Saturday, May 10, 2014

Yahoo! A puzzle, a mystery and an enigma

In my last post, I estimated Alibaba's value and concluded that its growth and profitability put it on a pathway to make it one of the most valuable IPOs in history. In this post, which I view as a companion, I am looking at Yahoo, a company that has effectively become a proxy for Alibaba, especially leading up to the initial public offering. To illustrate, Yahoo’s quarterly earnings came out on April 15, and it reported flat revenues and declining earnings. Bad news, right? However, its stock price jumped on the earnings report, as embedded in it was good news about Alibaba's revenue growth in the last quarter of 2013. In fact, in the context of valuing Yahoo! in my valuation class, I borrowed phraseology from Winston Churchill and described Yahoo! as a puzzle, coupled with a mystery and wrapped up in an enigma. Yahoo!, the parent company, is the puzzle (especially in how quickly it lost its dominance in the United States, and why), with a mystery (its 35% stake in Yahoo! Japan, which is prospering while the parent struggles) and an enigma (the 22.1% share of Alibaba). 
Note: Press stories estimate Yahoo's holdings at 22.6% or 24%, depending on whether you use diluted or primary shares. I used the 523.6 million shares that Yahoo owns in Alibaba and my estimate of 2368.67 million shares outstanding in Alibaba, including restricted stock units, in Alibaba to arrive at 22.1%.

Setting up the valuation
To value shares in Yahoo, you have to estimate the value of its US operations, but that is only a small piece of the overall value, since Yahoo owns 35% of Yahoo Japan and 22.1% of Alibaba. Neither holding is consolidated, and the way in which the accounting works effectively means that the key operating numbers that you see in Yahoo’s financial statements (revenues, operating income) will not reflect either of these holdings. To illustrate the tangled web of values, here are the steps to get to the value of equity in Yahoo:

Yahoo: The sum of the parts
Thus, to value equity in Yahoo, you have to value Yahoo, Yahoo Japan and Alibaba separately, and after aggregating your holdings in each company's equity (100% of Yahoo, 35% of Yahoo Japan and 22.1% of Alibaba), you also have to net out any taxes that will come due on capital gains if Yahoo plans to or is required to sell any of its holdings. In the case of Alibaba, it has no choice, at least on a part of the holding, since it will be required as part of a prior agreement to sell 208 million shares after the IPO

If you are interested in Yahoo as an investment, there are three ways in which you can approach the analysis.
  1. You can estimate an intrinsic value for each of the three pieces and add them together to come up with a composite intrinsic value. Now that Alibaba has filed its prospectus, you have the financial statements for all three companies.
  2. You can price each of the three pieces, by looking at a key metric (revenues, earnings, book value) and applying a multiple to it, based on how other companies like it (and that is a subjective call) are being priced in the market. 
  3. You can cheat and use the market pricing of one or more pieces to see how much you are paying for the rest of the company. In other words, you can check to see if the market is being internally consistent in its pricing of the pieces.
The Puzzle: Yahoo and its fall from dominance
I started with the parent company, a pioneer in the online search/advertising business that has long since been pushed to the sidelines by Google. Revenues have been declining at Yahoo! (US) over the last few years, going from $7.2 billion in 2008 to $4.68 billion in 2013 and the contrast with Google over the last decade is striking:

