Detailed analysis and thoughts on the Alibaba IPO

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Alibaba, the Chinese e-commerce company, is going public via an initial public offering underwritten by Goldman Sachs, JPMorgan, Morgan Stanley, Citigroup, and Credit Suisse. Alibaba was founded 15 years ago in 1999 in a one-room apartment in Hangzhou. It is now controlled by a 28-member partnership and proclaims that it will build a legacy which will last “at least 102 years.”

Numbers

This is a big deal because Alibaba may be valued at $165 billion. Below are the details of the IPO and the company. I want to go into detail here because I can outline what this means about the maturity of the technology industry, China, the transition to mobile and IPOs as an indicator of this economic cycle.

Alibaba Group Holding Ltd is a company based in China that controls about 80% of all online commerce. China is the world’s most populous country, the largest economy on a purchasing power parity basis and the second-largest economy in the world. That means that Alibaba is a very important company. Yesterday, Alibaba announced that it would conduct an initial public offering that is expected to raise more than any other technology company IPO in history.

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Interestingly, most of the IPO proceeds will go to Yahoo,which had bought a 40% stake in Alibaba in 2005 for $1 billion. But the terms of that deal give Alibaba an option to buy back shares by 2015 and they are doing so via this IPO. Alibaba repurchased $7 billion in shares in 2012, cutting Yahoo’s stake to 22.6%. And Yahoo must now sell 208 million shares, more than one-third of its now 22.6% stake of 523.6 million shares in Alibaba through the IPO.

Alibaba intends to sell a total of about 12% of its shares, raising $20 billion in the process. This would value the company at $165 billion and make Alibaba the biggest IPO of all time. Yahoo’s stake in the company would be worth just short of $40 billion. This valuation makes Yahoo’s own business worthless on a whole-company valuation-basis after backing out stakes in Alibaba and Yahoo Japan, where Yahoo has a stake worth $9 billion. It will be interesting to see if Yahoo’s shares appreciate with this deal.

Another interesting tidbit here is that the share voting structure contravenes normal rules and this is one reason Alibaba was not able to list its IPO on the Hong Kong stock exchange where companies must have a one share-one vote setup. After the IPO, the 28-member partnership will have exclusive right to nominate a simple majority to the board of directors, while other shareholders will not have that right. A dual-class structure has helped Mark Zuckerberg at Facebook and Larry Page and Sergey Brin at Google also control their companies after their IPOs. Ostensibly, control of the board gives Alibaba flexibility to expand into new areas to compete against Chinese internet giants Tencent and Baidu but I am sceptical that this is the true rationale for the voting structure.

According to the Wall Street Journal, foreign ownership is set up in Alibaba through something called variable interest entities or VIEs:

Alibaba Group has gone from being responsible for one of the greatest abuses of a complicated corporate structure used by Chinese companies to list abroad to setting the gold standard for how it’s used.

So says Paul Gillis, a visiting professor of accounting at Peking University’s Guanghua School of Management, and a longtime critic of “variable interest entities” or VIEs, a legal structure that allows Chinese companies to sell shares overseas even when Beijing deems their industry off-limits to foreign investment.

VIEs hold the licenses and permits that Beijing sees as sensitive, but the VIE itself is owned by Chinese nationals–typically the company’s founder or senior management—and not by the listed company. The listed company exerts control through contractual arrangements, but investors’ concern is that such arrangements are a poor substitute for actual ownership. The U.S. Securities and Exchange Commission worries that if the VIE holds too large a percentage of a listed company’s overall assets, or generates too much revenue, the owners of the VIE have an incentive to dissolve or ignore the contractual arrangements and break with the listed company.

According to Mr. Gillis, Alibaba’s VIEs house 7.5% of the company’s assets and generate 11.9% of its revenue, less than any other listed Chinese company.

In 2011, Alibaba used VIEs to move Alipay, its finance and mobile payments arm, into a subsidiary controlled by Alibaba chairman Jack Ma. Alibaba, therefore, only has a minority stake in Alipay. Yahoo, a minority shareholder, couldn’t do anything about this, even though the move was discussed at shareholder meetings. Yahoo said at the time that it was taken aback by this move. But Alibaba says the move was necessary because of the regulatory environment in China for the financial sector.

In terms of voting rights, buyer beware.

