Alibaba and the miraculous recovery

Unrealized gains in Alibaba’s portfolio investments repre-sent a substantial proportion of the company’s reported earnings. The performance of its portfolio investments has been remarkable, evidently beating the Shanghai Compo-site, the Hang Seng, the S&P 500, the Nasdaq Composite and virtually every US mutual fund manager. This reported performance seems at odds with the precipitous falls seen in a number of the company’s listed equity investments.

Alibaba and the miraculous portfolio strategy

The Firth Asian Systematic Equities Strategy is a fundamentally-driven stock selection approach that also has some valuable implications for cycle risk management.

Given its fundamental approach, the analysis of income statement, balance sheet and cash flow statement data is a core part of the process. Applying this strategy, one consequence has been that the largest risk position in the implemented portfolio is a highly negative view of Alibaba. Our approach has indicated a large disconnect between the company’s growth ambitions, what looks to be realistically achievable and what the market is pricing the company to achieve.

Clearly this has been wrong over the last year or so. Nonetheless, we know that historically it is almost impossible for a company to do what Alibaba is already priced to do. So in terms of our strategy, we continue to maintain our negative view. Having said that, we have been fascinated (for want of a better euphemism) by what the stock’s price has been doing. Consequently, we have spent some time looking at the underlying fundamentals in considerable detail to try to determine what may be driving this. I should add, this analysis is not part of our systematic strategy. It simply reflects our curiosity regarding this company. I also must stress that I am not a forensic accountant and so the following reflects the efforts of an enthusiastic amateur. Hence, I would love to hear from anyone who may be able to correct me on any of these points. Proceed with caution.

Attempting to read, cross-reference and ensure consistency across Alibaba’s vast 20 -F SEC filing (in excess of 300 pages) is an exercise in futility. It appears virtually impossible to do so given the manner in which data is presented. Nonetheless, we have identified some interesting issues.

By way of example, Alibaba reported interest and investment income of RMB 8.6b in the year to 31 March 2017. There also appears to be another RMB 2.1b in gains for available-for-sale securities. Comparing these figures with total net income of RMB 43.7b, we can see that a sizable proportion of annual income came from investment income. This is of course neither a positive nor a negative in its own right. However, the problem is that the magnitude of this income seems unusually high given other information presented in the 20-F filing, and compared with a range of external factors.

If we focus on listed assets, the 20-F reports fair value of listed equity at the end of 31 March 2016 as RMB 17.2b. There appear to be available-for-sale acquisitions of RMB 4.7b over the following 12 months and sales of RMB 4.4b. So let’s say we have a base value for assets at the start of the year ending March 2017 of 17.2 + 4.7 – 4.4 = 17.5¹. The 20-F reports the value of these holdings as at the end of that year as RMB 23.3b, i.e. a return of 33%. This appears to be a great outcome for the Alibaba treasury team. It appears to be an even more impressive result when you compare it with the performance of equity markets over the same period. For example, the Shanghai Composite rose by just over 7%, the Hang Seng index was up around 16%, the S&P 500 was up around 15% and the Nasdaq Composite increased around 21%. Alibaba’s portfolio investments beat them all handsomely.

To gauge just how good the Alibaba treasury team is, I searched on Bloomberg for large cap equity mutual funds in the US, and obtained a list of approximately 1000. For the period in question, the performance of Alibaba’s listed equities would have put them firmly in the top 10 on this ranking. In other words, the performance of Alibaba’s listed equity investments was better than 99% of US mutual fund managers. Amazing! But also eyebrow-raising.

One’s eyebrows rise further when we take a look at the actual performance of Alibaba’s known listed equity holdings. Over the 12 months in question Singapore Post FELL 17% in USD terms. Alibaba Health FELL 26% in USD terms. Alibaba Pictures FELL 20% in USD terms. There are exceptions (e.g. Sanjiang Shopping), but those known exceptions do not appear large enough to account for the extraordinary reported performance. I should add that some of the stocks mentioned above may be accounted for differently (i.e. under “equity investees”) and not under the listed equity investments. Nonetheless, it demonstrates issues with valuation and performance of company assets. Remember also, these comments only relate to Alibaba’s listed holdings. We have no way of knowing valuations applied to unlisted holdings.

