Should You Buy Into the Alibaba IPO?

Ali Baba and the Forty Thieves is one of the world’s most famous folk tales. Appropriately, its namesake e-commerce company has quite a story to tell to investors considering its initial public offering.

Alibaba Group Holding is China’s leader in online sales. Its retail and wholesale Web sites and mobile apps sold an estimated $270 billion (U.S.) in goods in 2013. By helping move that much merchandise, Alibaba can claim to be bigger than eBay (EBAY) and Amazon.com (AMZN). And unlike Amazon, which is notorious for suppressing its profits in order to invest in new businesses, Alibaba has maintained robust earnings even as it has moved into e-payment and cloud computing services.

This suggests that investors may clamor for Alibaba shares when the company goes public later this year on the New York Stock Exchange. We generally advise waiting at least 90 days after an initial public offering before buying in because that allows enough time for the hype to die down. Alibaba reportedly plans to hold its IPO sometime after the Sept. 1 Labor Day holiday.

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With Alibaba’s combination of fast growth, huge profit margins and a leading position in what will one day be the world’s largest economy, however, the hype may be real.

Alibaba operates several Web sites, including China’s largest shopping destination, Tmall. All of its sites are platforms for other sellers, so the 15-year-old company doesn’t do any direct selling or hold inventory.

Instead, Alibaba’s revenue comes from transaction fees, a small but profitable part of all that shopping. Alibaba posted revenue of $8.5 billion over the 12-month period that ended March 31. That makes the company look tiny compared with Amazon ($78.1 billion) and eBay ($16.6 billion). However, Alibaba earned nearly $3.8 billion over that period, dwarfing Amazon’s net income of $300 million and a $147 million loss at eBay.

Alibaba’s growth may be slowing, but its growth rate still easily outpaces most companies posting that level of profits. Sales increased 55% in the year that ended in March; net income increased nearly sixfold over two years. “Alibaba has a completely different model from Amazon, and that’s the reason for the high profit margins,” says Francis Gaskins, director of research at equities.com and a specialist in IPOs.

Alibaba can make a case that it has plenty of room for more rapid growth. The company says in its offering prospectus that only about 36% of China’s gross domestic product comes from consumer spending, compared with roughly two-thirds of U.S. GDP. Also, the company says that fewer than half of China’s 618 million Internet users are online shoppers.

Alibaba likes to say that its various components represent an “ecosystem.” In addition to the retailing operation, the ecosystem includes a payment-service company called Alipay; a logistics information system called China Smart Logistics; an online-marketing company; and (like Amazon) a cloud-computing business that serves other companies’ computing needs.

One batch of red flags comes in the area of corporate governance. Alibaba founder Jack Ma and a group of insiders will be allowed to nominate a majority of the company’s directors, despite the fact that Ma and his colleagues own a minority of the company’s shares (even before Alibaba goes public). In addition, the company allows Ma to make investments on its behalf. This is because Alibaba incorporated in the Cayman Islands so it could seek non-Chinese investors. But that status also meant it couldn’t invest in certain Chinese businesses. The arrangements with Ma are designed to work around that potential stumbling block.

What will Alibaba shares end up costing you? A Bloomberg survey of analysts in April valued the company at $168 billion; some analysts quoted in news reports have put the value above $200 billion. The company hasn’t decided how many shares it will ultimately offer, but a $200 billion market capitalization — roughly one-third more than Amazon and three times that of eBay — would price the company at slightly more than 50 times the prior 12 months’ earnings. That could actually be a cheap price to buy in to the Alibaba story.