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[Editors' Note, February 21: This article has been revised since original publication as author has replaced some content.]

[Author's Note, February 23: Due to an inadvertent error, Alibaba's most recent TTM sales were understated.]

I estimate the total value of the existing Alibaba Group to be $119 billion. If Alipay were still part of the group, my estimate would increase to $133.4 billion. Alibaba expects to have 3 IPOs. The first one must be worth at least $35 billion. In this article, I summarize the state of Alibaba's IPO, what's driving it, what investors should expect and how I valued the company. In the next article, I will examine the impact on Yahoo! Inc. (NASDAQ:YHOO).

5 Keys Things to Know about Alibaba's IPO

  1. Yahoo's obligation to sell 10% of Alibaba (reducing its stake from 24% to 14%) at the IPO price expires at the end of 2015. So, Alibaba must have a qualified IPO by then.
  2. A qualified IPO is one worth at least $35 billion at the IPO price.
  3. Alibaba has said there will be 3 IPOs in the following order:
    • E-commerce
    • Alibaba Financial, excluding Alipay
    • Big data and presumably, cloud services.
  4. Alibaba intends to use the proceeds from the IPO for acquisitions. So, an IPO will happen when Alibaba needs money for a key acquisition.
  5. Founder Jack Ma's desire to prevent shareholders from being able to alter the board of directors has delayed the IPO.

The Timing of Alibaba's IPO

While Alibaba has over 22 months to launch the first of its IPOs, I suspect it will be sooner rather than later.

Last December, Alibaba extended the drawdown period on its $8 billion loan from January, 2014 to December 31, 2014. As of December 11, 2013, it had $3 billion left, having used $5 billion to refinance existing debt. Adding up its investments and purchases since then, I estimate it has about $1.2 billion left.

Alibaba's Acquisitions and Investments since December, 2013

Date

Acquisition/Investment

Price Paid/Offered

Remaining Balance

January 24, 2014

CITIC 21 CN co. (0241.HK)

$170 million

$2,830 million

January 31, 2014

1stdibs.com

$15 million

$2,815 million

February 10, 2014

AutoNavi Holdings Limited AMAP

$1,580 million

$1,235 million

February 12, 2014

Tianhong Asset Mgt.

$43.4 million

$1,191.6 million

Examining Alibaba's purchases and investments over the last year, it seems clear it wants to be the dominant force for everything internet: e-commerce, finance, chat, travel, cloud services, etc. The big missing pieces are search and internet security.

Its offer for AutoNavi, maker of China’s most popular mobile map app is telling. Autonavi competes neck and neck with Baidu Maps. Although Alibaba already owned part of Autonavi, it is sufficiently important to Alibaba’s strategy that it offered to buy the rest. Alibaba’s offer is $21/share vs. AutoNavi’s ADRs' closing price on February 7, 2014 of $16.54. For US investors, that’s a 27% premium.

Last summer, Alibaba CEO Jonathan Lu said the timing of its IPO would depend on the availability of a good acquisition target. With its current focus on mobile, I think that target is Easou, the number 1 mobile search company in China.

While I don't know what a significant stake in Easou would cost, it could be enough to exhaust Alibaba's war chest, prompting the IPO. In addition, it is not the only company interested in Easou. There were rumors last year of a possible tie up between Easou and UC Mobile, but nothing has happened yet. So, Easou is still available.

Of course, Easou could be acquired using a mixture of cash and debt financing if the listing problems cannot be resolved quickly enough for an IPO.

While investing in Qihoo 360 Technology Co. Ltd. (NYSE:QIHU) would plug both the search and internet security holes, Qihoo is more important in desktop search than mobile search and it is also has a market cap of $12.7 billion. A significant stake in Qihoo would probably cost more and address mobile search less effectively.

The Listing Issue

Alibaba has not decided whether to list in Hong Kong or the US. Initially, it was said to be considering two classes of stock—one super-voting and one, not. But, Hong Kong doesn’t allow this. Its rule is one share, one vote. While Alibaba could have solved this problem by listing in the US which permits different classes of stock, using the same strategy employed by the founders of Facebook and Google to retain control of their companies, according to The Wall Street Journal, it has rejected this approach.

