“Backdoor Loophole” into the “Biggest IPO in History”

Checking out the Alibaba-related teasers from S&A Short Report and Private Briefing

There have been two pretty big promo campaigns about the Alibaba IPO in the last week or so — one from Bill Patalon in an ad for his Private Briefing, and the other from Mike Palmer for Jeff Clark’s S&A Short Report… so I thought we should try to take a look, answer some reader questions, and see if these two folks are touting the same “backdoor” play on Alibaba.

Alibaba, if you haven’t yet heard the buzz and hype, is a huge e-commerce company based in China — they offer a variety of different transactions in their marketplace(s), including business to business ordering (like for companies seeking Chinese suppliers) as well as direct-to-consumer sales (Taobao and others) much like those handled most often by Amazon or eBay in the US, with similarly huge market share to those two but in a faster-growing market, and they have a large payment network (AliPay) that is essentially their homegrown version of eBay’s PayPal.

They’re huge, and as one of the largest tech companies that is not public there has been a surge of interest in their IPO — something that’s been on many investors’ radar screens for several years but has really hit public attention now that they’ve actually filed their first registration for the public offering (that was a couple weeks ago) and a listing in New York (I think the Nasdaq and the NYSE are still fighting for that listing, don’t know where it will end up).

The likely date for their IPO seems to be sometime in August, though these things aren’t that predictable far in advance (it could easily be sooner, any later would be perceived as a delay), and it will almost certainly be a massive and heavily covered event — much like the facebook IPO two years ago or the Google IPO ten years ago. And Alibaba Group has some other similarities with those two — it will have a complicated ownership structure that keeps the current managers in control even without majority ownership, and added to that it’s got the complication of being a tiered ownership structure that’s designed to get around Chinese ownership restrictions (more on that from the NY Times here).

So these aren’t likely the last teasers we’ll see that focus on Alibaba, which will probably emerge as a $100+ billion company after the public offering (there are estimates that put it above $250 billion). And small investors obviously can’t buy directly into Alibaba shares before the IPO, even if we wanted to, so what is this “backdoor” that the folks from Money Morning and from Stansberry are touting?

The Stansberry pitch for the S&A Short Report opens like this:

“How to get in on the biggest IPO in American History… before it goes public.

“Normally, Initial Public Offerings (IPOs) are completely useless for ordinary, retail investors. But our expert trader has found a rare opportunity that allows you to jump in front of investment bankers and hedge fund managers to potentially make a small fortune on what is being dubbed, ‘The largest IPO in U.S. history.'”

And the Private Briefing spiel starts similarly:

“Chinese Internet giant Alibaba recently filed papers for what will surely be the biggest IPO in history… virtually guaranteeing ‘millionaire status’ to a swath of insiders, high-net-worth investors, and bankers.

“But on this particular deal, a lot of regular folks will get rich, too.

“That’s why I want to send you this urgent report.

“You see, under normal circumstances, mega-IPO profits are reserved for the ultra-rich.

“But the Alibaba IPO – a potential $20 billion deal – comes with a little-known ‘exception.’

“And for you, it could be a hugely profitable one.

“My newest research has led me to a backdoor way for you to make a fortune on the Alibaba deal RIGHT NOW… long before the shares go public.”

And what is it that they’re touting?

Private Briefing:

“… there’s an American company that was smart enough to build up a huge position in Alibaba over the years.

“And now that the Chinese firm has decided to go public, this savvy American firm is about to cash out. Big time.

“It could reap a $12 billion windfall on the deal. A payout that would more than double this company’s cash flow… in a day.

“I’m talking about an estimated 153% pop in the quick action – with the potential to rise as high as 400% if you’re patient and willing to ride the upside. It’s up to you.

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“I’m anticipating the initial gains to come fast – springing directly from the massive ‘Alibaba Shockwave Effect’ that’s already spreading through global markets – and will most likely end minutes after the IPO goes live several weeks from now.”

Well, that’s quite clearly a reference to Yahoo (YHOO), which owns 24% of Alibaba Group (and has otherwise been such a mess that it has often been valued based mostly on the anticipated return on their Alibaba shares).

But are they really touting Yahoo shares as some “secret backdoor” into Alibaba shares? That’s a little hard to swallow, given the overwhelming, breathless coverage the Alibaba IPO has received and the impact that estimates of Alibaba valuation already have on YHOO shares every day. But I suppose folks who don’t generally read the business press or watch CNBC might not know that YHOO isn’t really Yahoo these days.

Here’s how they put it:

“Take the backdoor company’s share price (which is currently very cheap) and add in the ‘Alibaba Effect’… those shockwaves I was telling you about being created by the IPO offering.

