The red flag in Alibaba’s earnings report

Before Tuesday's trading session, Alibaba (BABA), the Chinese online retail behemoth reported its second quarter 2014 results. Adjusted net income per share came in at $0.45, which is exactly what the Street was expecting. What excited the Street, however was Alibaba's revenue, which rose by 54% from the year-ago quarter to $2.71 billion, which exceeded the Street's consensus estimate of $2.61 billion.

So Alibaba's quarterly earnings growth of 54% is very good, and in itself, it suggests that the company's PE of 47.5 is reasonable. One flaw in the report is that the company missed analyst expectations on Non-GAP net income, and this was due mostly to the exercising of stock options. Yes, Alibaba's executives had a heck of a payday after the IPO, but that looks insignificant next to the growth.

Yet another “flaw” is the company's decreasing profit margin – it fell from 54.4 to 50.5%. That's not so bad either, however, when one considers that Alibaba's main global competitor, (in theory – the two still aren't fully head-to-head yet in most markets) Amazon.com (AMZN), has a profit margin of -0.25%.

In my estimation, one more flaw remains: the whole thing just fundamentally doesn't make any sense. Someone tell me how a Chinese retailer grows at 54% per year while the value of Chinese real estate is plummeting, and at a time when the precipitous drop-off in profits in Macau, China's city of legal gambling, suggests that Chinese disposable income has dropped to nearly nothing. And how does Alibaba achieve this rate of revenue growth while maintaining a 50% profit margin when Amazon.com has to push itself into the red to receive 20% growth while operating in markets that are coming out of, not falling into, a debt crisis?

The easy answer is that Alibaba has low expenses because it mainly does agency business, linking buyers and sellers, taking a commission, or taking money to raise seller visibility. But this is an incredibly difficult business to maintain, as it leaves any company that does it with no real power to control… anything. Alibaba is unconstrained by factories, assembly lines, quality control, warehouses and deliveries, but it is also without anything to sell other than name recognition and an agency service that easiliy could be usurped or duplicated at any time. Right now, the company seems to be spinning gold out of thin air, but its business model is either chimerical or, at best, ephemeral.

Someone is missing something here, and yes, that someone may turn out to be me. Then again, it may not. It's hard to fool the whole world, but those who have done so in the past have done so by tapping into greed and letting credulity take care of itself. The higher and faster Alibaba rises, the more it looks to me like it will end in a truly spectacular crash.  

Julian Close has been a business writer since the first day of the twenty-first century, having written for PRA International and the United Nations Department of Peacekeeping. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. He became a stockbroker in 1993, but now works for Fresh Brewed Media and uses his powers only for good. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

Julian Close

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

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