What’s Logic Behind Alibaba and JD’s Convertible Bond Issuance & Concurrent Repurchases?

• Alibaba and JD.com do not have too much capital or repayment pressure. Their motivations for issuing convertible bonds are clearly different from that of other companies’.

• The issuances of convertible bonds of Alibaba and JD.com are special in that the proceeds are used to concurrently repurchase shares and fund further share repurchases. The company is in effect "selling high and buying low" by selling call options with the exercise price higher than 30% of the current market price and using the proceeds to repurchase the undervalued shares. This indirectly allows the convertible bonds to be used as a value-recovering and arbitrage tool for the companies.

• This “financial sorcery” can be seen as a confirmation in companies’ stronger financing ability, which is positive to bondholders. If the convertible bonds are not exercised ultimately, the companies will enjoy very low-cost, long-term funding. If the convertible bonds are exercised ultimately , the companies could even be naturally deleveraged.

Alibaba and JD.com Do not Have Too much Capital or Repayment Pressure

After Alibaba and JD.com announced their annual or quarterly results, they both announced the issuance of convertible bonds and intend to use the proceeds for share buybacks. Investors could wonder why the companies are issuing new shares (issuing convertible bonds can be considered as one of the ways to issue new shares) and reducing their shares at the same time. It is deduced that the corporate government of two companies has certain issues.

To understand how this comes about, the first is to understand the motivation for issuing bonds. Generally speaking, most companies issue bonds for two purposes: to invest in new projects and new business expansion or to refinance the existing debt. Both of them reflect the company has capital or repayment pressures. However, Alibaba and JD.com are not short of capital. As shown in Table 1, they are net cash companies. Their leverage (in terms of adjusted EBITDA or free cash flow) is only about 1x. It is almost certain that the companies do not have too much capital or repayment pressure. Their motivations for issuing convertible bonds are clearly different from that of other companies’.

Table 1: Alibaba and JD.com’s Financial Data

Convertible Bonds are used as Value-recovering and Arbitrage Tool for Companies

As shown in Table 2, Alibaba and JD.com’s convertible bond issuances are quite similar in terms of contents and clauses. Compared to others companies’ convertible bonds, the issuances of the convertible bonds of Alibaba and JD.com are special in that the proceeds are used to concurrently repurchase shares and fund further share repurchases.

Table 2: Details of Alibaba and JD.com’s Convertible Bonds

We believe this is a right move by both companies to improve their own enterprise value. From the company's perspective, the issuance of the convertible bond is equivalent to the issuance of normal bonds and short a call option (the exercise price of the call is equivalent to the conversion price of the convertible bonds). If the company's share price is to rebound significantly, this would result in the issuance of more new shares (where the convertible bondholders would exercise their call options), but at a price that would be about 30% higher than the current market price. On the other hand, the company could immediately use the proceeds to reduce the number of shares outstanding, intentionally lower the dilution effect on the shares in case the new shares are issued going forward.

Simply put, the company is in effect "selling high and buying low" by selling call options with the exercise price higher than 30% of the current market price (which can also be interpreted as potential new shares issuance), and using the proceeds to repurchase the undervalued shares (including the immediate OTC repurchases and existing share repurchase programs). This indirectly allows the convertible bonds to be used as a value-recovering and arbitrage tool for the companies.

Of course, generally speaking, the market is not favourable to the issuance of convertible bonds. Since two companies announced the issuance of convertible bonds, Alibaba's and JD.com’s share prices plummeted by about 6% and 10% respectively. These are favorable to their strategies. On one hand, they can buyback their shares at a lower price. On the other hand, the drop in share prices could lower the probability of convertible bonds being exercised, and the companies could raise capital at a very low cost of borrowings. It is a "positive triple whammy".

However, in the future, if their share prices quickly rebound to a level above the conversion price, or even well above the conversion price, and the companies are yet to repurchase large portion of their shares in the market, the companies will face a certain degree of share dilution (about 1.3% for Alibaba and 1.6% for JD.com, see Table 3). Alibaba has therefore also hedged the position by subscribing the out-of-the-money call options on the company’s shares with financial institutions, presumably in preparation for the possibility of issuing a large number of new shares as a result of an unforeseen share issuance.

Table 3: The Dilution Effect of Alibaba and JD.com’s Convertible Bonds

The “financial sorcery” can be seen as Confirmation in Companies’ Stronger Financing Ability, which is Positive to Bondholders

This type of “financial sorcery” could be beneficial to shareholders. After all, it is confusing and might give investors the wrong impression that the management intends to harm the companies’ interests. For normal bondholders, this issuance of convertible bonds can be seen as a confirmation in the companies’ stronger financing ability. The company could raise capital by regular methods (the debt financing ability such as issuing new bonds and borrowing bank loans) and it is able to issue convertible bonds in conjunction with its own equity and debt financing ability.

Given their high cash levels and short-term and equity investments, coupled with the strong free cash flow generating ability from their businesses, the “financial sorcery” will not impact on the normal bondholders of Alibaba and JD.com, and could even be interpreted as positive:

• If the convertible bonds are not exercised ultimately, the companies will enjoy very low-cost, long-term funding. If the convertible bonds are exercised ultimately (in the case that the share price is higher than the conversion price), the companies could even be naturally deleveraged, as the convertible bonds will be converted into shares and the debt will not need to be repaid.

• Issuing normal bonds to repurchase shares would increase the company's leverage level. Directly using the cash on hand to repurchase shares would reduce the financial resources for debt repayment.

Therefore, investors may still consider the bonds of Alibaba and JD.com (see Table 4), while they should note that the bonds generally have longer maturities and higher duration risk.

Table 4: Selected Alibaba and JD.com Bonds