BABA Q1 2016: Two Accounting Gains Explain 92% of the Profit Growth, and a Second SEC Inquiry Opens

The Profit Line Two Deconsolidations Built

Alibaba's underlying commerce flywheel had a genuinely good year: China retail marketplace Gross Merchandise Value^» (GMV) crossed RMB3 trillion (RMB3,092 billion, $485 billion) for the first time, up 27% from the prior fiscal year, and the monetization rate^» - which fell in last year's post as mobile GMV cannibalized higher-yielding desktop revenue - actually recovered, from 2.44% to 2.59%, as mobile monetization caught up (mobile monetization rate rose from 1.79% to 2.51%). Income from operations, the cleanest read of the actual business, grew a solid 26% to RMB29,102 million ($4,513 million). That's the real story of fiscal year 2016 (ended March 31, 2016), and it's a good one.

It is not, however, the story the headline net income number tells. Net income attributable to ordinary shareholders nearly tripled, from RMB24,149 million to RMB71,460 million - a 196% jump dwarfing the 26% operating-income growth underneath it. The gap is almost entirely two non-cash accounting events, neither of which involved selling a single order on Taobao Marketplace or Tmall: a RMB24,734 million ($3,836 million) gain from deconsolidating Alibaba Pictures after a third-party share placement diluted Alibaba's stake below majority control, and an RMB18,603 million ($2,885 million) gain from revaluing Alibaba's existing stake in Alibaba Health the moment Alibaba obtained accounting control over it. Together these two gains total RMB43,337 million - 92% of the entire RMB47,311 million increase in net income attributable to ordinary shareholders year-over-year, and 61% of the full net income figure itself. Alibaba's own effective tax rate fell from 20% to 10% specifically because these gains aren't taxable.

The Alibaba Health side of that story has a related-party wrinkle worth sitting with, and a newly opened SEC inquiry that reads like it was written with this exact kind of transaction in mind. See Beyond the Usual below.

The Prescription

Cloud computing is still tiny - RMB3,019 million ($468 million), just 3% of total revenue - but it grew 138% this year, the fastest of any reporting line by a wide margin, on genuine infrastructure economics (more paying customers, more usage of higher-complexity services like CDN and database products) rather than marketplace network effects. This is Alibaba's actual second engine, still years from mattering to the P&L but compounding faster than anything else the company reports. Keep funding it disproportionately - the payoff, if it lands, looks nothing like another point of Tmall commission take-rate; it's a structurally different, higher-margin business built on infrastructure Alibaba already has to run for itself anyway.

What it should stop doing: leaning on related parties to manufacture accounting outcomes. Yunfeng Capital - a fund in which Alibaba's own executive chairman holds a 40% general-partner interest - agreed to give up its separate voting rights over its stake in Alibaba Health "at no consideration," handing Alibaba the accounting control it needed to book a RMB18,603 million gain (see Beyond the Usual). Every party to that arrangement is friendly to Alibaba's own leadership. Doing this the same year the SEC opened a second inquiry specifically into Alibaba's consolidation policies and related-party practices is not the moment to be found relying on exactly that playbook - a public company under active regulatory scrutiny over how it draws the line between "control" and "influence" should be tightening that line, not testing it again.

Key Financial Metrics

Fiscal year ended March 31, 2016 vs. fiscal year ended March 31, 2015

FX: RMB 6.4480 = USD 1.00 (March 31, 2016, per the company's own filing, based on the U.S. Federal Reserve Board's H.10 statistical release).

