Warren Buffett (BRK.A, BRK.B) hasn’t bought an initial public offering (IPO) in fifty years. The Oracle of Omaha has often said that IPOs are almost always bad investments, which may often be the case. Such a view is great guidance for new and inexperienced investors, but the key word of emphasis in his view is ‘almost.’ Some IPOs are, in fact, worth looking into.
Remember: an asset in any form can be mispriced, whether it is a house, rental car, piece of equipment, secondary stock sale, and yes, even an IPO. An asset’s value in any and all cases will be the present value of risk-adjusted future free cash flows after accounting for the current balance sheet net cash/debt position and other off-balance sheet assets/liabilities. Oftentimes, when reputations are at stake, underwriters may misprice IPOs (sell shares for cheaper than intrinsic value) in order to regain trust in clients. Controversy regarding the IPO could also present opportunities.
Following the Facebook (FB) disaster, where the company’s shares dipped below the offer price shortly after the open, the importance of underwriters’ clients making money on Alibaba (BABA) couldn’t have been of greater importance. That’s why, in our view, the underwriters priced Alibaba’s shares at $68 per share, a huge discount to intrinsic value and some $40 dollars lower than today’s levels. As for controversy, many continue to believe that the firm’s corporate structure is dangerous, though we note that all investments come with some degree of risk. This situation set up a perfect opportunity to capitalize on the firm’s mispricing. A position in Alibaba was opened in the Best Ideas portfolio on September 19 at $92.70, and the position was added to on October 22 at $93.20.
Alibaba’s shares are now approaching $110 each, and we think the company has further upside on the basis of the high end of our fair value range, which is currently $125 (see fair value range in the company’s 16-page report). Not only do we believe that the firm’s future free cash flows are mispriced under an optimistic scenario, but we like its business model much more than Amazon’s (AMZN), for example. The Chinese-based e-commerce giant doesn’t hold a lot of inventory like Amazon, and therefore, it is more of a pure marketplace for third-party vendors. The company’s runway for growth in China also remains incredible, and Alibaba’s opportunity outside of the country is a key source of fundamental upside (not factored into our fair value). Recently, for example, news leaked the firm may be collaborating with Apple (AAPL), and our valuation could be far too conservative.
Alibaba’s third-quarter performance, its first quarterly report since going public, was solid. Revenue jumped more than 50% thanks to strength in online marketing service revenue and commission revenue. Mobile revenue increased more than ten-fold during the period. Non-GAAP EBITDA advanced more than 30% in the quarter, and while the firm experienced some margin pressure during the period, the decline was not a result of ominous reasons. Management blamed extra consolidation expenses, planned investments in new initiatives (mobile), and increased tactical marketing for the reduced margin performance. We would continue to expect Alibaba to invest in its business to drive robust levels of top-line expansion, and we’d actually view these investments as a positive. This is why shares are reacting positively to the report.
Alibaba continues to be a holding in the Best Ideas portfolio, and we think the company has material upside potential on the basis of the high end of the fair value range, which is achievable (even excluding opportunities outside of China). Yahoo (YHOO) continues to benefit from its stake in Alibaba, which it acquired in 2005, before existing management took the reins. Our fair value estimate of Yahoo is unchanged.