Alibaba: Excessive Stock-Based Compensation Is Damaging Shareholder Returns

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About: Alibaba Group Holding Limited (BABA)
by: The Growth Guy
Summary

Alibaba's recent earnings report was positive on the whole, and their 40% revenue growth should be praised in light of the headwinds facing the broader Chinese economy currently.

Despite this, there were some issues that concerned me, with the most notable being the vast increase in stock-based compensation - up 37% YOY.

Although I am fine with rewarding management when praise is deserved, the flat share price over the last year makes me question whether their and my interests are aligned.

I plan on continuing holding due to my belief in the company's great potential but plan on carefully monitoring this number in the future.

On January 30th, Alibaba released their earnings for Q4 of last year. On the whole, their numbers were very strong when the recent weakness in the Chinese economy is taken into account. Most importantly, for me, the 84% growth in their Cloud Computing segment is outstanding, and I believe this is what will drive the overall business's growth over the coming years. A positive sign is that although revenue growth is so high, they continue to operate at a break-even level, suggesting that it should be able to make a profit in the near future.

Due to this, Alibaba has been mentioned in an increasing amount of bullish articles on Seeking Alpha which all mention how fundamentally undervalued Alibaba is. As an investor myself, who has also been very vocal about my love for their business model, much of this felt old to me. After all, the business has been growing at start-up like rates for many years now, and yet the current stock price is equal to that of September 2017.

If it isn't the business that is lacking, then another factor must be at play that is suppressing the share price - apart from the usual problems such as competition and the Trade War. After looking more carefully into their earnings, I believe that one of the biggest culprits is their spending on stock-based compensation (SBC), which after being mostly flat throughout 2016 and 2017 has seen a significant spike over the last year. This doesn't mirror their performance in the slightest, with the share price underperforming the market over the past year, costing shareholders around 105 billion.

Not only has this impacted their overall profits but highlights that management interests are not fully aligned with shareholders. This isn't a positive sign and is certain to erode shareholder returns if it continues, which all investors need to take into consideration since it explains why some sort of discount, when compared to its peers in the west, is likely warranted.

The cost misaligned interests

Before I jump to conclusions, let us examine the details of the earnings report that I am mentioning:

(Source: earnings report. Please note that although the SBC is added to the Adjusted EBITDA, this is since the report accounts for it as if it is a non-recurring expense. Unfortunately, this accounting trick is common and meant to hide the costs of SBC, despite this definitely being a recurring expense. For more information, click here)

As I have highlighted, SBC has increased from 5.1 billion yuan to just under 7 billion in the last year, a 36% increase YOY. While this is not unprecedented, with the growth rate being far higher in 2014 and 2015, this is mainly due to the company going public, and so there is more of an incentive to give employees stock options. If we only focus on the last few years, which I believe gives the most accurate representation about what we can expect in the future, then it is clear that the growth rate is accelerating.

Now, this could easily be a one-time occurrence, and growth rates could return to those of beforehand. If this is the case, this is a small issue at best and could just be coincidental. Yet, the fact it occurred on a down year for the stock does line up very well with my argument - that management wished to increase their returns due to them not receiving as much from stock appreciation. Furthermore, this event would also cause dilution, which would further weaken the stock price.

Another point worth noting is that, on a whole, SBC should be expected to stay in line with the total growth in the company, leaving the amount allocated to compensation level in percentage terms. If we were to look at the revenue numbers, these figures do seem reasonable, with them growing an almost equal amount. The problem with this is that over the long term, a business's valuation is the discounted value of its future cash flows, and in Alibaba's case, its income from operations has grown by only 3% since last year (look at income statement above.) This means that it is giving more as a percentage of net income to management than before, which will ultimately mean there is less money to be reinvested over the long term.

It's not all bad news

Despite all that I have said above, there is some good news. According to SEC filings, there has not been any insider selling (or indeed buying) over the past 12 months. This suggests that even if management is trying to boost their income using stock options, they are still keeping their money in Alibaba stock due to it being undervalued. This also means they still have a significant reason to focus on shareholder returns in the future as they have "Skin in the game."

Valuation

As I previously mentioned, from a purely fundamental perspective, Alibaba's stock price is at its cheapest point in recent memory, which is why I am still bullish on the stock currently. For example, although its earnings haven't increased, its PE ratio is still fairly low when compared to recent history.

Chart Data by YCharts

Furthermore, they continue to grow revenues off the back of the growth in the Chinese market, which, although slowing, is still nothing to laugh at over 6%. They are also very well positioned to take advantage of the continued growth in both SEA (Southeast Asia) and India, which still have a large runway ahead of them due to their favorable demographics. This is seen most clearly in their price to sales ratio, which is currently very cheap.

Chart Data by YCharts

This is why I believe that, at present, current shareholders should definitely hold their position, and it is still one of the best ways to invest in the Chinese market with lower risks than many other names. Especially with some strong catalysts on the horizon that should propel Chinese stocks, such as a possible end to the Trade War in March, this is a good time to be exposed to the Chinese market in your portfolio.

Conclusion

From a business perspective, this quarter was pretty good, and it is understandable why they have received mostly praise. As investors, it is crucial that we do not look at companies with rose-tinted glasses, and I believe this is one of such times where we should realize that, unfortunately, management is human and may at time operate with their own interests in mind, not that of shareholders. This is a number that I will be carefully monitoring over the next few quarters, to see whether this is small or a bigger issue that could signal a more worrying trend.

Disclosure: I am/we are long BABA, JD. 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.