The following research executive brief is authored by Ms. JIANG Lingjun from the Singapore Management University (SMU) Emerging Markets Club. KB Kee, managing editor of The Moat Report Asia and adjunct faculty (accounting) in SMU, is the Club advisor.
Alibaba Group Hollding Limited is an online and mobile commerce company. The company operates its ecosystem as a platform for third parties. In addition to its three China online retail marketplace, named Taobao Marketplace, Tmall, and Juhuasuan, Alibaba also operates Alipay, which is the most popular third-party online payment solution in China. Alibaba group’s revenue was USD6.73bn in 2013, up 65% compared with the USD4.08bn in 2012 (figure1). Meanwhile, Alibaba gained a net profit of USD2.85bn in 2013 , up 400% YoY; and for the first year, its net profit surpass its biggest competitors, Baidu and Tencent by USD1.41bn and USD0.41bn respectively. Amongst Alibaba’s various business, advertising has been the major source of revenue, as it has been contributing over an half of the total revenue in 2012 and is expected to reach 55.8% in 20131. The company smashed records with the largest public offering in US history, and it has achieved to be as valuable as Facebook after just one day on Wall Street.
Strong Market Position
Alibaba enjoys significant market position. Alibaba has a strong portfolio of Internet assets, its Taobao Marketplace, Tmall and Juhuasuan have a dominant position in their respective ecommerce segments. The company’s Taobao Marketplace holds a 90% share of the C2C market in China and Tmall accounts for 54% of the B2C market. The company’s market share is well above the 360Buy’s market share of 20.1% and Tencent’s 4% by the end of second quarter of 2012. In addition, the company’s Alipay is the most widely used third-party payment solution in China with more than 800m registered accounts as of December 2012 (figure 2). Strong market position indicates that the company has access to a large market, which is a competitive advantage. With the largest market share, Alibaba could enjoy economies of scope, which is achieved by offering different products through the same sales channels; as well as the economies of scale, which is achieved by a larger volume of sales. More importantly, market leadership allows Alibaba to enjoy the benefits arising from an expanding users base with positive sameside network effect. As a result, by gathering more attention from both sellers and buyers, Alibaba could benefit from earning more advertising revenue, which might otherwise go to the search engines like Google in the West. In addition, expanding network also helps Alibaba overcome one of the trickiest e-commerce hurdles, which is trust from the consumers. The old Chinese culture makes Chinese consumers reluctant to trust strangers, hence Chinese consumers certainly were not going to buying anything online from complete strangers. However, the popularity of Taobao and Tmall makes consumers less hesitant, because of the positive peer reviews that the company enjoys.
Ambition Plans to Build China Smart Logistics Network
Like other players in the online retail market, Alibaba is also facing distribution problems as the fragmentation of the Chinese logistics sector has undermined the value proposition for customers. As a result, they took an active role to confront the issue. Unlike 360Buy, Alibaba never wanted to build a logistics system on its own. Instead, it aims to take advantage of the existing logistic networks and capability. On January 2013, they announced a RMB100bn first phase investment in an unprecedented project, known as China Smart Logistic Network (CSN) program. Led by Alibaba, this project is joined by several major express delivery companies like Shunfeng, Yuanfeng; and financial institutions like China Yintai holding, Fosun Capital. Once completed, CSN program will be able to support an average daily transaction volume of RMB30bn, and will allow customers across China to receive their online orders within 24 hours. The plan is to choose 8 places in China to be the first-hub, then subnetworks will be formed around these hubs, so that the entire network could be cover the whole country. With the effect of this 24-hour nationwide delivery service, it will bring more users to Taobao platform, and even enable perishable foodstuffs to be sold directly to the rest of the country without going through layers of intermediaries. Unlike 360Buy, Alibaba holds the belief that given the vast geographic spread of the China market, it is impossible for any individual company to build a gigantic logistics network with national coverage to address all the logistics demands internally. By involving players from logistics and online retail industries, not only the capital investment will be less for each participators, it also solves the problem that online retailers faced with the lack of logistics know-how.
Since the project is conceived as an Open Logistics Platform, all the online retailers who participate and invest in this project can openly share facilities and logistics data. Most importantly, being the largest investor of CSN program, Alibaba will manage the whole process as the provider of a central supply chain, which will definitely grant the company with significant power to control the whole industry. According to Alibaba, the Smart Logistics Network will be able to process 10 times the current volumes of today’s online purchase, which worth RMB30bn.