“Well, the calculation can only come up one way.

“And that’s with the backdoor play’s stock price rising substantially.”

The spiel goes on to say that the unnamed secret company (clearly YHOO) could do a few things with their windfall — they’re selling part of their stake in the IPO so they can either dividend it out, buy back stock or make acquisitions, and the remaining shares they hold they could sell in the future or simply hold onto if Alibaba turns out to be as spectacular a grower as some predict.

Unmentioned, of course, is the fact that Yahoo will owe taxes on their Alibaba gains when they sell… or that they could always indulge themselves in the other popular tech company strategy, “sit on giant pile of cash for year and chuckle like Scrooge McDuck in his Money Bin.”

And though there are no further specifics save the prediction that this windfall will boost an investment in [Yahoo] by 153%, they also suggest that there are other ways to profit from this IPO:

“The first bonus play is yet another small company that figures to reap about $58 billion from the IPO. I expect its share price will get a sizeable boost – and fast.”

“Small company” my hiney — this one is Softbank (SFTBY for the ADR), the Japanese tech conglomerate run by Masayoshi Son (they’ve been in the news lately as well, following their effective merger with Sprint last Summer), and they are not small. Softbank invested about $20 billion in Sprint, and has a market cap of roughly $80 billion… probably a bit smaller than Alibaba will be if the optimistic projections about their share price are correct, but certainly not small (or even medium sized) in any way. Softbank owns even more of Alibaba than Yahoo does (this is why Alibaba is still not public — they got large investments from Yahoo and Softbank many years ago, so they didn’t need capital to grow), but is not selling any Alibaba shares in the IPO (recent speculation has been that the IPO will price at $72 a share, which Barron’s says would mean Yahoo’s stake is worth $37 billion, Softbank’s $57 billion.

So Yahoo will be cashing in to at least some degree, and has substantially more exposure to Alibaba as a percent of market cap (Yahoo’s market cap right now is $35 billion, and they have a billion or two of net cash on their books as well), partly because the after-tax value of Yahoo’s major assets (Alibaba and Yahoo Japan, which they own in partnership with Softbank) is so unclear… not just because we don’t know how much the taxes will be if and when Yahoo completes an “exit” of those holdings, but also because both are private companies with little disclosure and are difficult to value. That Barron’s article cites Yahoo’s stake in Alibaba Group as being worth $37 billion, the more conservative Morningstar analyst puts it at $17 billion (Yahoo has almost exactly a billion shares outstanding, so that makes the math simple as long as we’re talking rough numbers, that would be either $37ish or $17ish per share, YHOO currently trades just under $35 a share).

Alibaba Group isn’t a teensy little startup going public with just a sliver of equity for sale, this is a big stake in a huge company — we can guess at what it’s worth, but we shouldn’t take those estimates as being particularly reliable, anyone trading YHOO or SFTBY because of Alibaba will have to accept that the volatility might be quite high. Alibaba could go public in a hot market and get bid up to a massive valuation, or it could fall on its face if investors stop looking at their growth numbers with starry eyes and get nervous about China… or it could end up pricing roughly where the banks expect it to price, and Yahoo and Softbank might both see a post-IPO “sell on the news” effect.

Yes, you can absolutely make the case that Alibaba should be worth $250 billion (partly because Amazon, the most comparable US company, is so incredibly richly valued) and that Yahoo’s stake would be worth $100 billion and therefore, after taxes, Yahoo’s share price could double or triple as Alibaba booms. You can also make the case that Alibaba will go public at $100 billion and dwindle to $50 billion and Yahoo’s stake will be worth, well, something close to the $17 per share estimated by Morningstar. A lot of this has to do with how you think the hype cycle will hit the IPO — will it be facebook again, with a flat IPO and a six-month decline, or will it be a mega-hype IPO that everyone’s clamoring for a piece of that triples on the first day? If you can predict that, you win a job at Goldman Sachs.

If you flip through the registration filing, which doesn’t yet include their anticipated pricing for the offering (that usually comes at the last minute), you see that Alibaba Group reported nine-month earnings to December of last year that, if annualized, would mean the company had net income approaching $4 billion over the last year and was on pace to pretty much double its earnings year over year. So the big numbers are impressive, and it’s easy to be comfortable with a $100-150 billion valuation for Alibaba given that growth rate … even if you take account for the dilution that will come with the IPO sale of shares (some of the shares that are being sold, like part of Yahoo’s stake, already exist… some are being created, presumably to fund investment in growth — I don’t think it has yet been disclosed exactly how many shares will be offered, or what percentage are from selling shareholders vs. the company).

