Wednesday, 28 June 2017

'Open Sesame' on Alibaba

China has been the ‘workshop of the world’ since the late 20th century, providing cheap products to global markets, especially to the richer countries. Alibaba is now becoming recognised as an important addition to China’s economic prowess, although in the sphere of commerce rather than in production.
Alibaba’s business has been focused domestically upon the huge and growing Chinese market. It has been able to fend off Google and eBay, important US competitors. It has also benefited from funding by Goldman Sachs and Yahoo – who both provided much-needed cash in its early days – while managing to avoid their control of its operations. Now Alibaba is in a strong position to expand into other countries. So, rather than being prominent only as a big player in one big (Chinese) market, Alibaba could become a major global player too. When commerce is the core of a company’s business, then huge volumes are critical for generating revenues. Alibaba has been able to get these, helped by being based in China, a country with a strong government and also with the largest national population.
Here I do not plan to discuss all of Alibaba’s operations or its historical development.[1] Instead, I want to use the example of Alibaba to weigh up China’s economic challenge to the established order, when imperial economic power today takes on a much more commercial and financial form.

Millions and billions

Alibaba’s operations can most easily be summarised as a combination of Amazon, eBay and Paypal. But that understates the scope of its business as it expands into other areas. Nevertheless, the limit on seeing it as a global giant is that more than three-quarters of its commerce-based revenues derive from China, as does basically all of its profit. Its newer segments of business – including cloud computing, digital media and entertainment – are running at a loss, subsidised by the China commerce revenues.
In terms of stock market capitalisation, the main company, Alibaba Group Holding, was worth $365bn on 26 June. This was not so far behind Amazon’s $475bn value, especially if one also includes the separately managed Ant Financial arm (formerly known as Alipay) estimated at around $60bn. Alibaba’s profitability was also much higher than Amazon’s in the latest financial year, at $6.0bn versus Amazon’s $2.4bn for net income after tax and net interest payments.[2]
Alibaba started out as a business-to-business middleman, facilitating buying and selling, but this failed to generate much revenue. Now retail business (business-to-consumer) dominates its commercial operations. Hundreds of millions of Chinese use its systems to shop online, sell goods and make online payments. Alibaba has two retail sites: Taobao, selling products sold by smaller scale Chinese-based companies; and Tmall, which has attracted three-quarters of the world’s top 100 brand-names to sell into the huge Chinese domestic market. Although China is a poor country, 1.4 billion people and a growing middle class consumer base make it an attractive market for all global corporations.
Merchants on Alibaba’s Taobao site get a free listing; on Tmall, these bigger sellers pay an annual service fee, plus commissions on their sales ranging from 0.4% to 5.0%, depending on the product. However, revenues from these sites derive mainly from companies buying extra marketing services that Alibaba’s system provides, including its analysis of consumer activity to target advertisements. In this respect, it follows what other established companies do, like Amazon, Google and Facebook.
In the year to 31 March 2017, Alibaba had a huge volume of business: 454 million active buyers on its retail platforms and, in March 2017, 507 million active users of its mobile services. This potential for economies of scale is fundamental for a commercial operation, and one that helps Alibaba’s expansion into other countries.
The relatively low retail revenue per buyer deflates the importance of these numbers, and reflects low average Chinese incomes: just $36 per active buyer in retail revenue per year and $26 per person from mobile-based services. Nevertheless, a growing revenue per person multiplied by a very large and increasing number of buyers and users in China leads to big and rapidly rising total revenues. Alibaba’s China-based commercial revenues rose by 40% in the year to March 2017, reaching some $18 billion.
Helped by this position in a market US business would like to penetrate, Jack Ma, the principal founder and the controller of Alibaba, was the first foreign businessman to meet US President Trump in January this year. Playing up to Trump’s ‘America First’ policy, Ma promised that he could add one million jobs in the US if its small companies joined its commercial platform, Tmall, to sell their products into the Chinese market. This no doubt appealed to Trump, but it would also help Alibaba boost its revenues outside China, when its foreign revenues have so far been largely dependent upon regional Asian countries.

