Alibaba Initial Public Offering Comes With Unusual Structure

By Joe McDonald 

BEIJING -- Foreigners who want to buy Alibaba Group shares in the Chinese e-commerce giant's U.S. public offering will need to get comfortable with an unusual business structure.

Alibaba's online and mobile commerce businesses will be controlled by a "variable interest entity," an arrangement meant to allow investors to buy into Internet and other businesses in which Beijing bans or limits foreign ownership.

Used since the 1990s by Internet operators such as Baidu (BIDU) and Sina, (SINA) VIEs are based on contracts that say an offshore entity in the Cayman Islands or another corporate haven will control a Chinese company. Foreign shareholders get a stake in that offshore vehicle and profit, but no ownership of the Chinese company.

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"The VIE structure is the only way at present to play this game," said Paul Gillis, a professor at Peking University's Guanghua School of Management. "So if you want to invest in restricted sectors of China's economy, you have to get comfortable with the VIE structure."

Chinese regulators have left the status of VIEs ambiguous. Most operate uneventfully, but courts have rejected contracts if they were deemed to be an attempt to evade ownership curbs.

Regulators could shut down VIEs, but "that would be too disruptive," said Gillis. "They don't mind the ambiguity because it puts them in a position of strength over the companies to make sure that they comply with government policy."

Such uncertainty is one of a number of risks that investors have accepted to gain a stake in China's economy. Even after a steep deceleration in growth, it is forecast to expand by about 7% annually in coming years.

And Alibaba, based in founder Jack Ma's hometown of Hangzhou, southwest of Shanghai, represents an especially appealing industry.

Its Taobao, TMall and other platforms account for some 80%  of Chinese online commerce. Online spending by Chinese shoppers is forecast to triple from its 2011 size by 2015. And Alibaba is expanding into online banking, entertainment and other services.

Analysts believe demand for shares will be so strong that Alibaba could surpass the $16 billion raised by Facebook (FB) in 2012. That would put Alibaba at $150 billion to $200 billion, making it one of the most valuable U.S.-traded companies.

In a filing with U.S. regulators, Alibaba says licenses for its online and mobile commerce businesses are held by Chinese citizens to comply with legal restrictions. But VIE contracts will give shareholders "effective control," Alibaba adds. Still, it warns regulators "may not agree" they are legal.

An Alibaba spokeswoman, Florence Shih, declined to comment, citing the "quiet period" required by U.S. securities rules ahead of an IPO.

Investors can find a VIE gives them less control than they expect, according to a March report by Tom Pugh, a lawyer for the firm Mayer Brown JSM in Hong Kong. He cited the case of shareholders who lost control of a Chinese company when its founder blocked them from firing him by seizing the seals used to sign corporate documents.

In a dispute, foreign shareholders have to work through the Chinese legal system, which "may not be adequate or effective," Pugh wrote.

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In 2012, China's Supreme People's Court threw out contracts used by a Hong Kong businesswoman to invest in China Minsheng Bank. The ruling said agreements that "conceal illegal intentions" were invalid. A year earlier, an arbitration panel rejected a VIE contract involving Singapore-based GigaMedia  (GIGM) and a Chinese online gaming business.

Alibaba appears to have done its best to avoid problems by keeping the amount of business done through VIEs to a minimum, said Peking University's Gillis.

Only 11.8%  of Alibaba's revenue last year was generated by VIEs, according to its filing with the U.S. Securities and Exchange Commission. The rest went to entities that can be directly owned by foreign shareholders.

"They have one of the better VIE structures among Internet companies," said Gillis.

The ruling Communist Party promised last year to open online commerce to foreign competitors as part of efforts to make China's state-dominated economy more productive. That has raised hopes they might lift the ownership ban.

"There is some hope that China will fix this problem," said Gillis, "and that will be a good thing for investors."
Now let's look at TheStreet Ratings' take on some of these stocks.

TheStreet Ratings team rates BAIDU INC as a Buy with a ratings score of B+. TheStreet Ratings Team has this to say about their recommendation:

"We rate BAIDU INC (BIDU) a BUY. This is driven by a few notable strengths, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its robust revenue growth, growth in earnings per share, increase in net income, largely solid financial position with reasonable debt levels by most measures and solid stock price performance. We feel these strengths outweigh the fact that the company is trading at a premium valuation based on our review of its current price compared to such things as earnings and book value."

Highlights from the analysis by TheStreet Ratings Team goes as follows:
  • BIDU's very impressive revenue growth greatly exceeded the industry average of 19.9%. Since the same quarter one year prior, revenues leaped by 55.6%. Growth in the company's revenue appears to have helped boost the earnings per share.
  • BAIDU INC has improved earnings per share by 31.4% in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past two years. We feel that this trend should continue. During the past fiscal year, BAIDU INC increased its bottom line by earning $4.96 versus $4.78 in the prior year. This year, the market expects an improvement in earnings ($36.28 versus $4.96).
  • The net income growth from the same quarter one year ago has significantly exceeded that of the S&P 500 and the Internet Software & Services industry. The net income increased by 31.7% when compared to the same quarter one year prior, rising from $434.72 million to $572.56 million.
  • Powered by its strong earnings growth of 31.45% and other important driving factors, this stock has surged by 53.84% over the past year, outperforming the rise in the S&P 500 Index during the same period. Looking ahead, the stock's sharp rise over the last year has already helped drive it to a level which is relatively expensive compared to the rest of its industry. We feel, however, that other strengths this company displays justify these higher price levels.
  • Despite currently having a low debt-to-equity ratio of 0.55, it is higher than that of the industry average, inferring that management of debt levels may need to be evaluated further. Even though the debt-to-equity ratio shows mixed results, the company's quick ratio of 3.77 is very high and demonstrates very strong liquidity.
TheStreet Ratings team rates SINA CORP as a Sell with a ratings score of D+. TheStreet Ratings Team has this to say about their recommendation:

"We rate SINA CORP (SINA) a SELL. This is driven by multiple weaknesses, which we believe should have a greater impact than any strengths, and could make it more difficult for investors to achieve positive results compared to most of the stocks we cover. Among the areas we feel are negative, one of the most important has been a generally disappointing historical performance in the stock itself."

