Open sesame for China's Web king

Jack Ma's Alibaba.com enjoys a 69 percent market share in B2B e-commerce in China.

Birthplace: The apartment from which Ma launched Alibaba.com in 1999 is now used as an incubator for new startups.

Carnival scenes outside Hangzhou's Great Hall of the People during Alifest, the annual two-day gathering of Alibaba's 10,000 top suppliers.

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(Fortune Magazine) -- On the eve of Alibaba.com's $1.7 billion stock offering - the biggest Internet IPO since Google went public in 2004 - friends of founder Jack Ma warned that he was in for a harrowing ordeal.

"People said, 'Jack, you better get ready,' " Ma recalls. " 'You're going to have to see so many people, answer so many questions. You're going to have to talk and talk and talk.' " But in early November, two days after China's leading online commerce site floated 17 percent of its shares in Hong Kong, Ma is the picture of serenity.

Settling into a large chair at company headquarters in Hangzhou, the elfin entrepreneur smiles as he describes his state of mind during the 10-day, six-city investor road show that preceded Alibaba's offering.

"It was the most relaxed I've been in 10 years," he says. "I watched a movie. I visited some galleries in New York. I even played a round of golf." And now, he adds, "I am so peaceful."

Not so investors, among whom word that Ma had reversed his long-standing opposition to going public set off a mad scramble for Alibaba's shares. Multinationals - including Yahoo!, Cisco, and AIG - signed on as cornerstone investors. Among individuals, demand for shares outstripped the number offered by 257 to 1. And on its first day of trading, Alibaba's stock shot to $5.13, triple the opening price, lifting the company's market value above $26 billion.

It's tempting to dismiss Alibaba's debut as speculative madness: old-fashioned dotcom credulity meets newfangled passion for all things Chinese. The Internet is tightly regulated in China. And with 4,400 employees and sales last year of $182 million, Alibaba remains a small shrimp in an ocean of state-owned leviathans.

While Alibaba.com claims 25 million registered users, its own prospectus warns that because it charges for only a small percentage of its services, the venture depends on a tiny core of 22,000 paying "Gold Suppliers" for 71 percent of its earnings.

As of mid-November, Alibaba's shares were down somewhat, to $4.20, but trading at about 250 times projected 2007 earnings of $83 million, or about five times the multiple for Google - tough to justify by any conventional analysis of the company's fundamentals. And yet the House That Jack Built is an impressive property.

In the world's most populous nation, where the number of Internet users already exceeds 160 million and is growing at a annual rate of 23 percent, Alibaba.com commands a 69 percent market share in B2B e-commerce, the Internet sector many analysts believe best matched to China's authoritarian political system and export-led economy.

More important, though, is that Alibaba is prospering from a business model dedicated to serving a vital but disadvantaged segment of China's economy: small and medium-sized private firms.

China's rudimentary IT infrastructure, Ma explains, makes e-commerce a smarter play than search, social networking or entertainment. "In the U.S., e-commerce is a niche market because most businesses have their own tech staff, run their own Web sites and know how to handle credit and payment," he says. "What you need is something like Google (Charts, Fortune 500) to organize everything and help consumers find what they want."

In China, by contrast, fewer than one million of the nation's 42 million small and medium-sized enterprises have any Internet capability. For Alibaba, which offers a full complement of simple and efficient Internet solutions for fledgling ventures, that's an enormous opportunity.

"We're almost like a real estate developer," says Ma. "We make sure the space is cleared, the pipes are laid, the utilities work. People can come in and put up their buildings on our site." But Ma's ambitions reach well beyond e-commerce. "If we do this right," he declares, "we have the chance to build a platform that could become the Internet ecosystem for all of China."

Parts of that ecosystem were on display in Hangzhou in September, when an estimated 10,000 of Alibaba's best suppliers gathered for Alifest, an annual two-day carnival of speeches, listing tips, sales awards and schmoozing opportunities. For He Mei, a 24-year-old sales manager, it was a chance to be lionized by Ma during an awards ceremony in Hangzhou's Great Hall of the People. He used Alibaba.com to help his employer, Guangdong Gemacki Appliance, win a contract to supply electric heaters to a large Spanish retailer after Gemacki was dumped by its top Chinese customer.

"I'd never heard of this Spanish company," he says. "When they told me how many shipping containers they wanted to buy, I couldn't believe it." Gemacki, which had no export business in 2004, now counts nearly 200 buyers in Europe and the Middle East and is venturing into new product lines like batteries.

"You can't imagine how quickly customers find us," he says of Alibaba. "We make sure to update the Web site every day."

Lucky Le, boss of scooter manufacturer Zhejiang Bifei in Yongkang, not far from Hangzhou, says that last year German buyers were hounding him for shipments of a dirt bike he had designed within hours of posting photos of a prototype on Alibaba. Le expects his 50-man factory, which now cranks out 4,000 of the bikes a month, to ring up sales of about $8 million this year, nearly double those of 2006. Without Alibaba, he says, "that would have been almost impossible."

