A tale of two S-1’s

Today was a busy news day on many fronts. In particular, two notable companies filed to go public – New Relic and Hortonworks. These two companies do not have a lot in common, but they are both on my list of companies I want to know more about. It is a long list, so I am a bit behind, and I will try to play a bit of catch up here. More importantly, I think these companies say something about the changing world of software development, but they also mark an ominous note for the health of the current IPO window.

I know New Relic through some of the work I have done looking at developer tools companies. I have posted on this space in the past. New Relic creates software that helps other people make better software. They have a suite of tools for designing, streamlining and testing new apps. I know them mostly through their extensive work in the mobile space, but they do a lot more than mobile software. In that post I linked to above, I lamented the difficulty companies in this space have faced, so I am encouraged that New Relic thinks their prospects are strong enough to go public, and I think they are entering into some very large, untapped opportunities.

Hortonworks is the first of the “Hadoop companies” to go public. I am a big believer in Hadoop, but that phrase is pretty meaningless, like saying I am a big believer in databases. More to the point, I think the Street has a lot to learn about Hadoop and the changes it is bringing not only to the database industry but to the whole computing software space. Hortonworks has a business model similar to that of Red Hat, it gets paid for helping people use free software. Where Red Hat made Linux functional for the enterprise, Hortwonworks is attempting to do the same for Hadoop. For purely idiosyncratic reasons, I have never been a big believer in Hortonworks. Something about their marketing and positioning just never sat right with me. I had no rational reason for that gut feeling, but I want to be upfront with my biases, and my suspicions about Hortonworks were partially confirmed by a detail on the front page of their filing.

So we have one very new-day software-as-a-service (SaaS) company in New Relic, and an older model services and license model at Hortonworks. The Street really likes SaaS models now, but there is nothing wrong with Hortonworks model, at least in theory.

So we have one company that I have a vague good feeling about, and one that I have a vague not-so-good feeling about. The trouble with both companies is that they are both losing money. A lot of it. In the past nine months Hortonworks has lost $54 million from operations, while over that same period New Relic burned about $15 million. (And let’s not get me started about Hortonworks April year-end….)

Horton and New Relic financials

If the image above were readable, you would see that both companies have been losing money for a while, but are slowly improving. Well, the improving trend with New Relic is there. Hortonworks’ improvement requires a bit more faith. As I noted earlier, the two companies have very different models and probably should not be compared this way – 30% gross margins vs. 80% gross margins. These are very different companies.

There is a constant debate in the Valley as to whether or not we are in a ‘Bubble’. Those who argue we are point to things like San Francisco real estate, traffic on the 280 (let alone 101), and $19 billion for WhatsApp or a pre-revenue valuation of Snapchat of $7 billion. Those who say we are not in a bubble point to the fact that so many of today’s private companies are much more capital efficient. It costs very little to start a business when you do not have to spend any money on capex for servers, since you can run everything on Amazon’s cloud. In this era of ‘lean’ start-ups, the capital at risk is much lower than in the ’90’s dot.com Bubble.

What makes me uncomfortable is that we have two highly unprofitable companies filing to go public, and that has to be some kind of warning flag. Now there is an argument that we are in a golden age of software growth, and both companies tap into two very large market opportunities. So it makes sense that they should be investing heavily to build as big an advantage as they can right now. Companies do not need to be profitable to go public, but they should have a pretty visibile path to profitability. Otherwise, it just becomes an exercise in handing off risk to public investors, who have a much lower tolerance for new fangled ideas than venture investors. Even if we assume that both of these companies are making smart decisions about the risks they face, investors should start to get a little cautious that other companies with much higher risk profiles see these two come out and start to get ideas.

BABA: Portfolio Manager Summary

Alibaba is a bet on the growth of commerce in China, not just online commerce but a broad definition of commercial activity. Alibaba is now deeply entrenched in China’s business future. As the economy there develops, the Internet will be at the core of that growth, as opposed to commerce in more developed economies where the Internet is still something of an add-on or competitor to traditional commercial channels. If you think the prospects for this look good, and I do, then Alibaba is likely to prove a good investment.

