November 5, 2007
Alibaba’s Achilles heel
On Tuesday, the Chinese trade portal Alibaba will conduct an initial public offering on the Hong Kong market, and it seems to have set of an absolute feeding frenzy among institutional investors. The company has received an almost unbelievable $100 billion U.S. dollars in orders from investors, and many fund managers could get zero allocations when the initial public offering closes on Thursday. Alibaba has so far has raised more than 1.5 billion dollars from investors including at least $100 million from Yahoo, which owns 40 percent of the parent company. Demand for these shares has been so strong – exceeding share allocation by more than 150-fold, that the cash inflows caused the Hong Kong dollar to appreciate against the US dollar, forcing the Hong Kong Monetary Authority to sell its currency to keep it from rising beyond the official peg to the U.S. dollar.
On the surface, none of this makes any sense at all. While Alibaba has an impressive installed base- more than 24 million people have registered for the service, it’s technology is mediocre and it’s profits lackluster for a deal of this size. Alibaba made only $29 million in 2006, though this year it is forecast to make $83 million. Forbes pointed out that this works out to an “astronomical” price-to-earnings range of more than 100 times earnings.
So what got all these investors so incredibly excited? There are a couple of different theories. One is the salesmanship of their CEO Jack Ma – and he must be good if he convinced Yahoo to give away the store as they did in 2005. He skillfully sold global concepts like “China” and “manufacturing” and “the next Google” – downplaying his company’s many shortcomings. For example, in their launch prospectus they said “there are 42 million SMEs in China in 2006. Internet use has risen 23.4 percent annually since 2002, with 137 million users in 2006″. All this is true, but it has nothing at all to do with Alibaba- any company in China could have said the same thing. There may have been one more unspoken thing he sold, and that is the sense that the Chinese government will always be on Alibaba’s side. While Google is being blocked and having its traffic redirected to Chinese companies by Chinese authorities, Mr. Ma and his partners at Yahoo have made it clear that they will cooperate with the Chinese government. As the Financial Times put it, “Mr Ma has made no secret of his own willingness to co-operate closely with the Chinese authorities in any investigations into his company’s users. Clearly, a company with the support of the Chinese government, has far less financial risk then one whose business can be terminated by simply flipping a switch.
We are more than aware of the dangers here. In September, 2005 we wrote about Alibaba, and the billion dollar Investment Yahoo had just made. At the time, the Chinese Oil Company was trying to take over Unocal (since bought by Chevron) but I thought the Yahoo/Alibaba deal warranted much more attention than it was getting and expressed this concern:
I think the Alibaba takeover of Yahoo China is a big deal. Much bigger that CNOCC trying to pay too much for one of our little pissant oil companies. The Yahoo-Alibaba system could could evolve into a robust national trading platform- an export-driven engine that could help China become even more of an economic powerhouse. Since smaller countries would have to play by their rules they could even move towards a global trading platform that has domination of all major supply chains.
For writing this, this newsletter and portal was promptly blocked in China. Why would the Chinese government block an obscure little newsletter operating in a completely different part of the world, I wondered. Had I hit a nerve? In any event, my concerns about Alibaba dominating supply chains proved to be overblown and never happened- at least not yet. If anything, Alibaba proved to be rather bumbling, and there was talk in the financial community that Yahoo was greatly disappointed in Alibaba. When you pay a billion dollars for a minority share in a company that only makes $29 million a year, this is certainly understandable. Still, what if Alibaba became the “official” ecommerce system of China. Then the billion dollars Yahoo paid would be a fantastic bargain- maybe on a par with something like the Louisiana purchase. I think the possibility that Alibaba could gain some kind of quasi-official status in China is one reason for what I understand is called “wuli rexin” – or “irrational exuberance” among investors about this particular deal.
These investors should be careful of what they wish for. What do we have when you merge Government and Corporate interests? I’ll give you a hint- it is not “communism” and should the Chinese government get involved in “picking winners” – as they certainly seem to be doing, they could completely destroy Chinese entrepreneurship. Alibaba’s premium accounts cost a whopping 40,000 yuan, or $5,300 for Chinese customers, but far less for foreign customers. Isn’t it a possible that some of the Alibaba member base will begin to feel ripped off by these outrageous prices? Isn’t it also a possibility that some bright Chinese entrepreneur will figure out a way to offer the same- or much better services, at far less cost?
An interview in TechCrunch with the CEO of an American manufacturing portal had this take on the deal: “There is not a lot of depth in what their business is doing. They are basically a directory and that offers limited value beyond supplier discovery” said Mitch Free, CEO of MFG.com, “Alibaba has done a great job selling listings to suppliers in China. However, Alibaba is virtually unknown within the industrial community in North America and Europe. In order for their model not to implode”, he said, they will need to both “deliver value to their supplier customers in China” and also “build a brand and value proposition with the industrial-buying community in North America and Europe”. He concluded that, “those buyers have moved way past using directories and are looking for more transactional depth and process integration”.
There is already some indication that the smart money is getting out. Mr. Ma has even left two of his best companies out of the deal: its online shopping unit, Taobao.com, and its online payment services provider, Alipay. Why would the investors let him get away with this? Yahoo had a big run up on it shares as a result of news of this deal, but Terry Semel, Chairman of the board of Yahoo, made his largest trades of company stock in two years when he exercised options in late October to buy 2.1 million shares at $15 each and immediately sold them at prices ranging from $29 to $31.54. He walked away with a quick $32.8 million profit. If the Yahoo-Alibaba deal is so fantastic, why did buy and then immediately sell shares in his own company? Does he know something we don’t?
So the bottom line. With free and fair competition, Alibaba could be a good deal- but it probably isn’t. Without free and fair competition, however, Alibaba ironically could be a fantastic deal- but if that is the case, many people in the world may be turning to Yahoo and saying, “you created a monster”.