Alibaba's Looming IPO Shows That Smaller Players In The Chinese E-Commerce Industry Are Significantly Undervalued

| About: Alibaba Group (BABA)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

Alibaba Group Holding Limited (NYSE:BABA), the Chinese e-commerce giant, has captured the market's attention over the past year in anticipation of its record-setting IPO to come that appears to be growing in value as the IPO date approaches. All the attention on Alibaba is very positive for how the smaller Chinese e-commerce businesses will be viewed by the investment community. When comparing Alibaba's valuation metrics such as Price to Sales and Price to Earnings to the ones held by the Chinese e-commerce stocks currently trading in North America, they all appear to be quite undervalued in price.

Alibaba's Tmall owned just over 50% of the Business to Consumer market share in Q1 2013. In 2012, total Chinese online retail activity stood at 1.3 trillion Yuan. That is expected to nearly quadruple to 5 trillion in 2016 and double from there to over 10 trillion in 2020. With that kind of growth in the industry, it is not likely that Alibaba will be able to maintain more than 50% of the market share. The market has already developed to a point where a smaller player like Vipshop Holdings Limited (NYSE:VIPS) has found a niche for itself and has been able to achieve excess revenue growth as its market share increases. This phenomenon will likely continue as nimble smaller market players find a way to compete and Alibaba will get a smaller piece of a much, much bigger pie.

Alibaba announced earlier this week that it extended the drawdown period of an $8 billion loan in order to buy more time to launch its much anticipated IPO. The expectation was that the company was going to do its IPO in Q1 of 2014, but the loan extension likely means that the IPO will be delayed until later in the year, giving the company the time it needs to launch it how it sees fit.

While the delay is a temporary setback for traders looking to capitalize on Chinese e-commerce investing opportunities, it may actually be good news because it seems that as every month that goes by, the valuation of the proposed IPO increases. This fact certainly has not been lost on the company so a few more quarters of impressive growth will further increase those valuations and minimize the dilutive impact to the current private shareholders once the IPO does take place. Here's a rundown of Alibaba's increase in valuations over the past 16 months:

In addition to the pre-IPO valuations, Carl Huttenlocher, of Myriad Asset Management says that Alibaba could be worth $200 billion by the end of 2014 after the IPO.

Yahoo! discloses Alibaba's revenue and net earnings numbers as part of its quarterly and annual reporting. To easily find the numbers relevant to Alibaba on the Yahoo! reports, do a search on the term "Net income attributable to Alibaba Group" on the reports linked below.

For the 9 months ended June 30th, 2013, Alibaba had $2,018M net income on $4,959M of revenue compared to the same time period in 2012 which saw net income of $730M on $2,906M of revenue for 176% in earnings growth and 71% revenue growth respectively. Net margin for the 9 month period in 2013 was 40.7%. When looking at Yahoo's reporting on Alibaba for the 12 month period ended September 30, 2012, it achieved $485M of net income on $4,083M of revenue so Q4 (July to September 2012) had a loss of $245M on $1,177M of revenue. Adding these Q4 figures to the 9 months reported in 2013 and trailing 12-month numbers are $1,773M of earnings on $6,136M of revenue, or a 28.9% margin. Another important observation to take from the 12 month filing is that Alibaba lost $10.7M on $1,298M revenue in 2010, so becoming a profitable company has been a recent achievement.

If Alibaba's expected valuation is $150 billion, that would mean its trailing 12-month Price to Earnings multiple is 84.6 and its trailing 12-month Price to Sales ratio is 24.4. Morgan Stanley estimated that Alibaba would pull in $2,280M in net income for 2013 and $3,550M in net income for 2014. The forward P/E using the 2014 estimate would be 42.2.

Alibaba's rumored IPO and valuation increase from $40 billion to $150 billion over the past 16 months have had an impact on the Chinese e-commerce firms that are already trading on North American markets. VIPS was $78.35 on December 11, 2013, up 1,200% from $6 starting in September 2012. E-Commerce China Dangdang Inc. (NYSE:DANG) has risen from about $5 to $8.23 and Fireswirl Technologies (OTC:FRWRF) has risen 180% from 10 cents to 28 cents when looking at the price history of its more liquid Canadian symbol, FSW.

My article titled "Investors Afraid To Buy Into Chinese Internet Stocks Missing Out On Great Future Gains" provides more details as to what each company does in Chinese e-commerce, but a brief summary is provided for each next.