Instead Alibaba proposes that its 28-person partnership will nominate a majority of the directors. If shareholders reject some, the partners would propose new candidates. The process is similar to the approval process for Presidential nominees in the US. Thus, it may be accepted here. The unique approach mirroring part of the US governing process would suggest Alibaba is tilting towards the US.

How Big Will the First IPO Be?

I think it will be $35-40 billion. Ma can control the size by controlling what pieces of the Alibaba group to include. While it will be e-commerce, the IPO does not have to include all of Alibaba's e-commerce properties.

The fact that it is breaking up the IPO into 3 pieces supports my notion that Alibaba doesn't want the first IPO to be much larger than is necessary to meet the requirements of a qualified IPO.

Why Would Alibaba Deliberately Limit the Size of this IPO?

Because I think Jack Ma probably hates Yahoo and wants to minimize Yahoo's proceeds from the IPO. While an agreement exists which ostensibly incentivizes Alibaba to increase the IPO price from $15.43 to $19.29 by discounting Yahoo's proceeds by up to 20%, I doubt it would induce Ma to let Yahoo earn an extra $1 billion from the IPO.

How Do I Hate Thee, Let Me Count the Ways

When Jerry Yang bought a 42% stake in Alibaba for $1 billion in 2005, Yahoo was a relative powerhouse and Ma naturally expected Alibaba to benefit from its association with Yahoo. But the opposite happened.

In March 2009, Yahoo's then CEO Carol Bartz publicly humiliated Ma by telling him in front of Alibaba's executive team that he was doing a poor job running Yahoo China. She caused Ma to "lose face." In Asia, causing someone to lose face, even accidentally, is rarely forgiven. There is a Chinese idiom that says: "Men can't live without face, trees can't live without bark."

Six months later, Yahoo did it again. In September, while Alibaba was celebrating Ma's 45th birthday and its 10th anniversary during its annual AliFest conference, Yahoo sold its 1% direct share in Alibaba.com for $150 million. Bad timing and no advance notice made this another public embarrassment. Still, Yahoo was not done.

In 2010, Yahoo Hong Kong pushed into mainland China competing with Alibaba. That same year, the two companies disagreed about the PRC's censorship of search results, with Yahoo siding with Google. Alibaba called Yahoo's position "reckless." Another insider remarked: "Has Yahoo thought about its partners in China and Yahoo China before doing this?"

While enduring Yahoo's blunders, Alibaba has outgrown Yahoo. Its latest trailing 12 months sales [TTM] were 19% higher than Yahoo's, even without Alipay. And it contributed more to Yahoo's bottom line than Yahoo's core businesses.

A Key Step in Reducing the Value of Yahoo's Stake

In August 2010, Ma transferred ownership of Alipay from the Alibaba Group to a company he controls. Alipay's results were deconsolidated from Alibaba's during Q1 2011. Yahoo and SoftBank did not find out until March 2011 and were understandably upset, but Ma prevailed. The parties agreed that when there is a liquidity event affecting Alipay such as an IPO, the Alibaba Group will receive 37.5% of the IPO proceeds with a floor of $2 billion and a ceiling of $6 billion.

Alipay reported handling $148 billion in transactions in 2013. It levies a transaction fee of 0.7-1.0% on Chinese companies and 2.5-3.0% on foreign companies. Assuming it collected a 1% transaction fee on all of them, its sales were $1.48 billion, nearly a third of Yahoo's $4.68 billion.

Alibaba's sales grew 79.9% year-over-year in 2011, 73.6% in 2012 and 65.0% for the TTM ended September 30, 2013. While competition and its own size have contributed to its slower sales growth, not including Alipay's sales is a factor. The exclusion of Alipay's sales adversely impacts the total value of the Alibaba Group.

Valuing Alibaba

Since there is not enough information for an intrinsic [DCF] valuation of Alibaba, I valued it on a relative basis. For its peer group, I chose Baidu, Inc. (NASDAQ:BIDU), SINA Corporation (NASDAQ:SINA), Sohu.com Inc. (NASDAQ:SOHU), Qihoo, Youku Todou Inc. (NYSE:YOKU), Amazon.com Inc. (NASDAQ:AMZN), eBay Inc. (NASDAQ:EBAY), Google Inc. and Yahoo. While there are substantial differences between these companies in terms of size (Baidu being the closest in sales to Alibaba), my regression results were significant.