Yahoo versus Google: No mas!
The much heralded ascension of Marissa Mayer to the top of the company has not resulted in a turnaround in revenues, though the company continued to be profitable, generating $590 million in 2013 (translating into a pre-tax operating margin of 12.6%). If there was any positive news about Yahoo! in its most recent report, it is that ad revenues have stopped falling and that they increased 1.7% over the same quarter in the last year, though total revenues declined slightly and operating income dropped; the company generated $422 million in operating income on revenues of $4672 million in the twelve months ending March 31, 2014.
Intrinsic valuation: Assuming that Yahoo! will return to dominance or even get back to moderate growth is a reach. I will, however, assume that Ms. Mayer will find a way to stop the bleeding and that the company will muddle along as a mature company with stagnant revenues and stable margins. I assume a nominal growth rate of 1% for the next 5 years for Yahoo!, increasing to 2.75% in year 10, I estimate a value of $4.38 billion for its operating assets, but adding its substantial cash balance of $4.6 billion and netting out its debt of $1.6 billion, I derive a value of equity of $7.37 billion for the parent company.  You can download the parent company valuation by clicking here. (I used the last 10K filed by Yahoo and updated the numbers using the most recent 10Q).
A relative valuation (pricing): You can anchor your relative valuation of Yahoo! to revenues, EBITDA or operating income. Perhaps, the simplest way to do this would be to apply the median EV/Sales or EV/EBITDA  multiple for the sector (internet software and services) to Yahoo's metrics to estimate a value for just the parent company's operating assets. 
Yahoo: Estimated Enterprise Value using Median Multiples from Internet software & services
While it is tempting to apply these median multiples in the sector in internet software & services business to Yahoo’s revenues, you will get absurdly high values, since most of the companies in this sector are expected to have high revenue growth in the future,  and Yahoo! has little or no expected growth. In particular, we would expect Yahoo to trade at a much lower revenue multiple than its competitors. To get an adjusted revenue growth, we plotted EV/Sales against revenue growth for all internet stocks in the chart below:

EV/Sales versus Expected revenue growth: Internet software & services
There are outliers in this relationship, with higher revenue growth companies trade at higher multiples of revenues. (Twitter is one of the outliers in the graph, but this graph was prepared before Twitter's fall from grace last week. It is not as much of an outlier any more.)  In fact, the best fit line yields the following (and you can download the raw data used for the regression here):
EV/Sales = -0.94 + 21.21(Expected revenue growth) + 15.06 (Operating Margin)
R squared = 54.5%
Given Yahoo's expected revenue growth rate of 1% and current operating margin of 9.02%, we would forecast an EV/Sales ratio of only 0,63 for Yahoo .
EV/Sales Yahoo = -0.94 + 21.21(.01) + 15.06 (.0902) = 0.63
Applying this multiple to Yahoo’s revenues ($4.672 billion) yields $2,948 billion for Yahoo’s enterprise value, and adding the cash balance ($4.6 billion) and subtracting out debt (1.6 billion) yields a value of equity of $5.9 billion. Note that this is the value of only the parent company, since the revenues from the cross holdings (Yahoo Japan and Alibaba) are not incorporated into Yahoo’s revenues.)
Market price: Given the stock price of $33.76 at the time of this post, we have a market capitalization of $34.8 billion for Yahoo in May 2014, but that reflects the market’s assessment of the value of equity in the company with its cross holdings.

The Mystery: Yahoo! Japan
While Yahoo! has struggled in the US market, Yahoo! Japan has had more success in the Japanese market, as evidenced in the graph below:
Yahoo! Japan - Historical Performance
While there was a slowdown in 2012 and 2013, the company has been able to post a compounded annual growth rate of 22% in revenues and earnings in the last decade.
Intrinsic valuation: Estimating an intrinsic value for Yahoo! Japan, with a 5% growth rate in revenues for the next 5 years and much higher operating margin (40%) than Yahoo, yields an intrinsic value of $17.9 billion for the operating assets and $21 billion for its equity. You can download the valuation of Yahoo Japan by clicking here.
Relative valuation/pricing: Using the same regression on online companies that I used to value the parent company, I estimate an EV/Sales multiple of 7.91 for Yahoo! Japan, based on its expected revenue growth of 5% and operating margin of 51.72%.
EV/Sales Yahoo Japan = -0.94 + 21.21(.05) + 15.06 (.5172) = 7.91
Applying this multiple to the revenues of $3,929 million in 2013, we estimate a value of $31.1 billion for Yahoo! Japan’s operating assets. Adding cash and subtracting debt yields a value of equity of $34.2 billion for Yahoo! Japan.
Pricing: Yahoo! Japan is a stand alone and publicly traded entity, with a market capitalization of $23.2 billion in May 2014.