Metric	FY2016 (RMB)	FY2016 (USD)	FY2015 (RMB)	YoY
Revenue	101,143M	$15,686M	76,204M	✅ +32.7%
Cost of revenue	(34,355M)	($5,328M)	(23,834M)	⚠️ +44.1%
Gross profit (derived)	66,788M (66.0% margin)	$10,358M	52,370M (68.7% margin)	⚠️ Margin -2.7pp
Share-based compensation expense (all lines)	16,082M	$2,494M	13,028M	⚠️ +23.4%
Income from operations	29,102M (28.8% margin)	$4,513M	23,135M (30.4% margin)	✅ +25.8%, margin -1.6pp
Interest and investment income, net	52,254M	$8,104M	9,455M	⚠️ +453% (mostly two non-cash gains - see below)
Net income	71,289M	$11,056M	24,320M	⚠️ +193.1%
Net income attributable to ordinary shareholders	71,460M	$11,083M	24,149M	⚠️ +195.9% (92% of the increase is two non-cash gains)
Diluted EPS / ADS	RMB27.89	$4.33	RMB9.70	⚠️ +187.5%
Non-GAAP EBITDA	52,340M	$8,117M	40,753M	✅ +28.4%
Non-GAAP net income	42,741M	$6,629M	34,981M	✅ +22.2%
Non-GAAP diluted EPS / ADS	RMB16.75	$2.60	RMB13.97	✅ +19.9%
Net cash from operating activities	56,836M	$8,815M	41,217M	✅ +37.9%
Free cash flow (company-disclosed, non-GAAP)	51,279M	$7,953M	48,121M	✅ +6.6%
Cash and cash equivalents	106,818M	$16,566M	108,193M	⚠️ -1.3%
Short-term investments	4,700M	$729M	14,148M	⚠️ -66.8%

Balance sheet	Mar 2016 (RMB)	Mar 2016 (USD)	Mar 2015 (RMB)	YoY
Total assets	364,450M	$56,521M	255,434M	✅ +42.7%
Total liabilities	114,561M	$17,767M	97,363M	⚠️ +17.7%
Unsecured senior notes	51,596M	$8,002M	48,994M	+5.3%
Goodwill	81,645M	$12,662M	41,933M	⚠️ +94.7% (driven by Alibaba Health, see below)
Investment in equity investees	91,461M	$14,184M	33,877M	+170% (boosted in part by Alibaba Pictures moving here after deconsolidation)
Total Alibaba Group Holding Limited shareholders' equity	216,987M	$33,652M	145,439M	✅ +49.2%
Noncontrolling interests	32,552M	$5,048M	11,974M	+172%

Revenue grew a healthy 33%, and unlike last year's post - where the concern was margin compression eating most of the revenue growth - operating income this year actually grew faster than the historical trend, up 26% to a 28.8% margin (down only 1.6 points, mostly from continued investment in new initiatives like mobile operating systems and over-the-top TV). The real distortion this year sits below the operating line, not above it. Interest and investment income, net, exploded from RMB9,455 million to RMB52,254 million, almost entirely from the two non-cash gains detailed in Beyond the Usual below - neither of which represents cash Alibaba can spend, or business performance Alibaba should get credit for repeating. Strip those two gains out and net income attributable to ordinary shareholders would have grown roughly 17% year-over-year, not 196% - a far more modest, and far more believable, number given what the operating business actually did. Non-GAAP net income, which already excludes both gains along with share-based compensation and amortization, grew 22.2% to RMB42,741 million ($6,629 million) - the most honest single profitability line in this filing.

A tripled net income figure with 92% of its growth coming from two accounting events, not sales, is an accounting story - not a growth story.

