JD.com, Alibaba: Dilutive Buybacks, Sincerity or Trickery?

Starting from the listing of Baidu around 2005, in the past twenty years of Chinese assets going public overseas, especially in the tumultuous recent five years, there have been many unsettling events and drastic changes in the environment. One of the biggest changes, in the view of Dolphin, is that many listed companies have not yet adapted to the changing valuation system, which requires progress in corporate governance through iterations, more specifically, through buybacks.

Originally, since last year, many stocks have started to iterate and gradually implement some dividend buybacks. Some companies have even been quite sincere in terms of returns. However, recently, with JD.com taking the lead and Alibaba following suit in using convertible bonds to support buybacks, some market funds couldn't help but feel skeptical:

Aren't most Chinese concept stocks known for having ample cash flow? Why do they need to borrow money for buybacks?

The market is familiar with the high-level financing operations of major companies. In a high-interest environment, what is the strategy behind low-level financing in undervalued conditions?

On one hand, buybacks reduce share capital to boost stock prices, while on the other hand, potential dilution of share capital after convertible bond conversion occurs. What is the actual effect of these buybacks?

Is investing in Chinese concept stocks from a shareholder return perspective a true proposition or a false logic?

Below, Dolphin will attempt to address these questions, but before delving into them, let's first discuss why this is currently so crucial.

I. The Lost Good Days vs. the Belated Awareness of Chinese Concept Stocks

For a long time, Chinese assets going public overseas have generally been characterized by high GDP growth domestically, industry and self Alpha support leading to income and operational indicators growth far exceeding their overseas counterparts, as well as the extremely low interest rate environment overseas. The combination of low interest rates externally and high growth of individual stocks has resulted in a premium on growth valuation. Under this growth premium, the core focus of funds has been on earning price differential returns, with no demands on shareholder returns.

However, starting from 2022, these Chinese assets listed overseas have begun to face a completely opposite combination environment - high interest rates externally and low growth internally. The high interest environment externally means that the cost of holding equity investments is very high, as the US dollar funds lying idle can earn 5-6% returns by investing in money market funds and government bonds. Most Chinese assets at the individual stock level are facing the dilemma of domestic market competition and the difficulty of expanding overseas compared to maintaining the existing market share, leading to stagnant growth.

From the perspective of US dollar funds, the practical issue of investing in Chinese concept assets is: high external interest rates lead to higher costs of holding investments, RMB depreciation requires additional assumption of RMB profits for investing in China, and exchange rate losses under USD valuation. In addition to these two layers of macro risks, the growth potential of most individual stocks themselves has stagnated, and most of them do not have the habit of rewarding shareholders.

The result of the combination of these macro and micro issues is that the valuation of Chinese assets listed overseas is continuously squeezed, transitioning from growth stocks with valuation premiums to value stocks with valuation discounts. Many stocks have been squeezed to the point where only 60-70% of their net cash value on the books supports their valuation, and US dollar funds are still reluctant. The simple and direct reason for this reluctance is: "No matter how much money they have on their books, if they don't pay dividends or buy back shares, what does it matter to me." One of the key factors in reversing this issue is that with the new regulations, Chinese assets overseas have also begun to vigorously distribute dividends and repurchase shares. In fact, starting from the second half of last year, leading companies such as Tencent and Alibaba have shown significant repurchase efforts. Some companies have also expressed in private communications that they plan to allocate more funds for repurchases in their future capital allocation plans. However, the formal announcements to the public, which were based on the financial reports for the fourth quarter of last year released in the first quarter of this year, sent an exceptionally clear and loud signal: the return rate of dividends and repurchases relative to the company's market value generally ranges from 4-7%, which is comparable to the current risk-free rate level in the United States.

II. So, should companies repurchase shares?

As Chinese assets listed in the U.S. market have started to seriously distribute dividends and repurchase shares, from the perspective of potential investors with USD funds who are considering purchasing Chinese assets, there is at least a basic safeguard layer: buying in at a low enough price to mitigate the risk of downward stock price movement, coupled with comparable risk-free returns from dividends and repurchases. This is akin to buying into a controlled downward loss scenario, where any losses can be offset by the returns from dividends and repurchases, while also having the opportunity to speculate on stock price elasticity.

From a company's perspective, share repurchases are essentially about how a company manages its operating cash flow, how it allocates capital, achieves the highest ROI, and ultimately improves the company's ROE.

Generally, when a company has discretionary operating cash flow, it typically needs to allocate it towards:

1. Internal business investments

a) Expanding production on a certain track, investing in the future, building long-term barriers to entry, similar to Pinduoduo's early user subsidies; b) Exploring new tracks and markets, establishing a second growth curve—similar to Meituan's community group buying, Pinduoduo's TEMU, etc.; c) Maintaining stock investments in the current business volume, mature companies do not need to expand production, but need to make some basic updates to maintain the current business.

