Chinese E-Commerce Co: Real Growth or just Creative Accounting?

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Ever made an investment decision based on market hype? Multi-Act experts review a Chinese e-commerce company headed by a celebrated personality that appears to be outdoing its competitors. While the company seems to be a victor; a careful quality of earnings analysis by our team reveals some creative accounting practices that investors should not ignore. Analysis includes the company’s:

  • Adjusted Non GAAP EBITDA and Net Income
  • Capital Allocation
  • Low Tax Rate Sustainability
  • USD Denominated Debt

Questions arise about the said company’s profit margins, cash-flows and valuation. Read how this can impact investor decisions.

Market participants have a tendency to get hooked on to the latest theme and irrationally invest in the “rising story” only to make losses when the bubble goes bust. This tends to distort not just market prices, but can also lead a company’s management to use ‘creative’ accounting practices to depict valuation growth.

Many Chinese technology companies are getting lofty valuations in the private market. Our quality of earnings analysis of a well-known Chinese e-commerce company has indicated such creative accounting practices. And, as the E- commerce theme gains ground across the globe most of investors may be overlooking the impending landmines in the company’s accounts like reporting of higher net income on a Non GAAP basis and low tax rate.

1. Adjusted Non GAAP EBITDA and Net Income

According to the company’s Annual Report for FY15, its Non GAAP Net Income represents Net Income before share-based compensation expense. These expenses are shown under various cost heads from cost of revenues to SG&A and thus form ongoing expenses resulting in a question as to why should one adjust them back. A good probability maybe that such costs were not paid in cash, but even then it does represent a dilution in the shareholder’s ownership and is a cost to the company. Also had it been paid in cash instead of securities, it would have lowered cash flows.

As seen in the table above, if one adjusts Net Income for extra ordinaries like impairment and gain on revaluation of investments then the Net Profit margin appears nearly half of the Non-GAAP Net Profit margin and also shows more decline in Profit margin than on a Non-GAAP basis. In other words, when accounted for under standard framework of guidelines for financial accounting the Net Profit margin seems to be declining.

Note that the company has disclosed Non-GAAP net income by adjusting for all items without any tax adjustment. Also, note that the tax rate is very low and differs widely from statutory rate and so we have not made tax impact adjustment on extra ordinariness.

2. Capital Allocation

2c

Immediately after IPO, the company has grown in various areas through acquisitions. Note the growth in acquisition related balance sheet items shown in the table above (investment in Equity investees, goodwill, net worth etc.). Some notable observations are:

  • In terms of price to sales, the valuation of acquired companies ranges from 46x to 79x, but one may argue high growth makes worry about valuation meaningless. However, high valuations have often been one of the most important cause of permanent losses. The acquired businesses are emerging one and have no established barriers; the only element that can influence valuation is rapidly changing technology. Currently, such high valuation is being manifested in goodwill growth. Hence, the payment for goodwill depends wholly on future developments.
  • Large investment revaluation gains have occurred, due to step acquisitions. Cumulative revaluation gains formed 40% of tangible net worth at December 2015. In effect the company can increase its net worth or improve debt to equity ratio (D/E) by buying target companies in steps at higher price!
  • Some of the large investee acquisitions were accounted for at cost method. Note that such election of cost method results two differences versus Equity method
    • (a) pro-rata earnings/loss from such investment is not recorded in Company’s earnings, only dividend income is recorded and
    • (b) balance sheet valuation remains at the cost company paid for acquisition with no recognition of goodwill.

Let’s look at some of companies acquired:

  • One of the acquired companies is a social media platform in PRC and valuations in terms of Price/Sales is around 46x with the business still in operating loss and negative on operating cash flows.
  • The company acquired 66% stake in a developer of mobile web browsers in PRC in May 2013, following which it was accounted for as an associate at cost method in December 2013. A second time acquisition in June 2014 was at 125% premium over earlier price paid.
  • One of the acquisitions, an Internet television company in PRC, is making losses at operating level and the approximate value paid is at a Price / Sales ratio of 10X.
  • A 60% stake in a company that produces and distributes films and television programs, represents approximate Price /Sales of 79X with Sales near RMB 100 million, with the company making losses in operating income and operating cash flow level in 2014. High valuation paid is also reflected in large goodwill recognized by the company as per the 20F filing in 2015: “Goodwill arising from this acquisition was attributable to the synergies expected from the combined operations of the Company, the assembled workforce and their knowledge and experience in the entertainment and media industry in the PRC”.

3. Low Tax Rate Sustainability

Accrued tax expense as % of PBT has trended higher and was still below statutory rate. Hence, given a scenario wherein the tax rate increases, earnings will be lower than expected.

Moreover, as cash paid for tax is even lower than accrued tax expense, the earnings either are not real on tax accounting basis or as stated earlier the tax rate is way lower than statutory rate and thus there is a risk of lower cash flows than expected.

The holding company which issues shares is based out of the tax haven Cayman Islands. Moreover, there are various tax benefits for PRC operating companies for a certain period of tax breaks. Thus, there is the risk of possible tax rate increase in the future.

4. USD Denominated Debt

At March 2015, the company had RMB 79,899 million of debt denominated in USD. It equals 77% of Tangible net worth. While the cash of RMB 108,193 million appears ample, it is in RMB.  In the possible scenario of currency depreciation versus USD, this may prove to be a risk factor.

Summary

The company right now seems like a victor amongst its competitors given its significant acquisitions and the buzz around the celebrated face who heads it. On the other hand, the company’s accounting practices raise many questions about the company’s profit margins, cash-flows and valuation. Given the fact that the valuation levels resemble a bubble, a prudent investor should be careful.

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Multi-Act Equity Consultancy Private Limited 

(SEBI Registered Portfolio ManagerRegistration No. INP000002965)

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