August 23, 2021
In Jules Verne’s novel, Kin-Fo, the hero, is a rich oligarch who
decides to put an end to his life after learning that his main overseas
businesses have collapsed. Thus, he
instructs his mentor to murder him before his life insurance expires. Meanwhile, for a short while, he will live
life to the fullest. But when he learns
that, far from being a pauper, his affairs have prospered greatly, Kin-Fo no
longer wants to die; problem is that his mentor is nowhere to be found. Kin-Fo must now run for his life, and in the
process, he learns that life is infinitely precious.
Viewed from afar, Alibaba seems to have been on the run
lately, assailed at every turn by faceless bureaucrats intent on hacking away
at its fortune, relentless and determined in their pursuit.
As Alibaba runs, foreign shareholders also run, away, and markets
wonder if Alibaba will share the fate of the dodos.
I have no special knowledge of how the Chinese government
works nor do I have an insight into the Chinese Communist Party’s
deliberations. However, I believe that
human nature is universal, driven both by emotions and reason, and that
authoritarian regimes have characteristics in common. That is why, I will try to evaluate the
merits on investing in Alibaba and, in the process, try to answer some of the
key questions asked by investors.
Basic premise
The Chinese Communist Party (CCP) is a body that controls all
levers of power in China. Since it
regroups just 1/15 of the population, it derives its legitimacy not from
popular vote but from delivering better standards of living to the 1.4 billion
Chinese.
Its leader and Chinese president, Xi JinPing, seems to have
accumulated more power than his predecessors and, in the process, has pushed
aside political peers and interest groups.
As happens in similar situations, witness Putin in Russia, Chavez in
Venezuela, and others, retirement is not an option; staying in power is the
only way forward.
This means that, for both the CCP and Xi, survival is the only
thing that counts, and everything else either comes second or may be used to
that end.
Reading the world press, the CCP and Xi seem to feel that all
is not well in China ahead of next year’s presidential election: Covid-19
continues to have a negative impact on the economy, the rise in standards of
living has been uneven and mammoth companies have been accumulating data and
financial power on their own (i.e. beyond the tight control of the Party) and
to the detriment of the people.
Viewed from this standpoint, the actions of Xi and his
administration are logical and understandable.
They appear designed to ensure favorable short-term political goals as
well as solving China’s fundamental challenge: how to safeguard a regime founded
by Mao Zedong the legitimacy of which is best served by economic free enterprise?
My first conclusion is that the CCP and Xi will go
as far as they dare to achieve their goals.
But I also believe that destroying household savings and reverting to
economic socialism would imperil their survival.
My second conclusion is that China is not
“uninvestable”, rather that it is riskier than initially thought and thus
deserving of a wider margin of safety/error.
Let us review some of the risk factors raised in connection
with investing in Alibaba, and others.
The VIE structure means that
foreign investors own “nothing”
Typically, if foreign company XYZ seeks to list on US
exchanges, it will issue ADRs (American Depository Receipts). ADRs are certificates issued by a US depositary
bank and backed by shares of a foreign company (XYZ) held by that US depositary
bank abroad. For example, one Petrobras
ADR represents two ordinary Brazilian shares.
The ADSs (American Depositary Shares) issued by Chinese
companies have a much weaker structure. To
provide foreigners with an economic participation in its business, Alibaba set up
a Variable Interest Entity (VIE) in the Cayman Islands that grants ADS owners a
contractual right to a specific percentage of its profits. Such right is established by a contract
between the VIE and Alibaba. One ADS has
a call on the profits accruing to eight Chinese shares of Alibaba.
Put it another way, the holder of an Alibaba ADS owns shares
in a Cayman Islands company, the VIE, which in turns has a right to profits
generated by Alibaba, such right being instrumented by a contract between the
VIE and Alibaba.
Some non-Chinese companies issue preferred shares where the
holders have no voting rights but have either preference over holders of
ordinary shares in case of liquidation or with regards to the payment of
dividends. Holders of Alibaba ADS have
no ownership in the company, no voting right, and for the moment Alibaba pays
no dividend.