Key Operational Metrics

Total GMV, China retail marketplaces: RMB3,092 billion ($485 billion) in fiscal 2016, ✅ up 27% from RMB2,444 billion in fiscal 2015 - Taobao Marketplace GMV grew 18% to RMB1,877 billion and Tmall GMV grew a faster 43% to RMB1,215 billion, continuing the shift toward the higher-take-rate marketplace flagged in last year's post.
Monetization rate (China retail marketplaces): 2.59% in fiscal 2016, ✅ up from 2.44% in fiscal 2015 - a genuine recovery from the decline flagged last year, driven mainly by accelerated online marketing services revenue growth.
Mobile GMV as % of total GMV: 73% in the three months ended March 31, 2016, up from just over half a year earlier.
Mobile MAUs: 410 million in March 2016, ✅ up 42% from 289 million a year earlier.
Annual active buyers (trailing twelve months): 423 million as of March 2016, ✅ up 21% from 350 million a year earlier - still the primary GMV growth driver, per management's own attribution.
Mobile revenue, China commerce retail: RMB50,337 million, 63% of China commerce retail revenue in fiscal 2016, up from 30% a year earlier - mobile monetization rate improved to 2.51% from 1.79%, meaningfully closing the gap flagged as a concern in last year's post.
China commerce revenue: RMB84,321 million ($13,077 million), up 34% - retail marketplaces contributed RMB80,033 million (+34%), wholesale (1688.com) RMB4,288 million (+34%).
International commerce revenue: RMB7,629 million ($1,183 million), up 18% - retail (AliExpress) RMB2,204 million (+25%), wholesale (Alibaba.com) RMB5,425 million (+15%).
Cloud computing revenue: RMB3,019 million ($468 million), ✅ up 138% - the fastest-growing line in the business, still a small share of total revenue (see The Prescription above).
Other revenue: RMB6,174 million ($958 million), up 12% - includes UCWeb, AutoNavi, and over-the-top TV/YunOS, offset by the wind-down of the SME loan business transferred to Ant Financial Services in February 2015.
GMV settled through Alipay: approximately 75% of China retail marketplace GMV in fiscal 2016 - unchanged from last year, still Alibaba's single largest points of dependence on a company it doesn't control (see last year's post on the Ant Financial structure).

Beyond the Usual

A second SEC inquiry opens over the exact things this year's accounting relied on

Alibaba discloses two separate SEC matters in this filing. The first - opened January 30, 2015 after the SAIC "white paper" episode and flagged in last year's post - was concluded in September 2015: the SEC notified Alibaba it did not intend to recommend an enforcement action based on the information received. But earlier in this fiscal year, the SEC opened a second, entirely different inquiry, requesting documents and information on Alibaba's "consolidation policies and practices (including our accounting for Cainiao Network as an equity method investee)," its "policies and practices applicable to related party transactions in general," and its "reporting of operating data from Singles Day." Alibaba is voluntarily cooperating and states the SEC's request shouldn't be read as an indication of wrongdoing - standard boilerplate for any open inquiry. But the subject matter here is not abstract: this is the same fiscal year Alibaba used a related-party voting-rights waiver to consolidate Alibaba Health and book a $2.9 billion gain (see below), and reported a Singles Day GMV of RMB91 billion ($14 billion) settled through Alipay within 24 hours the same event the regulator is now asking questions about how it counts.

Alibaba first invested in Alibaba Health in April 2014 through a 70%-owned special-purpose entity, with Yunfeng Capital - a fund in which Alibaba's executive chairman holds a 40% interest in the general partner - holding the other 30%. Under the original shareholders' agreement, the underlying Alibaba Health shares were voted by Alibaba and Yunfeng Capital separately, based on their own effective interests, meaning Alibaba's own effective voting stake was only about 38% - not enough to control Alibaba Health, so it was booked as an equity-method investee. In July 2015, Yunfeng Capital agreed to give up its separate voting rights "at no consideration." That single change, with no cash changing hands and no shift in anyone's actual economic ownership, gave Alibaba accounting control over the entire 54% stake held by the special-purpose entity - control was reclassified, not acquired. Alibaba then revalued its previously-held 38% effective interest to Alibaba Health's Hong Kong Stock Exchange market price and booked an RMB18,603 million ($2,885 million) non-cash gain, of which RMB49,320 million was recognized as goodwill against only RMB1,290 million of identifiable net assets acquired - a deal priced almost entirely on the premium of gaining control, not on anything Alibaba Health actually owned.

