February 11, 2019 - 2:40am EST by
2019 2020
Price: 167.36 EPS 0 0
Shares Out. (in M): 2,592 P/E 36.74 0
Market Cap (in $M): 430,438 P/FCF 0 0
Net Debt (in $M): 0 EBIT 8,405 0
TEV (in $M): 336,094 TEV/EBIT 40 0
Borrow Cost: General Collateral

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I recommend entering a short position for BABA, last Friday (Feb 8, 2019)’s closing price is $167.36/share.

Alibaba Group is the dominant e-commerce company in China; everyone knows about BABA so I will not spend much time analyzing its various business segments. macklowe’s write up on Oct 04, 2017 has very useful information about the company. My thesis is not about BABA losing grounds in the next few years; in fact, BABA holds de facto monopoly position in China in many areas of its business activities and will continue to prosper as long as it can maintain friendly relationship with the Chinese government. Instead, the short thesis is based on people’s misconception about the current US/China trade war situation and is expected to be played out in the next 12 months. I think this writeup is likely to get many 1-rating because performance rating 1 means “would take opposite position” and many people do have legitimate reasons and strong belief about taking a long position in BABA. Also many people will consider a large part of this writeup to be totally off the mark because it’s discussing an acute political situation instead of analyzing financial numbers. I very much welcome people to rebuke my idea in the comment section.

prevailing perception
(1): BABA occupies a central position in China’s e-commerce, online payment, retail, AI world, and many other things. China just stepped out of poverty in the past three decades; we’re still in the early stage of the Chinese middle class moving to a consumption centric society and BABA will grow tremendously with this trend.
(2): Bears kept talking about counterfeit merchandises on Taobao, inflated accounting numbers, etc; they are missing the forest for a few bad trees.
(3): For a company with tremendous momentum growing 40% a year, a price tag of EV/EBIT = 40 is not expensive at all.
(4): BABA, together with a swath of other companies having significant Chinese exposure are unfairly penalized by investors’ fear of the US/China trade dispute; once the situation clears BABA will rerate very quickly; therefore we should be greedy to buy now when other people are fearful.

You can see how most people think about BABA in these seekingAlpha articles:

variant view
(1): America’s foreign policy toward China has changed dramatically over the past two years since Trump took office; and we have passed the point of no return since vice president Mike Pence made his speech regarding China foreign policy on Oct 4, 2018 at the Hudson institute. China will continue to prosper in future years but there is no way for its economy to grow the way it did over 2001 - 2018 since joining WTO. The “China GDP growth rate” people implicit assume in BABA’s market valuation is simply too high.
(2): BABA’s numbers are inflated. It’s hard to measure how fake the numbers really but we can safely say that the numbers we saw represent a best case scenario.
(3): The price. Value investors always enjoy talking about price. Here the price is EV/EBIT = 6 * USD_CNY using numbers for the past 12 months. The current exchange rate is USD_CNY = 6.75 so we are talking about EV/EBIT = 40, not a tantalizing number per se. This will become especially unsustainable when people realize there is a chance for the USD_CNY exchange rate to go significantly higher.
(4): When people realize how ugly the US/China trade war will be the downward pressure on BABA price will be tremendous. This turn of opinion is likely to happen within the next 12 months.

more details

Let’s discuss the US/China trade dispute first because that is the most mis-understood part. The first question is: why is Trump waging trade war against all other countries at the same time? Is he crazy, or is he just someone trying to actualize some red neck protectionist ideal to score some political points? To people who hate Trump based on (their) first principle or moral high grounds, this is a moot point: there is nothing to discuss, Trump is just stupid. To people having a vested interest in the success of multinational firms, Trump is an obstacle on their road to lobbying success. To anyone who is patient enough to look at some relevant historical data, the answer is very clear: the rest of the world is practicing mercantilism against US over the past 40 years and we must do something about it. The following plot depicts US monthly balance of trade since 1950:

