On February 1, 2018 Alibaba announced that the Alibaba Group Agrees to 33% Equity Stake in Ant Financial
Key statements in the press release:
The parties have agreed to certain amendments to their 2014 transaction agreements to facilitate the transaction.
There will be no cash impact to Alibaba following completion of the transaction.
Alibaba will acquire newly-issued equity from Ant Financial in exchange for certain intellectual property rights owned by Alibaba exclusively related to Ant Financial.
The companies will terminate the current profit-sharing arrangement under which Ant Financial pays royalty and technology service fees in an amount equal to 37.5% of its pre-tax profits to Alibaba.
Let’s begin the forensics
What’s being Sold?The Transaction is described in Article II, Sec. 2.1 of the Agreement, beginning on page 20. Alibaba subsidiaries, as described, are selling “Equity” (Sec. 2.1(a)) and “Assets” (Sec. 2.1(b))The Equity to be sold (Sec. 2.1(a)) is comprised of:
Designated Alibaba Subsidiaries will transfer 100% of Guarantee Company (F82) to Ant Financial
Designated Alibaba Subsidiaries will transfer 100% of Chongqing Loan Company (F51) to Ant Financia
Designated Alibaba Subsidiaries will transfer 100% of Libra Capital (A22) to Ant Financial
Designated Alibaba Subsidiaries will transfer 100% of Alipay Singapore E-Commerce (B15) to Ant Financial
The Assets to be sold (Sec. 2.1(a)) are comprised of:
Designated Alibaba Subsidiaries will transfer SME Loan Assets to Ant Financial
Designated Alibaba Subsidiaries will transfer 100% of Onshore Stage 1a Retained IP to Ant Financial
Designated Alibaba Subsidiaries will transfer 100% of Onshore Stage 1b Retained IP to Ant Financial
Designated Alibaba Subsidiaries will transfer 100% of Offshore Stage 1a Retained IP to Ant Financial.
Designated Alibaba Subsidiaries will transfer 100% of Offshore Stage 1b Retained IP to Ant Financial.
Designated Alibaba Subsidiaries will transfer 100% of Onshore Stage 1b Retained IP to Ant Financial
It’s typical in these agreements not to specifically describe the IP or Assets involved in the transfer, but the following disclosures on page 9 of the filing, in light of the press release, seems odd:
“Offshore Stage 1a Retained IP Value” means an amount equal to RMB 11,459,466,000.00
“Offshore Stage 1b Retained IP Value” means an amount equal to RMB 2,436,200.00
“Onshore Stage 1a Retained IP Value” means an amount equal to RMB 741,834,000.00
“Onshore Stage 1b Retained IP Value” means an amount equal to RMB 56,000.00
And on page 32 of the filing:
…Purchaser shall incur obligations to pay or cause to be paid to the persons specified below (or another person designated by the Seller) ……. in consideration of the Guarantee Company (F82) Transfer, RMB 422,619,540 to be paid to Alibaba.com China (B42) and RMB 181,122,660 to be paid to Zhejiang Taobao (T51)
…in consideration of the Chongqing Loan Company (F51) Transfer, RMB 2,574,936,000 to be paid to Hangzhou Ali Venture Capital (A54); and…
…in consideration of the Libra Capital (A22) Transfer, US$155,181 to be paid to the Seller (the amounts set forth in this clause (a) in the aggregate, the “Finance Business Consideration”)
…Retained Business Payment. Upon and in consideration of the Alipay Singapore E-Commerce (B15) Transfer (the “Retained Business”), the Purchaser shall incur obligations to pay or cause to be paid to Silverworld Technology (B17) US$6,307,989 (the “Retained Business Payment”) at the times set forth in Section 2.6 (or at such earlier times as the Purchaser may elect in its sole discretion).
The agreement also makes it clear that all taxes (if any) associated with the transaction will be the responsibility of Ant Financial. The press release stated that “There will be no cash impact to Alibaba following completion of the transaction.” But…When we add the payments due from Ant Financial detailed above in red, we calculate, at the current exchange rate of 6.34:1 a payment due to Alibaba of US$ 2.433 Billion. for the Equities and Assets transferred.
How can this be? I thought this was a non-cash transaction?Oh, that darned “Internal Financing” In the “Funding” Section of the agreement. (Sec. 2.4 thru 2.9 of the agreement (page 32 thru 37)). There are all sorts of “Funding Methods” described as to how Ant is going to pay Alibaba the US$ 2.433 Billion for the above described Equities/Assets. Sec 2.6 (a)(i)(A thru F). Certain payments are made at certain times for certain things. The terms range from “due at closing” to “sometime in the future”.
Here are a few of the terms:
…Upon the earliest of (i) the second anniversary of the Closing, (ii) the Purchaser Qualified IPO and (iii) the Alipay Qualified IPO, the Purchaser shall pay any remaining amount of the Finance Business Consideration that has not been paid pursuant to the preceding sentence
…the “Funded Amount Shortfall”),which may be repaid by the Purchaser……as determined by mutual agreement of Purchaser and the Alibaba Independent Committee no later than the earlier of (i) the one (1) year anniversary of a Purchaser Qualified IPO and (ii) the five (5) year anniversary of the date of the incurrence of the Purchaser’s obligation to pay the Funded Amount Shortfall
Section 2.6(b) ends with the following:
“For the avoidance of doubt, the list of funding methods set forth above is not intended to include all possible funding methods and the unavailability or lack of feasibility of one or more (including all) of the listed funding methods shall not relieve and shall not be deemed to relieve the Purchaser, in any respect, of its obligation to fund the Funded Amount.”
