Alibaba: The Audits Look Increasingly Bullish (NYSE:BABA)

Recently, the Securities and Exchange Commission (“SEC”) announced that it had concluded its audit review of U.S.-listed Chinese stocks. By all accounts, the review went well. The SEC completed its work ahead of schedule, indicating that the inspections went smoothly. Today, the PCAOB further announced that it had received good access to Chinese companies’ books after “thorough and systematic testing.”

We can’t say for sure that the total review went well (there’s more to audits than just “accessing” things), but the swift conclusion and glowing comments suggest that the SEC is about to hand investors some good news. So far, it has reviewed BABA and a few other companies’ books–it was these reviews that the glowing comments pertained to. We could yet see some smaller companies getting unfavorable reviews, but the news looks good for investors in Chinese blue chips.

The audit review isn’t over yet, as the SEC still has to finish reviewing documents. In addition to issues at facilities, accounting discrepancies can also trigger unfavorable audit opinions. We’ll have to wait and see whether the SEC thinks Chinese firms are doing good audits, but it shouldn’t be more than a few weeks’ wait. The final reports are expected this month.

This is all very encouraging news for Alibaba Group Holding Limited (NYSE:BABA) shareholders. Alibaba was one of the companies picked by the SEC to be reviewed first, so the SEC’s report on it should be out pretty soon. We don’t have an exact date on which the report will publish, but we do know that the SEC expects to republish reports by the end of 2022. Given that we’re halfway through December, that means we should be seeing something in a matter of weeks.

If any Chinese company is likely to pass the SEC’s audit inspections with flying colors, Alibaba is the one. As an e-commerce company, its business lacks any meaningful tie to state military or intelligence activities. Alibaba Cloud once held some government contracts, but those ended when China shifted to doing cloud services in-house.

There is little that Alibaba would need to hide from the U.S. government, so it’s likely to have given the SEC access to all the documents it needs. For this reason, I consider the upcoming audit review publication to be a bullish catalyst for the stock, as we’re seeing solid signs that the result will be a positive one.

Alibaba – My Fundamental Thesis

Alibaba is a stock I have covered extensively on Seeking Alpha and on Twitter. The basic gist of my thesis on the stock can be found in my past articles on the topic. To review briefly:

• Alibaba is cheap, with valuation multiples below those of similar-sized U.S. tech stocks.

• The company is growing, having achieved 68% growth in operating income and 61% growth in free cash flow in its most recent quarter.

• It also has a strong competitive position; it faces two main competitors in China, JD.com (JD) and Pinduouo (PDD), both of which have different business models than BABA’s own. Neither of these companies competes with Alibaba Cloud, which is China’s Cloud market leader. Alibaba competes with Tencent (OTCPK:TCEHY) in the Cloud and payments.

For a big picture overview of my thoughts on Alibaba, you can check out my recent article Alibaba: FOMO is No Reason to Buy, which covers the competitive landscape, valuation, and a few possible catalysts. Basically, the stock has both value and growth characteristics, a strong competitive position, and a number of catalysts on the horizon. I’ll dedicate the remainder of this article to discussing the audit review catalyst in detail.

Chinese Company Audit Reviews – The Background Story

The ongoing SEC reviews of Chinese audit documents are just the latest in a much longer saga concerning the delisting of Chinese stocks from the NYSE. Beginning in the Trump Administration, the U.S. began delisting Chinese companies thought to not be in compliance with U.S. auditing standards. After Trump left office, the Biden administration kept the former President’s policies in place. In fact, the policies accelerated after the new administration came in. In 2022, the SEC added dozens of Chinese companies to the “Holding Foreign Companies Accountable Act” (a list of Chinese companies being considered for delisting). Later, it banned exports of various chip components to China, and demanded that ASML Holding (ASML) stop selling EUV lithography machines to China. The trade tensions between the U.S. and China have been steadily escalating, which is part of why many people think that Chinese stocks will end up getting delisted.

