Sunday, September 20, 2015

The shortest post I'll ever write....

Last week, several news organizations (Barron's, FortuneBronte Capital , MarketWatch and CNBC) all published stories suggesting that Alibaba might actually be a fraud.  As you, my readers know, I've been writing about this potential fraud, and the projected global fallout for nearly a year now.   I'd like to take a moment to express my gratitude to these news organizations for finally validating my work.  Links below:

Barron's
http://www.barrons.com/articles/alibaba-why-it-could-fall-50-further-1442036618?mod=BOL_hp_highlight_1?mod=BOL_hp_highlight_1

Fortune
http://fortune.com/2015/09/18/alibaba-faking-numbers-hedge-fund/

Bronte Capital
http://brontecapital.blogspot.com/2015/09/job-interview-questions-size-and-scope.html

MarketWatch
http://www.marketwatch.com/story/can-we-trust-alibabas-numbers-auditor-has-never-faced-us-regulatory-scrutiny-2015-09-15

CNBC
http://www.cnbc.com/2015/09/14/alibaba-responds-to-barrons-story-calling-for-a-50-fall-in-stock-price.html


Monday, September 14, 2015

Anatomy of a Financial Contagion and Kayaking the Chicago Wilderness

Since I had so many hits on my cute little niece and nephew's sailing pictures on the last post, I've decided to share another personal photo.  Here's a picture of our latest Outbound-White-Water Adventure.   We wanted to stop at the Trump Tower for drinks on the 16th floor, but they told us that kayaks weren't allowed in the elevator,....we returned later by cab.  Hope you enjoy! As an insurance man, I learned a long time ago that you have to give the people what they want.





Ok....now back to business.....

John Laing, a Barrons Reporter and active reader of this blog, just published a Cover Story stating that "Alibaba could fall another 50%".  Of course, Alibaba responded with their usual PR vigor, in a 2,000 word rambling diatribe quibbling about metrics and statistics, generally assaulting John's "Integrity, professionalism and fairness".   As my readers know, I've been questioning similar virtues of Alibaba's business model within this blog for nearly a year.  From my perspective, Mr. Laing isn't the one lacking "Integrity, professionalism and fairness".  Nice work John.

That said, I've always enjoyed writing about things that have never happened before.  In the history of finance, I can't recall when, if ever, a lockup expiration included 60 % ($95 billion at the current Market Cap) of a company's issued/outstanding shares (Alibaba).  Moreover, the shares due to unlock are substantially owned by three entities.  Let's take the entities one at a time.

Jack Ma and Joe Tsai - 269 million shares -  Joe said that he was speaking for both he and Jack during the last Alibaba Investor Call, and that neither of them would be selling shares after the lockup expiration.  That's good enough for me.  Although, at the time, he didn't mention that they were taking a US $2 Billion margin loan financed by US Banks, using shares as collateral. Moreover, if Jack/Joe default on the loan, it will be more than a little difficult for the lenders to collect the money since Jack and Joe are safely in China.  Perhaps this tidbit slipped Joe's mind.

Yahoo! - 384 million shares - Based on what's being reported in the financial press, Yahoo! seems much more enamored with minimizing the tax impact of their potential future gain, rather than actually selling their shares and maximizing the gain in the first place.  Obviously, Yahoo shareholders would have done much better had they been allowed to sell some shares at $120 and had not been limited by the lock-up.  It's always sad when $46 Billion in value plummets to $24 Billion in a few months.  Really a shame.   

Softbank - 798 million shares - Now, let's talk about Softbank since they own 32% of BABA ($50 Billion at Current $63/share), are the largest single shareholder and will be able to cash out for the first time on September 21st.   They seem to be the wildcard.  It'll be interesting to see what they do after the lock-up expires and whether they might be predisposed to dump some shares next week.  By way of background, here's the vision statement from Masayoshi Son, the Chairman, and one of my favorite financial characters of all time:

As we confirmed in our “Next 30-Year Vision,” which we created in 2010, our ultimate goal is to alleviate sadness and increase everyone's happiness to the greatest extent possible through the Information Revolution.That's why we are trying to change the world—because we want to make everyone happy.

Yes, that is indeed a real vision statement.  It's even more surprising coming from a man who threatened to "set himself on fire" at a regulatory hearing, later explaining that he didn't do it simply because he "hadn't brought any petrol to the meeting".  Now, I've been in the insurance business for years, and I have to say that I've never once considered setting myself on fire in order to get a regulatory concession.  But hey, what do I know.

When I read that Vision Statement I couldn't help but think,....Hey, I wonder how "happy" everyone would be if he dumped a few hundred million shares of Alibaba stock on 9/21?

