The Alibaba IPO

| About: Alibaba Group (BABA)
This article is now exclusive for PRO subscribers.


Paul Goodwin, Chief Analyst of Cabot China & Emerging Markets Report, takes a look at Alibaba - the Chinese e-commerce giant that will be making its IPO later this summer.

Paul uses LinkedIn as an example to show how difficult it can be for individual investors to buy a hot issue at its IPO.

Despite IPO drawbacks, Alibaba will attract enormous investment because potential is huge: Alibaba owns 80% of China’s total e-commerce and 60% of China’s parcel deliveries come from its sales.

By Paul Goodwin, Chief Analyst, Cabot China & Emerging Markets Report

Alibaba, the Chinese e-commerce giant, will be making its much-heralded entrance into the U.S. market later this summer, and I've been fielding a fair number of questions about how (and whether) to play the IPO. Here's what I'm telling those who pose the question.

Making money playing IPOs is easy. All you have to do is get your broker to let you buy a modest amount at the initial offering price, wait until the stock doubles (or triples!) later that day, then sell and book your enormous profit.

In case you didn't get it, the use of the term "easy" in the previous paragraph was ironic. There's nothing easy about achieving perfect execution of this kind. The big money is made by traders who know exactly what they're doing and do it all correctly.

And those who make the big money generally do so at the expense of ordinary investors who take a chance on a high-risk bet … and lose.

Just as an example, let's look at the IPO of LinkedIn Corporation (LNKD), which came public on May 19, 2011. The stock priced at $45 on that day, and that's the price that investors who received shares from favored brokers bought it at. With all the demand, the stock actually opened at $94 and soared as high as $123 on its first day. At the close, LNKD was trading at $94.25, which represented a 109% profit for those who had shares at the IPO price. Interestingly, an initial offering that included just 7,840,000 shares generated a first-day trading volume of 38.7 million shares.

The real money was made by company employees, many of whom had been sold shares for a dollar apiece. Also cashing in were the venture capital firms that took equity stakes in exchange for large capital infusions and private market start-up investors who had purchased LinkedIn shares at around $20 in the previous year.

But for retail investors, people like you and me who hit the BUY button on our online brokerage programs, the odds were considerably less favorable. If we had been lucky enough to buy at the opening price (94) and sell at the closing price (94.25), we would have been flat on the day.

More likely, however, your buy order would have filled at a higher price. A month later, your shares would be selling at $65. And if your buy price was $115 or higher, you would have had to wait almost a year (until May 4, 2012) to sell with any profit at all. And LNKD was still trading just over $120 on February 7, 2013, and all this during an overall bull market!

Maybe you think that LNKD wasn't a typical IPO? Well, the truth is that there is no such thing as a typical IPO. What's typical is that companies often wait for good news before coming public. Many Chinese companies used the occasion of their first profitable quarter as the trigger for their entrance into the ADR market.

Companies also wait for enthusiastic bull markets to ensure that there will be some appetite for their new issues.

The bottom line is that I don't have much appetite for IPOs at all. I'm not likely to get an insider price on a new issue and I don't have any faith in my online brokerage's ability to sharpshoot a favorable execution on my sell order. If the best odds I can get on a stock are the equivalent of a coin flip, I'll just hold off, thanks.

Buying stocks is risky enough without stepping into the fast lane with my roller skates on.

All that said, here's some background on Alibaba.

Alibaba's founder and CEO, Jack Ma, has spent a couple of years moving his company slowly toward a public offering. Ma, a former English teacher, founded Alibaba in 1999 as a business-to-business site that let wholesalers search for Chinese manufacturers. Even at its earliest stage, the company included an auction-style bidding system that let potential suppliers compete for business. Domestic B2B transactions are handled on and a site called AliExpress gives smaller buyers access to goods at wholesale prices.

Two businesses have made Alibaba into the colossus that's grabbing headlines today. The first is Taobao Marketplace (Taobao is Chinese for "searching for treasure"), a business much like eBay that lets individuals offer goods to consumers. In late 2013, Taobao was the third most-visited website in China, its popularity stemming from its lack of registration fees and commissions and its free online payment system. Taobao was founded in 2003.

The second business is Tmall, an online marketplace where retailers can offer both domestic and global goods to Chinese shoppers. Tmall runs the eighth most-visited site on the Chinese Web.

Alibaba has moved steadily into every niche of online commerce, following in the footsteps of Amazon. It has a flash sale site, a comparison-shopping site, a group buying site and (since 2004) a third-party online payment platform (Alipay) that controls nearly half of China's total online payment market. The company has also moved into cloud computing, instant messaging, online entertainment and streaming TV and video.

Online shopping in China accounts for 7.9% of total shopping (the U.S. does about 6%) but is growing rapidly. Total gross merchandise sales have grown from $152 billion in 2012 to $248 billion in 2013. Alibaba owns about 80% of China's total e-commerce, and 60% of parcel delivery in China is said to be due to deliveries from its sales.

Alibaba gets much of its revenue from advertising, a channel that benefits from the company's denial of access to outside Web search services. If you want to search for a product on Alibaba's sites, you have to go directly to them, which massively increases visits and time spent, with concomitant increases in advertising rates.

Some investors have worries about Alibaba, specifically the company's Variable Interest Entity (VIE) structure that denies shareholders direct ownership of company shares. Investors will own shares in an offshore "entity" that simulates ownership through a series of contracts. There is nothing to prevent Alibaba from withdrawing a chunk of the company from the VIE, thus lowering its value. In fact, that's exactly what happened when Alibaba withdrew Alipay from the VIE in 2011, greatly ticking off large shareholders Yahoo (which owns 22.6% of Alibaba) and Japanese company Softbank (34.4%). Alibaba settled those claims and outlines steps it has taken to prevent a repetition of any such action in its prospectus.

The other worry is that founder Ma has insisted that the board of directors be appointed solely by a 28-member group of managers, all of whom are either employed by Alibaba or by affiliated companies. This will diminish the power of investors to influence the company's policies.

But Alibaba is so huge that very few investors are likely to sit out the IPO because of these minor problems. The company had 231 million buyers last year, nearly one fifth of China's population and nearly 40% of all Chinese who are online. And with an IPO coming up that may raise as much as $20 billion, Alibaba will have enough cash to move in whatever direction it wants.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.