Alibaba: Don't Pay 31x Earnings To Own A Black Box
- BABA skepticism continues
- Given the track record of foreign domiciled companies listed in the U.S., we believe skepticism is warranted and should be the default mindset for investors
- With tens of thousands of available instruments to invest in across U.S. markets and exchanges, there's no need to own Alibaba
By Parke Shall
It has been years that companies based overseas have been listing on the US and Canadian stock exchanges and over the course of this time a number of companies were found to have committed fraud.
For instance, there was the case of China domiciled Sino Forest where,
[The company faced] a hearing before the Ontario Securities Commission, which has alleged that they committed fraud. The company collapsed after a short-seller alleged in 2011 that it was a Ponzi scheme that could not account for its stated $3-billion in timber holdings in China.
There was also the case of China domiciled Puda Coal where,
Puda admitted it was basically a worthless shell company, court filings show. Its shares plunged in value on April 8, 2011, and the New York Stock Exchange froze them a short time later.
If you have the time and would like to do some reading on countless other examples of foreign domiciled, U.S. listed frauds, you can click this link.
And one of the common denominators between all of these companies wasn't only just that they were ripping off those buying their ADRs in the US market but also that nobody seem to understand exactly how these entities were set up to be public in the United States. No one understood the reverse merger and nobody understood that because these companies were outside the U.S. they were basically outside of the jurisdiction of U.S. regulators.
For instance, not many people understand that foreign filers are exempt from Regulation FD. A lot of investors also don't understand that owning shares in a VIE or owning depository receipts is not the same as owning shares of common stock of a United States corporation. Shareholders have significantly less rights, as detailed in this Forbes piece from 2012,
Variable Interest Entity ("VIE") structures were first introduced by Chinese companies listing in the US as far back as the year 2000 when SINA had its initial public offering on the NASDAQ. Effectively the VIE structure means that equity holders have a somewhat indirect financial interest in the revenue and earnings stream and do not actually have a claim on the assets of the company in question.
In any event, it should be noted that the use of VIE structures was explicitly designed to circumvent foreign investment in certain industries and companies. It has been a clever solution, but obviously the Chinese government is well aware of the practice and is said to be evaluating the use of VIEs going forward. The Chinese government has never explicity approved the use of VIE structures, but likewise it has not yet explicitly disapproved of their use either. As of August 2012, the consensus opinion among investors seems to be that China would be unlikely to take restrictive actions against existing companies which are structured as VIEs simply due to the fact that there are so many of them in existence and due to the fact that the financial interests involved are already massive. For example, Baidu (BIDU) alone has a market cap of nearly $50 billion and happens to be a VIE. However, the likelihood of government action restricting future use of the VIE structure is seen as being increasingly likely.
Given the amount of immense opacity that comes with these types of companies, we believe that all foreign domiciled US listed companies should trade at a significant discount to peers. Not only does the discount handicap the lack of shareholder rights and the opacity when it comes to understanding the business, and also handicaps an increased level of opacity for auditors and uncertainties due to major geographical differences.
With that said we want to turn our attention to an interview last week that didn't get nearly as much attention as we believe it should have. Former CNBC contributor and noted skeptic Herb Greenberg has been critical of Alibaba (NYSE:BABA) for some time now.
Often he has argued that the company is a black box of sorts and that investors may have significant difficulty in the future unwinding what appears to be a neverending chain of subsidiaries and parent companies that make the company even more of a black box than it would normally be just as a foreign listed name. Over the course of time that Herb has been critical publicly about the company, shares have risen significantly. Not only have shares appreciated significantly, but the US market assigns them with a PE multiple as if they were a US listed company. For instance, right now, Alibaba's PE is 31x, as you can see from the chart below.
This is a PE multiple you would expect from a robust and steady United States based company that is transparent and has a firm operating history to fall back on. In reality, what's happening is the market is putting this multiple on a company that really is somewhat of a black box. It's not based in the U.S., it does not need to adhere to Regulation FD, and visibility for U.S. investors is limited. Can we assume another 31 years of cash flow and operations at, or above, the company's current run rate? At a 31x PE, this is essentially what the market is pricing in.
We have argued also in the past that investors should be skeptical of Alibaba, most recently after Jack Ma told U.S. investors they simply didn't understand the business. We stated,
The United States capital markets are available to Mr. Ma for his convenience, but there is a standard in which Mr. Ma must meet and there are answers and disclosures that he owes to American investors and the exchange he is listed on. Instead of making dismissive comments, Mr. Ma should be thinking about what he could do to improve disclosure at his company.
Also, instead of encouraging this nonsense from Mr. Ma, US retail investors and institutions should be holding this company's feet to the fire and demanding answers, refusing to invest in the company or give them investment bank business until the company has done so. Everyone that is a part of the system that has allowed Alibaba to continue after these comments have been made are doing the United States capital markets a disservice.
Granted, we have been wrong if you shorted the stock at the time, which has risen in value since then. We are not coming out and saying that Alibaba is a fraud. We are not even saying that the company is materially misleading investors. All we are saying at this point is that given the concerns of noted market skeptics and the company's status as an Asian domiciled name, Alibaba could trade at a multiple which is a fraction of its current multiple and, to us, still be trading with a valuation that makes sense. The only thing stopping BABA from trading at 15x instead of 30x is confidence. How long can BABA keep investors' confidence?
Mr. Greenberg is a long-standing veteran of the financial industry. His skepticism in the past has often been found to be 100% warranted. He works alongside of a forensic accountant whose background is one of the best in the industry. Just to affirm, and his resume includes a PhD in accounting, a M.S. in accounting, a B.S. in business, a certification as a fraud examiner, a C.P.A. designation, 13 years as an accounting professor and 21 years developing quantitative models.
Similarly, short seller John Hempton, who also has an excellent track record of identifying fraud, has raised significant questions about Alibaba in the past, not just about the company's accounting but also about its logistics setup and its supply chain. We would encourage you to read his comments as well.
Finally, recall that months ago it was disclosed that the SEC had launched a probe into BABA. The Wall Street Journal reported,
Federal regulators are investigating the accounting practices of Alibaba Group Holding Ltd., the e-commerce giant whose blockbuster U.S. stock-market debut helped win a wide following for Chinese tech firms.
The company disclosed Tuesday that the Securities and Exchange Commission asked Alibaba to provide details of its accounting for a delivery affiliate, its operating data for the largest online shopping day of the year, and "related party transactions in general."
In the company's latest 20-F, it confirmed the investigation was ongoing.
It isn't always that when there is smoke, there's fire, however we believe that where there is smoke there should at least be a handicapping of the respective company's valuation. In this case, we simply have just not seen that with Alibaba. In fact, we have seen the opposite. We would avoid shares based solely on the skepticism of some of the bigger names in the industry, but we would also avoid shares because there is also essentially a put option on the company's valuation, wherein the market at any point could decide to rope in the multiple in the case of an economic downturn or more pronounced skepticism about the company.
Don't pay 31x earnings for a black box.
This article was written by
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