The Enigma: Alibaba
The final piece of the valuation is Alibaba, in whom Yahoo! has a 22.1% stake. Until last week, we were valuing Alibaba primarily through the financials that Yahoo was reporting for the company, since it was private and unlisted. With the prospectus now in the public domain, we can be more specific in both the intrinsic and relative valuations of the company.
Intrinsic value: Rather than rehash the intrinsic valuation of Alibaba, I will direct you to my last post, where I valued Alibaba's equity at $145 billion, post IPO. That valuation is built on the assumptions of revenue growth slowing to 25% (on an annual, compounded basis over the next 5 years) and a target operating margin of 40% (below the current operating margin of 50%). You can download the Alibaba IPO valuation spreadsheet by clicking here.
Relative valuation/Pricing: The second is to use the revenue and net income numbers, in conjunction with estimates multiples obtained by looking at other companies in the business and adjusting for Alibaba’s higher growth and profit margins. The table below lists PE and Price to Sales (which is a inconsistent multiple, but one we are stuck with since we have no debt and cash numbers) for sectors that may or may not match Alibaba’s business model:
Median Multiples: Advertising, Retail and Online Retail
The range of values that you obtain, using these multiples for Yahoo!, is immense, from a low of $6 billion (using EV/Sales of general retail) to a high of $285.6 billion (using a PE ratio of US online retailers). The bankers will undoubtedly gravitate towards earnings-based multiples and samples of internet firms as comparable firms during their roadshow. Using the EV/Sales regression that I used to value Yahoo! and Yahoo! Japan, with an expected revenue growth of 27% (from valuation) and operating margin of 49.07%:
EV/Sales Alibaba = -0.94 + 21.21(.27) + 15.06 (.4907) = 12.18
Applied to Alibaba's revenues of $7,911 million in 2013, adding the value of cash, cross holdings in Weibo & other online ventures and expected IPO proceeds of $27,963 million and netting out debt ($6,670 million) yields a value for Alibaba's equity of $117,623 million.
I would not be surprised if Baidu, the only other large, publicly traded Chinese online company that is structured similarly to Alibaba (as a Variable Interest Entity) is used for comparison and its pricing ratios are applied to Alibaba's metrics to arrive at value.
Baidu Multiples Applied to Alibaba; Enterprise values adjusted for cash, cross holdings and debt
On second thoughts, given how low these values are, relative to the rumored IPO numbers, it is entirely possible that bankers will avoid talking about Baidu as much as they can, since it will not fit their pricing story. 
Pricing: Alibaba is not a publicly traded company yet, but there is no shortage of estimates of how much the company will be valued at after its IPO. The rumored IPO estimates of equity value ( range from $150 to $200 billion.

The Bottom line
At this stage, we have three paths we can follow to estimate the value per share in Yahoo, which entitles you to a full share in the parent, 35% of the equity of Yahoo! Japan and 22.1% of the equity in Alibaba. In each case, I have netted out the taxes that Yahoo will have coming due on the 208 million shares of Alibaba that it will have to sell. Pulling together the numbers for all the valuation/pricing of the individual companies, here is where we stand:
1. All intrinsic value: Using the intrinsic value estimates that we have for the three companies in the mix, we can estimate an intrinsic value per share for Yahoo:

The taxes were computed based on the capital gains, the difference between the assessed equity value for Alibaba and the book value (from Yahoo's 10K) for these shares. Using intrinsic value estimates for all three companies, the value per share is $41.19, making it under valued by 18%, relative to the prevailing price per share ($33.76).
2. All relative value: Using the relative value estimates that we have for Yahoo, Yahoo Japan and Alibaba, we derive a relative value per share for Yahoo:

On a relative value basis, the value per share is $39.19, making it under valued by 14% at its current price.
3. Pricing break-even: There is a third twist that can be used to value Yahoo's equity. You can use the market pricing of Yahoo Japan and Alibaba to back out the value that the market is attaching to the parent company's operating assets. Since Alibaba is not public yet, this will require use of the estimated IPO value numbers (I will use $150 billion for the base case), but once Alibaba becomes a public company, the pricing will be the market value.

