September 2014 NEWSLETTER Dominion Global Trends SICAV PLC Alibaba: Very Strong & Fairly Valued This month we see the eagerly anticipated Alibaba IPO, which seeks to raise $21.1 billion making it the largest in history. We take a closer look at the rise of the Chinese ecommerce giant and what to expect in the IPO. Sharks, Thieves and Crocodiles! As the story goes: Ali Baba was a poor man, a woodcutter, and one night in the woods he discovered forty thieves visiting a magical cave in the forest. Concealing himself, Ali Baba overheard the secret password that opened the cave’s otherwise impenetrable door. He waited until the thieves had gone and approached the cave and uttered the now immortal phrase ‘Open Sesame’. The door swung open revealing a cave filled to the roof with untold treasures. Ali Baba went on to outsmart the forty thieves and become the richest merchant in all the land… This never happened. It is an Arabic folk tale from One Thousand and One Nights. The original Ali Baba fable however has much in common with the history of today’s ecommerce superpower of the same name. They are both stories of humble beginnings and astounding growth. Alibaba Group founded 15 years ago with just $60,000, in schoolteacher Jack Ma’s apartment, would go on to dominate the Chinese ecommerce market and become the world’s largest ecommerce company, with close to a quarter of a trillion dollars of goods traded across its platforms in 20131, dwarfing the gross merchandise values (GMV) of western giants such as Amazon ($100bln)1 and eBay ($76.5bln)1. It is also an unfinished story, for with its exposure to structural growth in its Chinese home market and the potential for international expansion, Alibaba may come to dominate the global markets and make good its vision to be a company that spans three centuries, lasting 102 years. In this article Dominion looks at the key elements of Alibaba’s success and provides some insight to the questions: How did Alibaba conquer China? What the future holds for Alibaba? And whether it is a good investment? In order to accomplish this we consider the company’s business model and what makes it different from competitors, the markets it operates in (including the growth drivers) as well as the valuation of the company in the build up to the IPO. page 1/8 www.dominion-funds.com September 2014 NEWSLETTER Dominion Global Trends SICAV PLC How a Crocodile Conquered China The Alibaba of today offers a dazzling number of services. Ranging from cloud computing platform Aliyun with over 1 million customers, wholesale marketplaces (1668.com and Alibaba.com), messaging services, a payment network (AliPay) to its vital retail online marketplaces Taobao, TMALL and Juhuasuan. The latter combined generate 84.5% of the Company’s $8.5 billion revenue. However, it was not always this way. China Retail Marketplaces Taobao Marketplace (Online shopping destination) AliExpress (Global consumer marketplace) Tmall.com Juhuasuan (Brands and retail platform) (Group buying marketplace) Alibaba.com 1688.com (Global wholesale marketplace) (China wholesale marketplace) Mr Jack Ma Alipay (Payment services)* China Smart Logistics (Logistics information system)** Alimama (Online marketing services) Data Platform Alibaba Cloud Computing (Platform for internal and third-party use) Exhibit 1: Graph outlining services offered by Alibaba Source: Company filing When Alibaba was founded it had but one small site, Alibaba.com, which focused on connecting small Chinese manufacturers with overseas wholesale buyers. If it had stayed as such it would just have been a footnote in Chinese corporate history, another middling company perhaps. However, the defining moment in Alibaba’s explosive growth came when Mr Ma’s focus turned towards serving the demand of China’s page 2/8 rapidly growing and newly affluent middle class. In 2003 he launched Taobao - which translates as ‘search for treasure’ a consumer to consumer (C2C) marketplace similar to eBay’s eponymous online marketplace. This change of focus proved to be smart given that consumption is today 36.5% of China’s $17.9 trillion GDP. “eBay may be the shark in the ocean but I am the crocodile in the Yangzi. If we fight in the ocean, we lose; but if we fight in the river, we win”. Mr Jack Ma Yangzi River, Crocodile However the sector was already occupied by eBay, who through its partnership with Eachnet controlled a market share of around 70% of the C2C landscape in China. Mr Ma famously remarked “eBay may be the shark in the ocean but I am the crocodile in the Yangzi. If we fight in the ocean, we lose; but if we fight in the river, we win”. He was right: today Alibaba has a market share of 96.5% in the C2C market and 50.1% in the business to consumer market. How did the crocodile defeat the shark? In the fairy tale Ali Baba defeats the 40 thieves with the help of a slave, a healthy measure of cunning and a lot of burning oil. Given that these are no longer considered acceptable business practices we must look elsewhere for the key to Mr Ma’s success, specifically the company’s business model and its key elements: an appreciation for Chinese consumer culture, the prioritising of trust in ecommerce, a better price and an asset light infrastructure. My Culture is your Culture “Chinese consumers like busy web designs with strong colours. Westerners prefer sparse sites like Google’s, but Chinese customers want their websites to be noisy, with lots of links.” Zhang Yu, vice president of marketplaces at Taobao. Taobao is a Chinese platform. This extends beyond the nationality of its employees or customers to the identity of its brand and its platform design. The website design was carefully crafted in order to provide ease of use and immediate familiarity for the Chinese consumer. Red and Orange are the brands primary colours symbolising festivity and prosperity. Similarly the layout of the website is full and busy with every space filled with information or pictures differing markedly from the