Valuation on the newly minted wide-moat firm may be reasonable, but potential investors need to appreciate the key business, regulatory, and stewardship risks, says Morningstar’s RJ Hottovy.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
As Alibaba begins trading today, I'm sitting down with R.J. Hottovy, our consumer equity strategist for his take on the company.
R.J., thanks for joining me.
R.J. Hottovy: Thanks, Jeremy.
Glaser: Let's start with Alibaba as a whole. We've been talking a lot about it. Can you give us a little bit of a background about what the business is, and if you think it has any competitive advantages?
Hottovy: We actually think Alibaba is a wide-moat company, and that's predicated on the network effect that it has.
Right now Alibaba has almost 300 million active buyers on the site; that's almost 20% of the Chinese population. It also has 8.5 million active sellers. When you get that many people together, it's a virtuous cycle and very difficult to supplant.
Alibaba is also making a transition from being mostly a consumer-to-consumer type of platform--more of what you think of being like an eBay--to a business-to-consumer platform. With access to that many consumers, I think a lot of third-party sellers, other merchants, other retailers are going to be very keen to partner with Alibaba. I think that network effect is going to maintain itself for a very long time.
Additionally, I think the company also has some brand intangible assets in its marketplaces. They are often the first place that people go to when making an online purchase in China--either the Taobao marketplace or the Tmall marketplace. So I think it has a brand intangible asset.
And lastly, I think it has some cost advantages in the fact that with its logistics partners, it puts more of the capital on them and really becomes more of a coordinator for logistics partners and runs a pretty asset-light model.
Glaser: So if it is a good business, I guess the question is, how much do we have to pay for it? It priced at $68 per share. It looks like it's going to start trading somewhere in the high $80s potentially. Does that seem like a reasonable valuation to you? How much do you think it's worth?
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Hottovy: That's about where we shake out as a fair value. We've assigned a $90 fair value estimate to this company. That's predicated on top-line growth of about 32% on average for the next five years, being driven by not only new customers coming to the platform and additional things being sold through the platform, but also increased monetization rates, the amount of money they take on each purchase--again, they're not actually the retailer of record--but the take rate they charge other merchants. I think, those are going to be the drivers.
Plus there are some other industry and government tailwinds. The Chinese consumer finding a lot more discretionary income--I think that will help out this business as well.
From a margin perspective, we think operating margins are going to grow from about 47.5% to almost 50% over the next five years. That doesn't sound great, but the company is going to be making a lot of investments in its business, whether it be infrastructure, new technologies, or new content similar to what we see with Amazon in terms of reaching out to its consumers and giving them a little bit of everything. I think we'll see a dip in those margins over the next couple of years, but over the five-year period, we'll see an improvement there.
$90 per share, I think, is a fair price. With a name like this, you could see hype taking it quite a bit above what we think the shares are worth.
Glaser: How do you look at the uncertainty? What kind of margin of safety would you want before considering shares like Alibaba?
Hottovy: I think with a name like this, you have to have a fairly high margin of safety. We've assigned a high uncertainty rating for this name. The Chinese e-commerce market is still relatively early-stage. It's becoming a preferred way of shopping, but it's still, at the end of the day, at a very early stage. Only approximately a fifth of the Chinese population are Alibaba consumers, and there's not as much penetration in terms of Internet shopping as we see in developed markets. So it's still an evolving process, and with players like JD.com and Amazon trying to get into the market, that's going to be a risk.
There are also regulatory concerns. When you're operating in a market like China, where the government has been known to put some pretty strict regulations in place on certain businesses, that's a factor that you have to consider as well. Competitive and regulatory risks are things you have to consider, and that's why we assign a "high" uncertainty rating on this company.
Glaser: Finally, how do you think about the stewardship? There were some high-profile issues a few years back with Alipay. Are you concerned about the stewardship of this company?
Hottovy: That is the primary concern for us, too. We've assigned a "poor" stewardship rating to this company. We do think, on one hand, the management team has done a very good job executing, building out its business, and investing in the right areas. However, the company operates under what's called a "variable interest entity" structure, where the shares effectively are traded through the Cayman Islands. The way that is structured, it does limit minority shareholders' vote. They don't have much of a say in the process, and that is a concern.
The other thing is the way the board is structured. The partnership structure does really limit the voice of minority shareholders as well.
And then, as you mentioned, the Alipay situation, where the company spun out Alipay, and the management team owns a larger stake than the company itself; that's also a concern to us.
Those are the kind of things you have to balance with a story like this. Taking that into consideration, and [crediting] the company for what it has done right, I think that's something you have to be mindful of when looking at an investment there. There are some unique aspects of the management and stewardship to the story.
Glaser: R.J., I appreciate your thoughts today.
Hottovy: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