The pattern is very clear: America is on a spending spree, we consume more than we make. It’s unthinkable for any other country to have trade deficit like this. The rest of the world is willing to sell goods to America for our IOU notes (i.e. US dollars) because our country has a very good credit history and we are a very wealthy country. American people are happy to buy cheap goods made in foreign countries with much lower labor cost; some people lost their jobs but they can still live comfortably on welfare because imported goods are so cheap. American investors are happy because they make a lot of money doing cost reduction by outsourcing jobs to third world countries. It seems that everyone is a winner in the globalization bandwagon; except that this cannot keep going forever. At some point foreigners will own so much American assets that a significant portion of our economic output will be shipped to other countries every year just to service old debt instead of purchasing new goods and our median living standard will degrade. (A rich farmer selling his farm to over consume year by year will eventually become a poor farmer.) I say median living standard because the situation in that hypothetical eventuality is very different for the capitalist and the working people. Capital is global but labor is not; if we are practicing true globalization then eventually American workers’ living standard will be the same as those in third world countries because they will all receive a market rate for their labor (and there will be a small group of super rich people while the rest of the population doing service jobs for them; this is bad), and that living standard is very low for two reasons: (1): there is a huge supply of cheap labor worldwide; (2): authoritarian regimes in developing countries will ensure their labor wage is low to make money together with western investors. This is a politically untenable situation and we must arrest the train before it hits that ugly place. So, sooner or later, the US government will try re-negotiating trade pacts to reduce our trade deficit and incentivize companies to hire domestically. It just happened that Trump is doing this very effectively and the media is trying to paint him as a protectionist who is crazily waging trade wars on all fronts.

The US/China trade dispute cannot be resolved by signing a few “treaties”; it requires fundamental changes that the ruling party of the Chinese government is likely unwilling to make. US trade deficit against China was $6M (million, not billion) in 1985, $1.6B in 1986, $10.4B in 1990, $83B in 2001 and was $375B in 2017 (which accounts for 2/3 of the total US trade deficit $566B), it’s growing 10% per year compounded over the past 17 years. The cumulative trade deficit against China since 2001 is a mind blowing $4.5 trillion dollars (over 23% of US 2018 GDP). This money fueled the miraculous growth of China over the past two decades; but more importantly, this money allowed the chinese communist party (CCP) to strengthen and tighten its grip of political power in China and also funded it oversea ambitions. It jeopardizes America’s global leadership. This is neither my personal speculation nor some zero hedgeisque conspiracy theory, but the unanimous conclusion of all stake holders in the US government, as can be seen clearly in this speech delivered by the vice president:  There is a youtube video for the speech here:

I highly recommend anyone interested in this thesis to read the above notes or watch the video; in my opinion this is no doubt the most significant US foreign policy change over the past 20 years. Let’s take a deeper look at Mike Pence’s speech. First of all, this is not Mike Pence lecturing his personal political opinion privately, but an official speech (notice that the speech is published on the government website He is representing the Trump administration to make the speech. From the content of the speech (which we will analyze shortly) it’s pretty clear that Trump/Pence most likely have gotten a nod from almost all senators and congressmen. They are definitely not making a fait accompli and trying to force dissenting senators’ hands later on; it’s not going to work that way. This speech irrevocably committed the US government to lead its allies to fight against CCP for a fair political and trade relationship. There is no return; even if Trump is out of office tomorrow the US government very likely will fight the trade war with China along the current course to its natural conclusion. It’s a matter of time, not a matter of if.

So, what did Mike Pence say in that speech? A short summary is that CCP, funded by China's unprecedented economic growth over the past two decades, has became a real threat of America's global leadership and also endangers many other countries' security, prosperity and freedom; therefore the United States must, and will play a leadership role to unite all stake holders to force a change.

Pence first talked about US government extending a friendly hand to CCP:
"From early in this administration, President Trump has made our relationship with China and President Xi a priority. On April 6th of last year, President Trump welcomed President Xi to Mar-a-Lago. ......"

but it turns out that they are secretly plotting our down fall:
" ...... Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States."

America had a friendly relationship with China since the beginning:
"When our young nation went searching in the wake of the revolutionary war for new markets for our exports, the Chinese people welcomed American traders laden with ginseng and fur. ......"

but things went down precipitously since CCP seized power:
" ...... But soon after it took power in 1949, the CCP began to pursue authoritarian expansionism. It's remarkable to think that only five years after our nations had fought together, we fought each other in the mountains and valleys of the Korean Peninsula."

however, the United States is still willing to help:
"...... After the fall of the Soviet Union, we assumed that a free China was inevitable. Heady with optimism at the turn of the 21th Century, America agreed to give Beijing open access to our economy, and we brought China into the WTO."

but Chinese government's actual behavior is very different from what it says:
"The dream of freedom remains distant for the Chinese people. And while Beijing still pays lip service to "reform and opening," Deng Xiaoping's famous policy now rings hollow."