So yes, there’s a good reason for the hype about Alibaba — it’s huge, it’s successful, it has its fingers in e-commerce, mobile commerce, business-to-business commerce, payments, online shopping of all kinds, and is growing fast and really without peer in what is gradually becoming a massive consumer economy in China. And Yahoo owns 24% of the company, which if you ignore the details about taxation and how much they’re going to sell and what demand will be for the shares, means YHOO should reap a cash windfall.

But Yahoo has also more than doubled over the last two years mostly due to Alibaba and Yahoo Japan, with a (small, I’d argue) additional boost coming from the enthusiasm for new CEO Marissa Meyer after the company had been given up for dead. Yahoo used to own 40% of Alibaba, but sold 40% of that position back to Alibaba in 2012 for $7.6 billion, and they used about half of that to buy back shares and half to fund investments in Yahoo’s growth, including acquisitions and restructuring. Alibaba may not have had the flexibility to plan an IPO if Yahoo had held that 40% and Softbank 40%, so the point is perhaps moot, but Yahoo sold that 16% stake for a lot less than people think it’s worth today.

Yahoo’s core business is still, I would argue, very threatened and not worthy of a particularly high valuation — their search partnership with Microsoft has been pretty fizzle-y and there hasn’t been any real revenue or earnings growth to get excited about from the core web portal and advertising business. They just can’t compete with Google for advertising reach and scale or with Facebook for “eyeballs” and display ads, though it’s certainly possible that they’ll continue stabilizing and will eventually grow — they certainly have almost unmatched scale (unmatched by anyone except Google and Facebook, at least), so if they can light the right fire under their user base it might help them.

I admit to being tempted by Alibaba, which is easy until they tell you the price you’ll have to pay, but I’d be more likely to go with Softbank personally if I wanted to buy into the Alibaba story before the IPO — Softbank’s stake is larger, their core business is more diversified and could easily grow (or provide a substantial catalyst, if they are able to merge T-Mobile with Sprint as is so often rumored), and they’re not going to sell their Alibaba shares right away so it’s more of a play on Alibaba ownership and growth than simply on the possible Alibaba IPO pop that may or may not come this Summer.

So our best guess is that Private Briefing is probably simply recommending a purchase of Yahoo shares — and a 100%+ gain in those shares is possible if the frenzy over Alibaba heats up, though I think that’s probably too aggressive. They may be suggesting a Yahoo options trade, perhaps, but in that case the likelihood is that they’d tease a much higher potential return to really get us excited.

And on that note, we should check in on what exactly the S&A Short Report folks are teasing … since that newsletter, edited by Jeff Clark, is generally options-focused. What are they recommending?

Well, it clearly also has to do with Yahoo — here’s how they tease it:

“Since Alibaba filed their paperwork with the SEC earlier this month, that gives us between 30 and 90 days to make what could be a very nice gain, with almost no risk. That’s the standard lag time between when a company files and open bell on day one of trading.

“I say ‘with almost no risk,’ because Jeff Clark has figured out a way to structure a trade in the options market that essentially allows you to make a trade with “no money down.” It’s a unique anomaly that sometimes occurs in the options market… and it’s available to savvy traders right now.

“I realize that may sound a little outrageous to you. You and I both know there’s no such thing as a trade with zero risk. But given the current state of our trade’s pricing, the options market “wrings out” most of the risk from your trade. As Jeff told me recently, “This is the type of trade I would put my Mother’s money into.”

“So as with any investment… there is risk — but I believe this is the smartest, absolutely lowest risk way to play the Alibaba IPO.”

Huh … so we can infer that it’s some kind of options trade on Yahoo, how about some more clues?

“The first is a very conservative trade. Jeff explains, “there’s no need to second guess this trade, or breathlessly watch every up-tick and down-tick in the stock. We can just stick with the plan… hold it through the hype period and take profits.”

“The second trade is a more aggressive play. Jeff recommends this trade if you want a very legitimate shot at cashing out with gains of 200% or more.

“And remember: Both of these trades will most likely be done before October. You don’t need to sit on your position for years to see gains. There’s a very good chance you’ll even be able to cash out WELL BEFORE Alibaba’s IPO.”

I’m not much of an options trader, so it’s quite likely that I can’t tell you exactly what Clark is suggesting… but he also does say this:

“He’s confident this is the only way a regular investor can make some real money with the Alibaba IPO because he’s actually seen this exact set up before…

“Huge company with a unique ownership structure announces IPO…

“Hype about the stock rages on for months…

“People do stupid things with their money.

