Nutshell

Alibaba (BABA) is set to go public with a pricing late Thursday for allocation and trading on Friday morning. It promises to be a monster IPO and a virtual proxy for the long-term growth of China and the Internet. Investors are understandably in awe of the story and frothing at the mouth to buy shares. Our own quick and dirty Intrinsic Value (IV) model suggests a share price of $124, well above the current $67 mid-point of the range.

China is a much larger and more rapidly developing market for online commerce than the US. On a “market capitalization/opportunity” basis BABA looks very undervalued relative to AMZN and EBAY.

Rather than recap a story everyone knows and add to the chorus of praises, it might be more valuable to take the other side and play the devil’s advocate.

The Real Risks

Takimg the flip side of such an exciting story isn’t easy but there are several ample targets for disappointment to explore within the Alibaba story, even if it is indeed a sparkling long-term success.

• The growth rate may have peaked. Recent slowing from 52% to 46% can be chalked up to the law of large numbers, but there are certainly signs that recent economic growth in China has been below expectations. Some analysts are proclaiming a period of weaker overall global growth, which would have a disproportionate negative impact on China growth. Whether that is the case or not, it’s possible for growth rates there to be more volatile. Because BABA has such a large market share in China, changes in the overall economy are likely to cast a shadow on their results.
• International growth will need to improve in the next few years for longer-term projections to be achievable. Most investors expect AliExpress to be the vehicle that drives better international growth. It’s too early to tell. As the offspring of Alibaba.com, which focuses on wholesale products, AliExpress offers mostly new merchandise in smaller quantities for retail buyers around the world. There appear to be a large number of gray market items on AliExpress that may cause some problems as the site grows. For example quite a few new branded tennis racquets are sold there at prices around $40 versus the typical $150 they cost in the US.
• The quality of merchandise on AliExpress will need to improve to continue to capture more global buyers. Right now the operative word is cheap but many of the “best sellers” are downright eye watering from a fashion standpoint. 
• Brand and reputation are still not globally defined. As international sales occur the nature of the transaction will help define what Alibaba is to the global consumer. For example today Amazon is thought of very differently than eBay. If Alibaba merchandise is of low quality, takes a long time to arrive and is poorly supported they could become associated with a poor consumer experience. This would limit their growth and margin opportunity.
• Competition will get tougher. Alibaba has already done well against Tencent and Baidu but the rivalry amongst these firms is getting more intense. As Alibaba competes more aggressively internationally it will be opening additional fronts of competition with possibly very competitive companies with honed efficiency and innovation chops to keep them at bay. Alibaba has the resources and management team to stay the course, even if means protracted periods of investment. Investors may not have the patience to weather periods of below trend margins or slower growth.
• Structure, tax rates and ownership structure is a puzzle. As long as the stock is going up and business is good few will worry about the convoluted structure of the company or question whether or not the low tax rates are sustainable.

All of these factors are included in the lengthy risk factors section of the F-1 filing so management is certainly aware of the. We were particularly impressed with their knowledge of claims that may arise from brand owners who won’t tolerate a large public company with $22B in cash supplying the globe with gray market goods.

Valuation & Conclusion

Based on the proposed price the gross market capitalization of BABA would be $165B. This compares to a combined $220B for AMZN and EBAY.  We didn’t bother to sharpen the pencil to work out an intrinsic valuation for BABA shares. The company has very high margins already and we’ve modeled them at a steady state with some additional benefits from scale. Growth is where there is a greater leap of faith because it demands improved international growth at some point, probably by 2016-2017. Given the enthusiasm for the IPO and the notion that BABA is a “one decision stock” we can expect the pricing and aftermarket trading to be on the upside.

Investors may remember the FB fiasco when rabid investor demand and greedy pricing created a situation where neophytes lost their shirts. History suggests caution is warranted and the use of limit orders very much encouraged. Our IV model is certainly constructive on the shares at the proposed price.

Bullets and Tickers

• Alibaba BABA IPO is set to price well and trade strongly in the aftermarket.
• Investors view it as a “one decision stock” to own for growth in China and on the internet.
• Our IV of $124 supports the bull case but decided to focus our note on risks.
• Growth, margins, and the brand globally still have much to prove.