Revenue

Unlike the majority of IPOs now coming to market, Alibaba is a very successful company in terms of revenue and earnings. According to its F-1 filing with the SEC, the company had a full fiscal year revenue of $5.55 billion and net income of $1.39 billion. Alibaba does not sell its own merchandise the way Amazon does. It is more akin to Amazon’s marketplace or EBay. So it serves as an e-commerce platform where it takes a cut of sales by others. For the quarter ending 31 December 2013, Alibaba’s gross merchandise volume totaled $84.96 billion. GMV for all of 2013 was $248 billion. That’s the largest in the world.

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Gross merchandise volume

Mobile

Mobile is mentioned 254 times in Alibaba’s IPO filing. So it is a big part of the story, especially because markets like China are building much larger penetration in mobile where markets in North America and Europe are already saturated. China has nearly as many mobile internet users as it does fixed-line internet users: 500 million versus 618 million. Alibaba itself has 136 million mobile monthly active users.

19.7% of the revenue came from mobile in Q4 of 2013, triple the 7.4% in Q4 of 2012. And Alibaba mobile sales accounted for 76.2% percent of all mobile retail in China in 2013, according to iResearch. Its mobile app Taobao is the most popular e-commerce app in China. Alibaba also has stakes in Alipay (18%) and UCWeb (66%). Taobao, Alipay Wallet and UCWeb are tops in overall app engagement rankings along with WeChat and QQ which are owned by competitor Tencent. None of these apps have decent numbers in the US, but in the mobile space, Alibaba also owns a stake in Uber competitor Lyft. Alibaba also has a 20% stake in mobile messaging client Tango.

Payments

Alibaba is not just about e-commerce. Like other big Chinese Internet companies like Baidu and Tencent, Alibaba Group has moved into China’s shadow banking finance and mobile payments industry. Now, this industry is subject to stringent regulations from the government and competition from regulated banks. But a lot of people see huge revenue potential here, especially in terms of mobile payments.

TechCrunch writes:

Alipay, An Alibaba Group affiliate, makes it easy for consumers to purchase goods online, while Alipay’s microfinance site Yu’e Bao (“leftover treasure” in Chinese), which launched in June 2013, lets users to invest tiny amounts of money — as little as one yuan (about 17 cents) — into a money market fund.

By the end of last year, Yu’e Bao had become the biggest single public fund in China, with 43.03 million users from more than 31 provinces who had made deposits of 185.3 billion yuan (about $30.4 billion).

According to iResearch China, public data shows that “medium-sized and small enterprises account for 98% of Chinese enterprises, create 85% jobs, develop 75% new products, invent 65% patents, fuel 60% GDP and pay 50% taxes in China.”

“The emerging and fast growth of Alibaba Financial will speed up the competition between financial trade organizations and therefore motivate the innovation and development of the traditional financial system,” said the report.

The decision by Alibaba Group and several of its competitors to move into the financial sector appear to be a big enough threat to state-owned banks that the government recently blocked new online payment services by Alibaba Group and Tencent. In March, the People’s Bank of China asked that mobile payments made by scanning a barcode be halted, citing security concerns.

The Chinese government also interfered with the plans of Alibaba and Tencent to launch their own virtual payment cards, which would have let customer buy e-commerce goods on credit. Despite that hiccup, Alibaba’s financial initiatives are a sign that the company will continue to innovate in a wide range of areas, and some of their initiatives may eventually influence companies outside of China.

Note that the relationship between Alibaba and Alipay is similar to the relationship between Ebay and PayPal. The SEC filing says that 3/4 of all transactions on Alibaba go through Alipay.

But, there are regulatory hurdles here. In March, after lobbying from regulated banks, China’s central bank blocked the issuance of virtual credit cards to tighten restrictions on online financial products. Alipay had been planning to offer these cards. Its shadow bank fund Yu’E Bao has also come under scrutiny because of state-owned banks calling for more regulation as their cheapest source of deposit funding is flowing out to Alibaba, Baiddu, Tencent and other shadow banks.

Tidbits

Alibaba also owns 39% of an e-commerce outfit called ShopRunner, an Amazon prime competitor that sells a $79 annual membership which gives shoppers free two-day shipping on orders from brand-name retailers like Toys R Us, Neiman Marcus and Calvin Klein. ShopRunner also makes money by taking a fee of 2-5% of purchases on partner sites. ShopRunner doesn’t charge an annual fee for American Express cardholders as Amex is an investor.

Conclusion

This is a monster deal. I think we are well into the frothy period of the cycle for the equity market. And that means Alibaba has picked a great time to sell. This is a blockbuster IPO as Alibaba is a premier e-commerce name in China. Expect great things from the company as time goes along.

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