Using the expected IPO value of equity of $150 billion, the conclusion you arrive at is that the market must be attaching a negative value to the parent company's operating assets. To the extent that this may just reflect the possibility that we are misplacing the Alibaba IPO, I estimated the value of Yahoo operating assets as a function of the value of Alibaba equity after the IPO.
Imputed value versus Intrinsic value
The results here are consistent with both the intrinsic and relative value assessments. Unless the Alibaba post-IPO equity value is less than $104 billion, it looks like Yahoo is mispriced, relative to how its holdings are being priced. 

What next?
While I remain concerned about the overall valuation of companies in the sector, Yahoo seems mispriced on every basis, intrinsic, relative and market pricing. I am aware that there are risks (as with any investment) and there are three concerns that I have:
  1. Cross holding complexity: Yahoo is a case study in why valuation becomes difficult in the presence of cross holdings. In particular, the accounting for cross holdings, though it has its own internal logic, creates inconsistencies across financial statements that both confuse and trip up investors. In the case of Yahoo, the cross holdings in Yahoo Japan and Alibaba are recorded using the equity approach. The net result of the accounting is that the operating numbers for Yahoo (revenues, EBITDA and operating income) reflect nothing from these holdings whereas the net income and book value of equity do reflect the cross holdings . So what? For those investors who are dependent upon enterprise value multiples (EV/EBITDA or EV/Sales), applying either of these multiples to Yahoo numbers, adding cash and subtracting debt, i.e., following conventional practice, will yield a value of equity far lower than the market capitalization of the company because you are effectively attaching no value to its cross holdings. It is true that you may be able to use net income as your base, since it includes the income from the cross holdings, and apply a PE ratio to it, but that PE ratio will have to reflect the composite expectations across three companies (Yahoo, Yahoo Japan and Alibaba) on growth and risk.
  2. The tax bite may get larger: I have assumed the minimum tax bite in my valuations, since it really makes no sense for Yahoo to liquidate its cross holdings now, unless it is forced to, as it is in the case of the 9% of Alibaba that it has to sell. It does not need the cash, its investors should get the pass-through value and it certainly does not want to pay the tax bill early. There are two scenarios, though, where this assumption may break down. First, if the market prices for Yahoo Japan and Alibaba skyrocket and Yahoo's price does not, the gap that we highlighted in the last section may get bigger. In fact, if it gets big enough, Yahoo may be forced to monetize the gap, i.e., sell its holdings in Yahoo Japan and Alibaba, pay the taxes, and still have money left over for its stockholders. The second relates to Yahoo's relationship with Alibaba. It is possible that Alibaba may be uncomfortable with Yahoo's continued large stock ownership and find a way, legal or extralegal, to get Yahoo to sell. 
  3. The "do something quickly" discount: There is a bias both among analysts and financial journalists towards CEO action over inaction, towards quick action over more deliberate choices and towards growth over retrenchment. Leading into the Alibaba IPO, there has been a drumbeat of articles like this one, this one and this one that are full of advice for Ms. Mayer about what she should do with the cash windfall that Yahoo will have after the IPO. Most of these articles suggest ways in which Ms. Mayer can use the cash to return Yahoo to its glory days. I think that Yahoo has lost the fight to Google and should concede gracefully. Rather than throw good money after bad, my suggestion is that Yahoo do the following: (a) concede that growth in its core business will be too expensive to go after, cut back on growth investments and run itself as a mature business (essentially what I have assumed in the intrinsic valuation), (b) work on making the performance and the pricing of its cross holdings more transparent to investors and (c) return the excess cash to investors. The upside of doing this will be that the gap between price and break up value may shrink, benefiting stockholders. The downside is that Ms. Mayer loses a chance (albeit one with low odds) to go down in history as the CEO who brought Yahoo back from the dead.
The cross holdings and the confusion they breed among investors it both an ally and a hindrance, an ally because it is one reason why the stock (in my view) is mispriced and a hindrance because it may take a while for the mispricing to become evident. Alibaba's IPO may seem an obvious catalyst but market corrections don't always follow the logical path. The tax issue is a nagging problem, but the company seems cognizant of the tax overhang and negotiated with Alibaba to reduce the number of shares that it would have to sell after the IPO. Finally, Ms. Mayer seems to be saying all the right things, talking about how how she plans to be a "good steward of capital", but talk is cheap and the pressure to go for bigger and better will be difficult to resist. On balance, none of these risks is enough of a deal breaker for me. Not only is there a gap between price and value with Yahoo but there is one between price (that the market is attaching to Yahoo) and price (that the market is attaching to Yahoo! Japan and Alibaba) and as a newly minted Yahoo stockholder, I am hoping that one or the other of these gaps will close.

