Happy Monday everyone! So, I have a nerd confession to make. I was actually excited for Monday morning this week just so I could see where Alibaba (BABA) was trading after its IPO (the biggest IPO ever) last Friday.

I first wrote about Alibaba in July, when I mentioned the upcoming IPO created a good opportunity to buy a big Alibaba investor, Yahoo! (YHOO) (turns out that was a right call and shares are up about 15% since then). The company’s IPO has been one of the most talked about events in the market for a long time, and I’m sure many of you are trying to decide whether to jump on the buying band wagon. To figure it out, let’s answer a few key questions you may have about Alibaba and its IPO:

  1. Start with the basics – what’s an IPO?

An IPO is an initial public offering, when a company makes its shares available to the public for the first time.

  1. What is Alibaba?
Alibaba founder Jack Ma plus Arnie (source: Reuters)

Alibaba is China’s biggest online commerce company. Reports say that 80% of China’s online shopping market is dominated by Alibaba. Alibaba is essentially a mixture of eBay and Amazon, with a little Google search engine thrown in.

Alibaba operates more as a connector between sellers and buyers than a distributor that sells its own products. Alibaba makes most of its revenue from fees and commissions that it receives from the two large Internet marketplaces. Alibaba has 231 million active buyers using its site, 11.3 billion annual orders, and $296 billion in annual merchandise sales – more than Amazon and eBay combined! In the same period Amazon (AMZN) had less than $82 billion in revenue and eBay (EBAY) had just over $17 billion.

  1. What happened when Alibaba went public on Friday?

On Friday, Alibaba had the biggest IPO ever. The IPO was targeted at $68, which is the price the first investors got to purchase it at (think of institutional investors like Fidelity). By the time the shares were available for purchase in the secondary market (think of me buying my shares from Fidelity), demand was so high that the price opened at $92.70. The stock rose immediately to almost hit $100 during the day and closed at $93.89.

On top of this, banks used a condition in their contracts to buy an addition 48 million shares, bringing the total value of the IPO to $250 billion.

  1. Sure Alibaba sounds big, but why is everyone going nuts over it?
The crowd the morning of Alibaba’s IPO (source: LA Times)

To start with, Alibaba has amazing financials. We know it pulls in a lot in revenues, which grew 39% last year. More importantly, it has great profit margins of 43%. This is an almost un-heard of figure in internet, especially when you consider Amazon’s pretty low margins.

But even though Alibaba is huge, it has plenty of room for growth. Currently, only 618 million people out of China’s population of 1.35 billion people use the internet. And of those 618 million people, less than half use online shopping. So that leaves almost a billion people as potential Alibaba customers, particularly as the middle class expands in China.

Plus, Alibaba seems to handle the general concerns over mobile incredibly well. (This is in direct contrast to Facebook’s crash after investors worried it didn’t appeal enough to 13 year olds glued to their iPhones). In the second quarter of this year, mobile sales accounted for a third of all goods sold on Alibaba’s marketplaces, which is up from 12% in the same period a year prior.

  1. This sounds a little too good to be true; what’s the catch?

Yes, overall Alibaba is a great investment. But there are a couple key concerns to be wary of before you make the decision to invest.

The first the state of regulatory affairs for a China based company. China operates under a high level of secrecy, and that spans as far as their accounting practices. An audit generally tests for proper and legal accounting by a corporation, to avoid a scandal like Enron that took advantage of investors. The problem is, Chinese secrecy laws mean the SEC cannot test their auditor’s work papers, or any of their audits. So the SEC doesn’t know that Alibaba’s accounting is 100% accurate.

The second concern is Alibaba’s unique governance structure. Alibaba is controlled by a group of insiders called the Alibaba partnership. This partnership can make a lot of decisions for the company without investor approval. This is a common trend in corporations, but the issue here is that the controlling insiders do not own the majority of the shares (the biggest shareholder, founder Jack Ma, owns 7.8% of the company). This may mean that incentives are not aligned between those who control the company and those who own the company.

An example of this occurred a few years ago, when Yahoo got upset that Ma sold Alipay without their permission (Alibaba’s version of PayPal). Then the concern over control was further illustrated this year after Alibaba made a few strange acquisitions. This past year the company lent $1 billion to one of its founders to finance an investment, and bought a stake in a Chinese soccer team. Alibaba also invested in a movie production company, that wound up having accounting irregularities after Alibaba failed to do proper due diligence. All of these purchases added up; the $1.85 billion that Alibaba spent on acquisitions in the second quarter exceeded the $1.64 billion in cash flows from the company’s operations during that period.

  1. I’m sick of asking questions. What’s the bottom line: buy or sit this one out?

Even though Alibaba’s governance structure and regulatory environment raise some concerns, I’m suggesting buying the stock. The company’s extremely impressive revenues and profits, combined with the huge remaining potential among China’s population makes it a buy on its own.

Comparing Alibaba to other companies indicates a buy position as well. The two closest comparisons to Alibaba are eBay and Amazon. We already know Alibaba dwarfs their revenues. Plus, at today’s trading price, Alibaba has a price to earnings (P/E) ratio of about 52. This is about double the P/E ratio of 26 eBay has averaged, which makes sense given their difference in size, and is significantly lower than Amazon’s P/E ratio of over 800 (yes, Amazon has an insanely high valuation premium). Not to mention, if you bought Amazon at its opening price the morning of its IPO, you’d be sitting on over 1,000% of return.

While I do advocate a buy, I don’t necessarily think you should buy right now. There tends to be a lot of excitement right after a big IPO, which may artificially inflate the share price. We’ve already seen Alibaba’s share price come down today to around $90 from its close near $94 on Friday. I’m going to see how Alibaba’s price changes over the next few weeks, and try to buy when it’s trading in the mid to low $80’s.

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