, 2016 20-F

Fast forward to the 20F - pg 40.  They did indeed "fire his sorry ass" to conform to 13(k) on this loan. I guess the other four "Strategic VP's" could easily pick up the slack.  However, it looks like the actual structure of the deal has changed significantly.   Per the recent 20-F, the RMB 6.9 Billion (US$1.06 Billion) loan was actually made to Simon by an unnamed PRC Bank.  Alibaba pledged RMB 7.3 Billion (US$1.12 Billion) of "Wealth Management Products" which are presumably carried on their balance sheet somewhere to guarantee the loan.  Alibaba also set up a RMB 2.0 Billion (US$ 300 Million) Credit Facility to Simon so he can afford to pay the substantial interest on the bank loan.

Here are a couple of questions I might ask about this reconstituted transaction if I were one of the SEC attorneys investigating this mess:

  • Where was the money that required the pledge/guarantee of Alibaba assets actually invested?  did it all go to Wasu or did Simon or Jack skim a bit off the top for vacation homes in the Adirondacks and/or Caymans?....Hey, don't get upset....I'm just asking a question.
  • Where did the "Wealth Management Products" come from?  What are they?  How did they come about and where are they on the balance sheet?  Did Alibaba buy a bunch of wonderful small business loans (aka non-performing) from ANT/Alipay using US Shareholder Money?  Is that the collateral pledged for the loan to Simon?  After all, it's a BILLION dollars 
  • What is the interest rate on the PRC Bank Loan to Simon?  What are the terms of this loan?  Which Bank is it?  They won't even disclose which banker was dumb enough to do this deal?
  • Does Simon really need a $300 Million Credit facility to pay interest on a billion dollar loan?  Even at 10% Simple Interest that's 3 years of Interest payments.  So whatever the hell the terms of the "investment" was in Wasu, it isn't flowing any cash?
  • WTF???....(This last question is just rhetorical and would add no value to the investigation).

Note: Wasu is a public company on the Shanghai Stock exchange.  On the date of the SEC Correspondence (August 12th, 2014) it was trading at $29/share.  It hit a high of $59/share in June of 2015 (Before the crash) and it's trading at $19/share today (a 33% haircut from August 2014).  The Market Cap today is about $4 Billion (Down from $6 Billion).  We don't know anything about the financial prospects of Wasu or the Ma, Xie, Shi partnership.  The only things we are certain of :

  • The value of the collateral (Wasu) underlying Simon's margin loan has declined substantially and is most likely under water. 
  • Based on the structure, Alibaba (and consequently US Shareholders) have credit risk by virtue of the pledge of (quite possibly dog-shit) "Wealth Management Products" to an unnamed PRC Bank, if for some reason Wasu stumbles into some cash flow or collateral valuation problems.  Apparently they already have since there is now a magical Alibaba credit facility in place to pay Simon's Interest on the PRC Bank "loan".


Perhaps that's why the SEC is looking into this?  I'm just sayin'....

.
Cainiao Network

If we perform a text search of the IPO Correspondence above the word "Cianiao" doesn't even come up once.  Apparently, this "rising star" wasn't even on the SEC's radar prior to the IPO two years ago.  Yet, it's a primary focal point of the recently announced Investigation.  Here's the disclosure from the recent 20-F (Buried on pg. 76 & 77)  As a point of reference the word "Cianaio" appeared 108 times in the current filing.

Cainiao Network completed a round of equity financing of approximately RMB10 billion (US$1.5 Billion) in March 2016. Existing shareholders and new investors, including major sovereign wealth funds and private equity funds, participated in the financing. We subscribed for Cainiao Network's shares on an approximately pro rata basis. As of March 31, 2016, we own an approximately 47% equity interest in Cainiao Network. See "Item 5. Operating and Financial Review and Prospects — A. Operating Results — Recent Investment, Acquisition and Strategic Alliance Activities — Logistics — Cainiao Smart Logistics Network Limited."

So....somehow, in just two years, they ended up with 47% of a money losing business, with an assigned a value of US$6.2 Billion? Astounding.....

Here's some more.....
"Through the platform approach, Cainiao Network integrates the resources of logistics service providers to build out the logistics ecosystem. As of March 31, 2016, Cainiao Network's fifteen strategic express courier partners employed over 1,700,000 delivery personnel in more than 600 cities and 31 provinces in China, according to data provided by them. Collectively they operated more than 150,000 hubs and sorting stations. The top six of these express courier partners handled the delivery of the majority of packages from our China retail marketplaces in the twelve months ended March 31, 2016. We believe that orders from transactions generated on our marketplaces represented a significant portion of these express courier partners' total delivery volumes in the twelve months ended March 31, 2016. Cainiao Network is still in an early stage of development. It has yet to monetize the majority of the value-added services it provides under the assisted-delivery model."  

"During the twelve months ended March 31, 2016, Cainiao Network and its logistics partners enabled the delivery of 12.2 billion packages from our China retail marketplaces. Currently, Cainiao Network primarily derives its revenue from end-to-end logistics solutions and generates a significant portion of its revenue from providing these services to Tmall Supermarket."

Hmmmmm......this is the first 1,700,000 employee "enterprise" that I've run across that is in the early stages of development and has yet to "monetize it's value".  Normally, when you are managing 1.7 million people you have some idea as to how to generate a profit.