Yahoo! Equity Valuation: Master spreadsheet (is linked to individual company valuations below)

Thursday, May 8, 2014

Alibaba: A China Story with a profitable ending?

Let me begin with a couple of confessions. The first is that I am not a China expert and what I do not know about the country vastly outweighs what I do. The second is that I start with strong negative biases about the Chinese governance system, political and corporate, that color my assessment of Chinese companies and investments. Having said that, I cannot resist trying my hand at valuing what may be the most valuable IPO in history in Alibaba, but as you review my valuation, keep both my ignorance and biases in mind. 

Alibaba: Setting the table
Since I had no exposure to Alibaba and its operations, I started my exploration of the company by visiting their flagship site, TaoBao, a chaotic and colorful hub where both individuals and businesses can offer their goods, used or new, for sale, at fixed or negotiable prices. Though modeled on eBay, Taobao is different on two counts. The first is that it is far more tilted towards small and midsized retailers offering new products for sale than to individuals selling used items. The second is that Alibaba, unlike eBay, does not charge a transaction fee, but instead makes its revenues primarily from advertising.

In 2010, Alibaba opened a new front in its business with TMall, a site for a selective list of larger retailers, playing an expanded role in the process for a larger slice of the transaction pie. On this site, retailers pay a deposit to Alibaba to reimburse buyers who receive counterfeit goods, a technical service fee to cover the fixed costs of carrying the store and a sales commission determined by transactions value. Alibaba also developed Alipay, a third-party online payment platform, akin to Paypal, that has grown in the last few years to dominate the Chinese online payment market. As we value Alibaba for its IPO, though, it should be noted that investors will not be getting a share of Alipay, because it has been separated from the company and will be operated as an independent entity. (Note: As Blake notes in the first comment, there is a clause in the prospectus that specifies that Alibaba will be entitled to 37.5% of the proceeds if Alipay is taken public or sold, with a floor of $2 billion and a cap of $ 6 billion in that value).

Alibaba has been phenomenally successful both in terms of both helping online retailing find its legs in Cina and becoming extremely profitable while doing so. In 2013, the company generated almost $4 billion in operating profit on revenues of approximately $ 8 billion and its rapid evolution from small start up to profitable behemoth are traced in the graph below:

Not only have revenues accelerated over the last three years (the growth story), but the company's profitability has surged even more. If timing is everything in going public, you can see that Alibaba has chosen a good time.

Alibaba: Four Steps to Valuation Nirvana
There are four steps to understanding how Alibaba has got to where it is today, where it can expect to go in the future and the risks along the way.
1. Enter a growth market early and mold it to your strengths: In 1999, when Alibaba was founded, online retailing in China was in its infancy. While the largest US online players (Amazon, eBay etc.) either ignored or mishandled the market, Alibaba not only adapted to Chinese conditions but played a key role in the evolution and growth of the Chinese e-commerce market, as China has become the second largest online market in the world, as shown in this comparative graph from this McKinsey's report on the market:

One key difference between the Chinese e-tailing market and US online retail is that the former has historically been much more dependent on online marketplaces (as opposed to retailer-based online sites)  largely because of Alibaba's influence.
Future: As Chinese consumers get increasingly comfortable buying online, the expectations are that the Chinese online market will continue to grow at high rates. In its prospectus, Alibaba estimates a compounded growth rate of 27% a year in Chinese online commerce between 2014 and 2018, and that number is in line with estimates made by other services. If these forecasts hold up, the online retail market in China will become the world's largest in the next few years.
Fears: Though there are few who seem to question the China story today, the history of growth in emerging markets is that there are always unpleasant and unexpected surprises on the pathway to prosperity. Investing in Alibaba is an investment in continued growth in China, and any economic or political troubles that operate as speed bumps on that growth will affect Alibaba disproportionately, since it generates almost all of its profits in China and is dependent on growing consumer spending.