That being said, Alibaba is a massive, complex organization and we think a few key elements of it need to be laid out clearly. Most people reading this will already be familiar with Alibaba’s overall structure and history. The company operates dozens of websites and physical businesses. The flagship product are the company’s suite of retail marketplaces which allow consumers to buy goods from the company’s merchant ‘partners’. This is analogous to Amazon’s third-party merchants, with the important distinction that Alibaba does not sell any goods directly.

In many senses, Alibaba is a textbook example of having a first mover advantage. From humble beginnings, they now touch on nearly every piece of online commerce in China. And their recent investments position them to expand into areas of physical goods and services.

Alibaba is best viewed as a ‘platform’. Meaning they have a core group of customers and users, and can generate serious growth through the ability to drive additional revenue streams from that base. This is why the Street is watching ‘monetization’ figures closely, revenue and gross merchandise value for each customer.

One of the key elements of that is their ability to effectively provide credit in the form of ‘generous’ working capital to their merchant partners. In China’s complex financial markets, this advantage is both hugely important and hard to fully grasp. Investors, should view Alibaba not only as a web commerce company but as a quasi-financial institution. We add that ‘quasi’ hedge because portions of the company’s financial offerings are not accessible to foreign investors, but the investment vehicle can still benefit from them.

That bit of complexity leads directly to the very important subject of risks. The most obvious ones are political risk around foreign ownership of China’s Internet companies, which for Alibaba manifests in a convoluted ownership structure. Investors have gotten accustomed to these “VIE” structures (Variable Investment Entity), but that should not diminish the risks associated with them. There is a fair degree of ‘faith’ involved in holding Alibaba shares. Second, the size and complexity of the company’s operations defy ready analysis. We expect noisy data flows for some time as investors piece together reliable data points for the company. Even a cursory reading of the company’s filings should make it clear that there are pieces of Alibaba that will never be fully understood by outsiders. Not least of these will be getting a full grasp of the financing and credit side of the company which we believe is an important part of its competitive position.

The 3 Roles of Alibaba

Alibaba has a lot going on. Parsing through its S-1 is not an easy task.

But I have begun to view the company playing three different roles:

  • Alibaba as a commerce platform
  • Alibaba as a ‘financial institution’
  • Alibaba as a venture investor

I plan to post on each of these in greater detail in coming weeks, but let me explain briefly here where I am headed.

Alibaba as a commerce platform

The core of Alibaba’s business is to provide online commerce platforms for its 279 million merchant partner accounts. They do this through a dozen key websites, and this is how they are most commonly viewed. What makes the stock really interesting is the company’s potential to capitalize on those relationships and find new ways to monetize them. In their last quarter, Alibaba generated about RMB 1,800 in merchandise value (GMV) and RMB 57 in revenue from each of those accounts. Those figures have been slowly growing over the four years of data we have available from the S-1, starting at RMB 1,337 and RMB 42 respectively in 1Q10. That is a good pace, and there are reasons to think the company can expand on them further. Put simply, Alibaba has figured out how to be useful to merchants, and there is reason to think they can expand on that in the future.

Alibaba as ‘financial institution’

Perhaps the most important feature they offer their merchants revolves around financing. For small and medium enterprises (SME) in China, obtaining access to financial services is hard. We are not referring to big, complex financial transactions but rather simple workhorse products like small business loans and receivables factoring. In the US, these services are commonplace at every bank, but are far less readily available in China.

Take the issue of working capital as an example. It is common for companies to pay their suppliers on 180 days or 270 day terms there. This is a circular problem, as one company cannot pay its suppliers because it can not collect from its customers. By contrast, transactions conducted on Alibaba’s platform have payment terms that are essentially reduced to shipping times. This is a huge advance, but one that is often overlooked.

Alibaba figured out a few years ago that they could do more than this. They have been steadily expanding their financial products over the years. On the consumer side, they have a range of lending and investment products. For SMEs, in 2010 they launched a Micro Loan service. These are essentially small business working capital loans, with terms of 7 to 360 days. The company has 400,000 borrowers signed up currently. The interest from these loans is reported as “Other Income” on the financial statements, and while small it is by far the fastest growing item on the income statement. We think this kind of product will remain a very important driver of loyalty and keep merchants on the platform.

