Description

Market Cap: USD 1.2 bn

Average daily trading value USD 5mm

1)      Alibaba Group at a 27-33% discount to the IPO price

China Dongxiang is a Hong Kong-listed Chinese mainland sportswear retailer. Investors might know it as the poster child for a competition short case study. In reality, it is Jack Ma masquerading in a cotton-poly tracksuit. Its largest holding is the Alibaba Group.

At the current price, investing in China Dongxiang is an attractive way to create an investment in Alibaba at a 27-33% discount to the expected IPO valuation. A sum of the parts analysis shows that at today’s price, most of the value of China Dongxiang is in fact attributable to the Alibaba stake and negligible value is attributed to the core retail business. The balance sheet is clean; half the market cap is cash and the company has no debt. Alibaba’s IPO provides a hard catalyst to unlock the value hiding in plain sight, which will occur in the coming days.

2)      Brief company background

China Dongxiang manufactures Kappa-branded clothing and shoes. It IPO’d in 2006 to much fanfare. The company competes in the highly competitive fashion sportswear category alongside domestic players Li Ning, Anta and foreign players such as Nike and Adidas. In the past, the company primarily sold its clothing through licensed distributors. In hindsight, this was a mistake. As a consequence, it lost control of merchandizing. The brand became tarnished, and inventory built up to extraordinary levels. A bit of interesting history in the annals of bad retailing: over optimism in 2010 caused Chinese retailers to over order Kappa products. When the demand did not materialize, China Dongxiang bought back the inventory in 2011. Since then, the company has been selling down inventory through discount channels. In 2013, the company began restructuring the business. This is still ongoing. The company changed its business model from the initial distributor-only model towards having more franchised and self-operated stores. In addition to competition, faddish elements with the brand and its ubiquitous logo led to consumer and investor fatigue. By now, everyone is aware that competition is fierce and industry barriers are low. This apathy towards the company probably explains why the Alibaba opportunity still exists. Additionally, China Dongxiang stock has modest liquidity — pretty good for an H-share, but not good enough for large funds. Such funds can create an investment in Alibaba through the far more liquid and less Chinese Softbank and Yahoo. In the interest of time and to avoid redundancy, I would encourage you to read the recent VIC Softbank write up for background on Alibaba.

3)      China Dongxiang’s Investment in Alibaba

In 2011, the company invested USD$100 mm in the Yunfeng E-Commerce fund. Yunfeng E-Commerce fund is an investment vehicle set up by Jack Ma in order to allow investors to invest specifically in the Alibaba Group. It gave Alibaba employees shareholders a chance to cash out. China Dongxiang’s Yunfeng investment is detailed in the footnotes to its annual and interim reports:

In September 2011, the Group subscribed for limited partnership agreements with Yunfeng E-commerce funds (“Yunfeng E commerce Funds”), pursuant to which the Group subscribed for limited partnership interests with a total capital commitment of USD100,000,000 (equivalent to RMB638,080,000 at historical exchange rate), which had been fully paid as at 31 December 2012. The Yunfeng E-commerce Funds are established for the purpose of making investments in Alibaba Group Holding Limited, a leading group in the Chinese e-commerce industry. (Page 110, 2013 AR)

Based on various news articles, China Dongxiang’s $100 mm investment was made at a $32 bn valuation of Alibaba. This is mentioned in the following links: http://goo.gl/I65e9r ; http://goo.gl/s4zJKk

At a $32 bn valuation, this implies that China Dongxiang held a 0.31% stake ($100 mm / $32 bn). As disclosed in the most recent registration statement, Alibaba will have 2,465 mm shares following the IPO (pg. 16, Form F-1). At $68, the high end of the IPO range, this implies a market cap for Alibaba of $168 bn. China Dongxiang’s stake would be valued at $523 mm immediately after the IPO.