more minimalistic western approach which eBay had exported to China. This sent a clear message; “we are Chinese and proud!” and allowed for early differentiation from their larger foreign rivals. Exhibit 2: Screen shot of Taobao layout. Source: Google Images page 3/8 www.dominion-funds.com September 2014 NEWSLETTER Dominion Global Trends SICAV PLC Trust Me I Am A Website The underlying foundation in all commerce - electronic or otherwise - is trust. Simply put, both the buyer and seller must believe they will not suffer from fraud. While familiarity breeds comfort it does little to inspire trust in a user. Therefore in order for Alibaba to create a sizable user base it had to convince people that they provide a secure service. eBay and Amazon originally provided this in the home markets through either escrow payment (eBay’s PayPal) or the secure logistics chain of Amazon’s owned distribution. Alibaba, however, had to go further. It was, and still is, serving a population with a low internet penetration (only 6.8% in 2003) that was far less familiar and less trusting of the internet. Accordingly, it is of little surprise that Alibaba has security fraud prevention and consumer protection woven into its business model. They offer flexibility in payments: with cash on delivery one of the options that eliminates receivership fraud and provides an easy bridge to ecommerce for new users. Though the majority of payment volumes (79%) flow through AliPay, an electronic payment platform created by Alibaba, which has the ability to hold cash in escrow and return it to the buyer should a dispute be resolved in the purchaser’s favour. Through these measures Alibaba has been able to convince over 230 million Chinese to use their site and the company records that disputed transactions are less than 0.08% of all orders. For a company to break into a market and take customers from its rivals it must offer, or at least be perceived to be offering, either a better service or price. In the case of Alibaba it offered both across its online retail marketplaces of Taobao, and latterly TMALL (a platform for established consumer brands) and Juhuasuan (a group buying platform). However, the company’s key differentiation was the tools it provided to sellers and the price it charged for these tools. On Alibaba’s platforms vendors create virtual storefronts, free websites, within the Alibaba web domain using tools and a virtual infrastructure provided by Alibaba. These pages would then be searchable through an Alibaba indexing algorithm. This search, explore and discover functionality allowed the company to provide search results, suggestions and most importantly advertising to buyers across its ecosystem, in a very similar way that Google does for users of its search engine. In essence Alibaba had created its own corner of the internet, a Chinese Walled Garden. page 4/8 The Walled Garden of the worldwide web This system fulfilled more than 5 billion packages in 2013, 0.7 billion more than the entire UPS global network in the same year and 54% of all deliveries in China over the same year. Exhibit 3: A Flowchart outlining Alibaba’s Market Place Offering. Source: Company Filing The company then offered a revolutionary pricing scheme for its C2C business, Taobao. Traditional ecommerce models relied on commission charged on sales. Taobao, by contrast is completely commission free. Instead the company charges merchants for upgrading their storefronts and advertising within the Alibaba ecosystem and search engine. This freemium pricing model provided a strong tailwind to merchant acquisition which in turn drew more consumers. This led to a virtuous circle - known as the Network Effect - as more sellers join due to the high volume of consumers using the platform and vice versa. These buyers now had an Alibaba account which could be used across all their platforms, the Alibaba ecosystem, allowing cross-selling opportunities and boosting user numbers for commission charging platforms such as TMALL and Juhuasuan. The numbers speak for themselves. Through a compelling combination of cultural awareness, a secure platform, page 5/8 networking effects and improved pricing and services Alibaba already has nearly one quarter of a billion buyers who are on average each placing 49 orders a year - for a combined total of 11.3bln per annum - with 8 million vendors. This provides a logistical challenge as these orders need to be fulfilled. Alibaba’s asset light business philosophy expands into its logistics. The company owns no physical logistical infrastructure but rather outsources to 14 chosen third party logistics companies, termed delivery partners. Together they employ more than 950,000 delivery personnel in over 600 cities. Orders are processed and channelled through a joint venture logistics platform, China Smart Logistics. This system fulfilled more than 5 billion packages in 2013, 0.7 billion more than the entire UPS global network in the same year and 54% of all deliveries in China over the same year. www.dominion-funds.com September 2014 NEWSLETTER Dominion Global Trends SICAV PLC Exhibit 4: EBITDA and EBITDA Margin, 2014 onwards forecasts. Source: Company Filing, Dominion Model. EBITDA (USD Millions) EBITDA Margin Scalable Business: Growth = higher margins Alibaba’s capital light business structure enabled the company’s rapid growth. Indeed the only significant investment in physical assets the company has to make is in data centres to support web operations. This means that as Alibaba grows it has to make very little incremental investment to support the additional revenue. The upside to such a scalable business model is that as sales increase, so do margins as the company generates operational leverage against the sunk cost of R&D investment. The graph above illustrates the near doubling of the post-tax operating margin. However, the flip side of such a business model is that a company must maintain their focus on R&D and technical spending in order