So the message is very clear: America has good intention and is doing its best to help develop China; but the Chinese government doesn't abide by the rule of law and the principle of freedom, and is always plotting for our demise. I highlighted the sentence about Deng Xiaoping because in this context it is an important political signal that many people overlook. For a top down organization like CCP, there are always dissenting voices (against its leader) within that are not heard;  (think of Khrushchev denouncing Stalin after Stalin's death). That sentence about Deng is essentially a reassuring pat and rallying cry for the fifth column within CCP: we support Deng's policy; it's the current leadership's evil policy we're against; dissenters can use Deng as a symbol to unite and fight.

Then Pence elaborated how CCP is not playing by the rules by naming specific things, including: currency manipulation, forced technology transfer, IP theft, secret state subsidies, made in China 2025 plan, oversea military expansion, etc, etc:

"...... Beijing has directed its bureaucrats and businesses to obtain American intellectual property -- the foundation of our economic leadership -- by any means necessary. ....... China wants nothing less than to push the United States of America from the Western Pacific and attempt to prevent us from coming to the aid of our allies. But they will fail."

Then Pence moved to talk about CCP's suppression of the Chinese people:
"Nor, as we had hoped, has Beijing moved toward greater freedom for its own people. ...... And by 2020, China's rulers aim to implement an Orwellian system premised on controlling virtually every facet of human life -- the so called "Social Credit Score." In the words of that program's official blueprint, it will "allow the trustworthy to roam everywhere under heaven, while making it hard for the discredited to take a single step.""

"And when it comes to religious freedom, a new wave of persecution is crashing down on Chinese Christians, Buddhists, and Muslims."

"As history attests though, a country that oppresses its own people rarely stops there."

Pence then spent a few minutes talking about several recent events about CCP's religious repression; especially about its action in Xinjiang where more than one million ethnic Uyghur (mostly of Muslim faith) were detained indefinitely without trial into the so called re-education camps. There are two questions: (1): why is CCP doing this? (2): why did Mike Pence talk about this? The first question is pretty easy to answer. CCP is not against Muslim, or any other religion. What CCP does is to repress or control all forms of organization. To maintain its authoritarian control, the CCP cannot allow any other political party to exist, let alone religious organizations (whose bonding is 100x stronger than any political party). That's why CCP is demolishing all religious organizations and forbidding practicing religion. Now why did Pence talk about this stuff? Answer: to tell the world that CCP is not just some totalitarian corrupt regime in a developing country we can cooperate with to make a lot of money, but a monster waiting for its moment to strike all of us down. Just imaging this: if the Chinese government is pained as a muslim suppressor in Iranian people’s mind, can the Iranian leader still promote trading with China? He then gave a few examples:

"In fact, China uses so called "debt diplomacy" to expand its influence. ...... Just ask Sri Lanka, which took on massive debt to let Chinese state companies build a port of questionable commercial value. Two years ago, that country could no longer afford its payments, so Beijing pressured Sri Lanka to deliver the new port directly into Chinese hands. It may soon become a forward military base for China's growing blue-water navy."

"As President Trump has made clear, we don't want China's markets to suffer. In fact, we want them to thrive. But the United States wants Beijing to pursue trade policies that are free, fair, and reciprocal. And we will continue to stand and demand that they do. Sadly, China's rulers, thus far, have refused to take that path."

Then Pence accused the Chinese government of manipulating American politics:
"...... To put it bluntly, President Trump's leadership is working; and China wants a different American President. There can be no doubt: China is meddling in America's democracy."

"Senior Chinese officials have also tried to influence business leaders to encourage them to condemn our trade actions, leveraging their desire to maintain their operations in China. ……”

Then Pence mentioned a recent incident most of us have never heard of:
"At the University of Maryland, a Chinese student recently spoke at her graduation of what she called, and I quote, the "fresh air of free speech" in America. The Communist Party's official newspaper swiftly chastised her. She became the victim of a firestorm of criticism on China's tightly-controlled social media, and her family back home was harassed."
You might wonder why is this thing related to US/China foreign relationship? Well, if you think of the intended audience of this speech it should be rather obvious. Authoritarian government likes to play the nationalism card in times of crisis; pressured by the economic problem, CCP definitely wants to paint America as an evil enemy nation to unite the Chinese people around it. Here Pence is basically saying that the US government is NOT against Chinese people, but against the Chinese government’s unfair trade practice and other questionable political actions. More concretely, Pence is saying to Chinese expat in the United States that things are ok even if the trade war further deteriorates.

