It’s official. Alibaba’s IPO pop was stupendous, Wall Street’s favorite clients get billions of dollars in found money, investment banks will pocket billions from those grateful clients for orchestrating the windfall, and the owners who let it happen should be thoroughly ashamed.
I almost forgot to mention: Now that we know—at least for now—the sheik’s ransom you’ll have to pay to own Alibaba stock, you should marvel at the show. But avoid the stock.
On Friday, September 19, Alibaba shares closed its first day of trading at $93.89. The stock shot into the $90s right at the opening bell and pretty much stayed there all day, registering a gain by the 4 p.m. close of $25.89. That’s a pop of 38%, from the offering price of $68, the insider price that underwriters charged institutional investors and a small group of individuals just before Alibaba started trading. At $93.89, the Chinese e-commerce colossus now boasts a world-class market cap of $231.4 billion. Its valuation exceeds those of such market veterans as Oracle and Intel (both $177 billion), and Pfizer ($193 billion).
This heavily hyped debut is a travesty in two respects. First, the euphoria over the gigantic opening-day jump masks what should be obvious: that every dollar someone earned in quick gains came from someone else’s pocket—and no one is talking about the losers, not even the losers themselves. Second, the valuation sets a benchmark for how much Alibaba has to earn in order to enrich investors. The Chinese e-commerce giant’s fabulous market cap makes the necessary climb quite steep; too steep for investors who missed the insider share price—the one time Alibaba really was a steal.
In the IPO, Alibaba, the company itself, and several of its owners, sold 320 million shares at $68, and the investment bankers reserve the right to buy 48 million more shares at the offering price. So let’s start with the total shares already sold, and likely to be sold, at the $68 price. That’s 368 million shares. The offering will then raise $25 billion. Remember, if Alibaba and its shareholders had gotten full value for their shares at the closing price of $93.89, they would have collected not $25 billion, but $34.6 billion. So they left $9.6 billion “on the table.” They also paid around $350 million in fees to their six underwriters. So it cost Alibaba and big shareholders almost $10 billion to raise $25 billion; that’s the equivalent to a sales charge of 40%. Isn’t Wall Street math fabulous?
So who are the winners and losers? As a group, the biggest winners are the hedge funds and other institutions that tallied $9.6 billion in paper and cash gains in a single day. As architects of the offering, the six underwriters are golden as well. They should recoup 30% of the $9.6 billion windfall handed to their clients in high commissions over the coming weeks and months. That’s $2.9 billion, in addition to $350 million in fees. Let’s not forget the managers, who granted themselves an option to buy 22 million shares at the offering price. Their one-day gains: $570 million.
Heading the list of losers are Yahoo, a major Alibaba shareholder, and Alibaba itself. Yahoo is selling around 140 million shares. The underpricing means it will receive $9.2 billion, instead of the $13.1 billion those shares would be worth, just one day later. That’s $3.8 billion in foregone funds. As for Alibaba, it’s raising around $8.3 billion, funds that will swell its coffers. At a $93.89 share price, Alibaba would have amassed over $11.5 billion. Left on the table: $3.2 billion, more than 1% of its market cap.
Now, let’s look at Alibaba as an investment for the great unwashed who didn’t get the insider price; in other words, you and me. We’d want a return on our Alibaba shares of at least 10% a year over the next 10 years. That’s quite a conservative figure considering that Alibaba is a speculative investment. Let’s also assume that Alibaba will issue 30% more shares to fund its expansion. We’re probably choosing a low figure here given its recent acquisitions binge: Alibaba spent $7 billion buying and investing in a sprawling portfolio of companies just in the quarter that ended on June 30.
It’s unlikely that Alibaba will pay a dividend anytime soon. So all of our gains will need to come in the form of stock appreciation. Using those metrics, Alibaba will need to grow its market cap from $231 billion to $777 billion by 2024. Keep in mind that the market currently awards only one company on the planet a valuation over $600 billion, and that’s Apple.
To get us there, how much will Alibaba need to earn? In the four quarters ended June 30, Alibaba posted net earnings of $4.9 billion. If its P/E (price-to-earnings) multiple of 47 falls to 20 over those 10 years—and 20 is still a premium P/E—it will need to show $39 billion in net earnings. That means earnings must grow by well over 20% a year. Other than government-owned Fannie Mae and Freddie Mac, only one superstar makes that kind of money: once again, it’s Apple. To put this challenge in perspective, consider that Microsoft earned $22 billion in 2013.
Alibaba could still prove to be a great company and still not achieve that gargantuan goal. Its P/E of 47 doesn’t sound outrageous for a fast-grower. But keep in mind that Alibaba is already a massive company with earnings that would put it in the top 50 of the Fortune 500. So it has to grow those already large earnings like a super-charged upstart. The law of large numbers is working against this remarkable success story. Indeed, at these prices, it’s more a story than an investment. So stay entertained, and stay away.