IPO: Market valuing Alibaba as if it were a normal US tech Co!

I am surprised! Having cleaned up the reported numbers a little (eg including stock comp and intangible amortisation – excl goodwill), and applied a broadly average growth discount trend, the Alibaba NPV on the WYT growth discount model comes within 5% of the post IPO price – nb this already adjusts for forward valuation horizon based on the rate of organic revenue delivery – for those with the growth rater service see the ‘Horizons’ tab.

So why the surprise?  – Because this suggests that markets in their hunt for growth are valuing Alibaba pretty much the same as they would an Amazon, LinkedIn, Ebay or Facebook. While the Alibaba that investors are buying may ape the business models of these, the instrument that is providing them with the exposure is entirely different.  In effect, what is being bought is a Caymans Island holding company (the “foreign owned enterprise”) with the right to participate in a non-existent dividend from the Alibaba companies (the “variable interest entities”), but without a direct interest in these assets. Although a complex structure theoretically allows a conversion into many,but not all, the underlying economic entities, this is not actually legal at present under Chinese ownership rules unless by another PRC entity and indeed may never be permitted. In addition to that, there seems little to stop these options being re-assigned to other entities.

So what does the prospectus say about these “Exclusive call option agreements” that the foreign owned enterprise has over the variable interest entities

What is says on Exercise price: “Equal to the higher of  (i) the registered capital in the variable interest entity; and (ii) the minimum price as permitted by applicable PRC laws. Each relevant variable interest entity has further granted the relevant wholly-owned enterprise an exclusive call option to purchase its assets at an exercise price equal to the book value of the assets or the minimum price as permitted by PRC law, whichever is higher”

Interpretation: OK, so this seems to enable the foreign entity to buy some of the underlying Alibaba companies at book value, which is low and therefore attractive, or at some unknown “minimum” price that may be determined by PRC law. Perhaps a Gweilo pays more law!

What it says on conversion: “Each call option is exercisable subject to the condition that applicable PRC laws,rules and regulations do not prohibit completion of the transfer of the equity interest or assets pursuant to the call options.”

Interpretation:  This is of course a big ‘IF’. Investors may hope that either the future bar on direct overseas investment will be lifted or that the entities can be parked into another vehicle that might hoodwink the PRC that it was still PRC owned. Many states however have long-standing ‘look-through’ legislation (such as the HMRC in the UK after ‘Dawson v Furness’) and one might also expect the PRC to exercise similar action. Indeed, the Alibaba prospectus warns

“However, we have been further advised by our PRC legal counsel, Fangda Partners, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, rules and regulations. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the opinion of our PRC counsel. We have been further advised by our PRC counsel that if the PRC government finds that the agreements that establish the structure for operating our internet-based business do not comply with PRC government restrictions on foreign investment in the aforesaid business we engage in, we could be subject to severe penalties including being prohibited from continuing operations”

This however, may be the least of ones worries. Check the small print of the options and you find

“The wholly-foreign owned enterprise may nominate another entity or individual to purchase the equity interest or assets, if applicable, under the call options”.

Naturally, one might have thought that this is part of the wheeze that would enable the Gweilo investors to park the assets into a PRC friendly vehicle and no doubt this was its intention, but wait a moment and think about this. The foreign owned entity will still be substantially controlled by Jack Ma and Simon Xie, who are also the ‘owners of the variable interest entities and as such they will also be able to “nominate” the “entity or individual” to exercise these options. As a shareholder in a Cayman Island holding company which has a right to a dividend for which there is no intention to pay and an option to buy the underlying assets at perhaps book value, that might be all it gets should someone else be “nominated” to exercise it, do you feel lucky? Well do ya?