BABA: F-1 Unwind

INTRODUCTION

Below is a review of BABA’s registration statement (F-1), which is over 500 pages, so we’re only highlighting the major points to keep this as brief as possible.  We’re emphasizing the risks to the story (since no other firm appears to be discussing them), but that doesn’t mean we’re negative on the company; we still have more work to do before we make a call here.  Feel free to reach out with any questions, or to discuss in more detail. 

NOTE OUTLINE

1. KEY TAKEAWAYS
2. BUSINESSES
3. BUSINESS MODEL
4. MAJOR REVENUE DRIVERS
5. MAJOR RISKS

 

KEY TAKEAWAYS

1. BABA Derives Majority of Revenues from Advertising: Despite the emphasis of Gross Merchandise Value (GMV) transacted through its platforms, the majority of revenues (~60% in F2014) comes from advertising, and roughly 77% of that is tied to its P4P ads, which is directly linked to the amount of traffic BABA generates of its sites.  That means revenue growth is largely tied to user growth. 
2. Dependent on the China Growth Story: BABA’s organic prospects appear highly dependent on the China growth story (particularly growing consumption patterns) given its astronomical share of the e-commerce market in China, coupled with its stated Market Opportunities/ Growth Strategies.  BABA makes multiple references to the opportunity in China given that it dwarfs many major economies in terms of consumption, internet penetration, and online shopping behavior.   That may be true, but the question is what is the real runway.  We’ll be working with our Macro team on the long-term picture in China, but their near-term macro view is calling for slowing growth.
3. At the Mercy of the Chinese Government: The most glaring yet undercovered risk is that none of its PRC subsidiaries or variable interest entities have been classified as an advertising company, which comes with a series of restrictive regulations that could hamper the business, along with a 3% tax on those revenues that could be enforced retroactively.  This doesn’t mean that PRC is going to drop the hammer, but it does mean that BABA has to play ball; whatever that means.
4. Contractual Obligations Limit Strategic Options: BABA has almost USD $10 billion in contractual obligations over the next 5 years, with ~$4 billion due in the NTM, $2 billion of which for “Investment Commitments” for equity interests in other companies that are yet to close.  BABA itself will only be receiving $10.1 billion of the $25.0 billion IPO proceeds.  Based on its CY 2Q14 balance sheet and IPO proceeds, we estimate that BABA a has net cash position of$ 10.5 billion; not much M&A ammo considering it generated roughly $8.5 billion in sales in FY2014.
5. Potential Near-Term Share Dilution Considerable: There are 368M ADSs floated post the IPO.  Another 128M shares are not subject to lock-up and freely convertible into ADSs.  After 181 days from the date of the prospectus (9/15/14), the lock-up will expire for another 427M shares.  Even if only a small portion of these share trade convert to ADS, the dilution could be considerable. 

BUSINESSES

1. Taobao: C2C/B2C shopping platform similar to EBay.  This is China’s largest online shopping destination,  and is the source of the majority of BABA’s  unique visitors and GMV (Gross Merchandise Value) transactions.  Taoboa offers products and services in over 100 different categories.
2. Tmall: B2C shopping platform similar to Amazon.  Tmall is China’s largest B2C platform in terms of GMV, representing roughly 1/3 of BABA’s GMV in China.  Platform also allows international companies to target Chinese consumers.
3. Juhuasuan: B2C group-buying platform similar to a Groupon.  Juhuasuan is the most popular group-buying platform in China, and BABA believes it is the world’s largest in terms of GMV.  Juhuasuan sellers must also be Taobao or Tmall to offer promotions.
4. 1688.com: a leading B2B online wholesale marketplace in China.  The majority of buyers on 1688.com are also retailers on Taobao & Tmall. 
5. AliExpress: Global B2C platform that allows international companies to buy directly from Chinese wholesalers and manufacturers.  Offers three different sites in the local languages of Russia, Brazil, and the U.S.
6. Aliababa.com:  China’s largest B2B online wholesale marketplace in China in terms of revenues.  Platform focuses on global trade.  Sellers are mostly Chinese wholesales/manufactures, but also include companies in India, Pakistan, Thailand, and the U.S.  Leading buyers are small and medium-sized business located in the U.S., India, and Brazil. 
7. Alipay: transaction service similar to PayPal.  BABA does not own Alipay due to certain PRC restrictions, but the company is majority owned by Jack Ma, BABA’s CEO.

 