4)      SOTP analysis

Putting all of this together in a sum of the parts analysis, I had to make a rough estimate of the value of the retail business. Excluding one-offs and non-operating items, the core business actually makes an operating loss, contrary to reported EBIT. Because the company is not profitable, I instead apply a multiple to revenues. I assume a conservative 0.7x multiple. This figure is up for debate, but I would note that other Chinese sports apparel / shoe retailers trade on average above 1.0x est. 2014 revenues (Anta: 2.8x EV/sales; Hosa: 2.0x; Belle: 1.4x; Li Ning: 0.8x).

(Note that the company’s reported financials are in RMB, but the company shares trades in HKD)

In the tables above, I have first calculated the NAV based on the June 2014 reported filing, which shows the Alibaba stake reported at “fair value.” Obviously, this is before the IPO was priced. Even on these outdated figures, China Dongxiang still trades at a discount to reported NAV.

The second NAV calculation is what I expect will occur after the IPO. There are some wrinkles that make this messy to explain. First, as disclosed in the F-1, Yunfeng plans to sell 18.75% of its Alibaba shares in the IPO (pg. 251). Thus, China Dongxiang’s 0.31% stake (via Yunfeng) will be reduced by 18.75% immediately after the IPO. Second, there will be further dilution of Alibaba’s shares by approximately 5.6% due to options and preference shares (pg. 14; F-1). I calculate that Alibaba’s diluted shares outstanding will be around 2.6 bn. After accounting for the Yunfeng sale and future dilution, China Dongxiang’s stake will decline from 0.31% to 0.24%. The Alibaba stake reflected in my NAV represents 0.24% x $168 bn using a 6.15 RMB exchange rate.  

In this base case scenario, the current price represents a 27% discount to the NAV. Market consensus seems to be that Alibaba will IPO with a $200 bn valuation (which seems to be based on a 30x multiple on $6.7 bn 3/16E earnings). If this were the case, the NAV discount would be around 33%.

5)      Risks

Alibaba’s IPO pricing is obviously a risk. Alibaba will price on Thursday after the market closes in NY and begin trading on Friday. Lest I be misunderstood however, this recommendation isn’t about trading a hot IPO and taking advantage of a “pop” which may or may not happen. Rather, I see this as a special situation investment where I expect the NAV gap to close. Alibaba’s price transparency after the IPO should cause this to happen.

A risk to China Dongxiang investors realizing the full value of the Alibaba stake is that it is unclear how the GP/LP economics of the Yunfeng E-commerce fund are structured. If there is a performance fee due to the GP, then a discount is warranted. As far as I am aware however, I do not believe this is the case. I plan to speak with management to clarify.  

In a similar vein, it is unclear how the Yunfeng E-commerce fund will eventually be unwound and how those proceeds will be distributed to China Dongxiang. It is also unclear how China Dongxiang management will treat the cash received. This uncertainty may create a discount, similar to what you might expect with a tracking stock. While I expect the discount to close after the IPO, a gap may still exist for this reason.

There is risk that Yunfeng’s stake has been diluted since 2011. It is reasonable to wonder if Yunfeng’s stake has been diluted since the investment was made in 2011. I do not believe this is the case, however. In February 2014, Chinese video game company Giant Interactive Group sold a stake in Alibaba to Tiger Global for $199 million. At the time of this sale, Alibaba was reportedly valued at $128 billion. In China Dongxiang’s 1H14 financial report, it reported Alibaba’s value at a “fair” market price of $394.8 million. This represents a 0.31% stake, which is the same as back in 2011 at the time of the original transaction ($394.8 mm / 128 bn = .308%), so I have reason to believe there was no dilution at Yunfeng.

The core retail business could continue to deteriorate. Following the restructuring, the new business model of franchised and self-owned stores will necessarily be more capital intensive than a pure distribution model. There is a risk management might misallocate cash into unprofitable areas of brick and mortar growth. This risk is somewhat mitigated by the low valuation we have ascribed to the retail business. Moreover, if we assume zero value to the retail and we fully subtract capitalized rent expenses just to be safe (RMB240 mm using 10x annualized 1H14 lease expense), the company still trades at a discount to NAV; by my estimates, the discount narrows to 10%. Heads I win, tails I don't win much.            

6)      Catalysts

Alibaba IPO, Friday, September 19, 2014

Catalyst