“​In fact, the last time Jeff saw the set up for this trade was during the Palm IPO of March 2000…

“And he walked away with nearly DOUBLE his net worth… by making a trade similar to the one he’s recommending today for Alibaba. Yes, you read that correctly — he nearly doubled his net worth with a single trade… remarkable.

“You see, Jeff understands that simply getting into the IPO by purchasing ordinary shares of Alibaba is probably a recipe for disaster.”

Clark has written before about his (risky) options trade that tried to fade the hype of the Palm IPO — it’s an interesting story, you can read his free article about it over at the Growth Stock Wire, but my key takeaway is this:

“The market was already pricing in the increased valuation of 3Com shares as a result of the PALM IPO. In the option markets, the expectations had risen to purely foolish levels.”

When prices rise to foolish levels, the expectation then is that you’re trying to sell into the foolishness… which is what he did:

“The pricing of these options was just nuts, and it was the result of tremendous hype surrounding the PALM IPO – hype that would disappear as soon as the stock went public. I did the only thing I could do… I sold the call options and collected $600 on each contract. In fact, since the premium was so large and the potential for profit was so high, I took a position that was about three times my normal size.”

You can read that story for the details, but he basically kept selling more options and would have driven his firm into bankruptcy, he says, if the hype had been correct and the stock had kept going up… but it didn’t, it faded after the IPO as he was expecting, and he booked all that money from selling options. Presumably these were naked call options, where he didn’t have the cash to buy the shares he would have had to supply to the buyers of those options if the stock price kept climbing — which meant he would have gotten margin calls quickly from his broker and it would have gone downhill quickly. While very profitable, clearly, he says he would do it more wisely today:

“The option market provides any number of ways to take advantage of mispriced, overhyped situations without exposing yourself to tremendous risks.”

I could have employed a relatively simple strategy that would have been equally as profitable, but considerably reduced my risks had I just done a little extra homework.”

What might that strategy be? It could be almost anything, but the likelihood is that you would bracket your trade in some way to cut off the unlimited downside that a naked call option sale presents — the simplest would be a short call spread, meaning that you sell a call because you think the stock is rising unsustainably but you buy a higher-priced call to cut off the potential losses just in case you’re wrong… with the ideal result being that both of those options expire worthless and you just pocket the difference. You can see this explained a bit more technically here on a TradeKing page, or CBOE has a free seminar in trading spreads here if you want more detail.

I have no idea whether or not this is specifically what Jeff Clark is recommending to his subscribers, but if it’s a “no money down” trade then he’s selling options — selling means you take on the obligation of either buying a stock or selling a stock, and if he’s skeptical about the hype surrounding Alibaba, as it seems from the tone of the pitch, then a short call spread/bear call spread makes sense.

Frankly, the valuations are not so out of wack that I’d compare this to the 3Com/Palm IPO and the wild speculation going into that one, so it might be that this particular trade isn’t as directly comparable as the ad implies — he may not be acting nearly as aggressive as he was then. Which is probably wise — I agree that Yahoo is probably a bit overvalued because of the Alibaba stake and is likely to deflate a bit after the IPO… but it’s not horribly overvalued, and you can make a case for Alibaba being really, really huge so the risk of betting against Yahoo is real. He might even be saying that we’re still early in the hype cycle and suggesting a bullish no-money-down trade similar to the ones Porter has been teasing for his Stansberry Alpha service, where he sells a put against YHOO and uses it to buy a call because he’s so certain that YHOO stock will get bid up crazy in the next two or three months. (You could, for example, sell a July $33 put for about $1.50 and use half of that to buy a July $39 call — netting a small bit of cash and giving you upside if the hype takes over in the next month or two, with the risk that you have to buy it at $33 if it falls below that. Not suggesting this, of course, but it’s another “no money down” possibility for riding hype.)

I find it interesting that we see two newsletter teasers about Alibaba in one week, with one of them pitching a purely bullish scenario and a way to get in early on the excitement… and the other implying that the hype is going to go over the top and crash, and you can profit from it in the short term. Me, my impulse is to stay away from Yahoo and think about a long position in Softbank as a long-term position… but that’s just “think about,” I’ve never gotten particularly close to actually buying Softbank and I can’t really get my head around what Alibaba should be worth yet.s

But really, all I can tell you is that these newsletters pitching a “secret” backdoor loophole that lets you get access to Alibaba shares are both talking about Yahoo, and it obviously ain’t so secret. It’s your money, though, so — secret or not — what do you think will happen? And do you feel like betting on it? Let us know with a comment below.

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