Introduction: Alibaba Group Holding Limited ("Alibaba" herein) has now filed its Form F-1 registration statement with the Securities and Exchange Commission. It may actually go public in September; we will know more about the Company by then. This article discusses what a first look at this document reveals, and correlates it with Yahoo! (NASDAQ:YHOO) stock.
Background: I and a number of other contributors to Seeking Alpha have been fascinated by the YHOO story. In my case, I was in the vanguard of non-techie Internet users, going way back to the early '90s, and Yahoo! was a core part of my online life; Yahoo! Finance has kept me as a user ever since it appeared. I well remember being astonished by the refusal of Yahoo to accept Microsoft's (NASDAQ:MSFT) takeover offer last decade. This has been a mismanaged, shareholder-unfriendly company until Dan Loeb forced change upon it. In the past two years, YHOO's stock price has approximately tripled as change came to its boardroom and executive suite. Amongst the change is the glamorous and dynamic Ms. Mayer as CEO and the surge in the value of the company's Asian stock holdings. These are mainly Alibaba but also include Yahoo! Japan ("Y!J"). Now we have some official information from Alibaba about itself, so we YHOO shareholders and potential shareholders have something to go on.
I think things look good, and here's my take on the F-1 following a first read through of the relevant parts of it.
Alibaba: The parent company that will do the IPO is a Cayman Islands holding company. Many of its Chinese operating companies are variable interest entities (VIEs) owned primarily by Jack Ma, chairman of the parent company and co-founder of Alibaba. This introduces additional risk and complexity to the Alibaba stock story.
The F-1 summarizes its main businesses as follows:
We are the largest online and mobile commerce company in the world in terms of gross merchandise volume in 2013, according to industry sources. We operate our ecosystem as a platform for third parties, and we do not engage in direct sales, compete with our merchants or hold inventory.
We operate Taobao Marketplace, China's largest online shopping destination, Tmall, China's largest third-party platform for brands and retailers, in each case in terms of gross merchandise volume, and Juhuasuan, China's most popular group buying marketplace by its monthly active users, in each case in 2013 according to iResearch. These three marketplaces, which comprise our China retail marketplaces, generated a combined GMV of RMB1,542 billion (US$248 billion) from 231 million active buyers and 8 million active sellers in the twelve months ended December 31, 2013. A significant portion of our customers have begun transacting on our mobile platform, and we are focused on capturing this opportunity. In the three months ended December 31, 2013, mobile GMV accounted for 19.7% of our GMV, up from 7.4% in the same period in the previous year.
In addition to our three China retail marketplaces, which accounted for 82.7% of our revenues in the nine months ended December 31, 2013, we operate Alibaba.com, China's largest global online wholesale marketplace in 2013 by revenue, according to iResearch, 1688.com, our China wholesale marketplace, and AliExpress, our global consumer marketplace, as well as provide cloud computing services.
As a platform, we provide the fundamental technology infrastructure and marketing reach to help businesses leverage the power of the Internet to establish an online presence and conduct commerce with consumers and businesses. We have been a leader in developing online marketplace standards in China. Given the scale we have been able to achieve, an ecosystem has developed around our platform that consists of buyers, sellers, third-party service providers, strategic alliance partners, and investee companies. Our platform and the role we play in connecting buyers and sellers and making it possible for them to do business anytime and anywhere is at the nexus of this ecosystem. Much of our effort, our time and our energy is spent on initiatives that are for the greater good of the ecosystem and the various participants in it. We feel a strong responsibility for the continued development of the ecosystem and we take ownership for this development. Accordingly, we refer to this as "our ecosystem."
Our ecosystem has strong self-reinforcing network effects that benefit our marketplace participants, who are invested in our ecosystem's growth and success. Through this ecosystem, we have transformed how commerce is conducted in China and built a reputation as a trusted partner for the participants in our ecosystem...
It is insufficient to discuss the value of this company without fully understanding the story as the Company itself tells it. The F-1 has some cartoon-type presentations of the large numbers of users and potential users in China and elsewhere. The financial numbers will suggest the gigantic scope of this ecosystem, and we do not need to review those numbers in this article.
The main point is that the various online parts of Alibaba work together. This is a cloud company, and if it wants to, it presumably could expand its cloud offerings just as Amazon.com has done, and be an important tech company per se in China. As the F-1 demonstrates, Alibaba is already a financing company, and has various opportunities (and challenges) in that field.