2. Differentiate and dominate: The story of how Alibaba beat eBay and Amazon is grist for strategic story tellers, but at its core, there are three reasons why Alibaba won (and eBay lost). The first is economic. By charging no transactions fees initially and depending entirely on modest advertising charges, Alibaba made itself a bargain to retailers, relative to competitors. The second is that Alibaba molded its offerings to Chinese culture and consumer behavior. The Economist’s characterization of TaoBao as an online bazaar is apt, since the site is colorful, chaotic and set up for online haggling between buyers and sellers. Third, the site is also attuned to the fact that the Chinese retail market is splintered, with thousands of small and mid-sized retailers who lack visibility, credibility and payment processing skills online and TaoBao offers all of those. The visibility comes from the traffic on the site, the credibility from Alibaba’s system of independent verification, paid for by sellers, and payment processing from Alipay,  In 2013, about 75% of all online retail business in China was routed through one of Alibaba’s sites. To provide a measure of the sheer volume of transactions on TaoBao and TMall, it is estimated that $5.75 billion merchandise was sold on Chinese online retail sites just on "Singles Day" on November 11, 2013, more than two and half times what US online retailers sold on Cyber Monday, and much of the merchandise was sold on the Alibaba sites. To get a measure of Alibaba's market share online, take a look at the breakdown of the biggest players in the B2C (retailers selling to customers), C2C (customers/small retailers selling to other customers), mobile markets and mobile payments in China:

In every segment, Alibaba is not just the leader but an overwhelming one.
Future: The domination of Alibaba creates a network effect, since retailers have to go where the customers are now, and as a consequence, they have to be on an Alibaba site to be noticed. That, in turn, make it easier for Alibaba to attract more customers, as the overall market grows, keeping the cost of customer acquisition low for the company.
Fears: The dark side of having as large a market share as Alibaba does is that almost all of your future growth will have to come from the overall market growing. The size of the Chinese market is also drawing in competitors who are willing to spend significant amounts of money to chip away at Alibaba’s market share, with Jingdong (360Buy) and Tencent offering faster delivery and better after-sale service.

3. Don't be greedy: While most online retail transactions in China go through Alibaba sites, the slice that Alibaba keeps for itself is very small. In TaoBao, in particular, its revenues are just advertising charges paid by retailers to list on the site, a very small portion of the total transaction value. In TMall, Alibaba does get a larger slice of the transaction revenues because it charges a transaction fee, but it is still only 0.5 and 1.5% of revenues. While this small share may seem like a negative, it has proved to be one of Alibaba's competitive advantages, since it has made it difficult for competitors to undercut it and offer better deals to customers and retailers.
Future: The question of how Alibaba's slice of overall transaction revenues will change over time, we have to make judgments on the relative growth of TMall and TaoBao. If the former grows faster than the latter, the slice of revenues that Alibaba keeps will increase over time. I was disappointed that Alibaba was not more transparent about the evolving shares of its two market places in its prospectus, choosing to lump them together as China commerce.
Fear: The market, especially in B2C, is getting more competitive, as international players like Amazon and EBay are coming back to the market, chastened by past failures, but perhaps having learned from their mistakes and deep pockets.

4. Avoid pretense: Alibaba seems to generate these revenues with little effort (and marketing costs) and since the company does not aspire to be a technological innovator, its R&D and development costs are negligible. These factors result in the company’s most impressive statistic: in 2013 it had a pre-tax operating margin of almost 50% and a net profit margin of close to 40%, high even by any standards. 
Future: Alibaba's high margins are a result of the network effect (that we referenced earlier) created by its immense market share and its limited ambitions (where it has been willing to settle for a small portion of revenues). While there is nothing to indicate that either will change significantly in the near future, there are signs that the company is getting more ambitious, planning large investments in social media companies and logistics infrastructure. 
FearAlibaba will have to start working harder (and spending more) to get consumers to continue to use its sites and to keep advertisers on its site. For instance, Alibaba has announced plans to spend billions in building a logistics network to allow for same-day delivery. These investments, while necessary to preserve Alibaba’s success, will reduce both margins in the future and cash flows in the near term.

