Over the past two weeks, institutional investors have piled into the Alibaba roadshow as if the company was handing out free money. The long awaited process started three years ago and the biggest tech IPO ever has the potential to pave the way for a tech rally not unlike the surge seen following the Netscape and Yahoo IPOs in the dotcom era.
But before its debut on the New York Stock Exchange on Friday, there are several things that retail investors should know about the the Chinese company which moves more e-commerce than Amazon and eBay combined.
Alibaba Group was founded in 1998 by a former English language teacher, Jack Ma, and grew out of his Hangzhou apartment. The eccentric, diminutive entrepreneur watched America’s love affair with the internet, and wanted to piggyback China’s export frenzy across the globe, knowing the idea would get the full support of the Chinese government. From the beginning the idea was that Alibaba, whose name comes from the “Arabian Nights” tale, would “open sesame” for China’s small and medium sized companies. Today, its role in transforming and empowering China’s middle class is akin to the effect Wal-Mart has had on rural America.
There were several initial iterations, including an online Yellow Pages-type service, and other blatant copycats of U.S. based internet startups, before the company initially settled on becoming a business to business platform for China’s exporters. In 2003, Alibaba unveiled Taobao, a consumer to consumer platform, setting its sights on eBay, which had made its intentions to enter the Chinese market public. For the first three years of its operation, Taobao did not charge transaction fees. It was a decision that allowed the company to fend off eBay and earned Ma business visionary status.
But the most critical competitive advantage came out of Ma’s ability to strike a deal with English speaking shareholders while his counterparts remained intrinsically domestic. As early as 2000, Masayoshi Son, the maverick Japanese entrepreneur and CEO of Softbank met with Alibaba founders and together with Yahoo in California, invested in the Chinese website. The deal was inked by Tim Koogle, Yahoo’s CEO at the time but the company’s representative was Jerry Yang, the Chinese American founder. Together with Son on the board, they provided Alibaba the validation and the operational support that enabled Jack Ma to leap forward ahead of its peers. Had Ma not worked with these two international counterparts, the story could have turned out differently, according to most observers.
Alibaba’s hold on Chinese e-commerce
Today analysts typically agree that Alibaba controls around 80% of the Chinese e-commerce market, which McKinsey predicts will grow to $395 billion by the end of 2015. While Alibaba abides by a one segment revenue reporting structure, three sites, in addition to Alibaba.com, Taobao, Tmall.com, and Juhuasan, drive Alibaba’s $8.5 billion in annual revenue.
Approximately seven million users list over 800 million products for sale on Taobao on any given day. The service is free to use, but with so many listings, (including 7000 results for a “cosmetics” search), many of these web entrepreneurs pay Alibaba to boost the visibility of their items.
Where Alibaba.com is B2B, and Taobao is C2C, Tmall.com is the Alibaba Group’s businesS to consumer offering. Tmall is geared towards the middle class, particularly in China’s growing metropolises, where consumers spend 27% of their disposable income on online shopping, as opposed to 18% in the more established cities of Beijing and Shanghai, according to data from McKinsey. Unlike Taobao, Tmall charges each seller a deposit, an annual fee, and a commission fee for each listed item.
Juhuasuan is a daily deals site, best compared to Groupon in the U.S. It expanded into Taiwan and Hong Kong in 2013, at a time when the service was controlling an estimated 90% of the Chinese daily deals market. Alipay, a secure payments processing service, is used to facilitate purchases on all of Alibaba’s platforms, but was separated from the parent company in 2011. Alibaba also holds significant equity stakes in Sina Weibo, often described as Chinese Twitter, and Youko Tudou, a service similar to YouTube but again geared towards the Chinese market.
While Alibaba competes on a global scale with American companies like eBay and Amazon, it really faces its primary competition from companies in its native China. Two of these competitors, JD.com and Baidu, are traded publicly on the Nasdaq. Alibaba’s nemesis and fiercest challenger is Tencent, a social media giant listed on the Hong Kong Stock Exchange with a market capitalization of $147 billion. It has four flagship products, WeChat, QQ, QZone, and Tencent Weibo, which when combined boast over 1 billion unique users. While Alibaba has reached out to Western allies such as Yahoo and Softbank, Tencent has largely remained more China-centric. The company reported revenues of $9.91 billion in 2013, the vast majority of which came from Asia.
Alibaba pursues growth strategy
In the lead-up to the IPO, Alibaba has pursued an aggressive growth strategy by leaning heavily on M&A. The company has spent $4.6 billion so far this year to acquire everything from a film production studio to a professional soccer team. Investments in American companies such as Lyft and Tango, meanwhile, are cited as evidence that Alibaba is intent on expanding its footprint in the United States. The investment that should pay off the most, at least in the short-term, is the acquisition of UCWeb. UCWeb is a search engine and web browser especially popular on mobile and in India as well as China.
