- Alibaba is under investigation by the SEC, however the risks aren’t “material” to investors.
- After comprehensively weighing the risks, I find it improbable that Alibaba is actively breaking SEC rules.
- Alibaba is undervalued and the negative spin gives investors an opportunity to buy Alibaba on the cheap.
It’s been interesting several weeks for Alibaba (NYSE:BABA) investors as the recent spate of negative news has hampered the valuation quite considerably. Notwithstanding the SEC investigation, Softbank sale and Chinese macro worries, the company still presents a compelling value-driven investment thesis.
The initial drop following the 20-F filing wasn’t that surprising, as markets tend to be very jittery in response to news. However, the drop was still modest (relatively) following the disclosure of the SEC investigation as volatility tightened with the stock trading in a $74 to $82 price range. The stock is still undervalued, but with recent negative news, I believe investors have an opportunity here at a $75 price, as the impact from the investigation isn’t very material to the long-term investment thesis.
Climbing the wall of worry
The impact from the SEC disclosure is fairly minimal even in a worst case scenario. The investigation into the business pertains to “fake” orders by merchants to boost their ranking on Singles Day. Even so, those fake orders don’t actually negatively impact revenue. So, even if the SEC were to require Alibaba to make accounting estimates on fake orders as total percentage of GMV, and reclassify results, it wouldn’t necessarily equate to a reduction in net revenue, nor would the GMV figure drop too significantly as the estimated impact is roughly at 20-30%, according to Oppenheimer Co.
I reached out to Alibaba’s investor relations/publication relations and they weren’t willing to make a public comment on the topic, and instead referred me back to the 20-F.
Here’s what Alibaba stated in its 20-F SEC filing:
Earlier this year, the U.S. Securities and Exchange Commission, or SEC, informed us that it was initiating an investigation into whether there have been any violations of the federal securities laws. The SEC has requested that we voluntarily provide it with documents and information relating to, among other things: our consolidation policies and practices (including our accounting for Cainiao Network as an equity method investee), our policies and practices applicable to related party transactions in general, and our reporting of operating data from Singles Day. We are voluntarily disclosing this SEC request for information and cooperating with the SEC and, through our legal counsel, have been providing the SEC with requested documents and information. The SEC advised us that the initiation of a request for information should not be construed as an indication by the SEC or its staff that any violation of the federal securities laws has occurred.
While reclassification of the GMV figure is a reasonable possibility, I wouldn’t read too much into this. The practice of “brushing” whereby Chinese vendors purchase their own inventory via fake customers isn’t really going to end anytime soon. Yes, the activity is considered illegal, but it’s not like Alibaba can deduct its revenue from those transactions on its financial statement as they are still actual transactions occurring across its various B2C platforms. It’s also difficult to determine which vendors are “brushing,” as the activity is considered illegal in China and is occurring off the radar of both regulators and Alibaba itself. After all, there’s very little incentive for retailers to publicly acknowledge they’re inflating their own results on Taobao or Tmall.
The definition of take-rates might actually change, but it really comes down to whether Alibaba will be required to reclassify some of its prior investor materials. So as long as the prior year figures are also adjusted, it shouldn’t cause too much confusion among buy/sell side analysts. I also want to point out that the SEC investigation isn’t an actual indication of whether Alibaba actually violated securities laws. I also believe the SEC is doing this investigation to verify whether Alibaba is actively participating in “brushing,” which seems highly improbable.
So, what about Cainiao?
The company is also under investigation for its partially owned Cainiao subsidiary, which is a little tricky and is also a convoluted topic. Based on recent conversations with Alibaba’s PR (6 to 8 months ago), I wasn’t really able to determine if there were any plans to directly monetize the subsidiary. Cainiao currently earns revenue as a part of an arms-length agreement with Alibaba (basically Alibaba splits a small portion of its revenue with Cainiao), but there’s no indication as to whether Cainiao will directly charge the logistic providers for using Cainiao’s logistical data network.
Also, I’m not going to bother assigning an independent valuation for the subsidiary as I never got a look at any of the pitch decks/offering documents, so assuming what the business is actually worth for shareholders beyond the implied value from the recent funding round would be difficult. I also have ample suspicion over Jim Chano’s criticism of Alibaba’s accounting policies, which I will discuss in greater detail.
Now, the reason the SEC is pursuing this investigation is due to the unaudited financial results from the subsidiary. After all, the private company isn’t subjected to publicly traded standards, so it’s hard to determine whether the reported figures comply with GAAP and FASB standards. There could be some discrepancies with IFRS, or the losses could potentially exceed what was reported separately in the 20-F filing. However, I’m skeptical of fraudulent practices because Alibaba’s behavior isn’t implicit of a company trying to avoid SEC scrutiny.
Here’s what Alibaba stated specifically in its 20-F with regards to its Cainiao subsidiary:
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. Cainiao Network completed a round of equity financing of approximately RMB10 billion in March 2016. Existing shareholders and new investors, including major sovereign wealth funds and private equity funds, participated in the financing.
When looking at the disclosure, it’s hard to determine Alibaba’s investment in that specific round as it owned 47% of Cainiao, which was recently valued at $7 billion. However, based on the current RMB exchange rate (which hardly fluctuates), Cainiao raised $1.52 billion. Alibaba already had a pre-existing ownership stake, as it got diluted in the most recent round. If its total equity raise was worth $1.52 billion at $7 billion, the dilution impact was roughly 21% assuming the valuation is implicit of post-money assumptions. Alibaba wasn’t the sole investor in that round, and it certainly didn’t increase its total ownership position in Cainiao, because it owns more than the 21% equity allocation from the most recent funding round. As of the 20-F, Alibaba has cumulatively invested $3.65 billion into Cainiao. I estimate the dilution impact was roughly 3% to 4%, so it’s exposure fell from 51% to perhaps 47%. Of course, I never took a look at the post-money value tables, so I can’t give “exact” figures.
