Oxstones Investment Club™By StevenOops,
People have been talking a lot about Alibaba lately. Normally names like this don’t make their way to value blogs that easily because, well, IPOs are for patsies, especially hot IPOs, right?
This CNBC article (http://www.cnbc.com/id/101596620) suggests that the latest estimates are between $80 and $150 billion. This is up from just a few $ billion four years ago and $40 billion just a year ago and has raised a lot of bubble talk among investors.
I don’t believe Alibaba is a bubble. In fact, I think if Alibaba’s valuation falls anywhere between that range, it’s going to prove itself to be a wonderful exception to the IPOs-suck rule.
Here’s why:
Plain and simple, Alibaba is an unregulated toll road on Chinese consumption. It provides a platform that serves hundreds of millions of consumers as well as tens of thousands of independent retailers over the Internet and it’s growing crazy fast.
To give you a perspective on the sheer scale of Alibaba’s operation, USD$5.7 billion of transactions were recorded on the company’s e-commerce platforms on last year’s Singles Day (equivalent to Cyber Monday in the U.S.).
$5.7 billion, in just one day! By comparison, the entire U.S. population spent “just” $1.5 billion on Cyber Monday in the same year. Alibaba takes a % cut from sales over its e-commerce sites for “rent”, which translates into a very high quality royalty stream.
The total sales that transacted over Alibaba’s sites in 2013 was in the hundreds of $billions, and this is despite that only 15% of the Chinese population has access to broadband Internet. Alibaba’s market share in Chinese e-commerce is estimated to be in between 80% and 90%, and will be the biggest beneficiary of rising internet penetration and per-capita consumption in the most populous country in the world.
The company made almost $3 billion last year and if I have to take a guess, it will probably make $4 – $6 billion this year (top-line alone grew 66% in Q1). The company has one of the strongest and fastest growing business franchises in the world. At an $80 billion valuation, Alibaba will likely trade below a market multiple over this year’s earnings! Even at $150 billion, valuation seems very reasonable and I am tempted to pick up a few shares.
A Few Case Studies
For your interest, I dug up some old files on a few similar “toll road” companies to see how they did after their IPOs. I wrote these cases a few months back so note that the numbers are a little outdated but still in the right ballpark.
Google (NASDAQ: GOOG)
Google is basically a tollbooth on the Internet information highway. Google went IPO in 2004 at $85 and earned $1.46 a share that year, so the price tag (P/E = 58) looked pretty hefty back then. Anyone who was discouraged by the high P/E multiple would have made a very dear mistake not to buy: Fast forward to today, the stock trades for $1,215 a share, adjusted for splits!
Despite the monstrous 1,329% run, I still can’t think of anyone sane who argues that Google is overvalued today. So if you take today’s price as a proxy for fair value, and discount it back ten years at a 10% discount rate, the intrinsic value of Google at its IPO was $468 a share, or a whopping 320 times earnings!
Baidu.com (NASDAQ: BIDU)
Google did really well in the year after its IPO, and its track record provided a good environment for the debut of another hot Internet stock – Baidu. China’s Google went public at $2.70 a share (adjusted for splits) and went up 350% that day. However, even if you bought the stock on the close of the IPO date at $12 a share or 80 times the company’s 2004 earnings ($0.18), you still would have made a nice 1,517% return over the subsequent nine years.
Discounting today’s price ($182) at 10% back nine years, Baidu’s intrinsic value in 2005 was $77 a share, implying a “fair” P/E multiple of 514 x!
MasterCard (NYSE: MA)
The credit card companies are a regulated tollbooth on global commerce. MasterCard was “demutualized” by its member banks (don’t they regret that?) in 2006. Adjusted for splits, the stock debuted at $4.50 a share, which implied a multiple of 17 x relative to the $0.27 a share they earned in 2005. That certainly didn’t look dirt cheap, right?
The stock trades at $78 a share today, for a cumulative return of 1,733% over a period of eight years (and this is ignoring the small dividends MA paid over the last few years)! What’s more amazing is that $78 discounted at 10% a year back eight years would have yielded you an intrinsic value of $36 a share, or a fair P/E multiple of 135 x!
