Alibaba’s Success Story Has A Sword Of Damocles Hanging Over It – Alibaba Group Holding Limited (NYSE:BABA)

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Alibaba’s success story

Alibaba stock (NYSE:BABA) continues to impress analysts and investors. The China-based company posted outstanding growth on all of its segments, and this is just the beginning. This stock is the story of a company with a start-up like growth, reminiscent to the early stages of Amazon (NASDAQ:AMZN) in 1999.

Because of these similarities, it’s no wonder that Alibaba is seemingly following Amazon’s footsteps business-wise. So, as Amazon taps into groceries and food markets, so will Alibaba with its ventures into India’s BigBasket. As another contributor pointed out already, BABA is consistently taking out pages from Amazon’s playbook.

Source: Paytm Mall, Alibaba may invest $200 million in BigBasket.

Furthermore, the fundamentals continue to strengthen as the company continues beating analysts’ expectations time and time again. The last earnings report was a resounding beat both on the top and bottom lines. It’s therefore no surprise to see analysts raving about how great the company is, with MKM Partners its top pick among internet mega-caps.

MKM Partners considers Alibaba to have the “best fundamentals” of any of the mega-cap tech stocks on Wall Street, raising its 12-month price target on the e-commerce giant.

Source: MKM Partners, as reported by CNBC

Nevertheless, BABA remains the most loved and hated stock on Wall Street at the time. Because although the bull case is compelling, bears – from Chanos to CPA bloggers – have been warning the investing community about accounting shenanigans performed by the company’s accounting team.

Expansion into international markets

All in all, there are two stories for Alibaba. The first one is about one of the fastest-growing mega-cap stocks in the US markets, with many investors pointing out that Alibaba is operating in a market that’s basically what the US was back in the 2000s. And although it is poised for further success and expansion in its domestic Chinese market, management has hedged the company against the eventual slowdown by expanding into the nearby international markets.

News about the company expanding into Malaysia via a partnership with Starbucks (NASDAQ:SBUX) to set up an e-commerce hub and its venture into India’s grocery market is just the beginning as this giant continues to grow into international markets. Also notice how Alibaba is expanding into Europe by cementing a logistics center (a crucial part of its business) into the strategic location of Bulgaria, all of these moves signal further expansion for the company. But at the end, it’s obvious that at some point Alibaba and Amazon will eventually battle each other for growth.

Source: Shunde Marriott Hotel

But the company’s growth won’t stop there. It’s also entering the tourism market by starting partnerships like the one with Marriott (NYSE:MAR) hotels. Chinese tourists will make more than 700 million visits yearly, and most of them are tech-savvy, which positions BABA at the center of a potentially huge market with its travel service platform, Fliggy.

So, although it’s not going to be a significant revenue contributor anytime soon, the company is positioning itself very well so far. Each holiday the traveling business grows even bigger, and if Alibaba manages to capture this somewhat untapped market because of the digital revolution, it could mean millions of dollars more in additional revenue for shareholders just from the Asia region. Imagine worldwide!

Aliyun and Alipay

All of this expansion is on the back of two components: its cloud business and online payments.

Aliyun (Yun means cloud in Chinese) is at the center of this new expanding market. Although the biggest competitor remains Amazon, in the future this segment could become one of the company’s leading drivers for revenue growth.

Wikibon is predicting enterprise cloud spending is growing at a 16% compound annual growth (CAGR) run rate between 2016 and 2026.

Source: Wikibon report

Source: IDC, 2016

So, if Aliyun experiences faster-than-expected growth (which is likely given it’s the main Chinese competitor), then this could become another huge positive factor for the company.

Also, Alipay (Alibaba’s PayPal) continues to experience great growth. In fact, the online payment revolution could end up replacing conventional banking in the future. As it stands today, Ant Financial Services Group (Alipay) is the world’s largest mobile and online payment platform.

All of these factors put together tie themselves very well into Alibaba’s primary business.

E-commerce revolution

When compared against China’s National Bureau of Statistics, Alibaba’s GMV (Gross Merchandise Value) figure was about $176 billion. In other words, GMV accounted for 92% of all of the country’s Online Retail Consumer Physical Goods.