We have spent so much time analyzing this Mike Pence speech (there are many many other subsequent documents showing similar things if you care to read official remarks on; I hope by now you understand that the current market condition is: (likely true): things will become clear when people’s unfounded optimism (about quickly resolving the US/China trade dispute) faded; instead of: (likely false): things will become clear when this stupid trade war worry goes away. Let’s face it: most of us want the US/China trade dispute to resolve quickly because we almost all have some long positions in companies doing business in China and most people like to believe in scenarios favorable to them; but as value investors we must see things as what they really are instead of what we would like them to be.

We now have a working hypothesis: the US/China trade dispute is going to be really ugly. The question then is: how does this affect BABA, the company and the stock price? I argue that this is very likely to drive BABA price down meaningfully over the next 12 months, from three aspects:

(1): BABA growth going forward will be slower than market expectation.
Bulls argue that BABA is a toll booth on the Chinese economy. As China migrates to a consumption centric economy, BABA will take a slice of profit for every piece of transaction. I agree with this. BABA has grown tremendously over the past decades since its founding. But China GDP has grown 10x from 2000 to 2018; do you think it will grow 10x over the next 18 years? Clearly not. I think people are over extrapolating BABA’s past trajectory. Sooner or later people will wake up and adjust the growth rate assumption in their models (hence the valuation).

(2): The current valuation is very high; especially after clearing out accounting fake numbers and taking into account of the possibility of CNY devaluation.

Let’s first review growth investors’ modus operandi. Last 12 month revenue is R; we’re still in the early stage of the growth story, the company will grow top line 40% annually for the next 5 years so let’s look 5 years forward 2024 revenue will be (1 + 0.4)^5 * R = 5.38*R. The company is still in the expansion phase so capEx is understandably abnormally high; if we consider the company 5 years from now in a no expansion mode (i.e. just run it for cash), then the pre-tax margin EBIT/Revenue is going to be much higher, let’s say the margin expansion multiplier is K = 1.5. So looking 5 years into the future, EV/T12M_EBIT = 40 becomes EV/(5.37 * T12M_EBIT * K) = 5. Such great business should trade at at least 15x normalized pre-tax profit so we’re looking at 3x our investment over 5 years for a 25% CAGR.

