Alibaba's Lock-Ups Have Expired. Should Its Investors Sell Everything?

"Starting tomorrow, our journey will get harder." — Jack Ma, September 19, 2014, the day Alibaba's shares began trading

September 21, US time, was the first day of Alibaba's second year on the NYSE, and the first day on which most Alibaba employees' shares came out of lock-up. Alibaba closed that day at US$63.9, down 2.8%. Since the IPO a year earlier, the stock has fallen 32%.

Of all the companies that went public in 2014, Alibaba was the largest and the most unusual. It is controlled through an unconventional "partnership system," and it had spun off its most promising business, finance. Investors still scrambled for the 320 million shares on offer, and the target offering price was raised several times.

On the day Alibaba rang the bell at the NYSE, shares that could in theory be bought at US$68 did not change hands until two and a half hours after the market opened, and the first trade came in higher, at US$92.7. By the close, Alibaba was China's largest internet company, worth US$228.5 billion.

Over the following year, large blocks of Alibaba shares that had been barred from public sale were released one after another. Yet the share price kept sliding. Since its peak in November 2014, Alibaba has lost US$128.5 billion in market value, almost half.

Anyone who owns Alibaba stock, or simply watches it, should ask: now that the lock-ups have expired, will Alibaba triple, as Facebook once did, or will it really fall another 50%, as Barron's has claimed?

In the near term, Alibaba's share price depends partly on whether its four largest shareholders (SoftBank, Yahoo!, Jack Ma and Joe Tsai, the partner who holds the most Alibaba shares) sell most of their stock cheaply once the lock-up ends. According to the filings Alibaba made before its IPO, the four hold more than 1.4 billion shares between them.

Lock-up periods for early investors and major shareholders after an initial public offering exist mainly to keep the share price steady and to stop employees and early investors from selling all at once.

The first confirmed non-sellers are two Alibaba executives, who together hold 269 million shares. On the August 13 earnings call, Joe Tsai said that he and Jack Ma had "zero intention" of reducing their holdings, and that the company would spend another US$4 billion over the next two years buying back its own shares.

Inside the group, when the share price fell below the offering price in August, CEO Daniel Zhang published an open letter urging employees to "forget the share price": "Alibaba's value lies in our pursuit of ideals and the value we create for our customers. That value does not change with the share price."

But a letter like this will not quickly ease the anxiety of employees who hold shares and watch the price keep falling.

IPO filings show that since its founding in 1999, Alibaba has granted current and former employees a total of 26.7% of its shares through stock options and other equity awards. Add the incentive grants issued every quarter since the listing, and a great many employees hold sizable paper fortunes.

A year before the listing, a post offering employee shares at US$28.5 each appeared on "Ali Flavor," Alibaba's internal forum. Even that price astonished veterans who had joined in the B2B era: as late as the end of 2011, shares changed hands internally for just US$10.

As the listing drew near, Alibaba's valuation kept swelling. Employee shares that had once been worth little became a scarce commodity in the eyes of outsiders. Some people speculated: buying and selling a few tens of thousands of shares could easily earn well over US$100,000.

Talking about the share price, or even about how many shares you held, became taboo in the office. An employee in one of Alibaba's core business units told QDaily that employee shares are part of the routine system of rewards and promotions, but the details are strictly confidential: they are not disclosed, and colleagues are forbidden to ask one another.

Laiwang, the social app Alibaba pushed hard a few years ago, has lost most of its users and is now essentially an internal messaging tool for employees. On the bulletin board of one anonymous group on it, "Strawberry," a rule stands out: "Do not discuss high-voltage topics such as pay, options and stock." But because posts and replies are anonymous, the subject keeps surfacing in near-code whenever the month-end performance review approaches. A mention of "BOC International" or the "Hong Kong One-Card," both used for overseas transactions, means an employee is settling a share sale.

In March and May this year, Alibaba released more than 400 million employee shares in two batches. It was the first large-scale lock-up release Alibaba had opened up, and many employees who had left the company, or who had risen to senior ranks, cashed out part of their holdings and paid heavy taxes on the gains.

Their timing was good: at the share price then, those shares were worth about US$36.9 billion. For the many younger employees who cannot yet convert their options into shares, or who have just received a few thousand shares with a promotion, the wait is much longer.

While they wait, they may be rewarded by a share-price rise on the back of record-breaking "Double 11" sales, or rattled by the panic a single 3,000-word negative story can set off.

Not long ago, Dow Jones & Company's Barron's devoted an entire cover story to portraying Alibaba as a company not worth investing in at all: overvalued, faking key figures, mired in counterfeit-goods disputes, run by managers who go back on their word, with an investment logic nobody can follow. It amounted to a summary of every doubt overseas markets have raised about Alibaba in recent years.

The author, Jonathan R Laing, concluded that Alibaba's shares could fall another 50% from current levels, to around US$30-40, and that investors should sell at the first suitable chance.

A day later, Alibaba replied with an open letter signed by Jim Wilkinson, the group's senior vice president for international corporate affairs. It answered and rebutted, point by point, the figures Barron's had used, called the report "lacking in integrity, professionalism and fairness," and said its conclusions would mislead investors.