2. External equity investments

a) In areas where the company is not proficient, using long-term equity investments to partner with others and let partners work hard for the company, as exemplified by Tencent.

3. Direct self-investment

This can be investing in oneself with high growth potential, like NVIDIA's dividends and repurchases, or visible absolute undervaluation like most Chinese concept stocks, where buying back one's own shares yields high returns.

The difference here is that if the repurchased shares are not cancelled, in the view of the author, it is like trading one's own stock, which is fundamentally no different from others trading one's stock. Only when the repurchased shares are cancelled does it truly benefit the shareholders.

Therefore, the issue of whether to repurchase shares is essentially a question of capital allocation efficiency. In the author's view, if the ROI of capital allocation is very high and can significantly outperform the idle costs in the eyes of fund managers (risk-free returns in the USD world, exchange rate losses in the current environment, and the amortization of equity incentives on equity), in such cases, it is understandable even without additional funds for dividends and repurchases. Here I would like to mention Pinduoduo, which has always been unique.

In the first few years after the company went public, it always referred to itself as an "infant", avoiding discussing profits and focusing on fundraising (for details, please refer to "Pinduoduo: Repeated Fundraising, Trick or Blessing?"). While most companies started to truly distribute dividends and repurchase shares, Pinduoduo directly confronted investors proposing share repurchases: "We have more efficient capital allocation opportunities, and currently do not consider repurchasing shares."

However, in the view of Dolphin, Pinduoduo, which has always had a very high input-output ratio, only appears to have high capital output efficiency. In fact, Pinduoduo currently has a conservative estimate of a quarterly loss of 5 billion, which amounts to a loss of 20 billion in a year. Despite the company's main site generating a profit of 30 billion in a quarter, a large amount of retained earnings are not used for operational investment and capital creation, but are kept in the account only earning interest (note that Pinduoduo has not engaged in external acquisitions like Alibaba during the process of accumulating retained earnings), which does not contribute to improving ROE. In other words, when the story of Pinduoduo's capital allocation comes to an end and its main site growth slows down, it still needs to address the issue of shareholder returns.

Setting aside Pinduoduo, focusing on the first two aspects of capital allocation mentioned by Dolphin, most companies are facing bottlenecks - the main track where they operate has become saturated or competition has intensified, and it is difficult to find a second curve. Expanding into overseas markets is challenging, and the path for equity investments has been largely blocked after anti-monopoly measures. Moreover, with generally low PE ratios of 8-10 times, investing in their own stock prices is actually an effective way to improve capital allocation efficiency and increase the input-output ratio for many cash-rich Chinese assets.

Under current market conditions, in fact, regardless of the relatively high valuations of US stocks compared to Chinese stocks, among the companies covered by Dolphin, except for Amazon and Tesla, most other giants have more or less engaged in dividends and share repurchases. Whether it's Apple, Google, Meta, or NVIDIA, many of them have started distributing dividends and repurchasing shares once their cash flow turns positive.

These companies generally have high valuations. From the perspective of return on dividends and repurchases, the returns are generally average. Investing in these companies essentially earns from the price difference of the stocks, but they all have a continuous and stable dividend/repurchase payout ratio, which many conservative investors also follow.

III. What is the dilutive buyback strategy of JD and Alibaba all about?

American companies are also very thorough in rewarding shareholders. For example, to repurchase shares for shareholders, in the low-interest era before 2022, it was common for companies to directly borrow money for buybacks. In the past two years, traditional energy companies in the US have faced pressure from Biden to increase oil and gas production and lower oil prices, but instead of increasing capital output, they have used the money to distribute dividends and repurchase shares for shareholders This time, the convertible bond repurchase initiated by JD.com and Alibaba, compared to overseas debt repurchases, may seem like borrowing money even when there is no need, giving the impression of a sincere repurchase. However, in reality, due to different financing tools and different interest rate environments during financing, the differences are quite significant.

For most companies in the US stock market, buybacks are done with low-interest debt in a low-interest rate era. The financing cost of debt is lower than that of equity financing, thereby driving down the overall cost of capital (WACC). However, looking at the operations of these two companies in China, with Alibaba being relatively more complex in terms of finance, let's take Alibaba as an example to examine the design of the financing repurchase:

1. For Investors: Named Convertible Bonds, Actually Call Options

1). Through convertible bonds (including green shoe options), a total of USD 5 billion was raised, with a net financing of USD 4.93 billion;

2). Debt portion: Interest rate of 0.5% (vs. current risk-free interest rate of US bonds of 5%+), interest paid semi-annually at mid-year and year-end; maturity date is June 1, 2031;

3). Equity portion: Initial conversion price of USD 105.04, a 30% premium compared to the announced price of USD 80.8 at the time of the convertible bond announcement;

4). Use: All used for operations related to repurchase - a. Initial repurchase of USD 1.2 billion, synchronized with the announcement of the convertible bond, repurchase price of 80.8; b. Future repurchases; c. Purchase of call options with a limit price of 161.6 USD.