Clearly, an ADS in a Chinese company offers less
than a classic ADR and pricing should reflect this situation.
China can declare null and void
the VIE structure
Trying to go around government rules is risky and the track
record of those who tried is not good.
I remember the case of investment banks in Brazil back a few
decades ago: foreign investors would enter into side agreements with the
controlling local shareholders to gain a say in key decisions, or a right of
veto, which the Brazilian laws prohibited.
Sure enough, the side agreements didn’t survive a dispute between
shareholders when one case was brought up to a local court.
The 2014 prospectus prepared in connection with the Alibaba ADS
issue states that, as per its outside Chinese legal counsel, Alibaba’s VIEs do
not violate any applicable law, regulation or rule in the PRC. However, counsel goes on stating that “there are
substantial uncertainties regarding the interpretation and application of
current PRC laws, rules and regulations.”
And Alibaba goes on saying that future laws, rules and regulations
regarding VIEs could be enacted.
Perhaps a more useful way to look at this issue is to place it
within a broader perspective: does the PRC want to have normal business and
financial relationships with the rest of the world?
In 2020, Alibaba was the most valuable ADR/ADS stock traded on
the NYSE and NASDAQ. It was not some
small outfit flying under everybody’s radar.
Since 2014, there have been many other Chinese IPOs following the same
VIE route; the Chinese government had plenty of opportunities to object to these
VIEs, and it hasn’t. That has widely,
and rightly, been interpreted as tacit acceptance.
The CCP may want to steer more capital raising and trading
towards Chinese exchanges, but it certainly doesn’t want to cut itself from the
rest of the world by flouting widely followed international rules.
Yes, there have been instances of governments doing so, but
the circumstances and motivations were very different. In 1917, the Soviet Union reneged on its
external debt and, in effect, locked itself out from the rest of the world to rebuild
itself as a communist country. North Korea,
Venezuela have defaulted on their debts and have then limited their
international dealings with a few sympathetic countries which extract their
pound of flesh to help them out. It is
difficult to imagine the CCP wanting to follow the same route.
The trade fights with the Trump administration also showed
that, for its great manufacturing prowess, China needed the rest of the world
to absorb its industrial output and keep millions employed. Isolationism brings poverty, not wealth.
My view is that it is very unlikely that China
would retroactively nullify the VIE structure.
China could, for all intents,
take over Alibaba and ruin it
The CCP has been vocal about its goals of redistributing wealth and cutting Big Tech down to size. It seems determined to do so, at least for the time being.
There have been examples of government using “cash cows” to advance
political or socio-economic causes; the results haven’t been good for
shareholders. They haven’t been good for
the governments either, although in at least one case, Gazprom in Russia, the
cost has been bearable.
In Russia, Gazprom has been used to exert pressure on Ukraine
and on countries that depend on it for a substantial portion of their energy
needs. It has also served domestic priorities
by selling its natural gas at a fraction of its export prices. Despite having a production more than twice
that of Exxon and a massive pipeline network, its market value is less than
half that of the US company.
The Lula administration pushed its oil giant Petrobras to the
edge of bankruptcy by interfering with its business investments and
management. In Venezuela, Hugo Chavez
ruined what once was the best oil company in the region, Petroleos de Venezuela
S.A., by redirecting its finances and management toward social spending.
Unlike Alibaba, it should be noted that Gazprom, Petrobras and
PDVSA are majority or wholly own by the state.
This makes government interference much easier. The CCP could still tighten the rules and
regulations which apply to Big Tech and effectively reduce its profitability by
reregulating the use and value of data, by limiting the pricing power of integrated
behemoths and by simply pressuring management.
It seems that it will.
I expect Alibaba’s life to become harder and its
freedom of action to be constrained. A quantum
change in risk level would be the entrance of the Chinese state in the share
capital of Alibaba.
Is Alibaba “investable”?