Since, oddly, there are no public statements or press releases on the topic, we have to do some more detective work to see what the probability of a major share-dump might be.

First....What is Softbank?

Similar to Alibaba and Tencent, Softbank is the Japanese version of a combination Hedge-Fund-Private-Equity-Tech-Business-Holding-Company.  They operate 769 separate technology businesses (as of 3/31/15) and are serial tech acquirer/investors.  Their major operating segments by sales are, Mobile Telecom (47%), Sprint (42%), Fixed Line Telecom (6%) and Internet (5%).  For fun, they do video games (Clash of Clans, Boom Beach, Puzzle & Dragons, etc.) robots (Pepper) and all sorts of other "cool" stuff.  They have a Current Market Cap of about US$ 64 Billion and a Book Value of $32 Billion.  Contra to what their financial reports would have you believe, their primary method of generating earnings is to write up asset values to what will soon be unsustainable levels, then use these valuations as collateral to support even higher debt levels and continue the cycle.  Here are some key balance sheet metrics (US$1.00 = 120.00 JPY) :
__________________________________________________________
                                                    6/30/13                       6/30/15
  Book Value                            US $24 B                   US$ 32 B
  Questionable Assets *            US $16 B                   US$ 82 B
  Tangible Book Value **        US   $8 B                  US$ (50)B
  BABA/Yahoo Gain***          US   $0 B                  US$  76 B

  Interest Bearing Debt             US $38 B                  US$  96 B
  • *Questionable Assets defined as Goodwill + Intangibles + Equity Method Investees
  • ** Tangible Book Value defined as Book Value less Questionable Assets
  • *** Represents the increase in Unrealized Market Value associated with Alibaba and Yahoo! JPN stock.  Alibaba Market Value of $65 Billion with a cost basis of $87 Million.  Yahoo JPN Market Value of  $11 Billion with a cost basis of $11 Million.  
___________________________________________________________

Softbank's unrealized gains on BABA and Yahoo! JPN stocks ($76 Billion)  have provided sufficient collateral to allow them to fund the floundering Sprint Business as well as invest in all sorts of fun start-ups and other currently unprofitable, cash-sucking businesses.  They are spreading "happiness" all over the place.  Feel free to review the Annual report for lists and metrics regarding these businesses.  The 2015 Annual Report Q&A (pg. 65) describes this philosophy going forward.

Q: Unrealized gains in Alibaba since its public listing in September 2014 stand at around ¥8 trillion. (US$ 66 Billion) How do you plan to utilize this share value?

A:We rate the future potential of Alibaba’s business very highly and consider our medium- to long-term relationship with them to be very important. Another point is that there are various fund procurement methods that we can consider by utilizing this unrealized gain. Our aim is to use such procurements to fund strategic investments that will increase our value.


In essence, they have been, and will continue to borrow money using Alibaba shares/equity as collateral and invest the loan proceeds in boondoggle, money-sucking businesses.  This should continue to make everyone involved (except the lenders) "very happy".

After reviewing the 2015 Annual Report, the financial statements for the quarter ended June 30th as well as the Investor Conference Video, here are my takeaways:

Investor Conference Video (i.e. The Strangest Financial Event I've Ever Seen) :

  1. The Investor Conference Recording was 142 minutes in length and Alibaba was only mentioned once (Minute 14:30)  describing Alibaba being the about the same size as Walmart in terms of GMV.  There was no discussion of possible disposition of the investment.  Moreover, none of the analysts asked any questions about Alibaba.  Am I the only one that thinks this is odd since the unrealized gain on the BABA stock is substantially equal to the current Softbank Market Cap?  Wouldn't someone care about this?    
  2. At minute 4:00 of the Recording, Masayoshi Son made an odd, rambling statement that, he was considering the merger of Sprint and T-Mobile,  but he had a cold last winter and was "less confident" so he didn't do the merger.  He continued to feel under the weather and thought he might sell the Sprint business, then in the Spring he felt better, his cold went away, so he thought he would keep Sprint and turn it around.  I really hope, for the sake of the business, that strategic financial decisions aren't influenced by whether the CEO has the sniffles at any given moment.
  3. In Minute 6:30 of the recording, he introduced "Pepper" a robot, to give the financial presentation.  Oddly cute?.... I guess. 
  4. In Minute 27:00 of the recording he described how he had convinced Sprint engineers to build a much better network while reducing operating cost and capital expenditures.  The plan was surprisingly lacking of details.  Going forward, Mr. Son promised that Softbank will be drastically reducing capital and operating expenditures while building a better network and improving customer service. 
  5. Minute 48:00 through 1:42:00 was dedicated to Analyst questions.  You all know how I hesitate to be direct, but I'll say it anyway.  These questions were really stupid.
  6.  In minute 1:23:30 of the recording, Mr. Son provided evidence that he was either delusional, needs a new translator or is an incredible liar/cheat. He said that "he had recently played golf for the first time in many years and shot two-under par". (He said this twice) The thought that a fifty-nine year old man could pick up a golf club after "many years" and play under par on any golf course (without windmills and clowns) is absurd.  A retired PGA pro who had dedicated his life to the game couldn't accomplish that feat.  I presume that since the video has been on the Softbank website for over a month, that the translation has been verified.
  7. In minute 1:24:00 Mr. Son described how he appointed himself the "Chief Network Officer" for Sprint and is personally redesigning the next generation US network since the Sprint Engineers' plan costs far too much money and was not "something excellent".  I'm not sure if I'd feel all that safe on a commercial flight if the CEO of Boeing appointed himself Chief Engineer, had no real background in aviation design and wanted to build "cheap and excellent" airplanes. 
 The June 30th 2015 Balance Sheet