It is very important to realize that though it is a young company, Alibaba has already achieved enough dominance that it has some resiliency against challenges. As it engages in its road show and other IPO processes, the proxies for its value, primarily YHOO in the U.S. and SoftBank (OTCPK:SFTBY), I expect headlines to scare people with news that a competitor of Alibaba has made this or that gain, etc., or that China is a mess because the overleveraged real estate sector is in recession, etc. What we can say now is that unless China truly falls apart as a functioning society, Alibaba and other Internet companies have lots of growth ahead, both through horizontal and vertical expansion. I view Alibaba as one of the world's few mega cap rapid growth stories, though it will be priced too richly to be my favorite stock, an honor that currently belongs to Gilead Sciences (NASDAQ:GILD).
The filing provides ample financial proof that this could be an extraordinary company and richly-valued stock, especially after the IPO proceeds allow it to engage in further expansion efforts. Here are some of the pertinent facts:
Mobile use is taking off to a tremendous extent. And the user base can grow substantially within China itself. As you can see, sales in the rest of the world are already growing at a low double digit rate:
|Year ended March 31,||Nine months ended December 31,|
|(in millions, except per share data)|
Cloud computing and Internet infrastructure
Net income per fully diluted share attributable to ordinary shareholders has soared. It was 57 cents (U.S. currency units) in the twelve months ending 3/31/13 and $1.23 in the nine months ending 12/31/13, but the 12-month data were skewed by a large payment to Yahoo!. A better representation of the operating results of the 12 month to subsequent 9 month comparison comes from the supplemental information:
Adjusted income from operations
Adjusted net income
Free cash flow
This shows about 50% growth in these metrics on a 9 month basis versus the prior year's 12 month results. Thus, Alibaba has been growing at an enormous rate, while meeting the challenges of the marketplace by growing within China and in foreign countries. It has been making great strides in mobile and growing its cloud capability and revenue from the cloud.
Let's try to value Alibaba by comparison to other large/mega cap U.S. Internet companies. There aren't many. There are Amazon.com (AMZN), eBay (EBAY), FaceBook (FB) and others such as Apple (AAPL) and Microsoft for which the Internet is not the key part of their value. Then there is Google (GOOGL), which as with Alibaba finds advertising its most lucrative product line. Google is now so diverse and so much into products such as Google Glass and driverless cars, and is so profitable and immense that I do not think it is fair to compare Alibaba yet to it (or to AAPL or MSFT).
My own view is though Amazon, with its major PayPal subsidiary, has many similarities to Alibaba, its valuation is idiosyncratic. My vote from a stock standpoint of the closest company to Alibaba amongst U.S. stocks is FB. Here's why.
Both Alibaba and FaceBook have dominant founders (or, in Alibaba's case, a dominant co-founder). Both companies are young and have risen to dominance in their large niches. Both have found ways to monetize their dominance via advertising while creating growing ecosystems that have successfully engaged many users. Both companies have immense leverage,and are in the growth phase of realizing that operational leverage.
FB has a valuation of about 40X consensus 2014 non-GAAP earnings of $1.43, and about 45X my estimate of GAAP earnings. I think that Alibaba has even greater earnings growth potential than FB, but that this is offset by its location, the problem with VIEs, and other issues that are disclosed in the F-1. Thus I would look for Alibaba to trade to similar valuations. The F-1 discloses that diluted earnings for the 9 months from April 1 to December 31 were $2.82 B. Share-based compensation was $309 MM and depreciation of intangible assets was $32 MM. This gives $3.162 B in cash earnings (ignoring depreciation charges for real estate). Call it $3.2 B for 9 months. Simply adjusting that to a 12 month time frame gets us to about $4.3 B. But that is historical. What growth rate can we assume?
We do not know. We are in the judgment phase. There will be some dilution from additional shares after the IPO, and there will be some investments for growth. So I will take a 40% growth rate for 2014 and call Alibaba's non-GAAP earnings $6 B. If it sold for 40X as FB does, that would give it a $240 B current valuation. But since we are guessing, and FB and other Internet stocks are under pressure, a 35X P/E gets us to $210 B. That's close enough to the $200 B I've been considering to call it that and believe there is lots of upside, both on a P/E basis and due to massive Chinese and international growth potential.
What is YHOO worth?: We have been told in the media that Yahoo! owned about 24% of Alibaba, but now we know that 22.6% is correct. I have been imputing a tax rate of 33% to Yahoo's ownership value of Alibaba stock, understanding that most of Yahoo's holdings will not be sold concomitant with the IPO and thus will incur no tax at that time. However, the tax rate on the gain between Federal and California tax is more like 40%, and several analysts use that amount. Using a blended rate of 33%, and assuming that Yahoo's tax basis for Alibaba stock is negligible, we come up with YHOO having after-tax claim to about 15% of Alibaba's value; that is, 22.6% minus 1/3 of 22.6%. If Alibaba is worth the $200 B I am guessing it is worth (at least), then YHOO has $30 of Alibaba asset value in it. Adding in the $6-7 in value that each YHOO share has from its Y!J stake gets us once again to the conclusion that at around $37/share, the operations and substantial assets of YHOO are receiving little if any value in the market.