That is the question, and if so, at what price? I think that the threats of a Chinese
government crackdown are real; therefore, BABA’s stock pricing should reflect
that.
The government has already announced the cancellation of several
tax and other incentives which made more economic sense when Alibaba and others
were startups, not tech giants. That
will have a negative impact, although perhaps not that big.
Regulating the use of personal data could be more damaging. So will rules taking aim at Alibaba’s sector
dominance.
Many commentators have advised investing in sectors now
favored by the Chinese government, including high value-added manufacturing,
healthcare and the environment. It is
likely that stocks in these sectors will see their prices rise, at least
initially.
But are corporations which are groomed and closely monitored
by the government more likely to be profitable and creative? Will government bureaucrats encourage risk
taking, straying from the consensus? Possibly. Airbus has been both a technological as well
as a business success. But there are not
so many such examples.
Finally, if the end result of government economic planning is
a fairer rise in standards of living, why wouldn’t firms dedicated to facilitating
consumption not benefit, even if their pricing powers have been clipped? There are risks to investing in any
country.
My view is that investing in China has proven riskier
than perhaps expected, but that it is “investable” at the right price. The same goes for a well-managed behemoth
like Alibaba.
To some extent, Jack Ma’s case reminds me of Mikhail
Khodokorvsky’s, the former head of defunct Yukos. Yukos was the biggest oil producer in
Russia. Like other oligarchs of his
days, Khodokorsky gained control and built Yukos up in the years that followed
the fall of the Soviet Union. He then
decided to enter the political arena, financing groups opposing Putin. He was jailed and Yukos was dismembered.
Jack Ma seems to have challenged the management of Xi, but he didn’t
enter the political arena. He created
Alibaba from scratch, not via a route as controversial as the privatization via
loans-for-shares in Russia. Finally, he
has been out of Alibaba’s leadership since 2018.
So there are enough parallels to be uneasy, but no real
equivalence to fear the worst.
Is there a price at which to buy
Alibaba ADSs?
I think there is, but I would allocate a modest portion of my stock portfolio to Chinese stocks at this time.
Value Line finds that its highest historic predictor of
Alibaba’s stock price has been a “least square linear” relationship with 28
times cashflows. Interestingly, it found
that for Amazon’s stock price the best predictor has been 27 times cash flows.
While Alibaba may have comparable growth potential, or more, the
China country risk should require BABA to trade at a discount to Amazon. If such
discount is 30% then a fair price today for the ADS should be about $220.
Another way to look at valuation is multiples of earnings to
BABA’s enterprise value, that is its market capitalization + debts – cash holdings. At today’s closing ADS price of $161, should
the company meet UBS analysts profit expectations of Rm161 billion (vs. Rm172
billion for 2020), the enterprise value to net profits multiple is around 14.5. This looks prudent under most non-catastrophic
scenarii.
Finally, a third way to value the company is to relate its
enterprise value to its active user base.
At today’s ADS price and at its active user base at 6/30/21, investors
put a value of $313/active user.
That is quite low. By comparison,
I estimate Amazon enterprise value per active user at around $4,500/active
user (which sounds too high perhaps for undercounting active users) . Although its business model is different,
Google is valued at around $2,000/active user.
The above calculations are very rough: using for example “adjusted
earnings” rather than GAAP; the definition of “active user” is not the same for
Alibaba, Amazon and Google; China’s wealth per capital is much lower than that
of the US or Western Europe, etc.
Rather than representing a benchmark for current valuation, I
believe that enterprise value/active user is a more useful indication of what
Alibaba could aspire to…if both it and China prosper.
In the end, it is very difficult to come up with a precise valuation of Alibaba as the biggest threats to its business future are non-quantitative in nature. As discussed above, I believe that Alibaba has a future, albeit a cloudy one for the foreseeable future.
Under current circumstances, $160/share appears to me as a
reasonable top price to pay given the circumstances. But I wouldn’t be shocked if BABA’s ADS price
dropped as low as $140.
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