Edmond Jackson's Stockwatch: Alibaba - a great play for traders

Every bull market has its defining moment. Does the flotation of Chinese online retailer Alibaba (BABA) on the New York Stock Exchange reflect healthy sentiment able to benefit stocks and the wider economy, or reckless gambling after years of monetary stimulus? If the former then Alibaba is a milestone in a bull market with years to run as it directs capital to newer more vigorous enterprise. But if this is increasingly a giant casino where risks are brushed aside then Alibaba is the classic over-ambitious deal struck near a market top - with a harsh reality check inevitable. So how rational are investors behaving?

At first sight it's a mania. Alibaba listed at $68, but such was the excitement on Friday 19 September, it opened at $90 and traded up to $99.7 then settled back at $92.7, capitalising the business at over $231 billion (£142 billion). To a contrarian mindset this looks a game of pass-the-parcel with dumping towards the end-of-day, typifying an over-exuberant market. But considering the nature of the beast there are genuine reasons for volatility based on Alibaba's fundamentals. One truth of equities is successful promising firms being the most difficult to value; they have a "high beta" i.e. are more volatile than the market. So while Alibaba's revenues are only a tenth of Amazon's and less than half eBay's, a 57% operating margin is massively ahead of eBay's 28% and Amazon's 1%.

Government relationship

Enjoying an 80% share of Chinese online sales, the world's largest internet market at twice the size of the US, investors are understandably groping to judge where Alibaba could be in say five to 10 years' time. Within China its relations with the government look likely to thwart competition although internationally rivals may copy its set-up; indeed, Alibaba's high margins are a motivation to do so. Browsing its website I can't say I'm compelled to buy anything in the way I regularly use Amazon and eBay; but Alibaba could steadily eat into their market share as it evolves.

With two retail sites for branded and non-branded items, Alibaba has grown net income from $1.4 billion to over $3.7 billion in its financial year to end-March 2014, on revenue up from $5.4 billion to near $8.5 billion. Meanwhile Amazon has turned a 2012 net loss of $39 million into a $274 million profit. It means Amazon's financial summary still shows a ridiculously high price/earnings multiple over 170 times forward and 500 historic, while Alibaba's forward price/earnings (P/E) is currently estimated at about 40 times.

Litmus test

It's entirely possible an emerging behemoth like this sustains a high P/E for years, but mind the company is very exposed to possible change in China.

This introduces another key reason to follow Alibaba: as a litmus test of the Chinese economy, which can determine whether the global economy improves or stays mixed-to-weak. Part of the difficulty assessing China is whether government economic statistics are credible, although an international business like this is challenged to fudge its figures. So its trading updates are likely to become significant for weighing the macro outlook.

A key downside risk currently is whether Chinese monetary stimulus can work as over-indebted firms lose appetite for borrowing - in a context where China's debt has soared over 250% of gross domestic product. September began with the central bank injecting a massive $81 billion equivalent into the banking system and giving banks more freedom to lend; but weak demand for debt risks a recession if this is mirrored in demand for goods, which reduces investment and altogether conspires for downturn. Property prices have fallen over the last four months but nothing like in Japan in 1990 or the US in 2008. For years there has been speculation of a debt/asset bubble bursting in China, but as yet the authorities have managed through. I would still mind the short to medium-term risks in China hence downside potential in Alibaba - which would broadcast national woes more vividly now it is a prime international share. From summary accounts in the prospectus (see table) this is as yet a China play.

Previously de-listed

Note how page 11 of the prospectus shows a Cayman Islands holding company structure; Alibaba has been criticised by some for sub-standard corporate governance, leaving control in the hands of a few. Voting power is a key element of equity value besides earnings and cash flows, hence some professionals have avoided this one. Indeed, Alibaba has previously de-listed from the Hong Kong Stock Exchange which had been unwilling to re-accept it, hence the US listing. The governance context can therefore be seen as a big relaxation in America's attitude to risk, by investors and regulators alike.

A lesser risk factor albeit pertinent, is Alibaba's service yet to be smartphone-friendly; something that management must resolve. I have repeatedly drawn attention to the turnaround achieved at Home Retail Group where smartphone capability was introduced to great success and will likely become the industry benchmark.

In fairness, a 36% jump from listing to closing price (on first day's trading) could be seen as the sponsors judging investor mood astutely - succeeding to raise $21.8 billion for the company while leaving something on the table to ensure participating investors a warm feeling, also something for traders to play with. In that sense it looks an all-round success, but mind this is a lot easier when sentiment is buoyant.

A great play in the making

So Alibaba falls into that category of popular highly-valued share liable to make contrarians shudder at what/when might be its debacle. The company's marketing opportunity is huge but its governance looks dodgy and there is no margin of safety for buying the shares - best left for speculators. Yet crowd enthusiasm shows a bull market very much alive, especially if third-quarter US company revenues and profits prove firm when reporting gets underway. If the Chinese leadership can manage through its debt challenges, buyers of Alibaba may enjoy further upside on a three to five-year view; but the stock is potentially a magnificent short if China's economy deteriorates. Take your pick, therefore, according to risk preference. For traders this is a great play in the making, either way according to news.

For more information see uk.alibaba.com/.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.