Highlights from the analysis by TheStreet Ratings Team goes as follows:
  • SINA's stock share price has done very poorly compared to where it was a year ago: Despite any rallies, the net result is that it is down by 41.56%, which is also worse that the performance of the S&P 500 Index. Investors have so far failed to pay much attention to the earnings improvements the company has managed to achieve over the last quarter. Despite the heavy decline in its share price, this stock is still more expensive (when compared to its current earnings) than most other companies in its industry.
  • The return on equity has improved slightly when compared to the same quarter one year prior. This can be construed as a modest strength in the organization. Compared to other companies in the Internet Software & Services industry and the overall market, SINA CORP's return on equity significantly trails that of both the industry average and the S&P 500.
  • Despite currently having a low debt-to-equity ratio of 0.39, it is higher than that of the industry average, inferring that management of debt levels may need to be evaluated further. Even though the debt-to-equity ratio shows mixed results, the company's quick ratio of 8.28 is very high and demonstrates very strong liquidity.
  • The gross profit margin for SINA CORP is rather high; currently it is at 60.62%. It has increased from the same quarter the previous year. Despite the strong results of the gross profit margin, SINA's net profit margin of 8.88% significantly trails the industry average.
  • SINA CORP reported significant earnings per share improvement in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past year. We feel that this trend should continue. This trend suggests that the performance of the business is improving. During the past fiscal year, SINA CORP increased its bottom line by earning $0.59 versus $0.45 in the prior year. This year, the market expects an improvement in earnings ($0.84 versus $0.59).
TheStreet Ratings team rates FACEBOOK INC as a Hold with a ratings score of C+. TheStreet Ratings Team has this to say about their recommendation:

"We rate FACEBOOK INC (FB) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its robust revenue growth, largely solid financial position with reasonable debt levels by most measures and impressive record of earnings per share growth. However, as a counter to these strengths, we find that the stock itself is trading at a premium valuation."

Highlights from the analysis by TheStreet Ratings Team goes as follows:
  • FB's very impressive revenue growth greatly exceeded the industry average of 19.9%. Since the same quarter one year prior, revenues leaped by 60.5%. Growth in the company's revenue appears to have helped boost the earnings per share.
  • FB's debt-to-equity ratio is very low at 0.02 and is currently below that of the industry average, implying that there has been very successful management of debt levels. Along with this, the company maintains a quick ratio of 12.48, which clearly demonstrates the ability to cover short-term cash needs.
  • Net operating cash flow has slightly increased to $1,341.00 million or 1.43% when compared to the same quarter last year. Despite an increase in cash flow, FACEBOOK INC's cash flow growth rate is still lower than the industry average growth rate of 17.69%.
  • Current return on equity exceeded its ROE from the same quarter one year prior. This is a clear sign of strength within the company. When compared to other companies in the Internet Software & Services industry and the overall market, FACEBOOK INC's return on equity is below that of both the industry average and the S&P 500.
TheStreet Ratings team rates GIGAMEDIA LTD as a Sell with a ratings score of D. TheStreet Ratings Team has this to say about their recommendation:

"We rate GIGAMEDIA LTD (GIGM) a SELL. This is driven by a number of negative factors, which we believe should have a greater impact than any strengths, and could make it more difficult for investors to achieve positive results compared to most of the stocks we cover. The company's weaknesses can be seen in multiple areas, such as its feeble growth in its earnings per share, deteriorating net income, disappointing return on equity and generally disappointing historical performance in the stock itself."

Highlights from the analysis by TheStreet Ratings Team goes as follows:
  • GIGAMEDIA LTD's earnings have gone downhill when comparing its most recently reported quarter with the same quarter a year earlier. The company has suffered a declining pattern earnings per share over the past two years. During the past fiscal year, GIGAMEDIA LTD reported poor results of -$0.68 versus -$0.26 in the prior year.
  • The company, on the basis of change in net income from the same quarter one year ago, has significantly underperformed when compared to that of the S&P 500 and the Internet Software & Services industry. The net income has significantly decreased by 3286.9% when compared to the same quarter one year ago, falling from $0.08 million to -$2.68 million.
  • Return on equity has greatly decreased when compared to its ROE from the same quarter one year prior. This is a signal of major weakness within the corporation. Compared to other companies in the Internet Software & Services industry and the overall market, GIGAMEDIA LTD's return on equity significantly trails that of both the industry average and the S&P 500.
  • This stock has managed to decline in share value by 2.13% over the past twelve months. The fact that the stock is now selling for less than others in its industry in relation to its current earnings is not reason enough to justify a buy rating at this time.
  • 36.22% is the gross profit margin for GIGAMEDIA LTD which we consider to be strong. Despite the high profit margin, it has decreased significantly from the same period last year. Despite the mixed results of the gross profit margin, GIGM's net profit margin of -108.33% significantly underperformed when compared to the industry average.
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