Alibaba Group is China’s largest retailer.  Unlike most retailers though it does not sell products but instead connects buyers and sellers online.  It makes money through advertising fees and commissions paid by sellers who want to prominently display their goods and other services on Alibaba’s websites to millions of merchants and individuals using its marketplaces.  Roughly 80 percent of all Chinese online shopping sales flow through two websites Alibaba operates which creates strong network effects.

The first website is consumer to consumer website Taobao (means “search for treasure” in Chinese) which allows 8 million small merchants (i.e., individuals and small businesses) to sell their wares to Chinese consumers and accounts for over 91 percent of consumer-to-consumer online sales in China.  Taobao sells everyday items like clothes, furniture, and packaged foods, as well as more unusual items such as rental boyfriends to accompany females to a social event.  As of March 31, 2015, Taobao had 219 million active buyers with a good balance of urban and rural customers.   Approximately 63 percent of buyers are rural, with the remainder spread across both tier 1 and tier 2 cities.  Tier 1 cities include most developed areas of the country such as Shanghai and tier 2 cities are 15 mid-market cities.  It is important to maintain buyers in these tier 2 cities, because although they account for just 8 percent of China’s overall population, they represent significant discretionary income, accounting for more than 59 percent of total U.S. imports in China.

Alibaba’s second website is business to consumer website Tmall (similar to Amazon), an online platform for global brands (140,000 brands) and retailers to reach Chinese consumers.  Tmall accounts for approximately 58.6 percent of all Chinese business-to-consumer internet sales.  The second largest competitor, JD, accounts for 22.8 percent of transactions.  This site gives thousands of international companies, including global brands such as Nike and Apple, easy access to Chinese buyers, in exchange for a commission that ranges between 0.3 to 5 percent.  The commission Alibaba charges depends on the gross margin for the merchant.  For example, businesses with higher gross margins such as apparel and luxury goods manufacturers pay higher commissions than a consumer electronics retailer who generates lower gross margins.

The reason internet shopping is so important to China’s consumers compared to consumers based in the U.S. is that China has a less developed bricks-and-mortar retail sector and a fragmented supply chain which forces consumers onto the Internet.  In other words, e-commerce in China is not replacing trips to shopping malls or national retail chain stores, because they are not well established.  Instead it is stimulating consumption that would not otherwise take place.  Chinese purchasing habits have essentially leapfrogged retail infrastructure, with whole generations beginning consumption on the Internet first.

We purchased Alibaba during the third quarter when the Chinese stock markets sharply declined which caused Alibaba’s stock price to fall from over $100 per share at the beginning of the year to as low as $60 per share (our average cost basis is $69 per share).  We believe we are investing in a fast growing business that is benefiting from a growing Chinese domestic economy run by a first class leader named Jack Ma, i.e., a compound machine.

Jack Ma

The main reason we qualified Alibaba as an investment is because we admire founder Jack Ma.  Ma has all of the qualities we look for in an ideal leader and a proven track record as shown below:

  • Visionary leader: Ma established what is probably the first Internet company in China and quickly saw the Internet as a tool to help China connect to the world.  He saw that China needed a lot of jobs that would be created by entrepreneurs and small and medium sized companies, so he figured the best way to help those businesses was to connect them to the world through the Internet.  Ma says, “It is my religion to help small businesses.”
  • Iteration philosophy: We admire Ma’s leadership style which is to manage experimentally and make changes incrementally which means he is constantly trying to find out what works and then empowers employees to makes changes with direct customer input.  For example, Alibaba constantly generates new business models, letting them run as separate units.  After testing them, it scales up the most promising ones and closes down or reabsorbs those that are less promising.
  • Customer first philosophy: Ma’s business philosophy has always been about helping others.  He believes if you help customers thrive then they will in turn help your own business grow.
  • Employee oriented: Even though Ma is constantly quoted as saying that he puts customers first he understands that it takes dedicated employees to make this happen.  Ma says, “It is the customer that pays us the money, it is the employees that drive innovation.”  As a result he is focused on building a strong culture and adheres to the philosophy that teamwork enables ordinary people to achieve extraordinary things.  The culture of Alibaba can be best described as one filled with close friends and family.  As Ma says, “We encourage our people to work happily, and live seriously.”  Ma was also generous with the company’s equity early on because he knew that in the long run, if people had (or could at least work towards) a stake in its success, they would work harder.
  • Does not focus on enriching himself:  When we examined Ma’s track record we learned Ma does not do things for his personal benefit.  A few years ago he believed his use of a corporate jet was extravagant so he purchased it from Alibaba for US$49.7 million, the original purchase price of the aircraft.  Ma is often quoted as saying, “Think about how you can help people rather than having dollar signs in your eyes.  To serve others and help others is key.”  In fact, what worries Ma the most is greed because he strongly believes when you put more emphasis on things such as a stock price then people forget what they are doing.  On a personal level Ma says, “Money isn’t happiness, it’s responsibility.  Real success is more about the inner world.  Real success means that your hard work benefits your colleagues, friends and society.”
  • Maintains a long-term view: Ma says, “Our decisions are guided by how they serve our mission over the long term, not by the pursuit of short-term gains.  We envision that our customers will meet, work and live at Alibaba, and that we will be a company that lasts at least 102 years.”  An example of his long-term commitment is for a long time Ma did not charge customers as he built critical mass on his websites even when it hurt him financially.
  • High insider stock ownership: Jack Ma owns 7.6 percent of the stock and co-founder Joe Tsai owns 3.1 percent.
  • Not influenced by Wall Street:  When eBay approached Ma about selling Alibaba, Ma refused because he felt then CEO Meg Whitman just wanted to please Wall Street and was not interested in building a long-term business.
  • Readily admits mistakes: Ma constantly admits mistakes and wants others to learn from them.  In fact, Ma is thinking of publishing a book featuring Alibaba’s 1,000 mistakes.
  • Does not copy the competition:  Alibaba has always been an innovator and whenever they announce a new strategy, such as recently announcing they want to target rural markets in China, competitors often quickly follow.  Ma says, “If everybody agrees with me, if everybody believes our idea is good, we do not have a chance.  Play your own game.  You should learn from your competitor, but never copy.  Copy and you die.”

