(This article is reposted from Caixin Media on May 6, 2014, posted here)
As Alibaba files for its initial public offering (IPO) in the United States, analysts everywhere are engaged in a great game of valuation prediction. What is Alibaba really worth?
We have seen every technique cited – from cash flow projections and comparables to synthetics pricing and grey market trading. Thus far the low-end of predictions have put Alibaba at US$ 80 billion to US$ 100 billion. The majority of estimates are in the US$150 billion range. And a few analysts are making headlines with predictions of US$ 250 billion and above.
However, underneath all these projections and fancy (i.e., questionable) techniques, there are really only a couple of real fundamentals to consider. From Yahoo’s public filings, we know Alibaba had net income of US$ 3.52 billion on revenue of US$ 7.95 billion in 2013. And the net margin was 45 percent, which is pretty amazing. So projecting all this forward looks great – especially if you assign a high growth rate.
The rest of the analysis thus far tends to be speculation about how big Chinese e-commerce is going to be in three to five years. McKinsey & Co. has published reports stating the market will be between US$ 420 billion and US$ 650 billion by 2020. And as Alibaba dominates business to business (B2B), business to consumer (B2C) and consumer to consumer (C2C) activity in China, that gives you some big revenue predictions. Projecting those forward with a high price-earnings (PE) ratio gets you valuations in the US$ 150 billion range. Note that as I am writing this Facebook is trading at a 75 PE.
Here’s the problem with all of this. Value ultimately follows from profits, which follows mostly from competition. And the competitive landscape in Chinese e-commerce is fundamentally changing. So that makes a lot of this analysis meaningless. What Alibaba is worth depends on competitors. And on one competitor in particular: Tencent.
There is currently a frenzy of deal activity in China’s Internet space. Baidu, Alibaba and Tencent are buying companies almost weekly. This frenzy is largely about the shift from personal computers to smartphones and how this is changing the competitive barriers. It is a transformative change in the Chinese Internet landscape and everyone is scrambling.
This transformation is what is letting Alibaba jump into various new online sectors such as portals, media, location-based services and social media. It is also opening the door to invasions of offline sectors such as finance, retail and transportation. You can see Alibaba (and the others) doing deals on an almost weekly basis against these opportunities.
But this transformation is also exposing Alibaba’s core business to new competition. And it is exposing its Achilles’ heel, its weakness in the mobile space. And this is the space where Tencent is strongest, and that is a problem for the IPO. The attractive earnings and growth everyone is modeling could easily change. What happens to the valuation if Alibaba loses 20 percent to 30 percent of the market share in C2C or B2C?
Tencent has the capital, the technology and the talent to seriously impact Alibaba’s value. First, is has a dominant position in smartphone usage, which is the future and exactly where Alibaba is fairly weak. And second, it has a significant ownership stake in the second largest e-commerce player, JD.Com Inc., which has B2C market share of 18 percent. If any company can take 20 percent to 30 percent market share from Alibaba in the next two to three years, it is Tencent.
Within the discussion of Alibaba’s valuation, I believe there is a lack of appreciation for how volatile and ruthlessly competitive the Chinese Internet space is right now. Ultimately Alibaba’s valuation will depend on its market share, its margins and its return on capital. Tencent can easily impact all of these. If Tencent moves aggressively after Alibaba, it will be forced to drop prices to defend itself – goodbye margins. And it will be forced to invest heavily – goodbye return on invested capital. How likely is it to maintain an 80 percent market share and high margins in this scenario?
So yes, Alibaba will remain the largest player in Chinese e-commerce. But its market share, margins and required capital expenditures are exposed to a level of competition it has not seen in many years.
My view is that we are only at the beginning of a new story for both Tencent and Alibaba. When you look at the Chinese supply chain’s use of Internet technology as well as the new markets that are opened up by the Internet, e-commerce is actually only a small portion of the total Chinese Internet GDP. Things are going to look very differently in a few years. Good luck modeling that.
Jeffrey Towson is a professor of investment at Peking University Guanghua School of Management. He is the author of The One Hour China Book (https://www.onehourchina.com/).