The shareholder litigation picture, six months on

The seven federal shareholder class actions flagged in last year's post - consolidated in the Southern District of New York under Christine Asia Co., Ltd. v. Alibaba Group Holding Limited - remain unresolved: motions to dismiss were fully briefed by September 2015, and as of this filing the parties are still awaiting the court's decision. A second front opened since then: in October 2015, three securities class actions were filed in California state court (San Mateo County), alleging materially the same IPO-disclosure claims under the Securities Act of 1933; they were consolidated as Gary Buelow, et al. v. Alibaba Group Holding Limited, et al., and Alibaba filed a demurrer in May 2016. Separately, the Kering-led counterfeit-goods lawsuit (Gucci, Balenciaga, Bottega Veneta, Yves Saint Laurent) is proceeding through discovery, with Alibaba's motion to dismiss the RICO claims still pending. None of this has produced a loss or an accrual - Alibaba still assesses the risk as remote - but three separate legal fronts, none resolved a year later, is a longer tail than a reader would guess from the headline "no material adverse effect" language alone.

Also unresolved but unchanged: the RMB2.0 billion loan facility Alibaba agreed to extend founder Simon Xie in April 2015 (flagged in last year's post) became available for draw-down on January 1, 2016, but had not been drawn as of this filing.

Alibaba's forward capital commitments jumped twelve-fold in one footnote

Alibaba's disclosed investment commitments - contractually obligated future payments for investment securities and equity investees not yet reflected on the balance sheet - jumped from RMB5,364 million to RMB65,597 million ($10,173 million) year-over-year, primarily the considerations for two deals that closed just after this fiscal year ended: the completed acquisition of the remaining shares of Youku Tudou for RMB28.4 billion ($4.4 billion), giving Alibaba 100% ownership of China's leading online video platform, and a pending RMB28.2 billion investment for a 19.99% stake in Suning, one of China's largest consumer electronics retailers, expected to close by June 30, 2016. Alibaba also completed a $1.0 billion acquisition of a controlling stake in Lazada in April 2016 - its first controlling international acquisition, giving it e-commerce platforms across Indonesia, Malaysia, the Philippines, Singapore, Thailand and Vietnam. None of this shows up in the fiscal 2016 income statement; it's a forward commitment a reader would only find by opening the commitments footnote.

The price of building a media and entertainment business shows up in a different footnote

Alibaba's disclosed commitments for licenses and copyrights - non-cancellable agreements to acquire content rights for its mobile media and entertainment business - jumped from RMB282 million to RMB3,770 million, a more than thirteenfold increase, alongside the acquisitions of Youku Tudou (online video) and continued build-out of the entertainment strategy discussed with Wasu (flagged last year). Co-location, bandwidth, and marketing commitments also grew from RMB5,134 million to RMB8,422 million, driven by the cloud computing and data platform investments discussed in The Prescription above. Both are the disclosed cost of businesses Alibaba is choosing to build beyond its original marketplace - visible only in the commitments footnote, not the income statement, since none of it has been spent yet.

The royalty and profit-share income Alibaba recognizes from Ant Financial Services under the Alipay Intellectual Property License and Software Technology Services Agreement - the perpetual 37.5% of Ant Financial's consolidated pre-tax income structure detailed in last year's post - fell from RMB1,667 million to RMB1,122 million ($174 million) this year. Alibaba attributes this plainly to Ant Financial's own increased marketing and promotional spending to drive user growth, which reduced Ant Financial's consolidated pre-tax income. Separately, in May 2016 (after fiscal year-end), Ant Financial completed roughly $4.5 billion of new equity financing; as of this filing, Junhan holds approximately 42.28% of Ant Financial, Junao approximately 34.15%, and other shareholders the remaining 23.57% - the ownership structure through which Jack Ma continues to control Ant Financial without Alibaba owning any equity interest in it at all.

More of Alibaba's cash is getting trapped onshore

The portion of Alibaba's PRC subsidiaries' and VIEs' net assets restricted from being paid out to the parent company as dividends grew from RMB26,902 million to RMB39,116 million, a 45% increase - PRC rules require a 10% statutory reserve appropriation before any dividend and prohibit distributing registered share capital, and these restrictions compound as the PRC business itself grows. Alibaba states it doesn't currently need these funds repatriated for working capital, but the trapped balance is now larger, in both absolute and relative terms, than it was a year ago.