Behind the design of this product, there are several key points: an extremely long maturity date, a conversion price with only a 30% premium under undervaluation conditions, and a very low financing cost for the debt portion relative to the risk-free interest rate, with the financing purpose being repurchase to directly support the stock price.

In other words, the equity behind this financing is far greater than the debt, and a 30% upward fluctuation within five years is easily achievable. It can be fully understood as Alibaba's investors having a call option at a premium of 30% compared to the market price of 80.8 USD/ADS, with the cost of the call option (referring to the embedded cost, the actual market price being the 0.5% bond interest), simply understood as the difference between the risk-free rate and the 0.5% bond interest rate.

2. Alibaba: Selling Call Options

In fact, Alibaba, as the counterparty in this transaction, is selling call options. Normally, this strategy is a bearish strategy, usually in a market and individual stock situation that is bullish overall. If it is believed that a stock has already significantly exceeded its fair value and the price is unlikely to break through, a call option is sold. For example:

When I believe that Pinduoduo at 200 RMB per share is a clear resistance level, I can sell a call option for Pinduoduo with a strike price of 200 USD. I am betting that the price of Pinduoduo is unlikely to break through 200 USD, and I aim to earn an option premium from it.

However, if Pinduoduo breaks through 200 USD and the counterparty chooses to exercise the option, in a naked short sale situation where I do not hold Pinduoduo shares, I will have to buy Pinduoduo shares at market price (let's say 300 RMB), and then sell the purchased shares to the buyer of this call option product at the price of 200 USD. Of course, the actual transaction should only settle the price difference part In terms of logic, selling this call option essentially means betting on a drop in stock price and earning a low profit - just the option premium. Once the stock price goes crazy and rises limitlessly, the potential loss for the seller is basically the difference between the strike price of this $200 call option and the market price, with theoretically unlimited losses.

If Alibaba's financing purpose is to boost the stock price through buybacks, this bearish strategy is likely to result in losses. Therefore, while selling this call option, Alibaba also executed a limit call option to further hedge the risk of this transaction.

III. What is Alibaba's actual cost?

In this transaction, Alibaba, as the counterparty to the investor, sold a call option on Alibaba with a strike price of $105 at a position of $80.8. The key question here is, what is the financing cost for Alibaba to issue this convertible bond. Here are three simple hypothetical scenarios:

1). Alibaba's stock price does not exceed $105.04, investors cannot exercise the option: In the end, they can only get back the principal plus 0.5% interest, so Alibaba's financing cost would be the interest payment at a 0.5% annual rate.

In this scenario, Alibaba has the lowest cost but also the lowest probability, unless its performance deteriorates significantly and macro conditions worsen, making it difficult for the stock to rise. For the original investors before Alibaba's financing, they would receive some return as shareholders. However, in this case, the convertible bond investors would only earn 0.5% interest, which is not motivating for them to subscribe to these convertible bonds.

2). Alibaba's stock price exceeds $105.04/ADS, investors all request to convert their investment into Alibaba's stock: This means physical exercise, where investors buy Alibaba's stock at $105. In this case, investors' profit would be the interest during the holding period, plus the difference between Alibaba's market price and the exercise price. For example, if Alibaba's market price is $140 at the time of exercise, investors effectively buy Alibaba's stock at a 75% discount, using $105 to buy stock worth $140.

At this point, Alibaba needs to use physical assets - stocks to meet investors' conversion demands. If Alibaba issues new shares to fulfill this, it would dilute existing shareholders' equity. If Alibaba uses previously repurchased shares to meet the conversion demand, it essentially releases the repurchased shares back into the market, increasing the float.

Ultimately, considering the financing and compliance costs of the convertible bond, from the perspective of existing shareholders, there is almost no buyback. Alibaba's buyback, rather than being a buyback, is more like a short option combined with a long position in the underlying stock.

From Alibaba's perspective, it has turned into: buying stocks at $80 and transferring them at $140 to bond investors at $105 (this operation almost nullifies the buyback effect, as the repurchased shares are released back into the market later), Alibaba earns the difference between $80 and $105, while bond investors earn the difference between $105 and $140, purely speculating on their own stock 3). Alibaba's stock price exceeded $105.04 per ADS, and investors requested to convert all their investments into cash: Convertible bond investors can exercise their cash redemption rights without diluting the share capital.

This means that the stocks repurchased by Alibaba will be cancelled, showing that Alibaba is truly conducting buybacks. In this scenario, Alibaba pays investors in cold hard US dollars, not physical stocks.