Um, okay. I had to read that a few times also. Because they say ‘nothing’ and give no comfort to shareholders, I’m gonna guess that……The US$2.4 Billion is somewhere around the book value of all of the “junk” assets transferred to Ant so Alibaba does not have to recognize a gain or loss on the transfer.
Issuance of Ant Financial Securities (the 33% Stake)The issuance of the Ant Financial 33% stake to a newly formed “Seller Designated Investment Entity” is described in Sec. 2.3 (pages 27 thru 32).
I’d assume that the “Seller Designated Investment Entity” would be wholly owned by Alibaba and a fully consolidated entity, but as surprise ownership interests tend to pop up in these deals and the Agreement, unfortunately, is silent as to the ownership of this new Investment Entity.
All we know for sure is that “within seventy-five (75) days following the Amendment Date, the Seller shall, and shall cause its Subsidiaries, to establish the Seller Designated Investment Entity” (page 31) Summary of the transaction’s Balance Sheet impact:
Alibaba exchanges $2.4 Billion of “Junk Assets” for an equal value of Cash and Obligations Receivable (C&OR) No change in total Balance Sheet valuation from this transaction
Ant Financial Exchanges $2.4 Billion for C&OR for an equal amount of “Junk Assets”. No change in Ant’s Balance Sheet from this transaction
Ant Financial exchanges 33% Ownership for C&OR. Balance Sheet increases by $2.4 Billion. Debit to C&OR, Credit to Capital
Alibaba exchanges $2.4 Billion C&OR for Interest in New Entity. No change in Balance Sheet value. Debit to “Investees” and Credit to C&OR
“New Entity” book value is $2.4 Billion. Debit to “Investees” and Credit to Capital.
The Transaction creates $4.8 Billion in new Balance Sheet book value. This is$2.4 Billion in Ant for the 33% Equity Issued + $2.4 Billion in the “New Entity”
No additional economic value has been created and no outside funding or resources enter the picture. Its all just moving journal entries around and creating “equity” and book value.The Accounting: Nowhere in the 6-K is there vital exact valuations of the Intellectual Property to be transferred as well as the current book/carrying value of same. But…(remember this, its gonna come up again later)
…there was a (marketing dept?) leak to the press, Bloomberg reported “through unnamed sources” that based on the next $5 Billion (5%) funding round, the valuation of Ant Financial will be roughly $100 Billion.
What Are Ant Financial’s Earnings?Even though they don’t describe this expense/accrual in the quarterly 6-K’s, in the most recent 20-F we can zero-in on the exact annual amount that Ant Financial is crediting to Alibaba for the 37.5% Profit Sharing Agreement (and thereby calculate the pre-tax income of Ant Financial):March 31st, 2017 YE 20-F (Pg. 193 of the filing, which ties to the Income Statement)
In fiscal years 2015, 2016 and 2017, under the Alipay IPLA, we recognized royalty and software technology services fee income, net of costs incurred by our company, amounting to RMB1,667 million, RMB1,122 million and RMB2,086 million (US$303 million), respectively, as other income.
So, 37.5% of Ant Financials Pre-Tax Income is $303 Million…
But…
this figure combines both the IPLA and the 37.5% “Royalty” profit sharing agreement and is “net of costs”. Lets go further…( page. 287 of the filing)4. Significant equity transactions, restructuring transactions, mergers and acquisitions and equity investments (Continued)(b) Restructuring of Payment Services (Continued)In connection with the 2014 SAPA, the Company also entered into an amended intellectual property license agreement with Alipay (“amended Alipay IPLA”), pursuant to which the Company licenses certain intellectual property and provides certain software technology services to Alipay and the Transferred Business. Under the amended Alipay IPLA, the Company will receive royalty streams and a service fee (collectively, the “Profit Share Payments”) which will be paid at least annually, amounting to the sum of an expense reimbursement plus 37.5% of the consolidated pre-tax income of Ant Financial Services, subject to certain adjustments. In addition, if the Company acquires any equity interest in Ant Financial Services, the Company will transfer an agreed portion of the underlying intellectual property to Ant Financial Services at the time of such equity issuance. At the same time, the Profit Share Payments will also be reduced in proportion to such equity issuances made to the Company. Income in connection with the royalty fee and software technology services fee under the Intellectual Property License and Software Technology Services Agreement and the Profit Share Payments, net of costs incurred by the Company, of RMB1,667 million, RMB1,122 million and RMB2,086 million were recorded in other income, net in the consolidated income statements for the years ended March 31, 2015, 2016 and 2017, respectively (Note 22).
