What You Need to Know Before Taking Double-Digit Gains on Alibaba (BABA) Stock

It's 13F season, when the world's largest hedge funds disclose their biggest holdings.

And this year, some of the world's best investors - George Soros, Dan Loeb, John Paulson, David Tepper, Louis Bacon Moore, Leon Cooperman - all have significant stakes in Alibaba Group Holding Ltd. (NYSE: BABA).

If it wasn't clear before, this makes it official that Alibaba has taken the investment world by storm.

Perhaps even more significant is the fact that, in quite a few cases, Alibaba has been the real bright spot in an otherwise tough year for most of these funds.

Indeed, since coming public at $68 per share on September 18, the stock has rocketed straight up to $111.24 per share, making it the sixth-largest U.S. company by market capitalization - only Apple Inc. (Nasdaq: AAPL), Exxon Mobil Corp. (NYSE:XOM), Microsoft Corp. (Nasdaq: MSFT), Google Inc. (Nasdaq: GOOG, GOOGL), Berkshire Hathaway Inc. (NYSE: BRK), and Johnson & Johnson (NYSE: JNJ) are more highly valued by investors.

By any measure, this is a remarkable run for a company that went public barely two months ago...

But, like the "candle that burns twice as bright," the question is whether Alibaba has come too far, too fast.

The answer is complicated, but our next move is simple...

Alibaba's Unique Business Model Is Its Biggest Strength

Alibaba is China's largest private sector company. It has more than 300 million buyers and 8.5 million merchants who sell almost 120 product categories on its sites.

The company operates a unique combination of Internet businesses that combine an online marketplace like eBay Inc. (Nasdaq: EBAY), an online payments business like Paypal, consumer e-commerce like Amazon.com, Inc. (Nasdaq: AMZN), and a proprietary cloud computing technology called "Alibaba Cloud" that handles the traffic and data management of the company and its partners. It also has a growing financial services business.

Alibaba operates an online marketplace and is not an online retailer like Amazon.com, so it earns money on a net commission basis. Its Taobao Marketplace is free of commission/listing fees and generates most of its revenues from selling advertising.

Taobao has over 95% market share in the consumer e-commerce sector in China while Tmall has 57% of the business e-commerce sector. With a combined 81% market share in overall e-commerce gross merchandise volume, Alibaba is by far the dominant player in Chinese e-commerce.

In sharp contrast to a company like Amazon, Alibaba outsources fulfillment and logistics to its 48%-owned affiliate China Smart Logistics Network, which enables it to keep billions of dollars of costs off its balance sheet and income statement.

If Amazon didn't include its logistics costs in its income statement, it would be much more profitable. China Smart Logistics Network operates a logistics information platform that links up transactional data to that of other logistics partners.

What makes this all so incredible is that the Internet and e-commerce are still in their early stages in China. It's virtually all upside.

With Chinese Internet penetration at only 44% and online retail transactions accounting for only 8% of total Chinese retail sales, it is easy to see why investors are exuberant over Alibaba's future growth prospects.

Monetization of usage is also in its early stages.

The overall monetization rate for Alibaba's China retail marketplace was only 2.55% in its 2014 fiscal year. The monetization rate from mobile phones has been improving to 1.49% in the most recent quarter from 0.98% and 0.58% in the two previous quarters, which are considered relatively low rates that should offer significant upside.

Over such a large base, even small increases in monetization rates could boost earnings significantly.

The bullish case for Alibaba, based on its unique business model, is extremely compelling, and for the moment there is every indication that BABA stock will continue to rally along with the overall market.

Clearly, Alibaba is a company with (nearly) everything going for it.

However, there's a variable in play here that's much more complex, and is, for now, unknowable.

And that gives me pause...

Ownership Structure Is Our Biggest Concern

The biggest risks regarding Alibaba stock relates to questions about its ownership structure and relationship with the Chinese government.

Western investors are still taking an enormous leap of faith when they buy stocks in Chinese companies.

In Alibaba's case this risk is elevated by the company's convoluted ownership structure, a business structure that keeps its payments processing and logistics businesses off-balance sheet, and lingering questions about the true nature of its relationship with the Chinese government.

Nevertheless, as long as the company keeps executing as it has in the past and can continue to manage its complex business structure and its relationship with the Chinese government, investors should be well rewarded over the long-term.

But that also assumes that the company has made accurate disclosures on all of these topics, something that investors must take on faith at this point.

The company divested its interest in its payment arm Alipay in 2011. Alipay was originally established in 2004 to operate Alibaba's payment services. Alipay still conducts, substantially, all of the company's payment processing services.

Alipay is now owned by Small & Micro Financial (SMF), soon to be Ant Financial Services Group. And SMF is controlled by company founder Jack Ma, one aspect of Alibaba's ownership structure that should raise questions. SMF also owns other financial services businesses affiliated with Alibaba, including mutual funds, insurance, and consumer and merchant loans.

The sale of Alipay was prompted by "regulatory concerns" although one has to consider that characterization with a jaundiced eye in the Chinese system.

The Management Structure Is Opaque, Too

The company is managed by a partnership committee consisting of Jack Ma, Joe Tsai, Jonathan Lu, Peng Lei (also known as Lucy Peng), and Zeng Ming. The management team is organized as a partnership where the number of partners is not fixed and changes over time as new partners are elected or existing partners retire or depart for other reasons. Each partner has one vote.  The partnership committee administers partner elections and allocates profits and bonuses subject to approval by the compensation committee of the board of directors.

The most exciting aspects of Alibaba are inextricably linked to the biggest risks related to an investment in the stock. The company has been able to grow due to the flexibility of its corporate structure as well as its presence in the fastest-growing economy in the world.

But with those benefits come risks that are, frankly, unquantifiable. From an operational standpoint, the biggest risk is the continued reliability of its third-party logistics affiliate China Smart Logistics Network. From a regulatory standpoint, the company needs to have continued access to Alipay to process its payments.

Indeed, 78% of its payments were processed through Alipay in the 12 months ended June 2014.

Any changes in this system would be severely disruptive to the business. Future growth will rely on continued monetization of mobile users and expected growth in use of the Internet in China as well as growth in the world's fastest growing economy.

Finally, Alibaba's legal structure is extremely complicated and opaque. The company operates across at least 290 consolidated entities. Investors have to be comfortable with the company's Variable Interest Entities (VIE) structure, which is used by other offshore listed Chinese companies.

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This is due to China's legal restrictions on foreign ownership and investments in certain types of telecommunications services including Internet content providers (in other words, China controls the Internet in order to censor it). Alibaba uses the VIE structure to own its Internet content licenses but is ultimately still subject to the control of the Chinese government.

It's Still Too Good to Pass Up

Armed with this new information and awareness of the two "known unknowns," the way forward for investors is clear:

BABA shares are still a buy, and a good one at that.
Assuming that Alibaba's financial statements can be relied on and that the Chinese government is not going to change the rules in the middle of the game - two Black Swans that investors must assume are not going to happen in order to buy stock - the issue is one of valuation.

With a $275 billion market cap, the company is trading at almost 60x earnings and has already shot through most of the original earnings targets set by Wall Street firms.

There is no reason to believe that growth will not continue at its current pace for the next several years - barring a serious deterioration in China's economy (which is slowing but certainly not collapsing) or serious operational problems with China Smart Logistics Network or Alipay.

For the moment, investors should feel comfortable owning the stock but they should do so understanding that this is, without question, the least transparent large company in the world.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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