Of course, we have been referring to this as something that ‘the company’ offers, but in reality, these services are provided by another company – Ant Financial, formerly known as Alipay. Alibaba spun this out ahead of the IPO to comply with government regulations. There are extensive contractual ties between the two companies, and executives receive incentive compensation from both companies. So while we see these financial services as very important to the core platform, investors should be aware of the risk and complexity associated with this relationship.

Alibaba as venture investor

Alibaba has acquired or invested in dozens of companies in recent years. There is no easy way for outside investors to track the progress of these deals. So we have started to think of them as a venture portfolio targeting China’s Internet. A few of these deals will end up as write-offs, most will produce decent returns and a few will prove big hits in their own right.

Of course, Alibaba is not a financial investor, they are strategic buyers, and this is what makes the deals potentially very interesting. A big driver of the company’s future prospects will be their ability to tie these investments into the core platform.

For example, last year Alibaba acquired Autonavi, the leading map data provider in China. Autonavi was a good business in its own right, selling a scarce asset into a growing market. However, done well, Autonavi could open up the door for Alibaba to enter all kinds of geo-centric busiensses. In particular, we think it would be interesting to see if Alibaba can use the asset to gain a bigger footprint among local services such as restaurants and repairmen. This would mark a bigger move for the company, beyond their traditional base of product sales. And that is just one potential example.

At heart, Alibaba has many levers they can pull to expand and enhance their core merchant platform.


Launching “Coverage” of Alibaba

Over the next few days I will lay out some of my thoughts on Alibaba. I have been reading through their S-1 filings since they became available and a few things stood out for me. If I had more free time, I would cover it as if I were still an analyst. I have actually built out the financial model and prepared most of an initiation report. As this site is just a hobby, and I have a newborn at home, I have not had the time to finish all that. Instead, I will post my analysis here.

But I think it is very important for everyone who cares about the Mobile Internet and the Appconomy to keep an eye on what Alibaba is doing. First, Alibaba is a big, important company, one of the five most important Internet companies in the world. And I would hear arguments for it being at the top of that list. Second, they are building Internet services without the path dependencies or conventional patterns established in the US, with their hand in many different pies. That is why it is so hard to say Company X is the Facebook of China, or Company Y is the Yahoo! of China, because Companies A through Z are trying out “All of the Above”, and no one is trying out more than Alibaba. Third, China is already a more advanced mobile society than the US or Europe in many ways. It is common to the point of ubiquity for people in China (especially the cities) to do their banking and shopping and everything else commercial on their phones today. China’s Internet companies are not only coming of age without constraint from existing Internet companies, they are also coming of age without constraint from many of the traditional forms of commerce and business which have been around for 100 years in Western economies.

As such, I think companies like Alibaba are going to show the way for Internet companies as well as mobile consumer behaviors.

Topping all of that off, Alibaba is just a fascinating company. It does so many things. For serious investors, this is a problem. No one is ever going to be able to get good quarterly checks on the company. And their M&A book is a giant Black Box that will confound forensic-accounting types forever. There is just a lot to parse here.

We are in early stages of BABA the stock, and investors are still learning what metrics matter, and more importantly, what metrics matter to all the other investors. The Street will pick a few to serve as proxies for the overall health of the company, but there is so much more going on.

To close, I think Alibaba will be ‘fun’ to cover, but while I think the stock has some good momentum, I am less certain about how good an investment will be. I think the stock will move higher over the next twelve months, but I also suspect there will be several opportunities to get better entry points. Like I said, I am not really covering the stock, but if I were, I would be initiating coverage with a Buy rating and $120 price target.

New Financial Models: Alibaba’s Micro Loan Business

Yesterday, I wrote about a Marc Andreesen interview/Tweetstorm that called for disruption of financial products through better technology. One of the examples he gave was the use of big data tools and social networks to provide enhanced consumer credit scores. This is an important idea, something we have been hearing about for a few years. Banks know enough about their customers through their own data stores, as well as a few online data sources, that they can create credit profiles that are a world better than traditional metrics like FICO.

In my post, I suggested that other companies were doing something similar with credit for businesses. I was thinking of Alibaba. I have been taking a close look at that company’s financial filings lately, and I stumbled on this interesting tidbit. It turns out that Alibaba has a side business in micro loans to merchants who sell products on Alibaba’s websites.