Alibaba: What next?
Alibaba is exceptionally profitable and will probably remain so for the near future. To value Alibaba, though, I had to make judgments on the following parameters:
1. Revenue growth: The expected revenue growth at Alibaba will be a composite effect of three of the four dimensions described in the last section.

In my judgment, Alibaba's revenues will grow at a compounded rate of 27% a year for the next five years, the same rate as the overall online retail market in China, with losses in market share being offset by a more diverse business model allowing it to keep a larger slice of transaction revenues. While that is a steep climb down from last year's growth, note that it is a compounded growth rate and that I am probably understating revenue growth in the first year or two but overstating it in the fourth and fifth year. Starting in year 6, that revenue growth will start sliding down towards a mature stage growth of 2.63%. With my estimates of growth, Alibaba's revenues in 2024 will be approximately $47.6 billion. To provide perspective, that estimate is 40% lower than Amazon's revenues of $78.1 billion in 2013, about 25% below from Google's revenues of $62.3 billion in 2013 and more than five times Facebook revenues of $8.9 billion in 2013.

2. Operating margin: The stratospheric margin enjoyed by Alibaba currently (of approximately 50%, pre-tax) makes it extremely unlikely that the margin will increase over time and more than like that it will decrease. In fact, while the numbers don't reflect this yet, the news stories about recent investments that the company  has had to make in logistics and technology suggest that it is not a question of whether the margin will decline over time but by how much. While the margins at TaoBao will remain high, the competitive nature of the B2C market will put downward pressure on operating margins at TMall. I will be assuming that the operating margin will decline over time down to 40% in 2024. To provide perspective again, Facebook reported an operating margin of 35.6% in 2013 and Google's pretax operating margin in 2013 was 23.4%. I would justify Alibaba's higher operating margin by noting that Alibaba spends far less than either Facebook or Google on R&D or technology. I also assumed that the tax holidays and credits that have kept Alibaba's effective tax rate at close to 10% will start to fade over time, and that the tax rate will move towards the Chinese statutory rate of 25% over time.

3. Investment: If Alibaba plans to ramp up revenues, as I have forecast, it will be called upon to make investments in logistics, technology or social media companies. While it is difficult to be specific about what form these investments will take, the company currently generates $1.93 in revenues for every dollar in capital invested (based on 2013 revenues and capital invested). I assume that for every $2 in incremental revenues in the future, Alibaba will have to invest a dollar in incremental capital. That will still make them more efficient than the typical US company in this space, where the ratio of sales to invested capital is closer to 1.40.

4. Cost of capital: Alibaba's business is a mix of advertising and merchandising (the transaction fees that it charges in TMall). Using a mix of 70% advertising and 30% online retailing as my mix, I estimated a cost of capital, in US dollar terms, of 8.84% for the company, at least for the next five years. As the company matures and growth eases, this cost of capital will decline to 8% by 2024.

5. Cross holdings: Alibaba has made investments in other companies in recent years, primarily because they offer technologies or products that will help Alibaba in its operations. These investments are recorded in the balance sheet at $2,093 million and the five biggest are listed below:
Since two of these companies, Weibo and AutoNavi, are publicly traded, I estimated the market value of these holdings and replaced the equity value on the balance sheet with the market values instead. The net effect was small, yielding a corrected value for the cross holdings of $2,087 million. Finally, the liquidity clause in the Alipay agreement entitles Alibaba to 37.5% of the proceeds from any liquidity event associated with Alipay (an IPO or a sale), with a cap of $ 6 billion and a floor of $2 billion on Alibaba's share. Alipay's earnings just from Alibaba in 2013 was $305 million and it likely that it will keep growing over time, suggesting that the value from a liquidity event is likely to yield a payoff to Alibaba that will be closer to $ 6 billion than $2 billion, in case of a liquidity event. That $6 billion, though, has to be adjusted for the likelihood that the entangled nature of Alipay (with Alibaba) will make it difficult to sell the company or take it public as well as the time value of money. Conservatively, I am adding an additional $ 3 billion to Alibaba's value to reflect both of these factors.

