BABAF - Alibaba: Buybacks IPOs And Other Hallucinations

2023-11-17 12:22:38 ET

Summary

• As I had expected, Alibaba continues to be cheap – and I believe it will likely remain cheap.
• The company seems to be rethinking its much acclaimed corporate restructuring and the series of IPOs investors were hopeful for.
• To assuage investors, Alibaba continues to buy back stock and introduced a small dividend, but I see some serious issues there as well.

Reducing Hallucinations

LLMs (large language models) such as ChatGPT have shown remarkable prowess in solving a broad range of problems, yet one of their remaining key issues are so-called “hallucinations”, i.e. their tendency to provide completely false information while sounding perfectly confident and compelling.

This is obviously very dangerous, as it is easy to fall for the perfectly expressed statements from a source we deem to have near unlimited knowledge.

As investors we often face the same problem, as we are confronted with information provided by the most knowledgeable source (company management), presented in a smart and compelling way (think presentation slides). And the sheer amount of information to digest in little time is frequently a problem in itself.

Quite often, the summaries provided by the issuer do actually not represent what investors would take home as key points, but what management would prefer investors to take home .

And, as in the case of Alibaba’s ( BABA ) Q2/24 earnings release , the most important information is buried somewhere in between, leading many analysts on this site to believe, at first sight, that everything was on the right track: Revenues and EPS were roughly in line with expectations, buybacks and even a dividend were announced – so why not quickly reiterate a roaring Buy rating?

Yet, considering how the stock fared following the release (-10%) – and, most importantly, the reasons for the sell-off ? the hastily issued Buy ratings actually resemble such LLM-like hallucinations.

Back in April 2023, surrounded by raging bulls in the midst of a just-announced near-term IPO frenzy, I felt pretty lonely laying out why “ Alibaba Will Remain Cheap One Year From Now ”.

That said, I still came to the multi-faceted conclusion that it could deliver market-like returns, resulting in a Hold rating. Actual returns so far have been much worse: While the market returned 10%, Alibaba is down 17.5% since April.

Hence, if going forward Alibaba delivered market-like returns from its April 2023 level, it would become a solid Buy here. It would require a 33% rally to simply match the S&P 500.

Instead, I decided to keep my Hold rating. Here is why.

The IPO Hallucination

To U.S. investors’ chagrin, Chinese companies have shown no restraint in cancelling IPOs, some even at the last minute. While Alibaba’ Ant Group IPO was cancelled before the fact, in the case of ride-hailing company Didi (DIDI) we might argue the IPO was effectively cancelled after the fact. While keeping the proceeds, of course. Didi’s main listing is now in Hong Kong.

Out of Alibaba’s widely acclaimed division spin-offs, so far only its logistics arm is effectively on track to IPO – in Hong Kong, not in New York. In contrast, those IPOs investors were hoping for the most have been put on hold (Freshippo) or cancelled (Cloud Intelligence Group).

Amid widespread consumer restraint, a grocery business IPO would likely not fetch the best possible valuation at this point in time, so delaying it makes sense.

The case of the Cloud unit is more complicated. A first surprise in this context was that former CEO Daniel Zhang quit just months after agreeing to lead the cloud business. The second one came with Alibaba's Q2/24 earnings release:

The recent expansion of U.S. restrictions on export of advanced computing chips has created uncertainties for the prospects of Cloud Intelligence Group. We believe that a full spin-off of Cloud Intelligence Group may not achieve the intended effect of shareholder value enhancement. Accordingly, we have decided to not proceed with a full spin-off, and instead we will focus on developing a sustainable growth model for Cloud Intelligence Group under the fluid circumstances.

I can’t help but doubt that this is the full story. To me, overall it looks like an attempt to put this unit under tight control (of the CCP?). First, the “right” CEO is chosen; then, after careful consideration, a standalone, public business, maybe even listed in the U.S. is deemed too risky for such a data-rich, military-sensitive thing as a cloud business.

Too speculative a thought? – Well, there is actually a precedent: Ant Group, which had its highly sensitive data trove brought step by step under tight control by the government, effectively expropriating its legitimate owners .