For a variety of reasons, small business credit in China is severely constrained. China’s financial markets are still highly regulated and not that mature. As a result, a very large percentage of credit ends up going to only the largest firms. Another problem is that there are few robust credit reporting companies in China. There is no obvious analog to Dun & Bradsheet. So while banks in the US are using data tools to supplement existing credit reports, Alibaba is essentially creating something new in virgin territory.

From their filings:

“Using transactional and behavioral data from sellers on our retail and wholesale marketplaces, we have developed a proprietary credit assessment model through which we evaluate our borrowers’ ability to service loans, assign credit scores to each borrower, pre-approve credit limits and extend loans.”

That’s a pretty good description of the process, probably the clearest piece of prose you can find in an SEC filing.

This is interesting for a few reasons. First, I do not know of any companies in the US that are trying this, please let me know in the comments who is. Consumer lending appears to be a market poised for change, but we have a pretty robust commercial credit market, and the opportunity for disruption may be much smaller there. There are a few companies I know that are starting to track private companies (like Mattermark and CB Insights), but I do not believe either of them have hard financial data yet.

Second, Alibaba appears to be doing this rather well. From other  parts of their filings, it is clear that their predicative model on creditworthiness is pretty robust. True, they still have defaults, but the defaults hew pretty closely to what they forecast each quarter.

Alibaba does have a few advantages here. In addition to providing e-commerce marketplaces for the people they are lending money to, crucially, they also control the payment system behind that. So they know their borrowers’ cash flow status in real-time.

My initial reaction to this was a sense that Alibaba is something special, a unique case. Then it occurred to me, that what we are seeing is a reshaping of finance. The idea of what constitutes a ‘bank’ or ‘lender’ can easily change. Imagine Facebook taking everything it knows about you and assigning you a credit score? Or Google aggregating search traffic to identify promising borrowers. And for that matter, why not Wal-Mart or Target. Anyone with enough data that they can gauge the risk of non-payment. Not that far-fetched. There is a lot of potential for disruption.


Adding to the “Entire Thing”

In an interview with Bloomberg Businessweek today, Marc Andreessen issued another clarion call for change. If software is going to eat the world, then when it comes to the finance industry “We can reinvent the entire thing.” As some of my past posts should make clear, I feel pretty strongly the same way. You can’t look at the finance industry today and claim things work the way they should. Certainly no one working in the trenches feels that way. For an industry that is supposedly the epitome of ruthless cutthroat capitalism, there are huge pockets of inefficiency. To be clear, I’m not making some moral claim, and I am not asking anyone to occupy anything. We can discuss the societal benefits of finance someplace else. Instead, I am arguing that most of the financial industry could do its job much more efficiently. And those changes are going to get forced on the industry one way or another.

In the Andreessen interview, he cites several good examples of how technology is going to change finance. He mentions the use of big data tools to assess credit scores for consumers. That caught my eye, because I am writing another note about a company that is doing something similar to gauge the creditworthiness of businesses.

My one complaint about the interview is that he does not go far enough. There are so many areas of the industry that need or are open to change. Things like Bitcoin and credit scores are a good start, but the title says the “Entire Thing”. I think that is the right sentiment, and want to add a few more to the list.

In my past notes, I have looked a lot at possible changes to equity research – the business of financial analysis for investors. This is a small field, but one which can still drive a lot of business, if done right. A complementary area that is also adrift are institutional sales forces, the people who take orders from big investors. Talk to most salespeople today and they are a glum group. There is a sense that their role is going to be entirely automated, or entirely dis-intermediated. Certainly, a lot of their work could be done by software or a low-cost offshore replacements. That is a reflection of management challenges, not their abilities.  What company does not need salespeople? The salesforce has a huge role to play, but not when they are burdened under incredibly weak software systems. I do not know of a single bank or large brokerage that uses CRM software in a constructive way. Alright, maybe one or two, but no one has developed a really good CRM tool for this kind of sales force. If I were to start a company today, it would be based on the idea of building a ‘social’ graph of Wall Street investors and hooking into this problem. I think there are a couple of companies nibbling around this, but so far no one has  quite nailed it. (The irony is that the one company that could do this, but has not, is Bloomberg, the publisher of the aforementioned interview, and likely among the top companies to get disrupted should Andreessen’s predictions prove true.)

