Alibaba’s IPO: What’s behind the ‘Thousand-pound Gorilla’?

Alibaba-IPO

In 1999, at the height of the U.S. dotcom boom, Jack Ma, an English teacher with big ideas, gathered 17 of his friends at his apartment in the eastern Chinese city of Hangzhou. He had been frustrated by how tough it was to start a small business in China, due in part to banks’ reluctance to extend loans, and he lacked the business connections necessary to get his company off the ground. So he borrowed a tactic from Silicon Valley: Use the Internet to empower enterprises by connecting them with customers all over the world. Alibaba.com was born.

On May 6, Alibaba Group filed for an initial public offering (IPO) of American depositary shares in the U.S. that is slated to become one of the largest in global history. The all-time IPO record was the $22.1 billion debut of the Agricultural Bank of China in 2010, according to Dealogic. As the largest e-commerce company in the world, Alibaba is valued at $168 billion, based on the average estimate of analysts surveyed by Bloomberg News in April. If it sells a 12% stake, Alibaba could raise $20 billion. The company’s preliminary prospectus shows that it intends to raise $1 billion, a placeholder figure used to calculate the registration fee, according to the filing with the U.S. Securities and Exchange Commission.

According to Kathleen Smith, principal at IPO investment advisory firm Renaissance Capital, Alibaba’s valuation would make it one of the 25 most valuable U.S.-listed companies. “Because of its size, the Alibaba IPO will find its way eventually into every institutional portfolio and benchmark index,” she says. The largest U.S. IPO to date is Visa’s $17.9 billion debut in March 2008, according to her firm. Facebook comes in a close second with $16 billion in May 2012, followed by General Motors Corp. at $15.8 billion in November 2010.

The filing has attracted widespread media attention, not only because of Alibaba’s size but also due to its charismatic leader. “Jack Ma is one of a kind,” notes Wharton management professor Marshall Meyer. “There’s a little bit of a rock star phenomenon here.” Ma’s fluency in English and buoyant demeanor have made him a media darling. At “Alifest,” Alibaba’s annual company gathering and Internet business summit, 49-year-old Ma has dressed up as a punk rocker singing Elton John songs in front of thousands of cheering employees. Former President Bill Clinton and ex-California governor Arnold Schwarzenegger have been keynote speakers at the event.

Alibaba operates Alibaba.com, which connects Chinese manufacturers and exporters with global buyers; Taobao.com, China’s largest online shopping site; Tmall.com, a premium branded shopping site; AliExpress, an online retail site connecting global consumers with Chinese businesses; 1688.com, a wholesale marketplace for small Chinese companies; and Juhuasuan, China’s biggest group-buying site, among others. Alibaba is affiliated with Alipay, a payment service similar to PayPal.

In calendar year 2013, Alibaba’s Taobao, Tmall and Juhuasuan sites processed $248 billion worth of transactions. That is more than triple what eBay handled last year in gross merchandise volume, according to Alibaba’s SEC filing. Alibaba has 231 million annual active buyers and a fast-growing presence on mobile with 136 million monthly active users.

Alibaba also is immensely profitable. In fiscal 2013, which ended on March 31 of last year, the company generated revenues of $5.55 billion with a net income of $1.35 billion — a 24% profit margin. Alibaba enjoys hefty margins by keeping costs low because it does not sell products or hold any inventory. Instead, it charges fees for offering a platform through which others transact business and services.

“Jack Ma is one of a kind. There’s a little bit of a rock star phenomenon here.” –Marshall Meyer

Yahoo holds a 22.6% stake in Alibaba while SoftBank Corp., the other major owner, holds 34.4%. Ma owns an 8.9% stake. Executive vice chairman and co-founder Joseph Tsai, a Yale Law School graduate and former New Yorker, holds 3.6%.

Alibaba’s U.S. arrival will have a ripple effect on other big tech companies, predicts Lawrence Hrebiniak, Wharton emeritus professor of management, who questions what Yahoo will do with its coming windfall, and how it will deploy the capital strategically. Also, Amazon and eBay could be motivated to act if Alibaba decides to launch major businesses in America, he notes. “It’s a thousand-pound gorilla entering the U.S with lots of money in the bank. It will be interesting to see what Amazon and others will do in response.”

The U.S. ‘Seal of Approval’

By choosing to go public, Alibaba realized that it would be facing tough scrutiny from investors. In a letter to employees obtained by The Wall Street Journal and published on May 7, Ma told his “Aliren” or “Ali people” that “lying behind the massive allure of the capital market, there is unparalleled ruthlessness and pressure. In this market, only a small number of outstanding enterprises can maintain a gallop.” He added that an IPO has never been the goal of Alibaba’s existence. “It is one important strategy and a vehicle for fulfilling our mission,” Ma wrote. “It is a gas station along the road to the future.”

The U.S. is Alibaba’s chosen domicile for its “gas station” — though exactly which exchange has not yet been revealed. But by choosing America, the company would be able to raise more money than it could in Hong Kong or elsewhere, Hrebiniak says. It also will be propelled onto a global stage by going public in New York. “This is the place to be,” he notes. Alibaba operates mainly in China through its various e-commerce sites. While a major force there, it is not a global household name like Facebook.

By heading to the U.S., the company also is taking a big step towards attaining global legitimacy and trust from investors. “U.S. accounting standards and enforcement have always been considered best in class, but they have become much more rigorous since the Sarbanes-Oxley changes in 2002,” according to David Wessels, Wharton adjunct professor of finance. Listing in the U.S. signals that Alibaba is a company willing to endure the harsh spotlight of this market. “It really does make a difference,” he says.