  1. The pace of borrowing & "investment" has been increasing dramatically. (2014 Annual Report pg. 60)  Interest Bearing Debt was US$ 96 Billion as of FYE March 31st, 2015, up from US $31 Billion two years earlier.  Even with all of the capitalized Questionable Assets, the debt to equity ratio has nearly doubled from 2.3 to 4.1. 
  2. Operating Margins have decreased significantly, 25% in FY ending March 31st, 2013, down to 11% for the FYE March 31st, 2015. (ibid pg. 51)  Hence all of the silly "Cut your phone bill in half" Sprint commercials where people chop AT&T phone bills in half with weed whackers and chain saws.  Apparently they are selling services at or below cost while they wait for Mr. Son's future cost savings to be implemented over "the next couple of years".
  3. Interest Expense has skyrocketed during the same period.  Increasing from $540 million annually (8% of Operating Income) to more than $3 Billion per year (37.5% of OI) FYE March 31st, 2015. (ibid pg. 51)
  4. As described above, illiquid, "Questionable Assets" (QA) are currently at US$ 82 Billion (47% of Total Assets).  Just as with Alibaba, Tencent, et al., more conservative accounting methods would require that most of these assets be carried at a much lower level and/or expensed, as they have little/no benefit to future earnings.  The sole purpose of these valuation methods is to goose profits in the short run.  These IFRS accounting shenanigans have become epidemic and are routinely buried in the financial statements of struggling businesses.  Few of these assets can be sold or converted to cash at any value much less their current carrying value.  In the words of a crotchety old auditor I used to know "My Ass has a lot of value to me....but it's worthless to you."   
  5. Tangible Book Value (BV - QA) is at  a deficit of US$ 50 Billion.  In other words, the business needs US$ 50 Billion in order to have a "real" BV of zero. 
Now, let's think about what might happen to Softbank if it continues to hold onto their Alibaba shares.  It's no secret that I've been less than kind about the accounting shenanigans going on at Alibaba.  If Softbank continues to hold onto Alibaba shares, they will fall victim to the continued decline in the BABA stock price, lose collateral value and eventually run out of financing options for the rest of their business.  The faster Alibaba's stock drops, the quicker Softbank will run out of soft collateral if they don't convert it to cash.  They have a limited window of opportunity.

If I were the treasurer at Softbank, I'd be formulating a clandestine plan to start selling a few million shares of BABA every day beginning the week of September 21st.  Unlike Yahoo!, I'd be in survival mode and focus much more on my ability to convert the unrealized gain to cash at a favorable number and far less on the tax impact.  Moreover, Softbank's initial plan of using various fund procurement methods (i.e. borrowing money) to monetize the unrealized gain on the BABA stock has a limited shelf life.  The last thing Softbank needs is more debt on the books.  As I said, the window is closing.

Of course, there are many reasons that Softbank might not sell their BABA shares.  Hubris, maybe loyalty to an old friend since Jack Ma is on the Softbank Board, or perhaps, like his golf game, Mr. Son believes that Alibaba's score card is much more favorable than reality.  All of these are reasons not to sell, but none of them are good.

The End Game

So now we're back to the original question.  What's the probability of a major Alibaba share dump next week?  If you had asked Yahoo! Shareholders, they might have preferred to have been able to sell a few shares at $100 rather than wait for a tax-free distribution at $40 or $50.  Softbank is in a much different, and more pressing situation.  Softbank needs cash.  They've gone into austerity mode cutting CAPEX and OPEX.  They have taken on a huge amount of debt very quickly and will have to start dumping Alibaba shares (or some other fire sale) to raise cash at some point soon. 

