Wednesday, November 18, 2015

I was talking with an analyst......

...over the weekend who is considering initiating coverage on Alibaba. The fundamental question she raised was "what's a reasonable target for the stock?" She's an avid reader of this blog and wanted my thoughts on how to "strip off the fluff" and zero in on the real value of the core business. As I had discussed in the last post, most analysts and Hedge Funds are concerned, and rightly so, about the veracity of the accounting (consolidation and asset carrying values), rapid cash burn as well as the GMV legitimacy.

We also discussed my "Bold Prediction", that Alibaba would be looking at issuing bonds soon. She revived an interesting alternative, that warrants some discussion. Jack and company might be accelerating the Ant Financial/Alipay IPO. Although, my prediction was based primarily on simplicity (They would cookie-cutter the November 2014 Bond Issue), an Ant/Alipay IPO could be much more lucrative, with estimates floated by the financial press of up to $50 Billion. My guess, after talking with friends "in country" is that the Alipay IPO is might be off the table, or at least on life support for now.

Here's why...

Based on the Alibaba IPO filing 424(b)4 filing (pg 258-267) there are several components of "Other Income, net" as reported on the financial statements.

1.) The transaction processing fees payable to Alipay/Ant(SMFSC) on Alibaba's platforms. According to the filing, this fee was running at about 4.5% of revenue and 0.14% of GMV at the time of the filing. Authors Note: Really? Alipay can perform escrow services for 0.14% of the transaction value? They must be incredibly efficient.

2.) Alibaba is entitled to 37.5% of the pre-tax Net Income of Alipay/Ant(SMFSC)

3.) Alibaba is entitled to 2.5% of the average Daily Loan balance, presumably to be accrued in the financial statements and reported in "Other Income, net".

4.) An IPLA - Intellectual Property (Royalty) agreement as well as a "Shared Services" agreement whereby Alibaba sends a bill to Alipay/Ant(SMFSC) on a regular basis. Presumably, this number is calculated by Maggie Wu calling the CFO at Alipay/Ant(SMFSC) and telling him/her what the number should be.

As is typical for Alibaba, the financial relationship with Ant/Alipay(SMFSC), namely, the transaction fees paid; the offsetting 37.5% pre-tax profit sharing; as well as the 2.5% commission on average SME loan balances, have never been disclosed since the day these line items were referenced in the IPO filing. Presumably, all of these expenses and revenues are netted/buried in "Other Income, net" line of the Income Statement.

With 900 million Alipay users and a significant financial interest/exposure/relationship, the numbers are clearly material and should be disclosed. Period.

According to the IPO filing, the transaction fees payable by Alibaba to Alipay for 2012, 2013 and 2014 were running approximately 4.5% of revenue and 0.14% of GMV at the time of the IPO. Since the transaction fees are netted against the profit sharing and commissions yielding roughly zero, we can do some extrapolation, providing there are no other "odd", undisclosed, material transactions thrown into the mix. Let's assume, for the sake of argument, that Ant financial is run like most of Jack's other businesses, i.e.) Like his own personal piggy-bank, presumably used to reward friends for their loyalty , provide a source of fun-money and fund odd, money-sucking eCommerce start-ups and acquisitions. If we assume that Alipay has no/little pre-tax profit, we come up with some interesting suppositions per the schedule below.

Per the above, based on the law of large numbers, let's say that the relationship of Alipay fees paid to revenue holds constant. When we apply the 4.52% ratio to revenue we can calculate the fees paid. We can also extrapolate and adjust Alibaba's Net Income to see what the business might look like if there was no relationship with Alipay/Ant(SMFSC). We can remove the fees (as a proxy for the Profit Sharing 37.5%, SME Loan Balance 2.5% payment and IPLA/Shared Services obligations owed to Alibaba) as well as the "Write-up/Gain" of "Deemed Disposals of Investees and other BS" as described in the financials. When we calculate "Adjusted Net Income" the exercise yields a stunning result. Namely, for an enterprise the size of Alibaba, it has no earnings/net-income to speak of . In fact, from 2014 prior to the IPO, Net Income has declined from US$3.1 Billion down to an annualized rate of roughly $2 Billion while Revenue is on pace to more than double during the same period. Again, with meteoric growth like this Alibaba should be hauling cash to the bank in dump trucks, yet they have puny earnings and are burning through cash. Perhaps Alibaba management should consider "managing to a profit margin" despite their repeated, public refusal to do so. Moreover, the above doesn't yet reflect the inevitable future write-offs of the rest of the "Questionable Assets" as described in my prior posts.

In addition, if we assume that Alipay has little or no pre-tax net income (37.5% Profit Sharing), we can conclude that the offset to the Transaction Processing fees is attributable primarily to the 2.5% payment on "Average SME Loan Balance" and calculate the amount of loans outstanding accordingly. This "SWAG" tells us that SME loans outstanding have increased rapidly from roughly US$8.1 Billion in 2014 to about $24.5 Billion today.

