Alibaba: U.S. Audit Inspection Is A Major Catalyst (NYSE:BABA)

Delisting is a spectre that has been hanging over Alibaba Group Holding (NYSE:NYSE:BABA) for more than a year. Under Donald Trump, the United States passed the Holding Foreign Companies Accountable Act (“HFCAA”), which threatened to delist Chinese companies from the NYSE if they didn’t meet U.S. auditing standards. When Trump backed the HFCAA in 2020, the act’s passage was immediately followed by three Chinese companies withdrawing from the NYSE. They were pretty small companies, though, and not that many investors noticed their absence.

This year, things started to change. In 2022, the Public Company Accounting Oversight Board (“PCAOB”) began adding large Chinese companies to the HCFAA. Notable names included NIO (NIO), Pinduoduo (PDD), and Alibaba. BABA was a relatively late addition to the list, and its inclusion caused quite a stir at the time. When news of BABA’s inclusion in the HFCAA list hit the markets, the stock tanked.

Today, Alibaba has a chance to prove that it is playing by the same rules as any U.S. company. China has invited U.S. audit inspectors to come in and evaluate its companies, and according to Bloomberg, they should be arriving in Hong Kong to do inspections this week. It’s possible that they’re in Hong Kong right now! If they are, then they will soon begin their review of Alibaba’s accounting stands, which will include:

• Reviewing audit documents.

• Interviewing auditors.

• Checking internal controls.

This audit inspection is a big moment for Alibaba. It has long been acknowledged that Alibaba is a good business, with high margins and strong historical growth. However, the many risk factors the company is exposed to have deterred investors who otherwise would have been interested.

If Alibaba passes the U.S. audit inspection, that could prove to be a real catalyst for its stock. It will be one major risk factor for the company eliminated, leaving the stock just that much freer to trade based on fundamentals. To be sure, there will still be risk factors in place even after Alibaba gets removed from the HFCAA (assuming that it does), but the list of risks will be shorter, which may go a long way in persuading investors who are on the fence about Alibaba.

Why Alibaba Stock is Cheap

One of the big reasons why Alibaba stock is attractive to certain investors is because it is pretty cheap compared to what the underlying business owns. At today’s prices, BABA trades at just:

• 12.1 times adjusted earnings.

• 1.8 times sales.

• 1.65 times book value.

• 11 times operating cash flow.

For a big tech company in 2022, these multiples are quite low. Alibaba is also pretty cheap in a discounted cash flow (“DCF”) analysis with no growth assumptions. Alibaba had $4.34 in free cash flow per share over the last 12 months. If you simply discount that amount at the 10 year treasury yield (3.4%), you arrive at a terminal value of $127. You can raise the discount rate all the way up to 4.8% and still get a terminal value of $90–slight upside to today’s price. All of these are simply terminal value calculations: no growth is being modelled or assumed. Therefore, if Alibaba does manage even slight growth in the years ahead, it is worth more than today’s stock price.

The problem for Alibaba is risk. There aren’t that many people who deny that Alibaba is cheap compared to the cash flows it generates. Instead, bears say that the stock is too risky, because shares are at risk of becoming un-tradable. If BABA is delisted from the NYSE, then it will be difficult for U.S. retail investors to trade it. Big institutions are well equipped for Hong Kong trading with overnight trading operations, but having to stay up late to buy or sell a stock may be a deterrent to retail traders. Additionally, U.S. markets are more liquid than their Hong Kong peers, resulting in lower U.S. trading costs. Delisting is not a real “risk” to Alibaba as a company, but it could reduce demand for the stock, due to inconveniences and costs associated with not being on the NYSE.

This is why the ongoing audit inspection is such a big deal for Alibaba. If it passes, then its status as an NYSE listed company will be secured. That’s one big risk that can be removed from the list of risk factors that investors think justify BABA’s discount.

Will Alibaba Pass the Review?

So far, I’ve established a pretty simple case for BABA’s audit review being a catalyst for the stock:

BABA is a cheap stock, uncontroversially, but many think that a mountain of risks justify the discount. If the risks go away, then, buying could pick up.