The valuation: The value that I obtain for the equity is approximately $130 billion, before IPO proceeds are considered, and in excess of $145 billion with the IPO proceeds built in. The valuation picture, summarizing my inputs, is below and you can download the spreadsheet with the valuation, if you so desire. (You can also download the prospectus by clicking here.)

The value of the operating assets in Alibaba, based on my assumptions, is $127.48 billion. Adding cash ($7,876 million),  the value of cross holdings in other companies ($2,087 million) and Alipay ($3,000 million), netting out debt ($6,670 million) and the value of equity options granted to employees ($3,190 million) results in a value for equity of $130.59 billion. Finally, since this is an initial public offering that will raise money that is going to be kept in the firm (according to the prospectus), I added an estimated $15 billion (the rumored IPO target) to arrive at an overall equity value of $145.59 billion. Again, working with the 2368.67 million shares outstanding, including restricted stock units granted to employees, that works out to a value per share of $61.46/share.

Rather than give you the usual caveats, which would be that my estimates are likely to be wrong and that you should make your own valuation judgments, there are four specific concerns I would draw your attention to.
  1. Status quo, not disruption: When you invest in young growth companies in big markets, you usually are hoping for disruption, since you need the game to be shaken up for these companies to displace larger, more established players. With Alibaba, though, that is not the case. This is a company that has in large part built the status quo for online retailing in China and benefits hugely from more of the same. Your biggest fear if you are an Alibaba stockholder is of a seismic change in either technology or Chinese consumer buying habits that will undercut Alibaba's network advantages.
  2. Corporate governance: Corporate governance at young technology companies is weak and it is toothless at Chinese companies. So, it goes without saying that if you buy shares in Alibaba, you should do so with the expectation that if you do not like the way the company is run, you will have no recourse other than sell your shares and move on. Since that is a conclusion that you would reach if you bought Facebook or Google shares, as well, Alibaba is not that unusual, at least in this sector.
  3. Legal Jeopardy: The shares that will be offered in the Alibaba IPO are not shares in the operating company but in a legal entity that is incorporated in the Cayman Islands. That legal entity, structured as a variable interest entity (VIE), owns the operating company in China. The reason for this complex holding structure is that the Chinese government has restrictions on foreign ownership in a wide range of businesses, including retailing, and this structure allows companies to evade those restrictions. The Chinese government is undoubtedly aware of the evasion and looks the other way, at least for the moment, though it does reserve the right to change its mind and challenge the legality of the structure. I am still a novice to the nuances of investing in a VIE, but there are others who know far more than I do and have posted on the dangers. While Alibaba seems to have structured it's VIE with more protections than most, I am still uncomfortable with the notion that my investment value is left to the tender mercies of Chinese regulators and law.
  4. The Silent Partner: While much of Alibaba's success can be traced to good management and a favorable market climate, it is also true that almost every successful Chinese company owes part of its success to friends in high places,. While I am not suggesting that the company is guilty of corruption or underhanded practices, it is also true that the Chinese government has tilted the competitive balance in Alibaba's favor in subtle and not-so-subtle ways especially against foreign competitors. The downside of being a beneficiary of official favors is that Alibaba will be asked to reciprocate at some time or worse still, it (and by extension, its stockholders) may fall out of favor. 
What next?
As I have noted in my previous pre-IPO musings on Facebook and Twitter, the IPO process is a pricing game, not a valuation one. Thus, it matters little what you or I or even the company think Alibaba's value is today. It matters more what investors, institutional and individual, are willing to pay for Alibaba in this market. In spite of the recent swoon in technology stocks, Alibaba brings together in one package many of those buzzwords that I referenced in an earlier post: it is a company with strategic aspirations, significant growth potential and expansion options in China, creating a perfect storm for sky-high pricing.