Now we are reading such investment pitch almost everyday; sometimes we forgot to question its validity. For the BABA case there are many ways this growth investor thesis can fail. Using last 12 months data and USD_CNY exchange rate = 6.75, BABA has: EV/EBIT=40 and EV/(EBITDA - CAPEX) = 56. These are mind boggling numbers. Even when we play the “looking 5 years into the future” game, we are looking at EV/(EBITDA - CAPEX) = 56/1.4^5 = 10.4, not cheap. Maybe a decade long bull market is enough to make everyone think 50x pre-tax multiple is a very reasonable valuation for a growth company. I think BABA’s current valuation is very high for the following four reasons:
(2A): As argued above, the trade war situation (from China’s perspective) is going to be a lot worse than people now think. The assumption of 40% growth several years going forward is not going to materialize. Put it another way, BABA’s revenue is not going to be 5x higher in just a few years.
(2B): The current reported numbers are most likely significantly inflated. Look at this example: 2018 singles day (November 11; this date is called singles day because 11/11 is four “one”s) transaction volume on Alibaba is $30.8B; China annual GDP is $12.24T; so just on that one day (admittedly a day when people’s propensity to shop is higher than normal) BABA’s transaction volume is 30.8 / 12240 = 0.25% of annual GDP; this is just hard to believe, especially given that a significant portion of China GDP is related to real estate stuff. It’s also well known that Taobao merchants use self ordering to inflate their transaction volume (“brushing”). There were numerous articles discussing this so I think it’s not worth repeating their arguments here. Suffice it to say that the numbers are significantly inflated.
(2C): Questionable related party transactions. The things here are really murky, and like insurance, all surprise is going to be negative. Let’s look at some past examples. Like many Chinese tech firms wanting to tap the global market, BABA uses something called VIE (variable interest entities); this is a complicated legal structure that I do not fully understand; but the rough idea is this: in order to do business in China, BABA needs various licenses; the Chinese government does not allow foreign investors to own these things so they belong to some VIE which is not controlled by BABA. Put it simply, something critical to BABA’s business does not belong to BABA shareholders (and they make complicated legal documents to convince investors that things are just fine). This means that when legal dispute happens the law is likely not on the side of foreign shareholders. And legal dispute does happen: just look at how Alipay is separated from BABA. Also BABA’s founder Jack Ma, one of the greatest business genius and a very charismatic man, just voluntarily retired from BABA and announced that he is a communist…
(2D): BABA trades in USD while its Business in China is conducted in CNY. The current exchange rate USD_CNY is 6.75. BABA’s value will drop if CNY depreciates against USD. If USD_CNY goes to 10 BABA will immediately lose 30% of its value (it’s going to be a lot more because people like to imaging more terrible things when terrible things happen). A lot of people think this is totally impossible. Isn’t stoping China’s currency manipulation part of Trump’s trade negotiation objective? Trump want China to appreciate its currency so that Chinese companies don’t enjoy such big cost advantage, right? This thing is actually a lot more complicated than it looks like. The Chinese government has a bureau called State Administration of Foreign Exchange (SAFE), whose function is to control all the inflow and outflow of foreign currencies   Individuals and companies doing business in China cannot exchange currency freely; bringing foreign currencies out of China is subject to very tight control. By law each Chinese citizen can only purchase $50K foreign currency each year. When companies receive USD from abroad they cannot move those dollars oversea easily. So there is one way limitation in the supply/demand of USD/CNY and that limitation is to support CNY. If this restriction is removed the equilibrium exchange rate for CNY would be significantly lower than now (You cannot use CNY in western countries; China has very significant inflation; so given the chance, wealthy Chinese people definitely want to hold their wealth in USD instead of CNY). Let’s think about these two questions: (Q1): when Trump says: stop currency manipulation, what does he mean? (Q2): what does China want? Let’s answer the first question first. What Trump really want (or any trading partner arguing about currency manipulation for that matter) is for the equilibrium exchange rate for CNY to be higher. i.e. don’t control currency transactions and don’t print so much money. On the other hand, China wants two things: a labor cost advantage, and a high USD price when they IPO their companies in the United States (so that they can fetch more $$$ from us); the first thing requires a cheaper CNY while the second thing requires a higher quoted price for CNY; so what they ended up doing is to print a lot of money and control the official exchange rate. We mentioned earlier that the US/China trade dispute cannot be resolved by a few treaties because Trump is asking for fundamental changes that the Chinese government is likely unwilling to make; this currency manipulation issue is clearly one such thing. Either China opens its market and let CNY freely tradable (extremely unlikely), in which case BABA will drop together with CNY, or the trade war escalates, in which case BABA will be hurt by China recession. There is no way out for BABA.

(3): BABA could just trade down substantially on trade war sentiment.
This point is obvious. If you look at the price history of US listed Chinese companies over the past year you can see that the fluctuate with people’s sentiment regarding the US/China trade dispute. Also look at the Huawei situation; if you wake up tomorrow and see something similar happens to BABA, the price action is going to be ugly. I’m not saying this will happen; but as I said earlier, all surprises here will be negative.

I argued for the hypothesis that the US/China trade war is going to be really ugly; and people will gradually understand this point over the next 12 months. Under that hypothesis BABA price faces downward pressure on three fronts:
(1): trade war causing real damage to Chinese economy thus hurting BABA;
(2): current valuation is very high if you consider accounting number inflation and possibility of CNY depreciation; the development of US/China trade war will make people understand these so far un-noticed problems;
(3): current market sentiment regarding trade war is very optimistic; things can only go down from here and BABA will trade down with it;

It’s not likely, but possible for BABA to trade back to $200+/share; I think this is only possible if we have a very bullish general market rally. Since most of us have a lot of long equities positions, we should be naturally hedged from a portfolio perspective.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


investors waking up to the US/China trade war situation

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