Mod Note (Andy): Professor Damodaran will be the keynote speaker at the 2014 WSO Conference! (June 28th in NYC). Get your ticket here.
Let me begin with a couple of confessions. The first is that I am not a China expert and what I do not know about the country vastly outweighs what I do. The second is that I start with strong negative biases about the Chinese governance system, political and corporate, that color my assessment of Chinese companies and investments. Having said that, I cannot resist trying my hand at valuing what may be the most valuable IPO in history in Alibaba, but as you review my valuation, keep both my ignorance and biases in mind.
Alibaba: Setting the table
In 2010, Alibaba opened a new front in its business with TMall, a site for a selective list of larger retailers, playing an expanded role in the process for a larger slice of the transaction pie. On this site, retailers pay a deposit to Alibaba to reimburse buyers who receive counterfeit goods, a technical service fee to cover the fixed costs of carrying the store and a sales commission determined by transactions value. Alibaba also developed Alipay, a third-party online payment platform, akin to Paypal, that has grown in the last few years to dominate the Chinese online payment market. As we value Alibaba for its IPO, though, it should be noted that investors will not be getting a share of Alipay, because it has been separated from the company and will be operated as an independent entity. (Note: As Blake notes in the first comment, there is a clause in the prospectus that specifies that Alibaba will be entitled to 37.5% of the proceeds if Alipay is taken public or sold, with a floor of $2 billion and a cap of $ 6 billion in that value).
Alibaba has been phenomenally successful both in terms of both helping online retailing find its legs in Cina and becoming extremely profitable while doing so. In 2013, the company generated almost $4 billion in operating profit on revenues of approximately $ 8 billion and its rapid evolution from small start up to profitable behemoth are traced in the graph below:
Not only have revenues accelerated over the last three years (the growth story), but the company's profitability has surged even more. If timing is everything in going public, you can see that Alibaba has chosen a good time.
Alibaba: Four Steps to Valuation Nirvana
There are four steps to understanding how Alibaba has got to where it is today, where it can expect to go in the future and the risks along the way.
Future: As Chinese consumers get increasingly comfortable buying online, the expectations are that the Chinese online market will continue to grow at high rates. In its prospectus, Alibaba estimates a compounded growth rate of 27% a year in Chinese online commerce between 2014 and 2018, and that number is in line with estimates made by other services. If these forecasts hold up, the online retail market in China will become the world's largest in the next few years.
Fears: Though there are few who seem to question the China story today, the history of growth in emerging markets is that there are always unpleasant and unexpected surprises on the pathway to prosperity. Investing in Alibaba is an investment in continued growth in China, and any economic or political troubles that operate as speed bumps on that growth will affect Alibaba disproportionately, since it generates almost all of its profits in China and is dependent on growing consumer spending.
Future: The question of how Alibaba's slice of overall transaction revenues will change over time, we have to make judgments on the relative growth of TMall and TaoBao. If the former grows faster than the latter, the slice of revenues that Alibaba keeps will increase over time. I was disappointed that Alibaba was not more transparent about the evolving shares of its two market places in its prospectus, choosing to lump them together as China commerce.
Fear: The market, especially in B2C, is getting more competitive, as international players like Amazon and EBay are coming back to the market, chastened by past failures, but perhaps having learned from their mistakes and deep pockets.
Future: Alibaba's high margins are a result of the network effect (that we referenced earlier) created by its immense market share and its limited ambitions (where it has been willing to settle for a small portion of revenues). While there is nothing to indicate that either will change significantly in the near future, there are signs that the company is getting more ambitious, planning large investments in social media companies and logistics infrastructure.
Alibaba: What next?
Alibaba is exceptionally profitable and will probably remain so for the near future. To value Alibaba, though, I had to make judgments on the following parameters:
1. Revenue growth: The expected revenue growth at Alibaba will be a composite effect of three of the four dimensions described in the last section.
The value of the operating assets in Alibaba, based on my assumptions, is $127.48 billion. Adding cash ($7,876 million), the value of cross holdings in other companies ($2,087 million) and Alipay ($3,000 million), netting out debt ($6,670 million) and the value of equity options granted to employees ($3,190 million) results in a value for equity of $130.59 billion. Finally, since this is an initial public offering that will raise money that is going to be kept in the firm (according to the prospectus), I added an estimated $15 billion (the rumored IPO target) to arrive at an overall equity value of $145.59 billion. Again, working with the 2368.67 million shares outstanding, including restricted stock units granted to employees, that works out to a value per share of $61.46/share.
- Status quo, not disruption: When you invest in young growth companies in big markets, you usually are hoping for disruption, since you need the game to be shaken up for these companies to displace larger, more established players. With Alibaba, though, that is not the case. This is a company that has in large part built the status quo for online retailing in China and benefits hugely from more of the same. Your biggest fear if you are an Alibaba stockholder is of a seismic change in either technology or Chinese consumer buying habits that will undercut Alibaba's network advantages.
- Corporate governance: Corporate governance at young technology companies is weak and it is toothless at Chinese companies. So, it goes without saying that if you buy shares in Alibaba, you should do so with the expectation that if you do not like the way the company is run, you will have no recourse other than sell your shares and move on. Since that is a conclusion that you would reach if you bought Facebook or Google shares, as well, Alibaba is not that unusual, at least in this sector.
- Legal Jeopardy: The shares that will be offered in the Alibaba IPO are not shares in the operating company but in a legal entity that is incorporated in the Cayman Islands. That legal entity, structured as a variable interest entity (VIE), owns the operating company in China. The reason for this complex holding structure is that the Chinese government has restrictions on foreign ownership in a wide range of businesses, including retailing, and this structure allows companies to evade those restrictions. The Chinese government is undoubtedly aware of the evasion and looks the other way, at least for the moment, though it does reserve the right to change its mind and challenge the legality of the structure. I am still a novice to the nuances of investing in a VIE, but there are others who know far more than I do and have posted on the dangers. While Alibaba seems to have structured it's VIE with more protections than most, I am still uncomfortable with the notion that my investment value is left to the tender mercies of Chinese regulators and law.
- The Silent Partner: While much of Alibaba's success can be traced to good management and a favorable market climate, it is also true that almost every successful Chinese company owes part of its success to friends in high places,. While I am not suggesting that the company is guilty of corruption or underhanded practices, it is also true that the Chinese government has tilted the competitive balance in Alibaba's favor in subtle and not-so-subtle ways especially against foreign competitors. The downside of being a beneficiary of official favors is that Alibaba will be asked to reciprocate at some time or worse still, it (and by extension, its stockholders) may fall out of favor.