Visa (NYSE: V)
When Visa was demutualized in 2008, its IPO was at the time the largest in U.S. history. The deal was significantly oversubscribed, and part of the reason was that people saw MasterCard had done so well after its high multiple IPO, they were hoping for a repeat of the experience with MasterCard’s larger competitor. Unlike MasterCard, Visa was also shielded from anti-trust liabilities through terms established among its franchisee banks, the benefits of which look like peanuts today but was a big thing back then. Consequently investors participating in the IPO paid a much higher multiple for Visa than they did for MasterCard.
Visa’s IPO price was $44 a share, a multiple of 34 x over its pro-forma EPS in 2007. Was paying up for quality the right move? You bet. The stock currently trades for $225, which discounted back six years would be worth $127. What was the fair P/E multiple back then? 98 times.
The reasons I used the four examples highlighted above are:
1) Their core businesses today are still more or less the same as what they were when the companies went IPO, so no significant changes have taken place to materially alter the initial investment theses;
2) All four companies have funded the vast majority of their growth with internally generated capital, not other people’s money;
3) Most of the value creation has come from business growth rather than capital allocation – the economic characteristics of the businesses mattered far more than the people;
4) Not many people argue that these stocks are overvalued today (in fact many smart value investors are still buying them) so it’s not unreasonable to use their current stock prices as proxies for their intrinsic business value.
The pattern was quite uniform among all four companies – their growth and business quality were so systematically underappreciated by the market that conventional valuation tools were simply rendered meaningless as the companies quick grew into and surpassed their valuations.
The Wonderful Virtual Toll Road
So what is it that made these “toll roads” such good investments when they went IPO at what seemed to be outrageous multiples? I believe they all shared the following traits:
Moat: They have extremely strong moats (network effect, or economies of scale reinforced through a positive feedback loop) that made them dominate their respective industries. Google and Baidu were basically national/multi-national monopolies, while Visa and MasterCard operated in a global oligopoly (also arguable if they were monopolistic themselves given that almost all vendors HAD to accept both cards). The barriers to entry were so great that substantially all of the value created by the growth in their industries accrued to the bottom line of these companies.
Growth Option: Their growth was assisted by significant secular tailwinds. These companies were virtually guaranteed to sustainably grow at a high rate and this was pretty much the consensus among market participants at the time they went IPO. The credit card brands grew on the back of a multi-decade long global transition toward a system of paperless money, while the search engines grew alongside the internet industry.
Scalability: They are technology/brand platforms that operate on the extreme high end of the scalability curve (we will talk about this in the next article I will post). Growth required little to no capital, and the incremental returns on capital for these companies kept on improving as they grew. Very few businesses operate with a structure that allows them to escape the natural diminishing returns phenomenon, but these companies did.
Margin Expansion: The “platform” nature of their business model meant that they operated with a mostly fixed cost structure. As revenue grew rapidly, margins also improved substantially as most of the new revenue fell onto the bottom line.
Does Alibaba fit into this framework? Let’s see:
Moat: Alibaba is certainly as monopolistic in the e-commerce business as Google ever was in search engines. It dominates over 80% of e-commerce volume in China and no competitor comes close. Alibaba’s moat is the network effect – buyers attract sellers and sellers attract buyers.
Growth Option: Say what you will about the Chinese real estate or credit bubble (yes, both problems will bite them in the ass eventually), consumption per capita in China is only going to go up, not down. In all likelihood, it’s going to go up at a very high rate for decades to come.
In addition, E-commerce will continue to take market share from brick & mortar retailers as it offers significant cost advantages (5% fee for selling on Alibaba’s T-Mall vs. 20% + rent on revenue for b&m).
Furthermore, transportation costs are extremely cheap in China. Shipping a pair of high-heels from Guangzhou to Beijing (equivalent to distance between San Diego and Seattle) via two-day express costs only RMB 10 (USD $1.70). Even your beloved Fred Smith can’t offer that kind of service.
Scalability: The e-commerce technology platform has literally infinite capacity when it comes to handling orders. If an e-commerce site is not scalable, I don’t know what is.
Margin Expansion: Similar to the above, most of Alibaba’s costs are fixed. Just for fun, let’s see if their margins went up at all in the last few years:
Yep, they did.