Team up with Huawei – Alipay Mobile Payment
Alipay has already built the largest users base in China, and is considered as one of the safest ways to make online payment in China; yet the company is still aiming for a larger market. In response to the rising mobile payment market, as well as consumers’ concern over the mobile payment security, Alibaba has announced a way to make its payments service, Alipay, even more secure on a smartphone. On 2 September 2014, Alipay introduced the fingerprinting technology in a deal that is linked with smartphone manufacturer Huawei. Alibaba will be introducing a e-payment app named Alipay Wallet to handle online-to-offline payments, and it will be integrated into Huawei’s soon-to-be-launched smartphone, the Mate 7, which boasts biometric security technology. To reassure consumers about fingerprint readers, Alipay notes that the fingerprint data is saved on the phone, but will not be accessed by any other third-party apps except for Alipay Wallet. This can be seen as the first step for Alipay in assuring its mobile users of the security and convenience of paying via its wallet app. This could very well kickstart the adoption of fingerprinting technology for payments in China, the world’s largest smartphone market.
In conclusion, Alibaba’s strong market position is likely to maintain with its upcoming projects that seeks to circumvent the industry’s challenges and ride upon the waves of opportunities.
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The following article is extracted from the Bamboo Innovator Insight weekly column about the process of generating investment ideas among wide-moat businesses in Asia. Each month, an in-depth presentation on one such business is featured in The Moat Report Asia.
“This is a huge international scandal,” Wang Donglei, the newly-appointed chief executive of China’s largest lighting and energy-saving lamp manufacturer, roared at a conference call on last Monday 17 Nov about the accounting fraud committed by the firm’s founder and controlling owner. “These banks misled the company and investors with false information. They did illegal things. These are major banks listed in Hong Kong. The embezzlement is being investigated by Chinese police.”
Last Monday is also the opening day of the much-anticipated Shanghai-Hong Kong Stock-Connect “through-train” door, creating direct access for foreign investors to one of the largest stock markets in the world with a combined value of $5.6tr. By expanding beyond qualified foreign institutional investors and sucking in new investment into Shanghai-listed stocks, the Connect was supposed to lower borrowing costs for mainland companies.
Could the prevalence of accounting fraud put the Connect at risk? Through the cases that follow, value investors need to be aware of a particularly brazen form of accounting fraud in which controlling owners use intercorporate loans to siphon off or tunnel out cash. Similarly, in Australia, intercorporate loans helped to facilitate the building (and later collapse) of the Alan Bond empire when the accounting fraud unravel. Descriptive cases detailing chronological events can inform about the fraudulent accounting acts after they happened but are inadequate in staying ahead of the devil who will invariably develop more sophisticated methods to escape detection. Thus, value investors need to out-think the devil – by first going back in time eight years ago to Nov 7, 2006 to understand the importance of the “Eight-Ministry Joint Announcement” that managed to curb accounting tunneling fraud, albeit for a short-while – and importantly, how controlling owners adapted the rule to continue their expropriation acts. Importantly, we spell out the urgency of top accounting researchers-practitioners and regulators to develop a composite measure to detect tunneling acts to alert and prevent “live” cases of corporate abuse instead of fighting fire with “forensic accounting” of “dead” companies in which the harm had been done. But first, let’s get back to the recent cases of accounting fraud and examine their hidden footnotes.
NVC Lighting (2222 HK) - Stock Price Performance, 2010-2014
Wang alleged that Wu Changjiang, the founder and former CEO of NVC Lighting (2222 HK, MV $709m) whom he had ousted in August, had embezzled funds totalling RMB623m ($101.7m) on behalf of a company subsidiary. Employees of four leading Chinese banks – Bank of China (BOC), ICBC, China Construction Bank (CCB), Minsheng Bank – who “conspired in the crime of diverting and defrauding” the company’s funds were also under police investigation. NVC stock has been suspended since 11 Aug when Wu was expelled on 29 Aug from the company. NVC’s products are said to be used in the 2008 Beijing Olympics and 2010 Shanghai World Expo, and Wu is also a prominent entrepreneur featured by BBC, thus attracting reputable investors including private equity firm SAIF Partners, Goldman Sachs and French electrical systems giant Schneider Electric (SU EN, MV $46.7bn) when it was listed in May 2010 raising $196m in a deal underwritten by Goldman Sachs and HSBC. Schneider had invested HK$1.27bn ($163m) in Jul 2011 for a 9.1% stake in NVC.
