Alibaba: Risks and Opportunities

Maybe I am a bit late to the party here, but since I was never likely to get an allocation of the IPO, I don’t feel like there is necessarily a rush. Alibaba (NYSE:BABA) begins trading on the NYSE today, with the IPO having priced at $68 per share. This represent a $168bn valuation–35x LTM EBITDA of $4.8bn and almost 18x LTM revenue. A high valuation for sure, but there is significant growth potential, so looking at trailing multiples is certainly a punitive way to asses value here.

I have not yet formed a full view on the Company, but I thought it would be helpful to lay out the Pros and Cons as I see them today to help reach a better conclusions.

On the positive side: Alibaba is (1) a clear eCommerce leader in China where (2) internet penetration and consumer spending are set to continue to grow dramatically. (3) Unlike its closest US comparable, Amazon.com (AMZN), the Company is highly profitable.

 (1) eCommerce Leader in China: This may be the most obvious and most compelling part of the investment case. With 8.5 million sellers, 279 million buyers and 14.5 billion orders annually (Source: Alibaba Roadshow Presentation, data as of June 30, 2014), Alibaba is the clear eCommerce leader in China. eCommerce is a tough business, where competition can be fierce and margins can be thin–scale matters and the network effects are significant. You want to shop where all merchants are selling, merchants want to sell where all the shoppers are buying and round and round we go. Alibaba shipped 6 billion parcels last year, which represents about two-thirds of all parcels shipped in China, the most populous country in the world.

(2) Internet Penetration and Consumer Spending: This is probably the reason I am most excited about the Company and its market. I can think of almost no stronger predictor of growth than an under-penetrated market in a developing economy. You have the benefit of “seeing how the movie ends” by looking at developed economies and the track record of developing economies following suit is spectacular. Furthermore, internet penetration is one of the best examples of this (one of the key reasons why I am excited about Yandex). The Company draws out attention to four metrics (source: Alibaba roadshow presentation):

Internet penetration: China 46%, US 82%
Mobile penetration: China 37%, US 68%
Consumer spending as % of GDP: China 36%, US 67% (real question mark about non-consumer/government spending in China being over-inflated)
Online shopping penetration: China 49%, US 64% (this is closer than I would guess!)

These are encouraging statistics. My favorite way to look at it however is this:

Source: WolframAlpha.
Source: WolframAlpha.

Looking at the chart above, its is fairly apparent that the internet has another 10 years of penetration tailwinds in China.

(3) Profitable eCommerce model: Alibaba has manages to sustain its massive growth rate while turning a profit. That is more than can be said for its closes US competitor, Amazon.com (AMZN). It is interesting to note that while Amazon has certainly been pushing for growth (and sacrificing profitability in the name of market share land-grab), it has not been able to succeed in China. Maybe this speaks to Chinese cronyism favoring Alibaba more than to Alibaba’s skills and expertise, but properly dealing with the government is a key part of doing business in China after all.

With 50%+ EBITDA margins, Alibaba has a real chance at generating cash for investors. I worry that life as a public company will mean more pressure to grow and the Company could easily head down the path of overvalued, non-strategic acquisitions (‘di-worse-ification’, to use Peter Lynch’s term), but it remains the case that meaningful profitability is a good place to start. While certainly elevated, EBITDA multiples (especially if we look at what is expected in the next 12 months) are actually somewhat reasonable at around 25x–one thing is for sure: I like the fact that we can talk about EBITDA multiples, unlike many of their peers in the technology world.

On the negative side: (1) The valuation is high and requires significant growth to be justified, (2) Investing through a VIE exposes investors to many risks and (3) growth opportunities beyond China are not proven.

 (1) Valuation: I discussed most of these points above (I could not resist!), but the simple reality is that unless the company continue to grow significantly, this valuation is not justified. The Company likely needs to at least triple earnings before this valuation makes a lot of sense. Is that doable? is it likely?

(2) Investing Through a VIE: When you buy shares of Alibaba, you are not buying a stake in the Company directly–the Chinese government does not allow foreign investors to do that. Instead, you are buying into a shell company that has a contract which gives it rights over the Company’s profits. This sounds like it is effectively the same thing, and in some ways it is, but ultimately it weakens the legal position of investor in the event of a dispute. You can argue Alibaba is now high-profile enough that there will not be any funny business, but it is important to remember that as recently as 2011, the Company separated its AliPay business without offering fair compensation to some of its major shareholders (Yahoo and SoftBank were very upset). There is no telling what might happen in the future, but the VIE structure certainly gives the lets the Company move in ways that are not shareholder friendly to a greater extent than in a more traditional ownership construct.

(3) Growth Outside of China: The Company’s chairman, Jack Ma, talks a big talk in terms of international expansion. It would certainly be great to see the Company succeed in other large markets in the region (Indonesia, Philippines, the US?), but the fact remains that its model is not proven outside China. One of the big breakthroughs for Alibaba, and an important reason that they succeeded where others failed, is that their of exchange and payments which is basically fraud-proof. Payments are held in escrow and not released until customers confirm they have received the desired goods. This has been crucial for their success in China (a country where fake bags and watches are more prevalent than the real ones), but may be little more than a hinderance to commerce in other economies. One way or another, the jury is still out on this respect, and it is hard to give the Company any credit for this. If anything I worry this could be a major source of ‘di-worse-ification’.

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Portfolio Review: Coach

My investment in Coach is off to a rocky start. It feels like it was an investment somewhat hastily made, but it is not clear if that is just my reaction to being 30% down in such a short period of time.  Either way, it is a good time to review the original thesis and be thoughtful about what to do going forward.