Other notable FYE 3/31/2016 Cainiao statistics disclosed,. (pgs 76, 77, 108 122 & 156)

  • 12.2 Alibaba Billion Packages Delivered.  10 packages for every man, woman & child in China last year.
  • Alibaba Ecosystem deliveries accounted for 60% of Cainiao revenue/volume (So the Cainiao Network actually delivered 20 Billion Packages?)
  • Cainiao Revenue was RMB 3,099 Million (US$ 477 Million)
  • Cainiao Net Loss was RMB 617 Million (US$95 Million)
  • Alibaba Revenue US$ 15,686 Million
  • Alibaba GMV US 485 Billion
  • Alibaba owns 47% of Cainiao.  
  • Equity method accounting required Revenues and Income/Loss be consolidated at 47% of the above revenues and losses.
Now lets have some fun with ratios!
  • Alibaba GMV per package delivered is $39.75 (12.2 Billion Packages)
  • Alibaba Revenue per package is $1.29
  • Cainiao Revenue per package is $0.02 (at 20 Billion Packages)
  • Cainiao Revenue per "employee" is US$280 per year.
  • Cainaio packages delivered per day per employee is 33 (at 20 Billion Packages).
  • Alibaba Revenue per "employee"is roughly $450,000/yr.
  • Alibaba GMV per employee is roughly US$13.8 million per year.  
Based on the above, if economic theory holds true in China, you'd think that more than a few of the Cainiao employees would frantically filling out employment applications to get a job at Alibaba. There would simply be more money available to pay them.  Again, I'm not an expert at Chinese mathematics, but I'd guess that $450,000/yr. is still more than $280/yr., even in China.

How could this rate structure even exist?  Two (2) cents per package wouldn't be enough to pay for the electricity to power the computers for the Cainiao "ecosystem", much less pay for the rest of the overhead involved. Would a price increase really be so hard to push through?  Maybe go up to 4 cents per package and double the revenue?  Presumably, all of the buyers, sellers and delivery businesses are somehow exchanging payments with each other through the Cainiao network.  Does the money stay in the system to provide additional float?  Does Cainiao hold the money for an extended period of time?  How does this work?  But again, the disclosure is so lacking that we have no idea how this presumably significant business, appearing virtually overnight, magically valued at $6.2 Billion in the 20-F operates or functions.  

Things that the SEC must certainly be looking at here:
  • The Consolidation/Equity Method Accounting.
  • There's a chance that the actual cost to deliver 12.2 Billion packages might be s hair more than 2 cents each.  Where are these costs?  
  • Were any securities laws violated re: the "Cainiao Round of Funding"?  They took care in mentioning that the subscription of shares was "approximately pro-rata".  Who got paid? Was it an illegal transfer of shareholder money? 
  • WTF??? (ibid) 

Alipay/ANT

I've purposefully not included an analysis of the Alipay disclosures in this post.  The only thing that I'll say at this juncture is:  "How could the largest payment processor in China, with no real competition, possibly announce a surprise 4th quarter loss?"  In their press release they celebrated the US$4.5 Billion "financing round" setting the value of this business at US$60 Billion; about the same market cap as American Express. (Founded in 1965, $5 Billion Annual Earnings)  Really?  Stay tuned....


Summary:

Of course, the very existence of the above described discussions in an SEC filing should ring the alarm bells and strike fear in the heart of any Investor.  The level of disclosed insider self dealing is unprecedented.  I can't even imagine the level of the potential undisclosed chicanery taking place.  How could anyone (other than highly compensated lawyers like Simpson, Thacher & Bartlett, paid handsomely to zealously represent the interests of their client) possibly argue that the basis of any of these convoluted transactions or relationships could be in the best interest of US Shareholders? The couple of examples above are the most egregious but most likely just the tip of the iceberg.  The responses to SEC questions in the pre-IPO documents are a nice window into how the investigative process works.  As we can see by the Wasu disclosures (i.e. Shareholders taking it "up the Wasu".) that the SEC either lacks the will or the political clout to stop any of this.....but they will, of course, continue to ask excellent questions!

If I were a betting man, as per past experience, the SEC will continue to ask direct, pointed, intelligent questions, Alibaba will continue to give absurd, confusing ridiculous responses and the dance will go on.   Investors will continue to read (or not read) the correspondence and try to parse the meaning of Alibaba Counsel's cryptic answers.  But, as always, the music will eventually stop and the dance will finally end when someone actually pulls the plug.  It could be the unnamed PRC Bank seizing the pledged Wealth Management Products after Simon Xie's default.  It could be US Investment Banks shutting off the capital spigot after really taking a hard look at the endless string of odd acquisitions and continuous thirst for financing which dwarfs "real" operating cash flow.  It could be a few insiders, in an effort to do the right thing (and save their skin) filling out the whistle-blower forms available on the SEC website, fully documenting all of the (alleged) dirty little secrets buried in the bowels of the corporate records.

In any case, just about anything could cause this silly house of cards to collapse.  But what history tells us is certain, is that the SEC, Accountants, Regulators and Rating Agencies won't do anything meaningful until Investors are severely damaged by this mess. They will need to see the "confession letter" to change their inherent bias.  The inevitable, can always be delayed, but it simply can't be stopped.

So my question is: As an investor, there are so many places out there to park your money.  There are growing, thriving, well run honest businesses listed on exchanges all over the world.  You can park money in any of these stocks.  You can hold cash, mutual funds, bonds, ETF's  etc.  You can put money in your mattress.  There are more investment alternatives than ever before. So why in the world, as an investor or a banker, would you put your hard earned money in the Alibaba ADR?