Vipshop has had great success with its flash sales strategy where its unique niche within the Chinese marketplace has enabled it to charge much higher fees to its clients who sell in its channel than its competitors, giving it quick rise to profits in 2013. Q3 saw 146% revenue growth for the company.

Dangdang is an "Amazon-style" of e-commerce company in China with 19% in revenue growth for Q3.

Fireswirl works to bring international brands to the online Chinese marketplace and had 128% revenue growth for Q3, along with 115% growth year-to-date.

LightInTheBox (NYSE:LITB) is a Chinese e-commerce company which sells primarily to foreign markets. It is debatable as to how much of a positive impact the domestic e-commerce industry will have on this company, but I will include them in the valuation and let each reader decide if it is appropriate to evaluate the company by using Alibaba as a basis for comparison. LITB saw a revenue increase of 33% for Q3.

VIPS is easily compared to Alibaba by using P/E or P/S metrics. With a market cap of $4.36 billion at a $78.35 share price, the company has a forward P/E of 36.78 and a trailing 12-month Price to Sales metric of 3.33. This compares very favorably to the 42.2 forward P/E and 24.4 trailing P/S of Alibaba calculated above. Applying the 42.2 P/E multiple to VIPS would lead to a stock price of $89.90. Applying the P/S of 24.4 to VIPS would lead to a stock price of $574.

Using the Price to Sales isn't a completely fair barometer at this stage as Alibaba currently has 41% net margin compared to VIPS of about 2.5%. But recall above that Alibaba was a money-loser in 2010. It appears that VIPS is only 2 years behind in terms of turning a profit and on a B2C market share of around 2% that is dwarfed by Alibaba's 51%. Add in the fact that Vipshop has a successful niche and maybe it is plausible that it will see 40% net margins in the near future and should have a Price to Sales metric above 20. But to be conservative, I will assume a P/S ratio of 10. Using that number would imply a tripling of VIPS to $235. If Alibaba is worth $200 billion by year end 2014, a 33% increase from $150 billion, then the appropriate 2014 year-end target for VIPS on the low end would be $120 based off of the P/E comparable and the high end would be $313 based off of the P/S comparable.

Comparing DANG to Alibaba is not quite as straightforward. At $8.23, DANG's market cap is $662M with a 0.74 P/S ratio but with no forward P/E as expectations are that it will still lose money next year. Net margins are about -5%, which have improved from -9% from the previous year. If the company was to have a steady state net margin of 5% versus a steady state margin of 45% for Alibaba, that would justify a valuation of one-ninth of Alibaba's P/S, leading to a 2.7 target. If DANG was valued at 2.7x of sales, the stock price would be $30. Adding in Alibaba's 33% gain and the appropriate 2014 year-end target for DANG would be $40. Even if you were to discount DANG by 50% to account for the slower growth compared to its peers as well as the big player in Alibaba, the target would still be $20.

The quarterly income statement for Fireswirl shows that revenue has been $45.5M for the past four quarters with a $600K loss. With a stock price of 28 cents, the company's market cap is $14M leading to a 0.3 P/S multiple on a margin of -1.3%. Margins for the four quarters previous to that were about -4.3% so it's reasonable to expect that Fireswirl will achieve an equivalent or superior margin to DANG's steady state of 5%. Assuming a similar 2.7 P/S multiple to DANG would lead Fireswirl to having a stock price of $2.50. Adding in Alibaba's 33% gain and the appropriate 2014 year-end target for FSW would be $3.35.

LITB has a $328M market cap at a stock price of $6.71. Its forward P/E is 31.95 with a 1.22 P/S ratio. Valuing the company at a forward P/E of 42.2 would lead to an $8.86 price target. Since its primary market is not China, it won't be valued at anywhere near Alibaba's P/S ratio, but a ratio of 5 would appear to be a legitimate target. At a 5 P/S, the company would be valued at $27.50. Adding in Alibaba's 33% gain and the appropriate 2014 year-end target for LITB on the low end would be $11.80 based off of the P/E comparable and the high end would be $36.60 based off of the P/S comparable.

Some investors will completely agree with this analysis, while others will challenge some of the assumptions and to the degree that Alibaba would positively impact these smaller players. What is undeniable though is that these smaller players in the e-commerce industry are so cheap when compared to Alibaba valuations that one has to agree on some level that they are all undervalued. Then it becomes an argument of exactly how much. From this article it is apparent that I believe they are all 3 to 10 times undervalued relative to Alibaba. It will be interesting to see how much they increase by Q4 2014 after the Alibaba IPO is complete.

Disclosure: The author is long VIPS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long VIPS, DANG and FSW.V