FFS! That’s still the combined figure. Lets continue…(F-90, on page. 323)22. Related party transactions (Continued) (i) In 2011, the Company entered into an Intellectual Property License and Software Technology Services Agreement with Alipay whereby the Company licenses certain intellectual property and provides certain software technology services to Alipay in exchange for a royalty fee and software technology services fee in an amount equal to the costs incurred by the Company in providing the software technology services plus 49.9% of the consolidated pre-tax income of Alipay and its subsidiaries (Note 4(b)), effective from December 2011. In 2014, the Intellectual Property License and Software Technology Services Agreement was terminated and the Company entered into the amended Alipay IPLA with Ant Financial Services. Under the amended Alipay IPLA, the Company receives the Profit Share Payments amounting to the sum of an expense reimbursement plus 37.5% of the consolidated pre-tax income of Ant Financial Services, subject to certain adjustments (Note 4(b)), effective from August 2014. Royalty fee and software technology services fee under the Intellectual Property License and Software Technology Services Agreement and the Profit Share Payments were recognized in consolidated income statements, net of the costs incurred for the provision of the software technology services reimbursed by Alipay. The amounts reimbursed by Ant Financial Services to the Company were RMB486 million, RMB274 million and RMB245 million for the years ended March 31, 2015, 2016 and 2017, respectively. Nowhere in the 20-F do they come right out and say that the Profit Sharing Amount (37.5% of Ant Financial’s Pre-Tax Income) paid to Alibaba is exactly $xxx.xx. Everything Alibaba management seems to report is always hidden, questionable and subject to adjustments and offsets. Here’s the schedule that should have been produced and included in the 20-F….and every 6-K for that matter:
So, let’s give Alibaba Management the benefit of the doubt. Alipay, with it’s more than 900 million registered users is the very definition of a monopolistic/mature business.
Moreover, even though Joe Tsai makes interesting comments like “Alipay daily active users have more than doubled in the current quarter” (from a a 60 minutes interview) it would have been nice to know what the number of Alipay users actually is, what they’ve “doubled from”. If we give management the benefit of the doubt and assume that all of the RMB1,841 is attributable to the 37.5% “Profit Sharing” which is absolutely not guaranteed given all of the evolving terminology, obfuscation, offsets, adjustments and weasel words described in the above footnotes #4 and #22, we can try to back into Ant’s Before Tax Net Income ($714 Million), apply a tax rate (Alibaba’s tax rate is 23%) to Calculate/Estimate “Earnings” ($549 Million) and a P/E.
At a $100 Billion Market Cap, the P/E is 182
When we compare Ant Financial’s estimated P/E of 182 at a $100 Billion Market Cap to a few other prominent Payment Processors
The first representation, by Alibaba Management, as to the “notional value” of Ant Financial came via a schedule and footnote in the May 5th, 2016 Investor Presentation (Page 23) just last year. Footnote below:http://www.alibabagroup.com/en/ir/presentations/pre160505.pdf(3) Ant Financial valuation based on reported valuation of USD 60 billion in media; Alibaba Group receives 37.5% of Ant’s pre-tax income now, and if regulations allow, Alibaba Group is entitled to acquire up to a 33% equity interests in Ant Financial. For conservative purpose, 33% is used in calculating Alibaba Group’s economics in Ant Financial here.
(remember that time, a few paragraphs up, when I told you to take note of something cos it’s gonna be important, this is that)…
…Those “unnamed sources” (marketing department) listed in the Bloomberg article, made its way in their SEC filings as their definitive (no questions asked!) valuation. Put your calculators away folks, nothing to see here. Go back to the safety of your homes!
Alibaba’s Financial Statements After the “Funding Round”So let’s say, just for fun, that the US$5 Billion funding round happens in the next quarter. For my own sanity, I’ve listed the proposed Journal Entry and revised Balance Sheet Below, all things being equal, as if the transaction had taken place in the last quarter.
Based on the above we see that back in 2014, after roughly fifteen years in existence, after all of that effort, Alibaba has accumulated only US$18 Billion in Book Value, had virtually no retained earnings to speak of ($190 Million) and, by all accounts, had maxed out their lines of credit
Simultaneously, by some fortuitous, amazing, happenstance, Alibaba Management aligned itself with US & Swiss Investment Bankers and in less than four years, based on the above projections of the presumed re-valuation of Ant Financial, Alibaba will have created more than US$142 Billion in Book Value
(Note that I know nothing about Chinese Tax Law, the $5 Billion Deferred Tax impact is purely a guess)
As we can see, most of the book value is housed in opaque, overvalued “Questionable Assets” (Investments & Securities relating to “Investees”. Intangibles, Goodwill & Land Use Rights), which, if Alibaba Management at does succeed at Ant Financial valuation,at $100 Billion, would bring “Questionable Assets” up to US$89 Billion (63% of the balance sheet)
Also the “Newly Formed Entity” will be written up as well based on the increase in the Ant Valuation.
So, if they can actually pull this off, $66 Billion in additional Book Value (i.e. collateral) and $56 Billion of Additional “Equity” would be created as well. Also remember, when we write something up we can always book valuation gains that hit the Income Statement.
So income of $56 Billion has been created, out of thin air.The end?
H/t Deep throat