While my readers may disagree with my conclusions, I guess the doubt itself is more than legitimate, given the precedents. And the fact that such doubts are very legitimate certainly doesn't help the multiple.

Moreover, the Cloud unit has been losing market share and experienced a sudden hit to its growth rate over the past few years: It grew revenues only 2% YoY in the most recent quarter, after growing 50% in fiscal 2021, 23% in 2022 and only 4% in 2023.

So there is much more going on than just “U.S. restrictions on export of advanced computing chips”.

Maybe the entire (or almost entire) restructuring will turn out to have been another hallucination? Will Alibaba spin-off any business at all? How can a company contradicting itself so frequently and so rapidly be seen as reliable and trade for a higher multiple? Is there still a realistic path way towards the reduction of the trading discount to Alibaba’s sum of the parts? – These are questions investors should have on their minds right now – and, sadly, there are no clear-cut answers.

The Buyback Hallucination

To assuage investors, Alibaba highlights its enormous share buyback program (almost $15B of buyback authorization in place) and the newly introduced dividend. It will be paid out right before Xmas and represents a small 1.25% yield on the current, beaten-down stock price. Overall, Alibaba will pay out about $2.5B, which is roughly 15% of its TTM free cash flow and 4% of its net cash, so a very, very small part of what it could pay. In addition, so far there is no clear commitment to this dividend, as Alibaba “will continue to review and determine the dividend amount based on factors such as business fundamentals, capital requirements, among others, on an annual basis.” So it might remain small potatoes. And even if it became a steadily growing dividend, it would not really move the needle. The vast majority of the cash generated by Alibaba would remain inside the company, since the company clearly stated on the call that a large one-time cash dividend is not considered.

In addition, “during the most recent quarter the company repurchased approximately 18.6 million ADSs (the equivalent of 148.4 million ordinary shares) for approximately US$1.7 billion”.

While this sounds nice, there are a few caveats to keep in mind:

18.6m ADS represent 0.7% of shares outstanding, so the current annual run rate of share repurchases is about 2.8%. While already a decent amount, the company could certainly do a lot more, especially considering where the stock is trading.

In addition, only very little of these buybacks effectively reach common shareholders, as most of the money is simply spent to neutralize share issuance: According to Seeking Alpha data , over the past 11 quarters Alibaba spent about $28B for buybacks, but diluted shares outstanding shrank only by 6.8%.

When considering longer time frames, things look even worse: Since 2014 shares outstanding have grown 11%, while buybacks cost shareholders almost $40B. This money was effectively shifted to insiders (and then some).

Not only do we have to take into account that the buyback money might not really help common shareholders, we also have to consider that Alibaba buys back only its ADS, i.e. the U.S. listed shares. Over time, this results in a greater proportion of the company shifting to its Hong Kong listing.

Seen together with the Cainiao Hong Kong listing plans (and keeping in mind what happened with Didi), there is some reason to suspect a sneaky long-term strategy at work: While the stock is down, Alibaba buys out American investors on the cheap, while issuing the same amounts of stock (or more) to its employees. This is not "capital returned to shareholders", this is how value is driven home. As I said in my first article on Alibaba: " Some Will Get Rich Before Others ".

The Short-Term Trading Hallucination

As I have always said, there is no doubt Alibaba is cheap: Excluding its net cash of $63B, the company is trading for about 8x earnings. And these earnings include negative contributions from some of its growth businesses.

That said, I reiterate my previous stance, refraining from providing a target price:

If I owned the stock, I would assume the discipline of a short-term trader and move according to my assessment of market sentiment and technicals. Since I believe that Alibaba does not principally exist for the benefit of its shareholders, I am not able to own the stock for the long term.

However, short-term trading is a dangerous business. It would have been easy to assume, given the high-profile encounter between the U.S. and the Chinese presidents, combined with very good results from Tencent ( TCEHY ), that Alibaba would do fine in the near term, carried by the wave of hope for more productive U.S.-China relations. But already before the quarterly release sentiment took a hit from Jack Ma's stock sales, as his family trust is selling off shares worth over $0.8B at depressed valuations. So even the idea that we might profit from the high price volatility to make some “quick and easy trade” might be just another hallucination.

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