Because of the limited data on Alibaba, I regressed Price/TTM Sales [P/S], Price/Book Value of Equity [P/BVE] and Price/Book Value of Assets [P/BVA]. The specific regression variables chosen represent growth, profitability and risk. All data are as of February 14, 2014.

Valuation Based on Price to TTM Sales

I regressed Price to TTM Sales for the nine comparable firms against TTM sales growth, TTM net margin and beta. The results are listed in the following table. A t-statistic of 2 or more indicates the variable is statistically significant. If the constant is significant, it means that the variables chosen do not explain the observed variation in the metric.

Constant

TTM Sales Growth

TTM Net Margin

Beta

Value/Coefficient

0.38

16.63

19.07

-0.10

t-Statistic

0.10

3.48

2.48

-0.05

For this regression, the constant was not significant. The R Squared was 0.783, meaning that 78.3% of the variation in these firms' P/S's are explained by the model. The significant variables are TTM sales growth and TTM net margin. Beta was not important, but its sign is right-riskier stocks should have lower multiples. The model is:

P/S = 0.38 + 16.63 * TTM sales growth + 19.07 * TTM net margin.

Plugging in Alibaba's TTM sales growth of 65.0% and TTM net margin of 42.3%, resulted in a P/S of 19.25.

So, Alibaba's value based on its TTM Sales is: $6.735 billion x 19.25 = $129.6 billion.

If Alipay’s sales were still included in the Alibaba Group’s results, total sales would be about $8.235 billion and my value estimate would be $158.5 billion.

While expected earnings growth is technically the correct variable to use as a growth measure, when I used it instead of TTM sales growth, the R Squared was only 0.39 and none of the variables were significant. The t-stats for earnings growth and net margin were less than 1.

Valuation Based on Price to Book Value of Equity

I regressed Price to Book Value of Equity for the nine comparable firms against TTM sales growth, ROE and beta. Setting the constant to zero, the R Squared was 0.715. The results are tabulated below.

Constant

TTM Sales Growth

Return on Equity

Beta

Value/Coefficient

0

20.48

31.69

-2.20

t-Statistic

N/A

1.90

1.77

-0.72

While none of the t-stats was 2 or more, the values for TTM sales growth and ROE are close enough. The model is:

P/BVE = 20.48 * TTM sales growth + 31.69 * ROE.

Alibaba's ROE was 116.8% because of a tax credit. Even without the tax credit it was 111.9%. Since excluding the tax credit would make little difference, I left it in. However, it is important to note that its ROEs for 2012, 2011 and 2010 were 18.1%, 13.0% and 6.1%, respectively. Part of the reason for the big jump in its ROE is more debt. So, instead of just one valuation based on P/BVE, I calculated a range depending on the ROE. Equity is as of June 30, 2013, the most recent data available.

Return on Equity

Price/Book Value of Equity

Valuation

116.8%

50.3

$139.8 billion

80.0%

38.7

$107.4 billion

60.0%

32.3

$89.8 billion

40.0%

26.0

$72.2 billion

20.0%

19.6

$54.6 billion

Valuation Based on Price to Book Value of Assets

I regressed Price to Book Value of Assets for the nine comparable firms against TTM sales growth, ROA and beta. Setting the constant to zero, the R Squared was 0.864. The results are tabulated below.

Constant

TTM Sales Growth

ROA

Beta

Value/Coefficient

0

5.274

13.460

-0.071

t-Statistic

N/A

2.18

2.52

-0.11

So, the model is:

P/BVA = 5.274 * TTM sales growth + 13.46 * ROA

Plugging in 65.0% for TTM sales growth and 43.9% for ROA, I got $113.2 billion for the value of Alibaba.

I also tried running the regression using Total Assets/Total Liabilities as the risk measure instead of beta. The results were similar. The R Squared was 0.870 and the estimated value of Alibaba was $103.6 billion.

Bottom Line

Based on the above relative valuations, I estimate the value of the Alibaba Group without Alipay as $119 billion. I did not use the estimates based on P/BVE because I am not comfortable using a ROE of 116.8%.

If Alipay were still part of Alibaba, its value would increase to $133.4 billion.

Source: Valuing Alibaba's IPO