In the week before the official launch of the Stock Connect, Wison Engineering Services (2236 HK, MV $450m) saw its share price plunged by nearly 60% in a day when its suspension for over a year was lifted on 12 Nov. Wison is a vast engineering-services empire controlled by its founder and billionaire Chairman Hua Bangsong, one of Chinese richest man. Wison builds refineries and chemical plants for domestic and international oil companies that include PetroChina and BASF. Wison was said to have obtained China’s highest certification to undertake petrochemical engineering work in 2007 when it bought a licensed, but near-bankrupt, quasi-government institute in Henan province. The 48-year old billionaire has not been seen since he was detained by Chinese investigators in Aug on bribery charges. Since the arrest, the company warned investors that it could post a “significant loss” for 2013 and might default on bank loans that total around $215m. Wison had earlier raised $195m in its IPO in Dec 2012. Similarly, when the billionaire chairman of Agile Property (HK, MV $bn) was taken into custody at end Oct by authorities, the disclosure was a shock to Western banks that had lent money to the company.
Wison Engineering Services (2236 HK) - Stock Price Performance, 2012-2014
Accounting fraud of Chinese companies are often long-running and not taken seriously with lax punishments meted out in the civil courts in the form of fines and no criminal charges. Last year, regulators found that Wanfu Biotechnology Agricultural Development (300268 CH) had overstated its financials for four years in a row, adding RMB740m ($120m) to its revenues. Ping An Securities, which brought Wanfu to the market, had its underwriting privileges halted for three months after the fraud came to light. China Securities Regulatory Commission (CSRC) also fine Minsheng Securities RMB2m for failed due diligence in Shanxi Tianneng Technology’s attempt to launch an initial public offering in 2011. It also gave a warning to Nanjing Securities for a similar violation when it advised Guangdong Xindadi Biotechnology in 2012. Both IPOs were halted after frauds were uncovered. Tianneng and Xindadi provided falsified financial information in their offering documents.
Underlying the accounting frauds at NVC, Wison etc is the use of intercorporate loans to “tunnel out” cash and assets from the firm. During 1996-2006, tens of billions in RMB were siphoned from hundreds of Chinese firms by controlling shareholders. Typically reported as part of “Other Receivables”, these intercorporate loans did not accrue interest and the principal was typically never paid back. A string of security regulations issued between 2001 and 2006 was largely ignored, primarily because market regulators had no jurisdiction over the controlling entities.
It took a joint statement on Nov 7, 2006 by eight government ministries threatening public disclosure and personal action against top management of the controlling entities to finally stop the abuse – albeit for a short while. Collectively, these agencies had the power to ensure top management of controlling shareholders will be arrested if necessary. By the Dec 31, 2006 deadline, 399 listed companies managed to resolve Other Receivables balance. Another 17 companies, with balances totally RMB9.2bn, failed to resolve their loans. In ten out of these 17 companies, top management of the controlling/colluding entities was arrested. Thus, this unusual show of political resolve resulted in the repatriation of most of the Other Receivables which amounted to close to RMB50bn at the end of 2006.
In the case of NVC, most value investors would have missed out Footnote 17 “Investments in Subsidiaries”, amounting to $114m in FY2010 (the IPO year), since it is not made as a reference in the Consolidated Balance Sheet. This amount corresponds roughly to the embezzlement amount of $102m by NVC’s founder Wu. For FY2010, we can observe that the net amount due from “subsidiaries” is over $28m and they are “unsecured, interest-free and are repayable on demand or within one year” and they should be classified as Other Receivables. Yet, the Other Receivables is understated at $9.1m.
These “subsidiaries” are often disguised forms of “Other Receivables” and are consolidated into the balance sheet as holding vehicles for artificially-inflated “Other Intangible Assets”, “Goodwill”, “Prepayments”, “Property, Plant and Equipment” (typically land use “rights” which are essentially “loans” given to local municipal government officials in exchange for inflated asset valuation), “Other Non-Current Assets” and even “Cash Equivalents”. As we have previously discussed in earlier articles with various examples of Asian companies, part of the cash that are tunnelled out are brought into “setup” companies disguised as customers and re-enter the listed vehicle as artificial sales generated, leaving behind the accounting transgression thumbprint which we will not repeat discussing here.
At NVC, of the $182.7m cash, $116m are non-pledged time deposits which are potential disguised Other Receivables and the $116m also correspond coincidentally close to the $114m Investment in Subsidiaries. The “healthy” $36.8m operating cash flow in FY2010 will be negative $20m when $56m of “time deposits”, classified under cash flow from investing activities, is rightfully classified under cash flow from operating activities. All these tunneling acts in cash outflow derive their source of inflow from the external funds raised, namely from the $201m raised in the IPO during FY2010. NVC’s auditor is Ernst & Young.
