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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