In fact the company itself concedes some issues with variation between listed asset market valuations and the valuations employed in its accounts. Buried deep in the 20-F notes is this alarming observation:

“In particular, the market value of the Company’s investment in Alibaba Pictures has remained below its carrying value of RMB30,102 million based on its quoted market prices since July 2015. As of March 31, 2017, the difference between the market value of this investment and the carrying value amounted to RMB14,487 million. For this investment, the Company further evaluated relevant positive and negative factors, including the development stage and business plan of Alibaba Pictures, comparison of actual financial performance against budget in recent years, business and industry outlook, capability of management team, collaboration with the Company, implied market value with reference to price-to-earnings ratios of comparable companies, valuation conducted by an independent valuer and geographic region, market and industry in which Alibaba Pictures operates. The Company determined that the decline in market value against its carrying amount was not other-than-temporary.”²

I’d be fascinated to speak with the “independent valuer” referred to. In a nutshell, the value of Alibaba Pictures in the books is roughly TWICE the market traded value (and has fallen another 8% or so since the balance date), but apparently this is “not other-than-temporary”. Unfortunately, over the last 2 years, Alibaba Pictures has not traded anywhere near Alibaba’s book value for the holding. Alibaba purchased a stake in Alibaba Pictures in June 2014. In 2015 the stock price staged a meteoric rise and Alibaba issued new shares to unrelated parties and recorded a substantial gain on their investment. The stock’s price plummeted after the completion of the transaction and has drifted lower ever since.

Another example of concerning valuation issues relates to Wasu Media. Alibaba has employed some of their investments as collateral for a RMB 6.9b loan (over USD 1b) to one of the Alibaba founders to support his investment in Wasu. The loan is secured against the Wasu investment. Alibaba has also entered into a further loan of up to RMB 2b with the founder so that they can repay the interest on the original loan. As at 31 March 2017, RMB 749m had been drawn down on that loan. Ignoring the related-party concerns for such a transaction, the share price of Wasu Media has fallen by nearly 70% since April 2015, when Alibaba first provided the collateral for the loan.

Hence, questions need to be asked regarding just how secure the loan is.³ Alibaba appears to be trying to rectify the matter by;

“The Company entered into strategic cooperation agreements with a major shareholder of Wasu in order to enhance the Company’s capabilities and profile in the entertainment sector in the PRC.”⁴

…so, more related party issues.

I could go on, but when one comes across red flag after red flag it does not seem surprising to learn that Alibaba is the world’s most shorted stock. What is surprising is the way the stock continues to head higher.

Of course not everyone is bearish. Of the analyst stock recommendations recorded by Bloomberg at the time of writing there are 47 buys, 3 holds and 0 sells. Alibaba has been happy to book billions of US dollars in profits on unrealized gains in their equity investments. However, they have not booked the subsequent billions of dollars in unrealized losses. Perhaps there is some way to reconcile these findings, but I am unable to do so.

Once again, it is also worth emphasizing these comments relate only to investments we can directly assess given they are listed. We have no knowledge of valuations applied to unlisted investments. The company’s intangible assets and investments in affiliates have increased by 730% from the 2014 accounts to the 2017 accounts, and these represent more than half the total assets of Alibaba. If we have extreme difficulties trying to reconcile value statements for listed tangible holdings, it beggars belief how one can deal with the intangibles.

Our core process states serious concerns with this. The additional research we have done highlights even more worrying factors (and those mentioned here are a mere sampling). It is also worth remembering that this company represents roughly 5% of the MSCI Asia ex Japan benchmark index

¹This is a rough approximation given challenges reconciling data, but nonetheless is a reasonable basis for reference.

²Alibaba Group Holdings Form 20-F, 15 June 2017, F-81.

³Alibaba’s 20-F describes these transactions as follows:

“In April 2015, the Company entered into an arrangement with a bank in the PRC to invest in wealth management products with an aggregate principal amount of RMB7.3 billion, of which RMB420 million was early redeemed in January 2017 and the principal amount was reduced to RMB6.9 billion as of March 31, 2017. The wealth management products carry an interest rate of 5% per annum, with a maturity of five years and the return of principal and interest income on the products are guaranteed by the bank. The wealth management products have been served as collateral to the issuing bank for the issuance of a financing amounting to RMB6.9 billion to one of the founders of the Company to support his minority investment through a PRC limited partnership in Wasu, a company listed on the Shenzhen Stock Exchange which is engaged in the business of digital media broadcasting and distribution in the PRC. The financing has also been collateralized by the equity interests of Wasu held by such PRC limited partnership. The founder has also pledged his interest in the PRC limited partnership to the Company. The founder is exposed to the risks and rewards of the Wasu shares held by the PRC limited partnership. The Company does not have the power to direct the activities of the PRC limited partnership. The Company entered into strategic cooperation agreements with a major shareholder of Wasu in order to enhance the Company’s capabilities and profile in the entertainment sector in the PRC. Such investment in the wealth management products is accounted for as a held-to-maturity security (Note 11).

In addition, the Company entered into a loan agreement for a principal amount of up to RMB2.0 billion with the founder in April 2015 to finance the repayment by the founder of the interest under the above financing. The outstanding loan balances were repayable in ten years and charged at a compound annual interest rate of 8.0%. Loan balances of nil and RMB749 million were drawn down as of March 31, 2016 and 2017, respectively.” Alibaba Group Holdings Form 20-F, 15 June 2017, F-61.

⁴ Alibaba Group Holdings Form 20-F, 15 June 2017, F-61.

Written by: Dr. Hamish Macalister