Barron's then corrected one statistical error in the article, but said it stood by nearly all of its figures and judgments.

In the US, Barron's, like the Wall Street Journal, is read closely by people in finance. After the story ran, many analysts wrote up their own views. Of the analyst opinions collected by the financial site SeekingAlpha, more than ten said that while they were somewhat worried about Alibaba's short-term prospects, they did not accept Barron's figures or arguments; two or three sided with Barron's and stayed firmly bearish.

According to MarketWatch data, 36 of the 45 analysts covering Alibaba currently rate the stock a "buy" and 5 rate it a "hold." No analyst has recommended selling it in the past three months.

Analyst Brian Nichols pointed out that the story looked like a rerun of what happened before Facebook's lock-up expiry three years ago. Back then, Barron's also ran a story saying Facebook had little room to grow and that a fair share price was only US$15, 40% below where its freely traded shares stood at the time.

In fact, Facebook answered the market's doubts about its mobile business and bought the fast-rising Instagram, and its stock jumped 13% on the first trading day after its one-year lock-up expired. Since its largest wave of lock-up expiries, Facebook's share price has more than tripled.

"I don't think these articles take an objective look at the company's own growth and valuation potential. They are trying to move the share price in the short term. So I expect this story, too, will be proven wrong," Brian Nichols said.

Alibaba's share price did take a hit: on the first trading day after the story ran, it fell another 4%, and the turbulence lasted several more days.

For a sluggish stock, the end of a lock-up is not all bad news. If more investors who believe in the company for the long term buy in at this point, they can help push the price up. But that requires enough shares on the market for them to buy.

Besides executives and ordinary employees, Alibaba has two other major shareholders, SoftBank and Yahoo, which together hold about 1.182 billion shares.

As things stand, SoftBank CEO Masayoshi Son, who secured a large stake in Alibaba early on with a US$20 million investment, may be in no hurry to sell. After all, his idea of taking SoftBank private, which would have required a lot of cash, has been shelved for now.

Earlier this year there were reports that, with SoftBank's share price down, Son had considered taking the company private with a partner, but in the end he gave up on the idea.

For the past eight months or so, Yahoo has been trying to move its 384 million Alibaba shares into a company called Abaco, to separate the value of its core business from the value of its investments, while avoiding as much as possible of the nearly US$9 billion in taxes the transfer would trigger.

Abaco has not yet gone ahead because of the US Internal Revenue Service (IRS). Meanwhile, Yahoo's stock has fallen 30% since the deal was proposed, and CEO Marissa Mayer's string of turnaround plans has not worked. To save itself, Yahoo might sell part of its Alibaba stake even if it has to pay the heavy tax bill.

In short, after a bumpy first year as a listed company, Alibaba's stock has gone from an "IPO you must not miss" to an investment whose growth potential investors find hard to read.

"Lock-up expiry is usually a catalyst for the share price, but I do think Alibaba Group still has two or three difficult quarters ahead," James Cordwell, an analyst at the investment firm Atlantic Equities, told Bloomberg.

Part of Alibaba's difficulty is that competitors are challenging its own businesses. Taobao, Tmall and the B2B trade business are the core of what Alibaba listed in the US.

The prospects of Taobao and Tmall are now in question. According to iResearch, JD.com's total sales in 2014 were about 40% of Tmall's total transaction value, up from just 21% in 2013. And in the first half of this year, the transaction value of Alibaba's entire e-commerce business grew at less than half JD.com's rate.

The other part is doubt about where China's economy is heading, and with it the future spending power of Chinese consumers. That bears directly on the future of Tmall and Taobao.

It recalls 2007, when Alibaba listed its B2B trade business in Hong Kong without Taobao; five years later the shares had fallen back to the offering price, and the company bought them back. The part of Alibaba with the brightest and safest prospects, Ant Group, is not part of what listed in the US.

Ant Group grew out of the third-party payment business that developed alongside Taobao from 2003. Over the years it has built a full lineup: a payment system, financial products, microloans, credit scoring and even an online bank.

In 2011, Alibaba's management announced that, in order to obtain one of the first third-party payment licenses issued by the People's Bank of China, it would move Alipay and related financial businesses out of Alibaba's VIE structure at the time. Because this was done without consulting major shareholders such as SoftBank and Yahoo or obtaining their consent, it caused an uproar among investors, and Alibaba's critics still cite it as a key example today.

After a high-profile Series A round, Ant Group is now valued at US$45 billion, and its investors include state-backed heavyweights such as the National Social Security Fund and Postal Savings Bank of China.

According to a fundraising pitch document obtained earlier by Shanghai Securities News, Ant Group is also preparing to go public as a whole, possibly as early as 2017, on China's A-share market or on the "Strategic Emerging Industries Board" that Shanghai is setting up and billing as "China's Nasdaq."

But however well Ant Group does, it has nothing to do with most Alibaba employees or with the company's investors on the NYSE. After this round of lock-up expiries, shareholders deciding whether to sell still face the same two old questions: Do they believe Tmall can hold its own against JD.com? And do they believe the Chinese economy, on which Alibaba's retail business depends, can regain its vigor?

In a story later today, we will use a set of charts to show in detail how, one year after its listing, Alibaba went from a sought-after star to a company doubted on every front.