While the IPO WILL fetch upwards of $20 billion, Alibaba the company will likely allocate around $8 billion that can go towards operational improvements. The current trend of growing through acquisitions should continue post-IPO. In fact, on page 133 of the investor prospectus, Alibaba indicated that the company intends to use at least some of the cash it raises to pursue additional acquisitions. The ephemeral messaging service Snapchat, set-top streaming provider Roku, independent movie production house Lionsgate, and enterprise software solutions like Intuit, Akamai, and Red Hat are all rumored to be on the shopping list.
Alibaba is expected to sell 320.1 million in the $66-68 per share price range, a figure bumped up on Monday from the initial $60-66 interval due to high institutional investor demand. In fact, the company likely could have commanded even more. For example, Twitter ultimately priced its shares 30% above its original price range, while Facebook stock increased the number of shares it would sell but still sold them for nine percent more than the initial highest value. Instead, Alibaba has apparently pursued a more conservative approach, wary of replicating Facebook’s infamous first-day stock incidents on Nasdaq.
Still, the IPO will be record-breaking. The company should raise as much as $25 billion, depending on whether the underwriters (Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Morgan Stanley, and Citigroup) claim their shares. The resultant market capitalization BEYOND $160 billion WILL make Alibaba the third most valuable Internet company in the world, behind only Google at $393 billion and Facebook at $198 billion. (See graph below).
Top 5 Tech Companies by Market Cap | FindTheBest
Ma is no longer the CEO, but he maintains an 8.9% pre-IPO equity stake in the company. Other stakeholders include Joseph Tsai, Ma’s co-founder and Alibaba’s vice-chairman (3.6%), China’s sovereign wealth fund, China Investment Corp. (2.8%), the private equity firm Silver Lake (2.5%), Japanese telecommunications and internet giant Softbank (34%), and Yahoo (23%), which originally purchased a 40% stake in 2005 for $1 billion. Softbank, for its part, will not be relinquishing any equity through the offering, but Yahoo is expected to dilute its shares down to 16%. In addition five of the six investment banks handling the IPO, Citigroup, Deutsche Bank, JP Morgan Chase, and Morgan Stanley, extended a $3 billion loan to Alibaba in late August with the hope of reaping benefits from the company unrelated to underwriting fees.
Alibaba’s public market investors might not be as lucky as those who will cash out this week. The company is unlikely to pay dividends, while Ma has gone on record to say that the company will continue to treat “customers first, employees second, and shareholders third” even after going public. But using Facebook, a comparable stock, as a reference, there could still be money to be made by investors jumping in now. The Mountain View-based company’s shares listed initially at $38 in May 2012, bottomed out at $18.06 in August that year, but has recovered to reach $76.43 as of yesterday’s market close.
As always, with the hype comes risk. In the case of Alibaba, most of the risk revolves around both corporate and political governance and less the fundamentals of the business.
Last September, talks between Alibaba and the Hong Kong Stock Exchange AUTHORITIES broke down because of disagreements over the degree to which Alibaba insiders will have control of the new board of directors. Under the current arrangement, a pre-established Alibaba Partnership will have exclusive control over the majority of the seats on the board. This raises questions over the extent to which the interests of shareholders without prior affiliations to the Alibaba Group will be represented, especially because the Alibaba Partnership will represent only a fractional equity stake in the overall company.
Complicating matters further is the fact that Chinese stocks have historically been weak performers. There are several reasons why, but in many cases the issue can be tied back to governance. In the latest wave of Chinese tech IPOs, a series of accounting scandals tainted Western perceptions. One theory says that companies that are able to pass through the bureaucratic hoops necessary for being listed on foreign exchanges are able to do so because of their strong ties to government and the Communist Party. These ties, under other circumstances, could also protect the company from fraud investigations. Meanwhile, the Chinese government prevents the SEC from reviewing audits performed on Chinese companies by Chinese auditors.
Chinese law complicates IPO
There is also the issue of the Variable Interest Entity (VIE). Any Chinese company wishing to raise money from foreign investors must technically operate as two separate entities in order to comply with the Chinese law that requires all corporations to be fully owned by Chinese citizens. The main corporation is registered in China and has claim to the number of licenses and permits essential to doing business in the country.
This is then supplemented by a VIE, a legal concept developed to work around this law. The VIE is a foreign-held corporation that can raise investment from outside of China and hold most of the company’s assets. While a legal technicality for most intents and purposes, the VIE does pose risk to shareholders who don’t happen to be Chinese. Under the two-entity structure, the owners of the VIE are contractually bound to funnel money to the offshore corporation. If the VIE ever attempted to sever its ties to its China-based corporation, it isn’t entirely clear what the claims of shareholders in the foreign corporation to the outstanding assets are. The issue came up in 2011, when Ma and other Alibaba executives decided to divest Alipay from the Alibaba Group, without informing Yahoo or its other major shareholders.
Some players in this multi billion dollar game cannot lose. Yahoo is one, as are Softbank and Masayoshi Son. The New Yorks Stock Exchange will also emerge victorious, having attracted the world’s largest IPO, and tech’s hottest property. A deluge of tech IPOs is sure to follow the mega-listing, as those in tech wait to see how Alibaba is received. China will celebrate not only having one of the three largest companies in technology, but also the record for the biggest IPO ever, and Alibaba will finally say open sesame to the U.S. market.
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