Cainiao’s operating loss of 183 million and 617 million RMB in FY’14 and FY’15 were consolidated into the financial statement and are reported separately. However, given the recent funding round, the company earned an equity gain also referred to as “mark-to-market,” which netted out the negative financial impact.
All of these practices seem legitimate, as mark-to-market gains is a value adjustment using a contra-account on the balance sheet, which reduces the risk of overstating the value of a financial asset if in the event the acquisition price was higher than the current market value. In other words, Alibaba is on the winning side of a transaction, so it gets to report an equity gain.
Mark-to-market value adjustments came as a result of major accounting standard overhauls following the 2007 financial crisis, so investors could keep better track of shareholder equity on a bank’s balance sheet. During the 2007-2009 years, there were many instances where the banks’ tangible book value was overstated, and upon implementing mark-to-market adjustments, the equity loss was so substantial that it quite literally destroyed the income statements of some of the bigger franchises. I would know, I had first-row seats when all of this occurred. So, these mark-to-market value adjustments help on the way up, but it also does just as much damage on the way down, so it balances out.
Also, according to the FASB, the requirements for separately disclosing the financial statements of a subsidiary requires that Alibaba owns more than 50% of its subsidiary. But, in instances where Alibaba owns less than 50%, it’s only required to disclose the separate financial results if the investment amount exceeds 10% of Alibaba’s assets, or if in the case Alibaba uses a separate subsidiary to own Cainiao and the combined figure of assets held in other subsidiaries inclusive of the parent company total to greater than 10% of combined assets, or if net income from the Cainiao subsidiary exceeds 10% of the company’s consolidated operating income inclusive of other subsidiaries proportionate share within Cainiao (if any).
In FY’15 Alibaba reported assets and net income of 364.45 billion RMB and 71.46 billion RMB, respectively. Alibaba’s investment into Cainiao totaled to 23.95 billion RMB representing 6.5% of Alibaba’s assets and net loss of 615 million RMB, which impacted net income of Alibaba by 0.86% (less than 1%). So, Alibaba isn’t required to disclose or consolidate the subsidiary figures, but it’s doing so voluntarily. Also, the mark-to-market impact pertains strictly to the balance sheet, whereas the income statement impact is pro-rata as a percentage of equity to the income statement. It’s only when Alibaba liquidates its Cainiao stake does the unrealized value adjustment transfer to the income statement. Since Alibaba hasn’t recognized a gain, it’s not required to transfer those gains onto the income statement.
Therefore, I detect very little suspicious behavior, because they’re disclosing more information than what FASB or GAAP standards currently require. The biggest tipoff of “suspicious behavior” is when a company reports less information than what’s required by regulators. But, in this specific case, Alibaba is disclosing more information on its subsidiary than what’s actually required. i.e., I see very little behavior that points to an intentional obfuscation of relevant information.
You really have to stretch your imagination here to believe there’s suspicious behavior by the management team. I believe a compelling counter-argument can be made to the bearish thesis (yes, even if that bear is Mr. Jim Chanos).
- For starters, Alibaba’s usage of other entities does not mean Alibaba is using multiple layers of entities to hide its equity interests. I believe the bears are making snap judgments based on prior experiences that may not equally apply (availability heuristic).
- I have also established that Alibaba’s financial reporting exceeds the standards required by the FASB, which reduces my suspicion quite considerably.
- There’s some conflict of interest in Alibaba’s dealings with its network of retailers, because Alibaba does benefit indirectly from “brushing,” but then there’s no incentive for any of the sellers to acknowledge that they’re willingly breaking the law, so there’s no incentive for sellers to directly report to Alibaba that they’re engaging in illegal activities.
- If Alibaba were to actively go after these sellers it will require a heuristic algorithm that will have an unacceptable failure interval (meaning that the sellers not engaging in brushing will also be caught in federal investigation).
- Therefore, Alibaba would only increase the paranoia of sellers on its major retail platforms, and would fail at detecting these schemes with enough success to justify the use of “conventional” fraud detection algorithms.
- Furthermore, the gross transaction volume of $463 billion (FY ending March’16) makes it prohibitive to manually detect these types of transactions, and it’s dubious that the government can successfully identify the 20% to 30% of sellers, so there’s no immediate risk of deteriorating transaction volume from a major crackdown on these fake transactions, so downside risk is limited.
- But then, I also begin to wonder if the Chinese government has any incentive to go after these fake transactions because fake transactions contribute to the country’s national GDP.
- The U.S. FASB enacted these mark-to-market principles in response to the financial crisis, and for good reason. There’s zero optionality for Alibaba to diminish unrealized equity gains, or make more conservative value estimates even if the valuation was arrived at in private pools of capital.
So, when combining the limited incentive of the Chinese government to detect these fake transactions, the inability to successfully identify and reduce to a high-enough threshold on the part of Alibaba, paired with the legal environment that prevents sellers from self-identifying; I believe these transactions aren’t going to go away anytime soon. The “financial downside” for shareholders is limited because these transactions will likely continue.
I also find it highly improbable that Alibaba’s management team is directly involved in these improprieties because it would be directly engaged in breaking the law, which makes it culpable, so there’s no incentive on the part of Alibaba to encourage these “fake” transactions either. So, investigations by the SEC is unlikely to turn up anything meaningful.
Therefore, after comprehensively weighing the risk factors, I continue to reiterate my buy recommendation on Alibaba.