Is It Time to Jump Into Alibaba's Stock?

Shares of Alibaba Group (symbol BABA), the e-commerce company co-founded by Jack Ma in 1999, have cooled off since their scintillating initial public offering. That makes this a good time to coolly assess the merits of this rapidly growing Chinese company.

The stock went public on September 19 at $68 per share, closed that day at $93.89 and subsequently reached $120, before retreating to its December 11 close of $104.97. At that price, Alibaba boasts a market capitalization of $261 billion, which is nearly equal to the combined value of Amazon.com (AMZN) and eBay (EBAY), two companies with which it’s often compared, plus retailing giant Costco (COST).

Investor excitement over Alibaba is understandable. The Hangzhou-based company will benefit enormously as larger swaths of China’s population join the middle class and go online to shop for life’s finer things, as well as necessities. Alibaba is already China’s largest e-commerce company, handling 80% of online shopping in the world’s most populous nation, while seeking to make inroads in Brazil, Indonesia and Russia.

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Alibaba’s Taobao Marketplace matches buyers and sellers much like eBay does, but it makes money selling ads to merchants who want their products to stand out. Alibaba collects fees on its Tmall Web site from some 50,000 businesses, including such giants as Microsoft and Nike, that sell directly to consumers. Moreover, Alibaba doesn’t hold inventory or own warehouses, as Amazon.com does, keeping its costs low.

Alibaba’s extraordinary potential became clear on November 11—Singles’ Day, a traditional shopping event in China. That day, the company’s two main Web sites served as middlemen for $9.3 billion worth of sales. That was a Guinness World Record for the highest online retail sales by one company in one day and represented an increase of 58% from Alibaba’s Singles’ Day sales in 2013. Analysts on average expect Alibaba to earn $711 million, or $2.22 per share, on revenues of $12.8 billion in the fiscal year that ends next March.

A number of high-profile investors have jumped on the Alibaba bandwagon. Shareholders include hedge fund operators Paulson & Co. and Soros Fund Management, as well as Fidelity Contrafund, the $111 billion mutual fund run by the estimable Will Danoff. Joe Fath, manager of T. Rowe Price Growth Stock Fund, which had 1.3% of its $44 billion portfolio in the stock at last report, says that holding Alibaba is like owning Google, Amazon and Ebay all in one. “I’ve seen very few business models as powerful as this one,” he says. “There are a lot of big secular trends that back them up.”

Indeed, Alibaba is well-positioned to benefit from growing consumer spending in China. Of the country’s 1.36 billion people, only 632 million are on the Internet, and only 231 million of them shop online. Consumers account for just 36% of China’s gross domestic product, compared with 68% in the U.S., suggesting that consumer spending in China has plenty of room to rise.

Alibaba’s chief executive, Jonathan Lu Zhaoxi, puts the potential this way: “Only 9% of Chinese people in rural areas use e-commerce. We consider this a big opportunity for the long term. Our vision is that we'll enable the farmers to sell their farm products to city people and globally.”

Of course, risks abound. Alibaba’s inner workings are opaque; the company has a history of making important moves without informing investors. Because of Chinese laws limiting foreign ownership, when you invest in Alibaba, you’re really buying shares in a Cayman Islands holding company with rights to Alibaba’s profits. Chinese regulators could one day require the company to keep more of its earnings in China, a move that could have devastating consequences for foreign shareholders. Plus, the company will remain under the tight control of founder Ma, now Alibaba’s executive chairman, and his associates, who control a majority of the board of directors despite a relatively small 8% ownership stake.

There’s also the matter of the slowing pace of economic growth in China. Although some experts believe that newly emboldened consumers will drive the next leg of China’s economic miracle, which would benefit companies like Alibaba immensely, investors may punish companies indiscriminately when they hear reports about decelerating GDP growth.

And finally, there’s the price of Alibaba’s shares themselves. The stock sells for a heady 47 times estimated earnings for the current fiscal year. Even using the $3.02 per-share estimate for the March 2016 fiscal year, the price-earnings ratio is a still lofty 34.

But the stock doesn’t look so pricey when viewed through the prism of Alibaba’s spectacular growth. Analysts, on average, see revenues jumping by 50% in the current fiscal year and by 38% in the March 2016 year, to $17.4 billion. And they expect earnings to increase by more than 30% annually over the next two years.

Growth of that magnitude is hard to find, which is why bulls love Alibaba despite the high valuation. “You can justify a high valuation just as you can with an Amazon.com, Google and Facebook because of the network effects—the more people who use a company’s services, the more valuable it is to you,” says Jay Ritter, a University of Florida finance professor who studies IPOs. “In certain industries, there tends to be a winner-take-all pattern, and Alibaba is benefiting from that.”