If convertible bond investors exercise their rights when the price is still $140, Alibaba will have to use cash to pay the difference between the exercise price of $105 and the market price of $140, instead of using share capital for payment. In this case, Alibaba is essentially using its own US dollar cash to bear the convertible bond interest and the cash difference between $105 and $140, without burdening shareholders.

In this situation, the final outcome will largely depend on the exercise price. Alibaba may end up guiding some positions to settle in physical stocks, spreading the cost among shareholders, while also making partial cash payments. Alibaba may hedge the cash payment part by buying call options during the exercise period to offset this cost, aiming to reduce cash costs and share dilution.

Four. Is it a true proposition or a false logic to invest in Chinese concept stocks from a shareholder return perspective?

Therefore, based on the above analysis, we can make the following rough judgment:

a. For ordinary investors, below the convertible bond conversion price (in Alibaba's case, below $80) and the lower the better, it is relatively safe to buy Alibaba. Once it exceeds the conversion price of $105, there may be selling pressure from bondholders after conversion, so caution is advised.

b. For ordinary investors who are not involved in convertible bond investments but value Chinese concept stock buybacks, when calculating the dividend/buyback return rate, it is recommended to deduct the buyback amount formed by the convertible bond financing and then reconsider whether to enter the market and how much to invest.

For example, Alibaba's conservative estimate for annual buybacks + dividends is $12 billion. If Alibaba uses all of the $5 billion for convertible bond buybacks, then the straightforward buyback amount after deducting the financing amount is $7 billion, resulting in a return rate of less than 4% for a market value of $190 billion.

Five. Is there really a cash shortage? Why issue convertible bonds for buybacks?

Now the question is, generally convertible bond financing, along with targeted stock issuance, is used as a financing tool when stock prices are high. It is less common to use this tool when stock prices are low. So, the question arises: Are JD.com and Alibaba really in need of money to resort to convertible bond financing in such a high USD interest rate environment and with their stock prices so low?

Regarding JD.com, Dolphin Jun's quick review on JD.com's convertible bond financing has already pointed out: Although JD.com's actual cash profits are not substantial, However, as a retailer, it has strong operating account receivables capabilities for suppliers and merchants, and from the perspective of cash balance, it is more than sufficient. Alibaba, needless to say, compared to JD's operating account receivables, Alibaba's accounts actually reflect operating cash profits, indicating that it is not short of money.

Not lacking money does not mean not lacking USD cash. According to Dolphin's understanding, each company has a certain limit on foreign exchange purchases, usually allocated by the local foreign exchange bureau directly or through local banks to customers in various regions.

According to a recent report quoting sources from foreign media, especially during this period of RMB depreciation pressure, some companies may be verbally instructed on their foreign exchange purchase limits per unit time. In addition, most Chinese concept stocks are controlled through VIE structures and are not truly domestic and foreign investment enterprises, making it difficult to freely remit "real compliant" profits and dividends. This essentially means that while these Chinese concept stocks may seem financially robust and not short of money, they actually lack USD.

This naturally leads to another issue. In the liberalized US stock market, for funds that invest in dividends and buybacks as a long-term strategy, what really matters is the proportion of dividend buybacks to current cash flow, and the hope that this payout ratio can steadily increase. Under this invisible ceiling, if Chinese concept companies apply this logic, there are clear logical flaws.

So, does this situation mean that the buyback logic of Chinese concept companies will completely collapse? In Dolphin's view, not necessarily:

a. Low total market value companies: For example, Vipshop, due to its small market value, has a small buyback requirement, making it difficult to reach the hidden limit of the exchange quota.

b. Companies with sustained cash flow from overseas assets, including operating assets with positive cash flow and equity assets. For example, Tencent, which has overseas gaming business that can account for 30% of the company's gaming revenue at peak times, as well as equity assets overseas. Besides being able to be sold, these equity assets can also provide Tencent with dividends and profits, allowing Tencent to continuously accumulate USD cash.

Therefore, after this wave of convertible bond buybacks, the real need for vigilance is still in companies with medium to high total market values (large buyback amounts, easily touching the limit) and overseas businesses bleeding or completely lacking USD profits. However, there are not many Chinese concept companies that can meet both high market value and overseas business standards.

Overall, Dolphin believes that the dilutive buyback demonstration by JD and Alibaba this time has reduced the attractiveness of investing in Chinese concepts through buyback logic. However, in the case of sufficiently low stock prices, the negative impact on short-term investors is not that significant.

The real core issue lies in the long-term perspective, where secondary funds investing in Chinese concepts based on dividend payout ratio (high dividend buyback sustainability) rather than dividend buyback yield (undervalued logic) will face a real existential question: whether to continue investing, and whether to take profits in a timely manner after investing.

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