- Gordon Chang believes that the Variable Interest Entity may not offer reasonable protection for U.S. based Alibaba shareholders.
- It's extremely unlikely that the legal interpretation of the Variable Interest Entity is subject to change, despite recent case studies. Legal precedent offers sufficient legal protection for U.S. investors.
- Investors should strictly focus on fundamental risk factors. The legal aspect has been blown a little too far out of proportion.
There has been tons of speculation over Variable Interest Entities. While the arguments presented by the bears sound extremely compelling, Alibaba (ABABA) investors can safely ignore the noise, and should instead focus on investing into the company based on intrinsic factors like cash flow, growth, and etc.
According to Gordon Chang:
Alibaba's e-commerce business is off-limits to foreign ownership, which is why investors, in one of the most anticipated IPOs in history, are not buying stock of a Chinese company. Instead, they will get shares of Alibaba Group Holding Limited, which is incorporated in the Cayman Islands. Group Holding Limited sits atop a complicated "Variable Interest Entity" structure that, through a series of contracts, gives the company the economic benefits of ownership of the Alibaba business.
The Supreme People's Court, the highest tribunal in the People's Republic, declared the contractual arrangements under consideration in the Chinachem case, similar in effect to VIE structures, to be illegal. The 2012 decision has no technical value as precedent-China, after all, is a civil law jurisdiction-but the court's reasoning is sound and consistent with rulings in other countries. All the Chinachem judges did was point out the obvious: complicated schemes will not be respected if they were structured to evade the clear intent of Chinese law.
Furthermore, according to Market Watch:
The Alibaba stock will buy you a stake in a Cayman Islands-registered entity which is under contract to receive the profit from Alibaba's lucrative Chinese assets but will not actually own them.
I'm going to tackle the core of his argument, and no I'm not an attorney. So don't expect me to know everything about Chinese law. However, I do find that the concern over the Variable Interest Entity to be blown way out of proportion, and it has been in the back of my mind all night. However, I'm going to offer a fairly cogent argument as to why the fears over Chinese laws are blown far out of proportion.
Ongoing whispers on the street kills the sex appeal of Alibaba
Many in the financial media outside of Gordon have consistently echoed the same risk factor that Alibaba mentions in its Form F-1 filing.
To summarize, the risk factor is whether the Chinese government will interpret laws differently from historic precedent, and that if the Chinese government does in fact interpret the law in a way that Alibaba's Variable Interest Entity will not be entitled to share in profits, the whole investment scheme for U.S. investors will crumble.
The argument presented by Gordon is fairly strong. The Chinachem case, clearly illustrates that a VIE structure may not be sufficient to protect shareholders. This case illustrates that a company is not honoring the spirit of the law, even though it's honoring the letter of the law. The intent is what's important, and in this case, Chinachem lost.
However, according to legal attorney's Alibaba is structured in a way in which shareholders will not necessarily trigger the national security review process. According to Latham & Watkins (a law firm that specializes in international law):
The national security review process has only been formalized recently and the scope of such a review is still not precisely defined and is capable of very broad application. However, it is at least clear that aggregate minority foreign shareholdings with no possibility of having 'actual control' in an industry sector considered to be economically, socially or technologically sensitive from the national security perspective will not trigger the review process.
In laymen terms, if foreign shareholders in a business don't have actual control over Alibaba, the review process is unlikely. Furthermore, Alibaba is being publicly listed, and is not under imminent risk of being bought by a major controlling stakeholder. Even if such a major stakeholder were to emerge, the ownership of this company would not result in control of Alibaba, but rather entitle the company to a share of the profits from Alibaba.
Since the intent of publicly listing in the United States through an ADR won't conflict with China's policies towards monopoly, and doesn't result in shareholders owning the actual Chinese company, expropriation sounds extremely unlikely.
How this pertains to Yahoo! and SoftBank
Yahoo! (NASDAQ:YHOO) and SoftBank aren't reflecting the intrinsic value of Alibaba. This is because investors aren't certain of the opaque regulatory practices of the PROC government. Assuming, the IPO goes ahead, without triggering a review process by the PROC, Yahoo! will eventually price in the added value from Alibaba.
Furthermore, if China were to enforce to the spirit of the law, the political relationship between the United States and China would be strained. Protectionism, up to a point may be reasonable, but if in the case Alibaba shareholders are stripped of ownership due to China interpreting variable interest entities differently, the loss for U.S. equity holders would be in the tens of billions based on the size of the IPO filing.