Credit Risk associated with Ant Financial (SMFSC)

You'd also have to be living under a rock not to have heard about the explosion of debt, "Wealth Management Products" (WMP's) and Money Market instruments in China. As we've all learned, rapid increases in debt levels, loosening of underwriting standards and easy money generally cause a corresponding increase in defaults. People/businesses get overextended and they can't pay their loans back. Who knew? Gordon Chang (Forbes) just wrote a nice piece on the acceleration of bond defaults in China referring to an eventual "debt tipping point" which might have some bearing on Alipay/Ant (SMFSC) going forward. Since nothing has been disclosed re: the financial condition of Alipay/Ant (SMFSC), as Investors we can either assume:

A.) That Alipay/Ant (SMFSC) is a button-down, smartly managed savvy financier making loans to only the most credit worthy businesses and individuals, at interest rates that protect shareholder value; or

B.) A bucket shop making bad loans at a breakneck pace to any knucklehead who walks in the door in order to show incredible top-line growth.

If I were to guess, since Alibaba management has never been shy about disclosing favorable financial metrics and we know nothing about Alipay/Ant (SMFSC) , I'm thinking the latter (B) is the more likely of the two.

What if Alipay charged "Normal" Processing fees to Alibaba?

Based on the 0.14% of GMV fee that Alipay charges Alibaba to process the escrow services, it's clear that either: 1.) The reported GMV number is silly (a distinct possibility as described in prior posts); 2.) Alibaba is getting the "deal of the century" on processing fees since the two businesses are related; or 3.) Both.

Hypothetically, let's say, for example that Alipay charges a "normal" processing fee of 2% of GMV. For the fiscal year ended 3/31/15, Alibaba's estimated processing cost increases from US$550 million to US$7.7 Billion. Adjusted Net Income (Excluding the $1.5 Billion of Asset write-ups as described in the Table above) is reduced from $1.8 Billion to a Net Loss of $5.3 Billion.

So with "real" sustainable earnings reduced from a roughly $2 Billion profit to $5 Billion annual loss, it's clear that without a fundamental change in the revenue/cost structure, Alibaba isn't worth as much as it appears. This is especially true if Alipay/Ant(SMFSC)/Jack requests a price increase.

Earnings Management

Finally, has it occurred to anyone that this construct is designed (perfectly) to manage earnings and siphon same away from BABA to Ant/SMFSC? and/or even visa versa depending on Jack's mood or which way the wind is blowing? According to the filings there are 300 +/- separate operating companies/businesses in the VIE. There's never been ANY discussion of which businesses are consolidated, accounted for under the Equity Method or how these far a-flung businesses (Movie Companies, Soccer Teams, Software Development, Logistics/Distribution, etc.) have an impact on Revenues and Expenses. On every 6K thus far, all of these diverse businesses and revenue/expense streams are reported in a big blob entitled "China Commerce". This is, of course, no accident. As investors, it's painfully clear that management has been going to great lengths to show us only the most favorable half of the puzzle.

Back to the Original Question.....

So what's the stock price target for this mess? There clearly is "some value" in a brand as ubiquitous as Alibaba. The tentacles reach far and wide. They are a "beloved" company. Everyone in China uses the Alibaba ecosystem.  I get it.

 On the other hand, all the signs of an Enron/Valeant/WorldCom/LTCM/Lehman/WAMU, etc-esque, out of control management, off the books, pervasive half-truths and financial mis-rep are all there. Given the above, the only thing I can be sure of is that the target price should be substantially below where it is today. After all of the write offs and recapitalization, the core business would probably be worth somewhere around 20x its 2013 earnings (prior to all of the Shenanigans) or roughly US$20 Billion.....so somewhere around $7 a share. Of course, current shareholders would be wiped out on the re-Cap as preference classes would generally get paid first. Unfortunately, that's just the way these things go.

Of course, there's a good chance that my calculations above could be materially in error, yet these guesses are all we have to go by. As investors, we wouldn't have to speculate and perform all of these financial gyrations if Alibaba management would simply fully disclose these numbers. But as we've seen so often in the past, subterfuge and obfuscation, describing only part of the puzzle are more the rule than the exception when it comes to financial disclosure for Alibaba and the rest of these odd eCommerce ADR's.

There you have it....like nearly every analyst out there, I'll agree......Alibaba is indeed a STRONG BUY....at $7.00 per share.





Additional Reading:

Alipay IPO
http://www.bloomberg.com/news/articles/2015-01-30/alibaba-finance-arm-said-to-plan-2016-initial-public-offering-i5je2vu0

Bond Default
http://www.forbes.com/sites/gordonchang/2015/11/15/chinas-largest-bond-default-ever-the-last-tipping-point/?utm_source=followingimmediate&utm_medium=email&utm_campaign=20151115


No comments:

Post a Comment