Check check check check. The icing on the cake is that Alibaba also (partially) owns a wonderful online payment franchise called Alipay, which dominates that business in China (you are right to think of it as the PayPal of China, except it’s bigger than PayPal! http://www.bobsguide.com/guide/news/2014/Feb/12/alipay-surpasses-paypal-as-leading-mobile-payments-platform.html)
Valuation
Okay, suppose Alibaba IPOs with a 30 x multiple, how is that cheap? Well, another way to ask the same question is: what can justify Alibaba deserving a multiple higher than 30 x?
Just for fun, I reverse engineered a present value calculation that indicates the average bottom-line growth that needs to be achieved over the next ten years for a company to deserve a 30 x multiple (assuming a 10% discount rate, 5% terminal growth, and value-neutral capital allocation):
The number is 10.4%. That’s the annualized bottom-line growth Alibaba needs to achieve over the next ten years for the stock to grow into its valuation. Hell, Alibaba grew 66% top-line in the last quarter alone! Can they grow 10.4% a year for the next ten years? You be the judge.
So what’s Alibaba worth? I have no idea and would be very skeptical to see anyone else reach an estimate with a high degree of accuracy. All I know is that it’s going to grow like mad for a very long time and it’s worth a lot more than $150 billion.
How to Play Alibaba
The most direct way to gain exposure to the company is to buy into its IPO. The problem with that is you have no idea what they will price the IPO at, and if you only have access to the secondary market (like me), you don’t know how much a premium you have to fork over on the first day of trading. If the company is valued at the low end of the indicated range, $80 billion, buying the stock is a slam dunk. If the company is valued at the recent “whisper” number, $250 billion, then you’d have to put a lot more faith in the growth prospect/management to get a satisfactory result out of an investment.
There are two alternative ways to participate, however:
Yahoo: Yahoo still owns a quarter of Alibaba. Yahoo has a market cap of $36.7 billion. I haven’t crunched the numbers, but back-of-envelop, you take out a few $billion for Yahoo US and Yahoo Japan, 25% of Alibaba is probably valued in between $25 to $30 billion.
That’s not bad except that stake is untaxed. Yahoo has a very low tax basis for that stake and the “hidden” deferred tax liability is quite significant.
An equally important issue is based on what I’ve read about Marissa Mayer (paying $58 million to hire a COO just to fire him a year later; paying Dan Loeb to get out of the stock, and this: http://www.vanityfair.com/business/2014/01/marissa-mayer-yahoo-google), I have no faith in the management’s ability to act as an intelligent steward of Yahoo’s valuable stake in Alibaba. Maybe they will sell it to buy something else to chase growth, who knows?
Softbank: Softbank owns about 37% of Alibaba and has a market cap of $90 billion. I haven’t looked into their domestic business/Sprint that much to figure out the implied value of their stake in Alibaba, but the company seems a lot more interesting than Yahoo.
The CEO is a real entrepreneur who started with nothing and is now the richest man in Japan (well, he was set back by $85 billion speculating in the dot-com bubble, but he certainly changed his ways afterwards). I also think his wireless strategy in the U.S. makes a lot of business sense.
Conclusion
If I have to take a guess which company will become the most valuable business franchise in the world in ten years, Alibaba is my top contender. However, investing in a Chinese internet company involves risks.
The biggest risk to Alibaba the stock is that Jack Ma isn’t that keen on keeping minority shareholders happy. Reportedly he separated Alipay from Alibaba in 2011 without consent from the company’s largest shareholders on the grounds that new regulations on third-party payment systems necessitated the change (which was actually true but he still should have asked first). The good thing was that the issue was eventually resolved between Ma, Yahoo and Softbank, but it still left a bad taste in a lot of people’s mouths.
I think once Alibaba goes public, the risk that Ma may screw minority shareholders will likely decrease given the increased public and legal scrutiny. However, should Softbank or Yahoo decide to exit parts/all of their shareholdings after the IPO, the concentration of shareholder power will also get diluted, potentially making it easier for minority shareholders to get screwed.
The VIE structure that Alibaba will employ should also be monitored to ensure that minority shareholders are protected from employees stealing parts of the business.
Disclosure
I am looking into Softbank and may very well buy a few shares if I like it enough.
Tags: alibaba investment analysis, Alibaba IPO, alibaba ipo comps, alibaba valuation, Baidu, Google, Mastercard, softbank, visa, Yahoo