BUSINESS MODEL

1. Online Marketing (~60% of FY2014 Revenues): Over 95% of BABA’s online marketing revenues are sourced from its Chinese retail marketplaces (Taobao, Tmall, & Juhuasuan).   The overwhelming majority of that comes from its Pay-for-Performance (P4P) ads where BABA gets paid when consumers click on a seller’s/advertiser’s ads.  Ad Prices (Cost-Per-Click, or CPC) are determined through an online auctioning process, where advertisers bid on the price and positioning of ad spots available.  BABA also delivers general display ads.  All its ads are delivered across its major platforms, and also on 3^rd-party sites, which generate roughly 5% of total revenue for BABA.  
2. Commissions (~25% of FY2014 Revenues):   BABA receives commission on the GMV transacted on both its Tmall and Juhuasuan platform, specifically on transactions settled through its Alipay payment services.  The commission rate ranges between 0.3% and 5% depending on the product category (higher margin product categories = higher commission rates).  BABA also generates commissions through its international retail platforms (AliExpress), but it contributes only ~5% of total commissions.
3. Member Fees & Value-Added Services (~10% of FY2014 Revenues): Primary avenue for monetizing its wholesale marketplaces.  BABA charges membership fees in the form of China TrustPass (1688.com) and Gold Supplier (Alibaba.com); both of which allow businesses to host storefronts (vendor’s own webpages on BABA sites) as well as “Value-Added Services”, which are basically data analytic tools, and storefront enhancements. 
4. Cloud-Computing & Internet Infrastructure: (~1 of FY2014 Revenue): Exactly as it sounds, BABA offers cloud-based computing/storage and web hosting tools for businesses.
5. Others (~3% of FY2014 Revenues): Mainly interest income off its micro loan business that offers loans with terms under a year to SMEs (Small and Medium-Sized Enterprises).  BABA no longer owns this business, but is partially liable for existing loan book.  Also included in here are storefront fees in the form of a software subscription to Wangpu, which is for decorating storefronts on BABA sites.

MAJOR REVENUE DRIVERS

1. The China Growth Story: BABA has a dominant presence in the Chinese Internet e-Commerce market.  According to iResearch data as July, Taobao and Tmall represent over 75% of all Chinese Internet shopping traffic in China (total visits, page views, & time on site).  Given BABA’s massive scale and limited room for incremental penetration, much of its revenue growth from here will be tied to the growth of the Chinese consumer; particularly internet users and internet shopping population.
2. Traffic Patterns Drive Its Ad Business:  ~60% of BABA’s revenues are generated from Advertising, and roughly 77% of that is driven by its P4P ads.  That means any slowdown in either user traffic and/or ad engagement of that user traffic will directly impact ad revenues.  For example, in CY 2Q14, the number of buyers on BABA’s Chinese Retail sites increased 51%, yet ad clicks increased only 39%; meaning ad engagement declined.  Traffic has also been migrating to mobile, which currently has lower advertiser demand and CPC rates.  In CY 2Q14, CPC rates declined -7% y/y, largely due to a largest shift in its mobile GMV %.
3. Tmall Migration a Major Tailwind: The majority of the GMV transacted in its China Marketplaces occurs on Taobao, where BABA doesn’t generate commission revenue outside of traffic directed there from its group-buying platform Juhuasuan.  Tmall GMV has been growing as a proportion of total Retail GMV, in turn, Commission revenue was the fastest growing portion of its China Retail revenues.  Tmall GMV currently represents 1/3 of its total China Retail GMV, so there is runway here, question is how much, and how much influence BABA has here.
4. Monetizing Alipay Wholesale?: BABA is not currently monetizing Alipay transactions settled on its Wholesale platforms, which generated roughly 70% of its total payment volume on Alipay in CY 2Q14.  We’re not sure why BABA hasn’t done so to date.  The fact that its two wholesales businesses are it longest running businesses suggests there could be a structural headwind to doing so (potentially lower margin profiles of wholesale businesses, competitive dynamics).  Still, a nominal fee on those transactions, if possible, could make a big impact; something to watch out for.

MAJOR RISKS

1. Mobile Monetization: As mentioned above, advertisers are not willing to pay comparable CPC ad rates for mobile ads relative to desktop ads.  The mix-shift effect will pressure CPC rates unless advertiser demand catches up with the migration of GMV toward mobile.
2. Incremental User Growth May Have Limited Yield: Per-capita retail consumption is considerably higher in Tier 1 & 2 cities (35 major cities in China) relative to the rest of China; $5.4K vs. 1.9K, respectively.  BABA penetration of the total population in Tier 1 & 2 cities in the LTM was slightly over 40%, but likely much higher for working-age individuals.  User growth from here may come with a declining per-capita GMV on its sites.
3. Market Share to Cede: While BABA has dominant market share in the China e-commerce market, it has been ceding traffic share to competitors over the few years to competitors according to iResearch data.  Given that BABA still draws over 75% of e-commerce traffic in China, we suspect it has more share to lose than gain from here.
4. At the Mercy of the Chinese Government: None of BABA’s PRC subsidiaries or variable interest entities have been classified as an advertising company, which comes with a series of restrictive regulations that could materially hamper the business, along with a 3% tax on those revenues that could be enforced retroactively. 
5. ADR Holders Have Essentially No Control: the ADR terms allow the Alibaba Partnership to maintain majority control over its board of directors, and BABA also has voting agreements with both Softbank and Yahoo to vote their shares along with Alibaba partnership.  The shares underlying the ADS from the IPO represent only ~15% of BABA’s outstanding shares.
6. Potential Near-Term Share Dilution Considerable: There are 368M ADSs floated post the IPO.  Another 128M shares are not subject to lock-up and freely convertible into ADSs.  After 181 days from the date of the prospectus (9/15/14), the lock-up will expire for another 427M shares.  Even if only a small portion of these share trade convert to ADS, the dilution could be considerable.  

Let us know if you have any questions, or would like to discuss in more detail

Hesham Shaaban, CFA

@HedgeyeInternet