The Sarbanes-Oxley Act, or SOX, was crafted following a series of high-profile accounting scandals involving Enron, Tyco, WorldCom and others. The Act’s goal was to strengthen corporate governance at U.S. public companies. “It’s very costly,” says Wharton finance professor Luke Taylor. “Firms usually need to hire a lot of extra accounting and audit personnel to comply with this law.” But the upside is that a company gets a “seal of approval,” Taylor adds.

After announcing in March that it would go public in the U.S., Alibaba tacitly acknowledged the image problem of Chinese companies abroad. “This will make us a more global company and enhance the company’s transparency,” it said in a statement. Alibaba also said that it could seek public trading of its shares in China one day: “Should circumstances permit in the future, we will be constructive toward extending our public status in the China capital market in order to share our growth with the people of China.”

Alibaba had wanted to list on the Hong Kong Stock Exchange but ran afoul of corporate governance laws due to a complicated partnership structure, says James Angel, a Wharton visiting finance professor. As for China, the company would face limits in listing on Chinese stock exchanges, he notes. These exchanges restrict investments to locals and qualified foreign investors with plenty of capital; shares also trade in the Chinese renminbi currency. That means Alibaba would not be able to raise as much capital and would also see less liquidity in transacting the currency.

Listing in the U.S. signals that Alibaba is a company willing to endure the harsh spotlight of this market.

Another challenge is that Alibaba’s IPO would be subject to the China Securities Regulatory Commission, which can throttle the number of issuances coming out to avoid overwhelming the country’s IPO market, according to Angel. Indeed, Alibaba’s IPO filing listed 16 regulatory risks related to the Chinese government. They include changes in laws for online and mobile payment services and an “anti-monopoly” regulation. These complications from the government are in the backdrop of any foreign investment in Chinese companies, with their attendant consequences. “Regulations Alibaba faces in China could have a big effect on its value” in the IPO, Taylor notes.

Global investors also have had shaky confidence in local Chinese stocks due to reports of falsified data coming from some companies, Meyer notes. While Alibaba is “a firm everyone believes is … fairly transparent,” he says, a U.S. listing would further boost investor confidence in the stock.

Building a reputation as a trusted business in China has been central to Alibaba’s success. For instance, it set up Alipay in such a way as to generate trust among buyers and sellers. Buyers balked at paying until they received and inspected the products they bought, and sellers did not want to ship goods until they were assured of payment. “This lack of trust posed a stifling challenge for the development of online commerce in China,” the company said in its filing. Alipay held buyers’ funds in an escrow account until they received and approved of the products, and then paid the sellers. “We let trust become our asset,” Ma said during a May 2013 speech at Stanford University.

Partners as ‘Evangelists’

A main difference between Alibaba and U.S. companies is leadership by a large partnership. The company was founded by a big group of people, and it is run today by 28 partners comprising managers of Alibaba and affiliated companies. New partners are added yearly to keep fresh ideas percolating. According to Alibaba, the group structure is meant to maintain the company’s culture even after the founders retire. The group also has the right to nominate more than half of Alibaba’s board, a perk Hong Kong regulators frowned upon.

Alibaba is incorporated in the Cayman Islands, but business is conducted through its subsidiaries and “variable interest entities,” the company’s filing said. It set up the corporate structure to get around Chinese restrictions on foreign ownership of local companies. Alibaba’s “variable interest entities,” controlled by Ma and 100% owned by Chinese citizens, hold licenses and operate the e-commerce sites in China. Such a complicated structure is a “red flag for investors” because it could hide “sweetheart deals between various entities,” Angel says.

Western investors have to understand the risks associated with operating “variable interest entities,” or VIEs, in China, Meyer notes. “The Chinese government could outlaw it at any time,” and it has made noises about doing so, he adds. That is because China sees how VIEs are circumventing Chinese ownership rules.

The track record of Chinese IPOs in the U.S. is another worry. According to Renaissance Capital, the number of Chinese IPO listings in the U.S. has rebounded of late, but recent performance has been mixed. Thus far in 2014, shares of the five Chinese companies that went public in the U.S. have risen 9.4% on average on their first day of trading, but dropped 10.8% thereafter, the firm says.

While Alibaba is “a firm everyone believes is … fairly transparent,” a U.S. listing would further boost investor confidence in the stock. –Luke Taylor

Alibaba’s ‘American Dream’

Despite the criticism of its partnership structure, Alibaba insists that maintaining it is critical to preserving the company’s culture. “We view our culture as fundamental to our success,” Alibaba said in its filing. Instead of creating a dual-class ownership structure that concentrates ownership in the hands of a few founders, the company wanted partners to share power and ensure continuity even after the founders retire. Each partner is a “culture carrier” and “evangelist” of the firm’s mission and values, according to Alibaba.

What is the company mission? Alibaba says it is “to make it easy to do business anywhere.” If the vision sounds like something a Silicon Valley company would say — Facebook aims to make the world more open and connected, for example — the similarity in tone may not be accidental. In his May 2013 speech at Stanford, Ma said: “Without Silicon Valley, there would not be an Alibaba.”

Ma credits Silicon Valley for his perseverance in the face of daunting odds in starting a successful Internet company in China. “Many have guaranteed I will fail,” he noted during his Stanford address. But during a trip to the tech region, he noticed people working long into the night and office parking lots were full. There was something to this Internet thing, and he knew it would transform China. “The American dream that was ignited here didn’t only inspire Americans. It has also helped countless Chinese people.”

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