In the case of Wison, Footnote 34 shows Investment in Subsidiaries and we can observe that the amount due from subsidiaries has exploded from RMB61m in FY2012 to RMB959m in FY2013. Note that the source of cash inflow is derived from the RMB1bn raised in its IPO during FY2012. Unfortunately, this sharp rise in this “Other Receivables” amount by nearly RMB900m does not re-enter back into the listed vehicle as artificial sales generated but is totally tunnelled out. “Cash” balance has fallen by over RMB1.1bn in FY2013, along with gross amount due from contract customers which also mysteriously declined by the same corresponding amount of RMB1bn. And again, it was revealed that the gross amount due from contract customers include advances to suppliers amounting to RMB216m in FY2012, which should be classified as Other Receivables, and surprisingly, the amount of advances to suppliers in FY2013 was not disclosed in the Annual Report 2013 – the auditor is Ernst & Young. As a result, sales collapsed by RMB1.2bn in FY2013 and the highly profitable Wison registered a steep net loss of RMB513m in FY2013 as compared to RMB636m, RMB589m and RMB534m in net profits in FY2010, FY2011 and FY2012 respectively.
The accounting and economics of tunneling provide an important organizing framework for interpreting “propping” acts in which the controlling shareholders instigates favourable asset-related transfers to “prop up” the earnings of a firm to excite the market with corporate event announcements that include IPOs, SEOs, earnings announcement etc. Such propping actions are needed to facilitate and sustain long-term tunneling. In the absence of tunneling incentives, such costly forms of earnings management are difficult to understand in the eyes of the western investors.
As we have discussed, intercorporate loans classified under “Other Receivables” have shifted to other accounts in disguised forms that include “Other Intangible Assets”, “Goodwill”, “Prepayments”, “Property, Plant and Equipment”, “Other Non-Current Assets” and even “Cash Equivalents”. Thus, even though the income statement, balance sheet and even operating cash flow may appear healthy, the cash and assets are already tunnelled out and propping acts are continuously fashioned to draw in external funds and cash inflow to carry on the accounting charade. The different legal systems between Hong Kong and China create additional opportunities for expropriation by companies that can shift assets across the border, because rulings by courts in Hong Kong are not enforceable in the mainland. And the Connect could potentially exacerbate the propping-tunneling problem. Thus, there is a sense of urgency to develop a composite measure that captures the true “Other Receivables” that has artificially inflated revenue and earnings.
The tunneling problem in China and Asia has stubborn roots. Until these root tensions are fully addressed, insider tunneling will pose an ongoing challenge to reform in China and the seemingly pretty-looking financial ratios and accounting numbers at the typical firms are potentially propped up to suck in capital for subsequent tunneling acts.
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Tibco Software provides software solutions to over 4,000 customers worldwide. Customers include companies like Union Pacific, Fed Ex, Macy’s and Procter & Gamble. It’s a great business in that Tibco Software generates high returns on invested capital and their services are critical for their customers to run their businesses. As a result, once they land a client and build a custom made software solution, client retention is very high. This results in a fairly predictable revenue stream from which we can readily estimate the company’s intrinsic value.
On March 28, 2014 we built a two percent position in Tibco Software in our Intrinsic Value Equity Strategy. Our average price paid was $20.04, or about 75 percent of our underlying estimated intrinsic value. Notice in the graph above how Tibco Software’s stock price has tracked our underlying estimated intrinsic value over the past 12 years. Also, notice how much more volatile Tibco Software’s stock price is than it’s underlying intrinsic value. With each stock purchase, we are trying to take advantage of the fact that the stock of a typical company is about three times as volatile as its underlying business or estimated intrinsic value. When we purchase shares at a large discount to our estimated intrinsic value, we do it based on the fact that it is highly probable that at some date in the future a company’s stock price and underlying intrinsic value should converge.
On September 29th, 2014, Vista Equity, a private equity firm, announced it was going to buy Tibco Software for $24.00 per share. The buyout price was eight percent below our estimated intrinsic value of $25.37. This buyout was the catalyst for the convergence of Tibco Software’s stock price and intrinsic value. Most of the time market forces will be the catalyst for the convergence and usually it takes longer than six months for the convergence to happen.
We are more than happy to take advantage of stock price volatility. A company’s stock price tells you very little about the quality of its business and its underlying intrinsic value. We monitor hundreds of companies—each week comparing their stock price to our estimated intrinsic value. We only look to buy companies when they trade at a substantial discount to intrinsic value. It is this “margin of safety” approach, that Ben Graham first talked about nearly 80 years ago, that is the centerpiece of Granite Value Capital’s investment process.
The above post has been excerpted from a recent newsletter of Granite Value Capital.
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