to maintain its network and technological edge. Currently this appears to be the case: Alibaba have 48% of its 20,884 workforce dedicated to these tasks, either in engineering (35%) or web operations (13%). Growth Drivers: A Technological and Demographic Perfect Storm Alibaba’s growth has been nothing short of spectacular with 72% and 52% revenue growth in 2012 and 2013 respectively, while profits have grown 157% and 88% over the same periods. To understand how the Company grew so fast and to glean future growth opportunities we must also consider the structural growth drivers in the company’s key market. There are two elements to economic growth: demographics and productivity. The former is concerned with population size and make up, while the latter with technology and workforce efficiency. Similarly we can split Alibaba’s growth along demographic and technological lines. page 6/8 “The right thing at the wrong time is the wrong thing.” Joshua Harris Alibaba launched its first consumer focused site in 2003. This displays either a considerable amount of foresight or extreme good fortune, as the millennium marked the new beginning of a Mega Trend which will change the world - The Rise of Emerging Market Consumers. By the end of 2003 China’s GDP per capita was $1,490, by 2013 it had more than tripled to $6,560. This meant that those formerly on a subsistence lifestyle were moving to cities, finding higher paying jobs, joining the middle class and starting to spend on discretionary items. This proved a strong structural growth tailwind for consumer focused companies such as Alibaba. Chinese Internet Population 700 600 500 400 300 200 Though this trend is very much still in motion, it is fair to argue it is no longer the largest factor affecting the growth of Alibaba. The rise of ecommerce is now the dominant influence as more and more people come online in China. In 2008, 298 million Chinese had access to the internet. Today China boasts the world’s largest online population with 618 million people online out of a population of 1.37 billion, therefore a penetration of 45%. By 2016 the online population of China is forecast to grow to 790 million, an increase of 27%, driving penetration close to 60%, still below the developed world average of circa 85%. Currently only 49% of Chinese internet users shop online, spending some $300 billion or 7.9% of total Chinese consumption. However online shopping spend is forecast to more than double by year end 2016 to $611 billion - 11.5% of consumption - online penetration and ecommerce adoption continues to increase as smartphones become increasingly pervasive across the Middle Kingdom (Alibaba already has 136 million mobile users) and urbanisation continues. 100 If in the long-term we assume China can reach western levels of penetration - both in internet and online shopping - one could expect an online population of 1.16 billion people with 870 million online shoppers spending some $1.36 trillion per annum. This implies that the market - even with conservative spend per capita penetration - can more than double again after 2016, providing Alibaba with a high growth home market for many years to come. 300 0 Shopping (USD Billions) Online Shopping in China (UDS Billions) 900 100% 800 80% 700 600 60% 500 400 40% 200 20% 100 0% 0 EBITDA (USD Millions) EBITDA Margin Exhibit 5: Chinese ecommerce drivers. Sources: CNNIC for 2008-2013, iResearch for 2014-2016 page 7/8 www.dominion-funds.com September 2014 NEWSLETTER Dominion Global Trends SICAV PLC Good company does not a Good Investment Make Renowned investor Warren Buffet once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Throughout the preceding course of this article we have laid out the strengths and weaknesses of Alibaba and it is fair to say that it is a strong company. However, given that its forthcoming IPO is the most hyped of the year and has the potential to become the largest tech IPO ever - overtaking Facebook’s IPO - it is highly unlikely that the Crocodile of the Yangtze will list for a ‘wonderful price’. Therefore we must ascertain what a fair price would be that could justify an investment. Using a discounted cashflow model we calculate the company to be valued at $174.5 billion ($72.69 per share). However this method neglects any premium (or discount) that the market may apply to the company. Given its higher margins, strong net cash fiscal position and enviable incumbent position one could reasonably argue that Alibaba is deserving of a premium against its peer group. This is in spite of questionable decisions made by management in the past including the hiving off of AliPay in 2011 as a separate non connected entity or the purchasing of half of Gaungzhou Evengrande football club. A peer group of leading Chinese ecommerce companies, including the likes of JD.com, Tencent and Baidu offer valuation benchmarks and suggest a valuation of around $162 billion ($67.50 per share) for Alibaba. This would be close to the top end of $66 to $68 per share initial pricing of the company and suggests that the timing of the IPO is beneficial to selling shareholders. If the company does price at the top end of the range then some will deem this unattractive and will opt instead to invest in Yahoo which currently holds 24% of Alibaba shares. However, as the company prices, one thing is not in doubt; the Crocodile of the Yangzi River is about to leave China and make its mark in the world. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Investor Warren Buffet 1. Source: Company Accounts © 2014 Dominion Fund Management Limited (“DFML”). All rights reserved. DFML is licensed by the Guernsey Financial Services Commission under the Protection of Investors (Bailiwick of Guernsey) Law 1987, as amended. DFML is a member of the Dominion Group of companies. Registered Office: Ground Floor, Tudor House, Le Bordage, St Peter Port, Guernsey, GY1 1DB. Company no. 42592 page 8/8 GTC-ALINEWS-SEP2014 Yangzi River, China www.dominion-funds.com