Furthermore, the Chinese e-commerce market is forecasted to grow another 50% to approximately $1.5 trillion in sales by 2018. So, this segment (Alibaba’s primary segment) is operating in a market that is growing at an astonishing pace. This figure alone basically guarantees another year of at least 50% growth year over year for Alibaba’s shareholders, since it virtually owns the Chinese market.

Because of this, the e-commerce segment contributed with over 85% of the company’s revenue for the last quarter. So, as long as this section keeps growing at this pace, investors should continue to reap profits. Add to that the growing Chinese middle class, and you have a recipe for massive success as a company.

It is for these reasons that online retailers are well positioned to venture into the online grocery business. And we’re starting to see significant moves by the biggest companies already.

Online Groceries

Think about the following quote:

Online food and grocery penetration is still less than 1%, suggesting the infancy of the category and its potential opportunity.

Source: Tata Group to enter online grocery business with GrocerMax acquisition

To me, this signals again another multi-billion dollar untapped market for online retailers, particularly Alibaba. Thankfully, it’s already following Amazon’s footsteps on this issue, and it’s aiming to transform the Chinese online grocery market with the introduction of Tmall Shops.

“These Tmall shops will be a supermarket, a post office, a travel agency, or even a community bank…”

Source: Lin Xiaohai, vice president of Alibaba

Tmall logo

So, there are massive opportunities for online retailers on this segment. According to Morgan Stanley, the food and grocery sector will have a CAGR in India of 141% by 2020 and will contribute $15 billion, or 12.5%, of overall retail sales. It’s reasonable to expect that we’ll see similar growth in the developing markets, particularly Asia, which is in focus for Alibaba.

As a side note, it’ll be useful to continue to watch whatever Amazon does, since Alibaba seems to copy its every move, for e.g., buying South China Morning Post (like Bezos bought the Washington Post). So, since Amazon doesn’t appear to want to further disrupt the lower amount of foot traffic at Whole Foods by turning it into something very different from what it was, Alibaba will most likely follow suit with Tmall.

At any rate, it seems that the company is taking its approach to this new segment. In the past two years, it has invested a total of $8 billion into the expansion of brick-and-mortar stores through a series of investments and acquisitions. Apparently, since Alibaba doesn’t hold inventories, it’s able to maintain ample margins that translate into hefty profits for shareholders.

It’s worth noting that most of these partners are “mom-and-pop” shops. The average store owner is 45 years old or older, works 12 hours a day and makes a meager income, according to Alibaba. Also, 70% of them operate in tier 3 and tier 6 cities.

Performance and Valuation

Alibaba stock is up almost 100% YTD. Source: Google Finance

Alibaba continues to enjoy a start-up-like growth rate. At some point, this should slow down. But it doesn’t seem to be imminent in the next few years, given that China is still an untapped market and the rest of Asia is full of possibilities.

So, from a financial perspective, a potential plateau is not yet on the cards, but remember, many valuation models for Alibaba are based on DCF (discounted cash flow) valuations, and if any slowdown (for any reason) were to occur, the company could face sharp revaluation given its generous price.

Still, for as long as the primary e-commerce segment continues to grow at a 50%+ rate, investors should do very well.

At this rate, Alibaba should become a $1 trillion market cap stock eventually. In fact, if it keeps doubling in price for the next year and a half, it’ll probably be the first US company to reach that mark. Remember, the GMV market is at a $500 billion mark at this point, but CEO Jack Ma hopes to lift that metric to $1 trillion by 2019. This increase would essentially double BABA’s revenue in two years (at least). So, the stock still holds much upside left in it.

It’s worth noting that currently Alibaba sports a $425 billion valuation. Some have argued that if the company were valued at its average five-year P/E ratio, the stock could easily be worth at least $220. Also, keep in mind that even MKM’s target of $220 could prove to be conservative, because if Alibaba continues to such impressive growth in the future, it could surpass a $1 trillion valuation easily in the next few years.

Alibaba’s sword of Damocles

At this point, I can’t blame anyone for wanting to invest into BABA hand over fist. After all, it seems like this stock could be even better than Facebook (NASDAQ:FB) or Amazon in their early stages. But can it be too good to be true?