Institutional sales forces and equity research are nice side shows. And really, the equity market is small potatoes. Do you really want to make big changes the Entire Thing? Then the place to look is the bond market, which is valued at something like $30 Trillion in the US alone. Despite its size and importance, the bond market is about as inefficient as a market can get. There is no central exchange, no floor to ring a bell on, no easy way to keep track of prices. Everything is a negotiated sale on imperfect information. It has festered this way for years because of a variety of conflicted interests and massive inertia. Everyone knows it has to change, but few people want to say it. That is starting to change. Last month, the world’s biggest investor Black Rock issued a white paper calling for reform[PDF] of the corporate bond market. They suggest a number of technical changes to bond market practices, but I think some good software could extend the changes much further. As with much of finance, there are all sorts of regulatory hurdles, and it is hard to see a five person start-up going against that, but then again maybe what the world needs is to see an attractive alternative.  I have tried to avoid using the word ‘disrupt’ in this piece, it gets overused, but I think it applies to the potential for change here.

Like I said, that Bloomberg interview is a good start, but there’s a lot more that can be done.


A few thoughts on splitting up companies

After the big news this morning about HP splitting in two pieces, I wanted to put in my two cents. I have followed HP for a long time, but have not been close to it for years. So I have a lot of opinions about HP, its future, its management team, its winding strategic path and its pattern of M&A, but I will avoid those for today’s post. Instead, I just want to cover the idea of splitting a company in two.

Divestitures and spin-offs are something that the Street loves. Corporate Finance classes teach the idea of focused companies, it is as close to a religious principle as you can find in MBA 101. And as Joel Grenblatt points out in his great investment book, investing in spin-offs are usually a great investment strategy.  The idea is to let investors pick their risks. If you want a low-growth, high dividend company you will soon be able to buy one piece of HP (HP Inc.), but if you prefer higher risk, faster growth companies, you will soon be able to buy the other piece (HP Enterprise). This widens the scope of investors who can participate, capturing both growth and value investors. And not for nothing, it is generally easier to model, follow and conduct checks on smaller companies, which means it is easier for the analysts to do their work.

But what makes sense to the Street often conflicts directly with the reality of running a company. Put simply, splitting a company is hard. Let’s just say this is a subject with which I am a little familiar. There are so many fine points that have to be considered – from large things like who owns the brand and who owns the patent portfolio, to the small things like who gets which office furniture.  Done poorly, it can wreck both the parent and spin-off.  But doing it well, requires a huge spend on lawyers and consultants and accountants, not to mention employee distraction time.

When HP first suggested doing something like this a few years back, customers revolted, as many enterprise buyers were concerned that they would not get support from both sides of the company. If you bought your servers and desktops from one business, but purchased those through a consulting contract with the other side of the company… well those things cause confusion. I think the whole computing market has shifted a lot since then, so these concerns are less pressing, but I imagine the HP salesforce is going to be one of the trickier areas to split up. Manufacturing is also going to be easy. The PC/printer side (HP Inc.) has massive scale (e.g. a top 3 Intel customer), so the other side of the business will soon lose access to that volume pricing. My favorite spin-off issue is IT. How do split the IT services of a company? Often, the way this is done is for one company to provide transitional services to the other for some period of time until the other side gets its own operations in order. The irony is that HP has for years built a business providing outsourced IT for other companies. Now one side of the business is going to get to ‘enjoy’ what its customers have endured for years.

Now it bears mentioning, that HP has done this before. Most notably with Avago their chip business, and Agilent their test and measurement business, which recently split itself again. So HP has experience at doing this. I read through some of the management presentations and analyst commentary this morning about the transaction, and I got the sense that management had clearly thought through many of these issues. I really doubt that they have a full plan, because you need to tell everyone about that, but it did sound like they have some of the key issues sorted out.

This is an old company with many large acquisitions layered on. They say it will take a year to complete the spin-off, and people who have done this sort of thing agree that is a rapid timetable. They have a lot of work to do.

Nonetheless, I suspect this is going to prove a difficult transaction. Maybe not for investors, but definitely for employees.


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