There is little doubt in my mind that some Chinese stocks will in fact be delisted. However, Alibaba specifically has a good chance of making the grade, as I’ll show in the next section.

Why Alibaba Is A Top Contender For A Favorable Audit Review

There are several reasons why Alibaba is a top contender for a favorable audit review by the SEC.

The first is the simple fact that China has no incentive to withhold data from foreign investors. The U.S./China audit dispute ultimately comes down to the U.S. wanting more data and China wanting to protect sensitive national security information. When it comes to industries like semiconductors, telecoms and social media, disclosing complete information can sometimes compromise national security. Semiconductors are used in drones, telco data includes peoples’ locations, and social media can be used to gather intelligence. Offering these kinds of companies to full audits by foreign countries can be a national security risk. For example, if you let a foreign country’s auditors inspect a chip maker’s facilities, they could bring trade secrets back home with them. Chinese companies that handle such information may not be able to comply with SEC audit requirements.

Alibaba is not such a company. It’s an e-commerce firm, meaning that it helps people buy and sell goods online. It does so through business to consumer (“B2C”) services like AliExpress and Tmall, and business to business (“B2B”) services like Alibaba.com. In neither B2C nor B2B use cases is Alibaba required to store sensitive national security data, so it should be able to offer the SEC reasonable access, both on site and in documents. I don’t think Alibaba’s recent foray into chips detracts from this point, as BABA’s chips are not going to be used in military devices.

Why A Favorable Audit Review Is A Catalyst

The reason why a favorable audit review would be a bullish catalyst for Alibaba is because the company is currently trading at a discount to fair value, its price being held back by perceived risk factors. The risk factors holding back the stock’s price include U.S./China tensions, COVID Zero, and lingering concerns about 2021’s tech crackdown. Many of the perceived risk factors have been overcome. For example, we haven’t heard about any new regulatory measures since early this year, and China has eased its COVID control policies. A favorable audit review opinion would be just the next catalyst we’d need for another leg up.

Alibaba would have significant upside based on nothing other than its valuation converging with that of U.S. big tech companies.

At today’s levels, the NASDAQ 100-Index (NDX) trades at:

• 24.5 times earnings.

• 6 times book value.

• 3.6 times sales.

By contrast, Alibaba trades at:

• 12.3 times adjusted earnings.

• 1.79 times book value.

• 1.9 times sales.

Were Alibaba to hit the NASDAQ-100’s earnings multiple, it would rise 100%.

Were it to hit the NASDAQ-100’s price/book multiple, it would rise 235%.

That’s a significant amount of upside.

Now, of course, there’s more to an analysis than just comparative multiples. The U.S. and China are totally different markets, and the NASDAQ could just as easily fall as Alibaba could rise. In fact, I personally think the NASDAQ is likely to fall from today’s levels. However, with the news we got today from the PCAOB, we know that there is a good sign the audit reviews will go well. If they do go well, then we’d expect Alibaba to make some gains. Personally, I’m in the stock until $150 at least.

The Bottom Line

What a year it has been for Alibaba. We’ve seen plenty of volatility, lots of ups and downs, but ultimately, the stock has out-performed the NASDAQ-100.

This year, we are seeing many China-related risk factors beginning to wane. There have been no new regulatory upheavals, Zero COVID has basically been ended, and now it looks like the de-listing risk is about to go away too.

That doesn’t mean that there won’t be plenty of risks in the future. The U.S. and China still disagree about Taiwan, and BABA does face competitive pressure from JD and Pinduoduo. But the most pressing and serious risk factors seem to be fading. That in itself doesn’t make Alibaba a buy, but the idea that China as a whole is “uninvestable” is losing credibility by the day.

There is a good chance, then, that Alibaba could see some upside just from investors buying China index funds. And if valuation means anything, as I think it does, we should see a day when Alibaba shares are going for $150. Of course, BABA stock will be volatile, but for the enterprising investor, volatility is merely an opportunity.