Target Valuation Range

~$195.5 billion market capitalization, ~18.3x trailing GAAP P/E but ~30.4x on Non-GAAP earnings - a fairer read of recurring earnings power. Reported GAAP earnings are inflated by the two non-cash gains detailed above; on Non-GAAP earnings the stock is priced for a lot of future growth, not the bargain the GAAP P/E^» makes it look like.

Alibaba's ADS closed at $79.03 on March 31, 2016 (the quarter's period-end), against 2,473,927,859 ordinary shares outstanding. Alibaba has not split its NYSE-listed stock since its IPO, so this remains the actual nominal price quoted at the time. The stock had closed fiscal year 2015 at $83.24; over this fiscal year it fell as low as $58.97 (September 2015) before recovering to $79.03 by this fiscal year's close.

Market cap → enterprise value	FY2016
ADS price (period-end)	$79.03
Shares outstanding	2,473,927,859
Market capitalization	~$195.5B
Total debt	$8,959M
Less: cash and short-term investments	$17,295M
Enterprise value	~$187.2B

Peer-multiple sanity check	FY2015	FY2016
Trailing P/E (GAAP)	~53.4x	~18.3x (diluted EPS $4.33, inflated by non-cash gains)
Trailing P/E (Non-GAAP)	n/a (not disclosed)	~30.4x (Non-GAAP diluted EPS $2.60)
P/B	~8.9x	~5.8x (book value/share ~$13.60)
EV/Revenue	~15.9x	~11.9x
EV/EBITDA (Non-GAAP)	n/a	~23.1x (EBITDA $8,117M)

P/B fell mechanically because the equity base grew faster than the stock price. The Non-GAAP P/E excludes both non-cash gains, share-based compensation, and amortization - a materially more expensive (and more honest) read of the multiple the market is actually paying.

DCF (base/bull/bear, illustrative only): Two fiscal years of public-company data is still a thin base for a full multi-year DCF.

Scenario	Key assumption	Implied value
Current (FY2016 close)	actual market price, for reference	$79.03/ADS (~$195.5B market cap)
Bear	the litigation overhang (three separate unresolved actions) or the new SEC inquiry produces a real financial or reputational cost, mobile monetization gains stall out, and the newly-acquired businesses (Youku Tudou, Lazada, the pending Suning stake) drag on margins longer than expected	~$46.80/ADS (~$115.8B market cap) - market prices off Non-GAAP earnings power more strictly, multiple compresses to a high-teens P/E (18x) on Non-GAAP diluted EPS of $2.60
Base	GMV growth (27% this year) moderates but stays well above 15% for several more years, the mobile monetization gap keeps closing, cloud computing keeps compounding off a small base, and the litigation resolves without a material loss	≈$79.03/ADS (~$195.5B) - the current ~30x Non-GAAP multiple holds roughly flat as earnings grow into it
Bull	cloud computing (138% growth this year, still just 3% of revenue) becomes a second major profit engine, the Lazada acquisition gives Alibaba a genuine foothold in a second large consumer internet market, and Tmall's continued share gains keep pushing the blended monetization rate higher	≥$79.03/ADS (≥~$195.5B) - justifies today's multiple or better

Reverse DCF: To justify the current ~$195.5 billion market cap purely on today's fundamentals, Non-GAAP free cash flow (RMB51,279 million/$7,953 million this fiscal year on the company's own disclosed basis) would need to compound at a high rate for many years running - directionally consistent with what a still-27%-GMV-growth platform needs to deliver, but a reminder that the reported net income figure driving the low headline P/E this year is not the number this valuation math should actually be run on.

Alibaba Group Holding Limited's Form 20-F annual report for the fiscal year ended March 31, 2016, filed with the U.S. Securities and Exchange Commission.