Ownership and financing

The ownership and control structure of Alibaba is murky or, more charitably put, difficult to pin down. The Alibaba Group Holding company was registered in the Cayman Islands in June 1999, and there is, in addition, a system of contractual links between its many subsidiaries. Good luck in working your way through its 303-page 2016 annual report, with 74 of them giving ‘Notes to consolidated financial statements’.
Jack Ma started out by being moderately generous with his offering of a (very) small stake in the fledgling company to the initial group of employees, but had later to divest a much larger share of it to important early backers and suppliers of funds. More or less the first was Goldman Sachs, which lent Alibaba $3.3m and later sold its stake very profitably for around $22m, although much too early to realise dramatically higher returns. Sometimes you just cannot be greedy enough.
Another important supplier of early funds was Yahoo, which still maintains a stake after later reducing its holding. The biggest backer of Alibaba, however, was Japan’s Softbank, which has built an important share. According to the 2016 annual report, Jack Ma owned 7.8% of Alibaba Group, other directors owned 4.7%, Softbank had 32% and Yahoo had 15.4%. However, this understates Ma’s position.
At first sight, the ownership numbers would imply that Jack Ma has little control over the company. However, this conclusion is questioned by an important deal, one ostensibly made to get around Chinese government restrictions on foreign ownership of non-financial companies. This was when Ma took control of Alipay.
In the early 2010s, almost all of the payments made through the Alibaba commercial system were transacted through its subsidiary Alipay, which handled $700m per day in transactions. Alipay had an ‘escrow system’ for security of payment, whereby funds were transferred to the seller only after satisfactory delivery of goods to the buyer. This payment system proved very attractive to users, especially given inefficient Chinese bank payments and the low use of credit cards in China, since it improved the chance of getting your money back after being delivered poor quality goods. Although Alipay itself did not necessarily make any charges directly, and so was not an important source of funds to the main company, it was nevertheless a key part of the Alibaba operation, important for keeping the buying/selling/services business model ticking over.
In 2011, news emerged – buried in a quarterly Yahoo earnings report – that Jack Ma had taken control of Alipay in the previous year or two and had transferred it out of the Alibaba group. The price paid by the company owned by Jack Ma was roughly $51m for a business that was seen as then being worth around $1 billion. This was done through a so-called Variable Interest Entity (VIE) structure, something that other companies have also used to get around China’s regulation of foreign ownership of companies licensed to operate payment systems in the country. However, whatever the motivation behind the deal, it meant that a VIE company largely owned by Jack Ma would now control a key Alibaba-related business.[3] After its expansion into other areas, Alipay is now Ant Financial. Today it is estimated to be worth very much more.
Such deals may have been a reason for Hong Kong’s stock exchange to reject the initial public offering (IPO) of Alibaba shares on the public capitalist market, although it appears that the most important issue was the favoured voting positions of Alibaba’s founding shareholders that were seen as being detrimental to new shareholders in an IPO. The New York Stock Exchange nevertheless accepted the deal, no doubt encouraged by the potentially lucrative transaction fees. In September 2014, the IPO sale of some shares in Alibaba Group Holding (ie minus Alipay) raised a record $25bn, with reported fees amounting to some $300m.

Alibaba and Ant Financial

Alipay was renamed Ant Financial in 2014. Based on its 2016 round of fundraising, which brought in China’s sovereign wealth fund and other state institutions, it has been valued at $60bn, but there is no detail of costs and revenue flows in Ant Financial’s 2016 report. Nevertheless, it is certainly big. Ant Financial performs more than 150 million payments per day, 10 times the volume for Paypal; it is the world’s third largest cash management service, lends money to small businesses and offers insurance services.
Alibaba’s own annual report shows the following key fact: 37.5% of Ant Financial’s pre-tax income is due to Alibaba (although I have not been able to find what that income might be!). There are also many other flows of income between the two groups, with Alibaba paying Ant Financial for bank processing costs and operating costs – roughly $760m in the 2016 financial year – and the latter paying Alibaba royalties, fees for software technology and for other services. The impression given in one table of transactions is that Alibaba pays Ant Financial more than it receives, roughly a net $350m in the 2016 financial year, but that will probably exclude the share of pre-tax income Alibaba gets from Ant Financial. More information on the latter’s business will be published when it eventually lists its shares on a stock exchange, an event expected to happen by 2019. In the meantime, both companies are continuing to expand into other markets and other countries with acquisitions and cooperation deals, including in the US and Europe.

Alibaba and global corporate trends

The company’s name comes from the story of Ali Baba and the Forty Thieves, one of the ‘Arabian Nights’ tales. The hero, Ali Baba, finds out the command ‘Open Sesame’ for the cave in which the thieves have hidden their stolen treasure. Jack Ma chose the name as something that would both be recognisable in global markets and encourage consumers to think that they too could find treasure. In the same way, the name of one of the company’s original sites, Taobao, means ‘searching for treasure’ in Chinese. But the company name is more revealing than might have been intended about Alibaba’s business.
In economic terms, Alibaba is not itself stealing or receiving stolen goods, although through its powerful mechanism it is taking a cut from the commercial transactions taking place, including through selling its advertising services. In this, it is at one with key developments in the world economy over the past few decades: don’t produce anything; instead take a share of the value that others have produced by managing the markets in which they operate!
Monopolisation of commercial relationships has been a fundamental feature of global corporations, so much so that most of the leading companies by stock market capitalisation these days are ones that have a strong commercial power, rather than being powerful producers. For example, Amazon is now worth more on the stock market than ExxonMobil, and so is Alibaba. Apple Inc, the world’s largest company in these terms, has the largest capitalisation of a private company, but does very little production itself and relies on its domination of supply chains for assembly and its consumer market power – one should also note its use of the financial system.[4] Alibaba’s business model fits with these important trends and it could well develop into another of these powerful global companies, supported from its strong domestic base in China.

Tony Norfield, 28 June 2017

[1] For more detail on these I would recommend Duncan Clark’s book, Alibaba: The House That Jack Ma Built, Ecco, 2016, and this article by Louise Lucas, ‘Alibaba bets on do-it-yourself globalisation’, Financial Times, 23 May 2017.
[2] Alibaba does not have Amazon’s system of warehouses for delivering many of its online ordered goods, which saves it some costs. Instead, it delivers most goods within China through the ‘warehouse and delivery network partners’ of its 47%-owned affiliate, Cainiao, which employs 1.7 million delivery personnel and operates in more than 600 cities in China.
[3] See Duncan Clark’s book, pp219-224.
[4] See my review of Apple’s business here.

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