This all makes sense in theory, but what exactly are Alibaba’s chances of passing this audit review?

According to Brendan Ahern, CIO of KraneShares (which runs the popular CSI China Internet ETF (KWEB)), they’re actually pretty good. In a recent Forbes article, Ahern pointed out that:

• Alibaba uses PwC Hong Kong for audits.

• PwC is a trusted accounting firm in the United States.

• PwC Hong Kong is ultimately overseen by the PwC national office in the United States.

• PwC has always given BABA clean audit opinions.

So we’ve got a U.S.-supervised auditor reviewing Alibaba’s financial statements already, and they are not complaining about the company withholding any crucial information. If the PCAOB audit inspectors are operating in good faith, then they’ll likely be pleased with what they see when they inspect Alibaba this week. There is an outside chance that the audit inspectors are not operating in good faith, and that this is all just theater being put on by political actors who made up their minds long ago. But the fact that the U.S. and China managed to reach a deal at all suggests that both parties are willing to cooperate. We know that the relevant parties met and negotiated, and that at least one of them was willing to compromise. So, there’s reason for optimism that Alibaba’s audit review will turn out well.

Competitive Advantage

Potentially, the PCAOB’s audit review could have positive implications for Alibaba relative to competitors. Not all Chinese companies have been able to meet the SEC’s audit standards. Last month, Five Chinese firms voluntarily delisted from the NYSE when it became apparent that their information was too sensitive to put into the hands of U.S. regulators. China’s government doesn’t think that BABA possesses any such sensitive information, as it is letting the company hand over its audit documents. Over time, Alibaba may accumulate an edge over firms that can’t list in the United States. The NYSE is a massive, liquid market, which lets companies raise capital on favorable terms. We’d hope that Alibaba doesn’t have to issue any more stock–its ongoing buybacks are a major part of the bull case. But there are scenarios where Alibaba having access to the NYSE would be a positive. For example, if BABA’s partially-owned subsidiary Ant Group were to list in New York, its affiliation with Alibaba could help it get the necessary regulatory approvals. That in turn could enrich Alibaba shareholders by boosting the balance sheet value of their indirect Ant Group holdings.

Risks and Challenges

As we’ve seen so far, Alibaba getting a clean audit review from the PCAOB would be a huge catalyst for its stock. BABA is uncontroversially cheap, the bear case on the stock mainly has to do with risks–if the delisting risk is thwarted, that could trigger some buying. However, there are risks stemming from the potential catalyst itself, including:

• A negative opinion from PCAOB auditors. If the PCAOB’s auditors review Alibaba’s audit documents and don’t like what they see, that could cause all kinds of problems. It could trigger demands for more information that China won’t want to supply due to national security concerns. It could lead to demands that Alibaba change its auditor. It could put us back to square one, where Alibaba is on a three-year timeline to delisting. Any of these scenarios is possible. If they become too frustrating for Alibaba’s management to deal with, they may choose to delist from the NYSE voluntarily, as many Chinese firms have already done.

• New tensions between the U.S. and China. If U.S. auditors deem Alibaba and other Chinese companies’ audit standards inadequate, that could inflame tensions between the U.S. and China, which are already at odds with one another. This year, the two nations have already sparred over sanctions against Russia, China’s war games in the Taiwan strait, and Nancy Pelosi’s visit to Taiwan. A major dispute about audit materials that China considers vital to national security could add further fuel to the fire. Alibaba, as an e-commerce company that sells to consumers, is not likely to be the company that causes disputes over sensitive national security data. But other companies involved in the broad U.S./China audit story might.

The Bottom Line

The bottom line on Alibaba’s audit review is this:

It is the company’s best chance yet to prove that it will remain tradable on the NYSE, and put investor concerns to rest. There is no shortage of recognition that Alibaba stock is cheap, but there is this vague sense in certain segments of the market that BABA shares will someday be confiscated or otherwise become un-tradable. If Alibaba passes its audit reviews, those concerns will be put to rest. Viewed in this light, the audit reviews could prove to be a positive catalyst for BABA.