With the Alibaba roadshow kicking off this week, ConvergEx's Nick Colas reviews the second-order implications of this historic transaction. Over the next two weeks investors will have to consider important issues, such as which stocks money managers will sell to fund their BABA purchase and what securities (stocks and ETFs) hedge funds may short to pair against an Alibaba long position. And consider: "Do big IPOs signal a market top?" Also, with an estimated $7 billion in fresh cash and a valuable public stock post-IPO, BABA will also be able to play the M&A game aggressively. Just consider its corporate North Star: "Our mission is to make it easy to do business anywhere" (the first line of the S-1 summary). In short, Colas concludes Alibaba really is a big deal (at 27.3x trailing EV/EBITDA).
Via ConvergEx's Nick Colas,
Some 22 years ago I stood on the floor of the New York Stock Exchange with the management of the first Chinese company to come public in the U.S. Brilliance China Automotive made minivans in Shenyang under license from Toyota as well as producing its own somewhat older designs. The initial public offering was for shares in a Bermuda based holding company that owned shares in a Hong Kong business which in turned owned a piece of a charitable trust that held stock in the auto business. Despite that complexity, the allure of owning a piece of the Chinese car market generated tremendous investor interest. The IPO priced at $16, the first trade went off at $20, and the stock eventually doubled.
Fast forward to today, and global investors still want a piece of the China growth story – this time in the form of the country’s largest e-commerce business, Alibaba. With the roadshow reportedly kicking off this week for what could be the largest IPO of all time, you’ll be hearing a lot about this transaction as the roadshow travels the world drumming up demand. Behind that understandable focus on the transaction, however, sits a whole range of secondary issues for investors to consider.
To organize our thoughts on the topic, here is a “Top 10 List of Questions” regarding the Alibaba IPO besides the relatively straightforward matter of where it prices and how it trades in the aftermarket:
1. Do super-sized IPOs indicate a market top? Investment bankers use the phrase “IPO window” to describe the conditions needed to successfully launch a public company. It is a subtle alchemy of investor confidence, market appetite for the company’s industry and strategy, and fresh money flows into capital markets. Very few IPOs get done during market troughs; many more make their debuts anywhere from the midpoint of a cycle all the way to the peak.
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Looking at a history of the top 10 IPOs of all time in U.S. markets (above), you can see that mega-IPOs do tend to happen towards market tops. Visa (#1 spot) came in March 2008, and AT&T Wireless (#6 spot) debuted in April 2000. ENEL (#2) priced in November 1999. Facebook (#3) and General Motors (post-bankruptcy edition, #4) are more recent at May 2012 and December 2010, and obviously neither augured a lasting drop in U.S. equity prices. Scan the rest of the list, however, and you will see dates like late 1997, 1998, and mid 2001.
2. Do capital markets get twitchy right before large IPOs get priced? The simple answer is “Not really”. Looking again at our Top 10 IPO table, we see that the average return for the S&P 500 for the 5 days prior to pricing is 0.0%.
3. How about after the deal gets done? Our math shows that the average 5-day return for the S&P 500 post-pricing is a modestly positive 0.2%. That might be a “Sigh of relief” rally that a large transaction came out OK, or just the natural upward bias of capital markets since the early 1990s.
4. How will institutional investors fund their purchase of Alibaba? Press accounts put the size of the BABA IPO at up to $21.1 billion. In order to fund their purchase of the new company, some money managers may choose to sell a portion of their existing holdings. Which stocks – if any – come under pressure will be somewhat of a Wall Street guessing game for the next 2 weeks.
The most likely candidates will be other large capitalization growth oriented technology names. Some might be Chinese listed; others will be household names on U.S. exchanges. Alibaba has some pretty powerful business fundamentals to commend it, both in terms of top line growth and outsized profit margins. It will be difficult for many growth managers to ignore those factors and simply stick to their existing portfolio allocations and positions. We’ll be looking for large “Program” trades – those that feature more than one security for sale in this case – in the coming days.