Furthermore, based on the way the Fifth Amendment is worded, in the United States Constitution, property cannot be taken away unless with just compensation. At least according to the Cato Institute's interpretation of the Fifth Amendment:
Thus, owners today can get compensation when title is actually taken, as just noted; when their property is physically invaded by government order, either permanently or temporarily; when regulation for other than health or safety reasons takes all or nearly all of the value of the property; and when government attaches conditions to permits that are unreasonable, disproportionate, or unrelated to the purpose behind the permit requirement.
Of course, this constitutional amendment only applies to the United States on a federal and state level. I don't think the constitution when interpreted includes the jurisdiction of foreign countries. However, this country was founded under the belief that people and companies are entitled to property, and the way the constitution is worded establishes moral ethics.
If you study ethics, a common theme is established as to where fairness originates. Much of the constitution was built around John Locke's Two Treatises of Government, and is generally agreed upon by consensus that this is what's considered to be morally "ethical." Westernization is built upon an ethical belief that what's mine is mine, in other words.
Therefore, if China were to nullify Variable Interest Entities, the political relationship between China and the United States would be severely strained. Many of the Chinese ADRs in the United States are ownership based on Variable Interest Entities, and by China changing its interpretation of law would in turn result in taking away the value of property.
However, in this case, China would be taking away property from U.S. citizens and corporations, which would infuriate U.S. politicians, and may result in counter protectionist measures of its own against Chinese companies, or severely damage trade relations.
Plus, the United States' military industrial complex isn't a joke. Look at what happened when Russia attempted to annex Crimea. I doubt China will be let off the hook if hundreds of billions of dollars in ADRs were lost to due to a change in the way ownership is interpreted by the PROC government.
Fundamentals of Alibaba somewhat appealing
Alibaba has diversified itself into four segments. Overall, the high valuation is supported by above growth rates in both top and bottom line, which is why analysts are anticipating the equity to price itself in the $200 billion to $250 billion range.
Over the past four years, Alibaba has grown its revenue at a CAGR of 50.83%. The abnormally high growth rate comes from its e-commerce, and wholesale platform. The companies cloud business is near non-existent, and isn't very competitive domestically or internationally.
It seems that Alibaba's bottom line growth is significantly higher then top line as the company has been able to improve profit margins. Domestically, consumption growth in China is expected to trend higher, but wholesale growth has flattened in many of its e-commerce outlets.
Selling direct to consumer, and international growth seems to be Alibaba's primary growth channel going forward. Furthermore, Alibaba can continue to build upon its cloud business, and become a major cloud hosting solutions provider in China, or what many multinationals refer to as the Asia Pacific.
Currently, analysts speculate that China's e-commerce needs haven't been fully satisfied, and the amount of infrastructure build out needed will be massive.
According to Reuters:
To cope with the China surge, as much as $2.5 trillion may need to be invested in buying land and constructing warehouses alone over the next decade and a half, according to one builder.
This level of infrastructure build out, assumes that the volume of consumption through online channels will grow exponentially. For now, Alibaba, and it's network of warehouse distributors have been able to manage current volumes. But to take further advantage of this trend in consumption Alibaba is expected to invest aggressively over the next 10 to 15 years, which helps to explain the high valuation to begin with. Furthermore, Alibaba is the primary e-commerce hub in China, with 80% of e-commerce transactions going through Alibaba in some shape or form.
This near monopoly on e-commerce in China, and the rapid rise of projected spending on back-end infrastructure, indicates that we're still in the beginning stages of a massive ramp-up in Alibaba's growth. So even though the stock may be trading at or above 152 times earnings, I believe that the high valuation is merited. Furthermore, Alibaba's business has a high barrier of entry, making it difficult for smaller e-commerce companies to operate, giving it a very strong moat.
Assuming Alibaba successfully raises $18 billion at IPO, it's unlikely that any smaller competitor will be able to match Alibaba's scope of inventory, and scale of operations.
Sure, China can technically interpret the Variable Interest Entity in a way that's heavily unfavorable to U.S. investors. But if that were to occur it would infringe upon morals that have been established centuries ago. Not to mention, it's the equivalence of stealing property from U.S. corporations and returning it to Chinese corporations/citizens.
I doubt, the United States would allow that to happen without severe repercussions, and I doubt China would take the risk. Stealing has been deemed universally wrong ages ago.
Therefore, I have great conviction that the risk factor shareholders should be worried over shouldn't be over the variable interest entity, or the way the company is legally structured. Instead, investors should strictly focus on Alibaba's fundamentals as a business.
Overall, I like Alibaba's fundamentals. The barrier of entry is massive, and Alibaba's capital raise of $18 billion will go towards building out fulfillment centers, which would lower costs, and further improve volume on its various e-commerce platforms. Furthermore, Alibaba has high market share of Chinese e-commerce transactions, giving me great conviction that if investors buy-into this trend early, later on 10-, 15- years down the road, investors will reap a very solid return on investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.