Alibaba: A $20bn bet on China’s consumers

Simon Wilson reports

What is Alibaba?

It's by far the largest player in e-commerce in China a bigger business than Amazon and eBay combined, with up to 500 million customers, accounting for around 80% of China's online sales, and 60% of all packages delivered in the country.

Alibaba was originally founded in 1999 by Jack Ma as an online business-to-business trading platform that helped Chinese firms find customers abroad. It first came to global attention with Taobao, a site similar to eBay, which was so successful that it saw eBay's market share of e-commerce in China crash from 80% in 2003 to 7% in 2007 before the US giant gave up and went home.

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Alibaba also operates the dominant player in business-to-consumer retail, Tmall, and has expanded into many other areas, including online payment system Alipay (which is not included in the flotation).

Is it profitable?

Very. In 2013 revenues grew 50% to $8.4bn as the number of packages it delivered to Chinese consumers topped five billion and profits surged threefold to $3.7bn. This year, according to the group's latest results, after-tax profits are set to be even more impressive, at $2bn for the second quarter alone.

Fans of the company reckon there's even more to come. Consumption still accounts for a small slice of the Chinese economy (37% last year, compared with 67% in America). As China's economy matures, more disposable income will be spent online, and Alibaba should reap even greater rewards. That's not to say that it can expect a free ride: domestic rivals are growing (see box). Nevertheless, it remains the dominant player.

How much is it floating for?

Less than some analysts expected: between $60 and $66 per share, meaning that the company could raise around $21bn from its initial public offering (IPO), valuing the firm at around $160bn. That would make Alibaba the biggest ever technology or internet IPO a colossal deal by any standards.

Yet some market observers were surprised, and reassured, by the apparent conservatism of the float price; plenty of pundits had predicted a valuation of more than $200bn.

That said, an investment in Alibaba remains exceptionally high risk. For one thing, you wouldn't be buying the underlying businesses, you'd be buying a "variable interest entity" (VIE).

What's a VIE?

It's a way of getting round China's restrictions on foreign ownership of companies in strategically important sectors, including the internet and technology. To enable foreign investment in his business, Jack Ma set up an offshore holding company in the Cayman Islands.

Foreigners buy shares in the offshore "variable interest entity" and are contractually entitled to a slice in the firm's profits. But the firm itself, and all its assets, remain the property of Ma and other Chinese founders of the group enabling it to obtain all the necessary government licences it needs to operate.

Is that legal?

Astonishingly, given that big names such as Yahoo and SoftBank are long-term major shareholders, and that international investors are about to stump up more than $20bn, the legality of the VIE structure is a grey area that has never been tested in the Chinese courts.

Moreover, under a ruling made in 2012, any contract that a court deems to have been designed as a means of "concealing illegal intentions" is automatically void a catch-all provision that gives the authorities enormous leeway to control what is and isn't permissible, and poses obvious risks to investors' cash.

Isn't that worrying?

Indeed. For years, investors have tolerated the risk of VIEs, because China has allowed major internet companies, including Baidu and Sina Corp, to operate in this way. VIEs are used for many major Chinese listings abroad: overall, about half of China-based companies listed on the Nasdaq or New York Stock Exchange use this structure.

In other words, they are not an unproven mechanism that should automatically deter interest. On the other hand, Jack Ma does have a track record of using his firm's opaque corporate governance to pull a fast one on outsiders.

Such as?

In 2010, Ma sold fast-growing Alipay to an entity owned by Ma and his key lieutenants, without even telling theboard, and without thesay-so of its biggest outside investors, Yahoo and SoftBank, who only foundout about the deal much later.

Part of the intense customer-service culture at Alibaba includes the constant mantra that "customers come first, then employees, then shareholders". You can't say he hasn't warned them.

Who are Alibaba's biggest rivals?

For Alibaba, the "glory days of slapping around the eBay interloper are long gone", reckons Bill Powell in Newsweek. JD.com, which has just completed its own successful IPO in the US, is coming after Alibaba with an "asset-heavy" business model akin to Amazon.

But the main challengers to Alibaba's dominance in e-commerce are Tencent, China's leading social media company, and search giant Baidu. WeChat, a popular messaging service developed by Tencent, for example, includes an electronic payment system that allows retailers access to its 400 million users.

And WeChat is currently "stomping" all over Weibo, the Twitter-like service owned by Sina.com, in which Alibaba owns an 18% stake just one example of how rapidly this space can change.