This conclusion has been reached by more superficial analyses widely on the Web, but they forget to account for taxes. Giving Alibaba a fair value, such as Baidu (BIDU) receives, and as I have done here, allows us to think of YHOO as seriously undervalued.
My own guess is that YHOO is worth at least $20/share on a takeover, given billions in cash and no debt currently on its book and its numerous users, its famous brand name, its intellectual property and know-how, etc. Thus the new information on Alibaba leads me to a moderately high-confidence estimate that YHOO is worth $55-60 B, or roughly $55-60 share on a sum-of-the-parts basis.
Of course, companies should trade at a discount to their asset value, and it is up to investors who may even accept my numbers to decide how much discount to demand. My own take is that Alibaba and Yahoo's operations both are likely to appreciate. After all, most of the U.S. economy is mature, but one part that is immature is the Internet. Buying YHOO here seems to me to have a reasonable margin of safety.
Other considerations: The more the low interest rate environment persists even as obvious signs of inflation are all around us, the less attractive cash and fixed income are. Thus, this bizarre interest rate environment makes traditional equity valuation measures almost irrelevant (with apologies to Jeremy Grantham, John Hussman and others). Alibaba and FB provide great examples of possible sensible equity holdings when compared with the alternatives. Let us take a seemingly "too high" valuation of 50X forward GAAP earnings for either company. That is a 2% earnings yield, and somewhat higher than that on a cash basis. To be conservative, I'll use 2%. Now, both Alibaba and FB are quite likely to increase cash generation rapidly over the next several years. This is because they are poised for sales growth and have substantial operating leverage, so that EPS can grow faster than sales. So, you can buy a 2% bond that goes out 7 years, or you can start with a 2+% cash on cash yield (or, a 2% GAAP earnings yield) and see that become perhaps 6% after 7 years. (Merely a 10% growth rate would give a 4% earnings yield after 7 years.)
Now, if we think of stocks such as GOOGL, they have grown very large and maintain P/E's not of the 17X implied by a 6% earnings yield but 25-30X in this stock boom, and 20X or more in less exuberant markets. So buying the highest quality growth stocks at what graybeards call bubble P/Es can both give decent earnings yields that shareholders receive, and the chance (likelihood?) for share appreciation as well -despite the very high P/E. This conclusion is the clear result of the massive and sustained results that the average stock gave during another era of financial repression, the late 1940s. Stocks were ridiculously cheap in retrospect, but an America scarred by the Great Depression was not interested. Stocks are not cheap now, but as was the case then, periods of financial repression tend to allow the best stocks to beat bonds hands down, no matter which way long term interest rates move.
Thus, I believe that Alibaba has immense potential upside to its valuation. The current worry over Internet bubble 2.0 is not leading all that many investors to think this way, but the older I get, the less I care about the worry du jour. Alibaba may stumble, and stumble badly, and more that is relevant will be learned about it in the days, weeks and months ahead. However, based on what is known now, it looks to me as if YHOO may well be very undervalued even as stocks such as Twitter (TWTR) crash toward more reasonable valuations.
Conclusion: The current stock market reminds me of the 1999-Y2K period, but with a twist. At that time, anything Internet was overpriced, with no exceptions. Other groups, such as Old Economy stalwarts such as homebuilders and machinery companies, were cheap. Today, a dichotomy also exists. It is much more stock-by- stock today, not industry-by-industry. I have made my preference for large dominant companies at reasonable valuations clear in my articles this year. These include Johnson & Johnson (JNJ), Schlumberger (SLB), Taiwan Semiconductor (TSM), CVS Caremark (CVS) and Oracle (ORCL), in addition to GILD. Thus, it's not too surprising that I can analyze YHOO and find it to appear to have a nice margin of safety even as it tries to engineer a difficult operational turnaround.
Risks abound with Alibaba and therefore with YHOO, and my guesses about Alibaba's 2014 cash generation could be far off the mark. In fact, the Alibaba IPO may not happen any time soon if ever. Nonetheless, understanding numerous uncertainties, a first look at the F-1 of Alibaba Group gives me comfort that my holdings in YHOO continue to have the potential for substantial upside action.
Disclosure: I am long YHOO, FB, SFTBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.