Source: Richard Westall‘s Sword of Damocles, 1812

Alibaba seems to be a very complicated company when you look at its financials. If you go to its latest 10-K, you’ll see that the company is in many ways a conglomerate. Other enterprises, such as Berkshire Hathaway (BRK.A, BRK.B), are structured similarly. However, the problem with Alibaba is its disclosures.

On top of that, since this is a China-based company, it’s even more suspicious of this sort of behavior from its accounting team.

“China’s financial markets remain so opaque there are serious questions about whether investors are receiving basic protections”

Source: Senator Bob Casey, a Pennsylvania Democrat who raised concerns about Alibaba and Chinese IPOs in 2014

For example, as previously mentioned, Alibaba handles about 92% of China’s GMV, or in other words, its online Retail Consumer Physical Goods. According to China’s National Bureau of Statistics (NBS), these sales grew at just 28.6%. The problem is that Alibaba’s primary revenue driver comes from this market that grew at only 28.6% but somehow managed to post top line growth of 56% for the quarter.

This revenue growth would seem very unlikely because of only the law of large numbers. The company had to double the revenue per online transaction somehow to accomplish this feat – something that on such a large scale would seem impossible. Even more dubious when you realize that for Alibaba to report a sale, it does not necessarily have to be closed on the platform, it just needs to be somehow “reported as closed.”

Also, there’s the issue that Alibaba doesn’t seem to consolidate its losing subsidiaries into its financial statements. In other words, the company has paper losses that haven’t been accounted for – at best they only have side notes or merely tables on the reports, but they are not presented and accounted for in the company’s bottom line.

For example, take Alibaba Pictures, which is a publicly traded company in China. Since this is an Alibaba asset, it has to be accounted for in its balance sheet, but the problem is the method of its accounting. In this case, instead of using the traditional (and prudent) mark-to-market method, the company chose the carrying value approach. In other words, what it paid for the investment.

In this case, Alibaba Pictures is traded at about half what Alibaba paid for it. Nevertheless, this loss isn’t reported, only disclosed. This situation occurs because it’s accounted for as how much it paid for the asset and not how much it’s currently worth on the market.

Source: Google Finance

As you can see, the company has faced massive devaluation. The decline showed in the figure above would represent a $2.1 billion loss for Alibaba. But this loss didn’t hit its bottom line because of accounting magic.

And the list goes on, because Alibaba Pictures is only one of many businesses that the company doesn’t value at the current market price, but rather its made-up carrying amount. Other subsidiaries (all currently presenting paper losses) are Alibaba Health, Koubei, Cainiao, et al.

Source: Alibaba FYE 2017 – 20F

This situation is even more worrying when you add up all the Investment Securities, Goodwill, Intangibles, Land Use Rights and Investments in Investees (like Alibaba Pictures). This figure amounts to roughly $44 billion, which represents 56% of the company’s total balance sheet. But it’s even more unbelievable when put into context that at the time of the IPO, these same items totaled almost zero in the balance sheet. In other words, close to half of the asset growth for Alibaba (as presented on its balance sheet) has come from accounting magic.

Conclusion

There are two tales for Alibaba.

One of a company with a visionary CEO and start-up like growth. With Alibaba taking over the world in just a few years, and the growth is just starting.

The other one about the most shorted stock on Wall Street, and I don’t think it’s because it acts as a proxy hedge as others have pointed out. I believe the reason is that it could very well be the next Enron.

All in all, I can’t advise anyone to short the stock based on this, because SEC investigations take years to conclude. Neither rating agencies will sound the alarm (Enron had a Buy rating before it went bust). And even if Alibaba’s success story is a scam, it still has a lot more options to continue the show running for a while and many ways to raise more cash, if needed (i.e., the Ant Financial IPO).

Nevertheless, it’s undeniable that there are a lot of dubious accounting practices at Alibaba. However, Wall Street loves a good story, and right now the prevailing narrative is bullish with no end in sight. But if indeed there’s a scam and the whole show ends badly, the stock could very well take a tumble back to double digits in just a few days.

Because of these reasons, all I can say until the SEC investigation concludes (Alibaba’s Sword of Damocles) is caveat emptor.

I wish you the best of luck in your investing.

Disclosure: I/we 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.



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