5. How does all this shake out in the world of exchange traded funds and index investing? Alibaba is a Chinese company listed on a U.S. exchange, the NYSE. That makes it a bit of tough fit for many index providers, who like to see local listings even if the stock also trades on a U.S. exchange. It also eliminates it from inclusion in the S&P 500, since that index tracks “Leading companies in leading industries of the U.S. economy”. All this makes it hard for many ETF providers to include the stock in their portfolios, which largely track well-recognized passive indices. One exception will be Krane Shares, an ETF provider that specializes in Chinese investment products. Our conversations with that group lead us to believe they are looking to add BABA shares to one or more of their offerings.
6. How about options? While Alibaba will not initially appear in many indices, it will likely have a very quick launch in terms of trading listed options. The criteria here are pretty accommodating for a liquid name, and options should begin to trade a week or two after the IPO. The critical question will be how options traders assess the future volatility of the stock, and they will clearly look to comparable companies in the technology space as well as Chinese equities. Given the interest in the name, we would expect options trading in BABA to quickly become one of the more liquid names on U.S. options exchanges.
In addition, options players will be looking at the logical sale candidates I mentioned in the last 2 points. One possible options strategy: buying volatility in a basket of names that could see selling pressure into the BABA IPO. Another idea: upside call buying in such names on pricing day, expecting a post-IPO bounce as the selling pressure abates.
On a related note, one interesting fact: the average CBOE VIX Index on pricing day for the Top 10 IPOs of all time is 25.3. That is more than double the current price of 12.1. Yes, the VIX has been plumbing its historical lows for much of the year. At the same time, this comparison does highlight just how much lower it is now than most “Normal” periods when similar mega-transactions have typically priced.
7. Is the current market structure going to be able to handle the stress of a few days of abnormally high volume in one name? The most recent precedent for a large IPO is, of course, Facebook’s troubled offering in 2012. At the same time, that experience now comes with a silver lining – the stock has done very well since going public. It is impossible to know if Alibaba’s first few days as a public company will go off without a hitch, of course. Still, investors may be more willing to use near term price dislocations as a buying opportunity rather than wait for the dust to clear given their experience with Facebook.
8. How will hedge funds look to “Pair” their position in BABA? Hedgies don’t necessarily have to sell a position to buy Alibaba; they can simply short another security and purchase the IPO with the proceeds. The big question will be “What to short”? It could be a single name in the U.S. or China. It could be an ETF that focuses on technology shares or Chinese equities. We’ll be looking at the short positions on such companies in the coming months to see if there is a “Favorite” source of BABA-invested capital.
9. Will Alibaba become acquisitive with its new equity currency and cash hoard? The mergers-and-acquisitions template for post-IPO mega-cap technology companies is pretty well established. Get public, and use the stock as an acquisition currency to buy new products and services. Such purchases tend to look pricey against current financial results, to be sure, but they open up the company to new growth vectors over the medium and long term. While Alibaba certainly has ample growth opportunities in its home market, we’d be surprised if it did not make some strategic acquisitions – perhaps large ones – in its first full year or two of public ownership.
And one point worth mentioning on this topic: nowhere in Alibaba’s mission statement does the company limit its ambitions to merely the Chinese economy.
10. Who else stands to benefit from the Alibaba IPO? To say the U.S. equity trading business has been slow this year is an understatement. For at least a few days later this month, however, trading in newly public BABA should provide a boost to trading desks around the Street. Past that, Alibaba has the potential to act as a large cap “Halo” around equity investing, especially in technology and Chinese stocks – if it does well. The average “Pop” for IPOs in 2014 has been almost spot-on the traditional 10% expected increase, according to Dealogic for transactions done by top-10 underwriters. A larger bounce could help engender greater interest in equity investing if it holds up over time.
To sum up, Alibaba really is a “Big deal”. Its size and unique investment story is going to dominate the market’s attention for the remainder of the month. Beneath the big questions, like “How is the roadshow going?” and “Where is the book on price?”, lies a host of potential opportunities.