Valuation

At our average cost basis of $68.78 we paid a total enterprise value of $160 billion.  Before you think we have gone off reservation let’s examine our purchase price in more depth.  First, ask yourself what you would pay to be the marketplace for all Chinese goods, in other words the infrastructure for China’s e-commerce.  To help you calculate this value consider China is the largest e-commerce market in the world where some 632 million Chinese out of the nation’s 1.37 billion people use the Internet.  For comparison, there are 2 billion e-commerce users worldwide.  For the last 12 months ended June 30, 2015 there were 367 million active buyers (10 million active sellers with over 1 billion products) that placed an order on Alibaba’s platforms.  The total value of these transactions totaled US$409 billion, making Alibaba the largest company in the world by the Gross Merchandise Value exchanged on its platforms.  To put this in perspective, total retail e-commerce sales in the United States from 179 million shoppers amounted to only US$298 billion in 2014 (source: U.S. Census Bureau), or 73 percent of Alibaba’s Gross Merchandise Value. Finally, compare our purchase price to Amazon which has a $300 billion market capitalization yet captures less than a quarter of U.S. online retail sales at a lower margin.

Turning to more traditional valuation metrics, Alibaba produced $12.3 billion in revenue as of March 2015 and should generate $15.2 billion in revenue by March 2016.  At our purchase price we paid an enterprise value to estimated 2015 sales ratio of 10.5 times.  As far as a multiple to earnings, at our cost basis we paid 26 times 2015 estimated earnings of $2.65 per share and 20 times 2016 estimated earnings of $3.44 per share.  We believe these earnings would be higher if it were not for Alibaba’s recent investments in its technology infrastructure to transition to mobile transactions and as a result believe we are buying Alibaba at an even lower earnings multiple.  We balanced the higher valuation with a lower sizing in the portfolio as a 3 percent position and hope to increase our position in the future.

Political Risk

The most realistic threat to Alibaba is political risk.  As long as founder Jack Ma stays in the good graces of the Chinese government our investment is protected.  We believe at the current time this is not an issue as the first visit of China’s President Xi Jinping to the U.S. included Jack Ma in the delegation.  If you understand the Asian concept of “face” you will understand how big an honor it was for Ma to be included as he was carefully vetted by the Chinese government.  Interestingly, President Xi governed the same province where Alibaba was founded and has known Ma for a long time, often holding up Ma as the prime example of what future businesses in China should model themselves after.

Other Red Flags

We are concerned that online shopping in larger cities in China may have already reached saturation.  We still believe there will be natural growth from existing customers buying more products but higher growth will have to come from new customers from rural cities.

We are also carefully watching the billions that Alibaba received from its recent IPO and which it has been spending on a range of peripheral industries such as media, entertainment, logistics and cloud computing.  Some of these investments are directly related to Alibaba such as the cloud computing business which is very similar to Amazon’s Web Service platform, which provides Internet processing for various entities, including the Chinese government.  Other acquisitions are in unrelated fields such as Alibaba Pictures which produces films such as Tom Cruise’s most recent Mission Impossible film, a smart-phone manufacturer, department store operators, electronics retailer Suning, appliance manufacturer Haier, and a hotel management information software company.  Our greater concern is that these acquisitions and investments may distract management.  In fact, ever since Ma passed the CEO title to Yong Zhang in 2013, Ma has been spending his time on these outside investments and in other pursuits, such as tackling environmental issues.

When asked about these investments Ma says he does not want to build an empire but rather an ecosystem, which is less likely to be toppled.  This ecosystem would be developed around the platform that consists of buyers, sellers, third-party service providers, logistics service providers, marketing affiliates, independent software vendors, various professional service providers, and strategic alliance partners.

Fortunately, Alibaba is following Ma’s approach of iterating and testing when making these investments.  Alibaba in many cases starts with an initial minority investment followed by some sort of agreement to work more closely together.  If Alibaba determines the company fits into Alibaba’s ongoing business strategy, they will increase the investment or acquire the company in full.  Examples of this type of approach include investments in UCWeb (China’s largest mobile browser company in terms of monthly mobile active users), AutoNavi (China’s leading provider in digital map, navigation and location-based services), and social network company Weibo Corporation.

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This post has been excerpted from a letter to partners of Compound Money Fund, LP.

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