Pretending like I will be able to predict short term fluctuations such as this one is not productive, but it does highlight the risks in trying to “catch a falling knife”. I still believe, however, that being thoughtful in situations like this can be a way to generate outsize returns. The market can overreact to short term trends (both positive and negative ones). If you are dealing with a good business, this can present a long term opportunity. Whether or not luxury handbags is truly a good business is a fair question, but opportunities seldom arise in “obvious” good businesses–or maybe I lack  patience!

Company name: Coach Inc. (NYSE: COH)

Investment thesis: Coach is a (1) leading luxury brand (2) trading at an attractive valuation.

(1) Leading luxury brand: I like companies that enjoy a strong brand. It is one of the few assets that can allow a business to earn above average returns for a long time. Unfortunately, I am not the only investor out there that has noticed this, so companies with strong brands tend to trade at a premium which can easily erode such above average returns. I view Coach as a holder of such a brand, and it’s recent poor performance as an opportunity to invest in the business at a moderate valuation. This does not come without it’s risks. Maintaining and growing a brand requires focused execution. Moreover, in the case of a luxury retailer, if the brand is damaged, you have very little left. A brand like Coach is a great asset, but it may be their only valuable asset.

The luxury industry trades at a premium multiple. I find this to be partially justified because it’s overall growth potential (the rich are getting richer) and it’s ability to generate very high cash flow (high gross margins and operating leverage) when things go right.  Business can be somewhat fickle however, with a strong new entrant or a bad collection possibly having outsized effects. Nobody needs a $400 bag. A lot of people do want one.

Gross margins can be a good indicator of the brand’s power. A commodity product will not be able to sustain a high gross margin–to do so you must enjoy some kind of ‘monopoly’, and a strong brand is one of the few kinds of monopolies that are allowed to exist for the long term. Patents expire, but brands are forever (other examples of sustainable, unregulated monopolies include software platforms and any service that operates under a ‘network effect’, like marketplaces, exchanges or social networks). The char below shows gross margin and price history for coach for the last 14 years:

COH Gross Margin
Source: CapitalIQ.

It is interesting to note how dramatically the stock has reacted to changes in cross margin in the past, especially when you consider it is all within a fairly narrow band (between 70% and 78% in the last 10 years). Note the significant reduction in gross margin (from 78% to low 70s) in 2008-2009 as the company pushed into a more mass market position–this turned out to be a great move, as it significantly broadened the market for the Company. The recent further decline has been a result of heavy discounting and more product going through the outlet stores. I think this has been a result of additional competition on the retail high street, from the likes of Michael Kors (KORS) and Kate Spade. KORS in particular has been rolling out stores aggressively (500 shops per year on a base of 1,560 at the end of FY 2014), which has been tough for COH. There is no denying that the strategy has been working for Michael Kors, but you have to wonder what happens when they hit a ceiling and the brand cools down a bit. The Google Trends chart below paints an interesting picture (too bad there is no data before 2005 to compare to COH’s rise):

Relative Search Frequency. Source: Google Trends.
Relative Search Frequency. Source: Google Trends.

Fashion is an industry plagued by fad risks. Catching a falling knife has its risks, but I think trying to catch a rising flame is riskier.

(2) Valuation: I made my investment in Coach on 2/18/2014 at $48.36 per share. Since then the Company has disclosed its new strategic plan and the shares have fallen in value about 25%. I think being too focused on a given ‘cost basis’ is one of the biggest biases investors must deal with, so I will try to continue on this assessment independently of my own basis.

On an LTM basis, the valuation looks very attractive. While this is somewhat irrelevant given the business’s current trajectory, I think it is helpful to highlight the kind of returns we might expect if the Company is capable of returning to its prior peak on a sustainable basis:

TEV / LTM EBITDA: 6.5x

TEV / LTM EPS: 13.2x (7.6% earnings yield)

Looking at analyst projections for the year ended June 2015 however, is more sobering:

TEV / June ’15 EBITDA: 9.3x

TEV / June ’15 EPS: 19.4x (5.2% earnings yield)

The more interesting questions however, is what we may expect from Coach in the long term. Their recent restructuring plan gives a bit of insight into their current plans and expectations. The next two years represent a period of significant investment (what thy call “invest and resent”). While that message has definitely fallen on deaf ears in Wall Street, I am intrigued by the idea of a brand like Coach embarking on a significant investment (which will require significant financing) now that interest rates are low and debt is available. If they can execute it well, it could leave them well positioned to be aggressive when the market softens and others are forced to retrench. Again, this is not without its risks: execute poorly and and they could find themselves in a similar or worse position with a looming debt load and no hope of refinancing it.#

It is also interesting to consider rival and Wall Street darling Michael Kors (KORS), a Company currently trading at an EV of $14.5bn (50% higher than COH’s $9.5bn) with an LTM EBITDA of $1.2bn (compared to COH’s $1.4bn). The price to sales differentials are also outstanding (2x for COH vs. 4x for KORS).  The growth prospects for KORS surely look good now, and Coach is set to go through a challenging period, but the valuation gap is quite significant. A lot of things need to go right for the KORS valuation to be justified, while just a couple of things not going ‘as wrong’ for COH would make the stock look like a bargain.

Conclusion: An investment in Coach is not without its risks. Ultimately I come down on the side of it being a quality franchise trading at a depressed valuation. A strong brand, with a rich history that is going through a rough patch as a result of a combination of a poorly timed strategy just as new competitors entered the market. Fashion-focused companies will have their ebbs and flows over time, and it is better to invest when they are down so we may benefit when they come back into favor.