So, in my humble opinion, the probability of a Softbank share dump is very high.

The Magic of the Equity Markets

The next question might be, once Softbank actually starts pressing the "sell button", how will the market react, how low will the price go and when will it hit bottom?

Unfortunately, for all of you readers out there who are ready to bet the farm on an Alibaba or Softbank short, it's simply impossible to tell.   I think Warren Buffett said something like "An informed investor can always tell what's going to happen, he/she just can't tell you when, or how big it will be."  I remember a few years ago when the Facebook lock-up expired.  Once it was determined that Zuckerberg wasn't selling any shares, the stock price actually spiked 10% and hasn't looked back since.  To be sure, the Facebook lockup expiration pales in comparison to what's about to happen with Alibaba, but it illustrates how unpredictable stock prices can be from day to day.

In any case, now we have four related businesses Alibaba ($162 B Market Cap), Yahoo! ($30 B), Softbank ($64 B) and Yahoo JPN ($22 B), all of whose fortunes are inextricably intertwined, with a total current Market Cap of  $278 Billion.  As of the beginning of the year, the combined Market Cap of these businesses was $403 Billion.  These businesses are worth 32% less today than they were nine months ago. 

As I had said in this blog and on the CBS 60 Minutes website almost a year ago, and I'm holding to it, the realization of Alibaba's true economic value will probably put Yahoo! out of business or at least force a restructuring.  The same fate might well be inevitable for Softbank if Mr Son doesn't make the right decisions over the next few months.

Anatomy of a Financial Contagion
  
Now, given the above, let's take this debacle a step further.  The total liabilities (bank debt/bonds/payables/etc.) of the above four businesses, which might become impaired as a result of this revaluation, are roughly $180 Billion.  Much of this debt is owned by Investment Banks (aka "the Usual Suspects") or securitized and held by other "sophisticated investors".  Btw - "Sophisticated Investor" is a buzzword generally describing an investor prone to use significant leverage.  Since IB's are generally leveraged at 10:1 right now, the multiplier effect would yield an equivalent equity effect of roughly $1.8 Trillion. (i.e. a $180 billion write down/off in bank assets (loans) would wipe out the equity supporting $1.8 Trillion in assets and require the affected banks and Sophisticated Investors to be re-capitalized.)  To put this in perspective, Wells Fargo (WFC), the sixth largest bank in the world has assets of roughly $1.8 Trillion with a Book Value of $180 Billion.  The multiplier effect of a failure/recapitalization of a bank the equivalent of WFC, and the effect on their counter-parties would be, at least for the purposes of this post, incalculable.  (Note: WFC has not participated, to my knowledge, in any of the above securities nor do they do any business with Alibaba, Yahoo, Softbank, etc.  WFC was used to simply represent the approximate size of the assets impacted)

Finally, are we about to see another wheezing canary?

Needless to say, the week of September 21st might be a very interesting week for Alibaba and Softbank, causing the demise of yet another unwitting canary inhaling this toxic financial gas.  There's simply no telling what might happen to the Alibaba share price if Softbank, Yahoo!, Jack or Joe start selling shares.  In any case, if they do, one certainty is that the share price absolutely won't increase because of it.  The real question is: once the selling starts, "when will the full value reset happen and how big will it be?"  As usual, we have a pretty good idea as to what's going to happen, we just don't know when or how big it will be.

There you have it......I really hope this blog helps "alleviate sadness and increase everyone's happiness to the greatest extent possible".




__________________________________________________________________________
Yahoo! IRS Ruling - BABA Spin-off taxable.
http://www.sec.gov/Archives/edgar/data/1011006/000119312515314494/d35793d8k.htm

Masayoshi Son - Career Highlights - Losing $70 Billion and threatening to set himself on fire in a regulatory meeting.
https://www.hottopics.ht/stories/how-to/masayoshi-son-ceo-lost-70bn-in-day-before-conquering-world/

Softbank Presentation - QE - 6/30/2015 - 8/6/2015
http://webcast.softbank.jp/en/results/20150806/index.html#_ga=1.221685468.556696685.1442074116

Softbank Presentation Materials - QE - 6/30/2015 - 8/6/2015
http://cdn.softbank.jp/en/corp/set/data/irinfo/presentations/results/pdf/2015/softbank_presentation_2015_001.pdf


Softbank - Financial Statements - QE - 6/30/2015 - 8/6/2015
http://cdn.softbank.jp/en/corp/set/data/irinfo/financials/financial_reports/pdf/2016/softbank_results_2016q1_001.pdf