It's fitting that Alibaba is headquartered in Hangzhou, the capital of Zhejiang province, where the engine of growth is private enterprise, not state-led investment or mammoth infrastructure projects - and most of the businesses are homegrown, not the product of foreign investment.

Alibaba's B2B site is the virtual incarnation of Yiwu, the free-wheeling boomtown two hours inland that is host to the world's largest wholesale mall, a sprawling maze encompassing more than 50,000 stalls. You'll find someone hawking just about anything there: socks, plastic flowers, drinking straws, sports equipment, bathroom fixtures and Christmas ornaments.

Ma styles Alibaba as the champion of small proprietors. "Alibaba wants to help small and medium companies grow," he says. "They are the future, the next wave of China's growth." Ma may be the world's least likely Internet billionaire. At 43, he is revered as the "grandfather of the Chinese Internet" - although he says he never heard of the World Wide Web until 1994.

A former Red Guard-turned-language-instructor, Ma polished his English guiding foreign tourists around the shores of Hangzhou's West Lake. He lectured at a teachers' college and, in 1995, established China Pages, an online directory that is generally recognized as China's first Internet-based company.

That venture, hobbled by a fractious partnership with one of China's state-owned companies, never got off the ground. Ma worked briefly for a government-controlled company, then launched Alibaba from his Hangzhou apartment in 1999.

Over the years, Ma has said that the catalyst for his interest in the Internet was a 1995 visit to the U.S. He had been dispatched to California by a government entity to settle a dispute between a Chinese firm and a U.S. partner. When Ma called on the partner at his Malibu mansion, or so the story goes, the man brandished a gun and locked Ma in his house for two days. Ma talked his way out of the situation by agreeing to become the man's partner in an Internet startup in China, even though he had no idea how the Internet worked.

Ma refuses to elaborate on the incident other than to describe it as a "terrible experience." But he talks readily about what happened after he fled California to Seattle, where an American friend showed him how to search the Web. "It was my first time to touch a computer keyboard," Ma recalls. "I used one finger to type in the word 'beer.' " The search yielded information about Japanese beer, American beer and German beer, but nothing on Chinese beer.

He tried a second search using the words "China" and "beer." Still nothing. In short order, Ma persuaded his friend to set up a home page for his Hangzhou translation service. "At 9:30 we launched the home page, and by 12:30 I had six e-mails. I said, 'Whoa! Interesting!' If I could help Chinese companies list on the Internet and help foreigners find their Web sites, that might be a good thing."

Using the Internet to connect Chinese suppliers to foreign buyers remains the essence of Alibaba's business model. The company's Web platform provides Chinese firms ready-made online "storefronts" to list their products and services in more than 5,000 categories. Buyers entering the words "China" and "beer" into Alibaba.com's search engine today will find more than 6,000 listings - not just for Tssingtao but also for beer mugs, beer coolers, brewery tanks, neon beer signs and Evermate International's Slot Machine Beer Dispenser.

Registration, listing and basic features of the site are free. Alibaba's profits come from the roughly 1 percent of users who pay for membership packages that offer priority placement for their storefront and products in site directories and search rankings.

Over the years, Alibaba has started an online shopping site (Taobao.com), an online payment service (Alipay.com), a platform for classified ads (Koubei.com), and, most recently, an online marketplace for publishers and advertisers (Alimama.com). It also runs Yahoo China, the nation's No. 3 search engine, as the result of a 2005 deal in which Yahoo! (Charts, Fortune 500) paid $1 billion in exchange for 39 percent of the group. Alibaba, Ma boasts, is now the equivalent of Google, eBay (Charts, Fortune 500), Amazon (Charts, Fortune 500) and Craigslist rolled into one.

If that sounds like hyperbole, consider this: so did Ma's boast that Taobao.com could take down eBay after the U.S. online auction giant muscled into China in 2003. eBay had deep pockets and formidable technological resources, and it added to those advantages by acquiring EachNet, then China's online auction leader. But Taobao countered with savvy site design that catered to local sensibilities, better customer support and a willingness to offer its services for free.

Today, according to Analysys International, a British research firm, Taobao has a market share of 83 percent, compared with 7 percent for eBay China. Last December, eBay sold a majority stake in its Chinese venture to Tom Online, a company controlled by Hong Kong billionaire Li Ka-shing.

The legend of Jack the Giant Killer required some revision in 2005, after Ma joined forces with Yahoo. Ma had begun to recognize that search had critical applications in e-commerce. But he knew he lacked the resources to build a competitive search engine from scratch. The deal with Yahoo - hatched during a 10-minute encounter with Yahoo founder Jerry Yang at a retreat in Pebble Beach, Calif. - solved problems for Yahoo as well.

Much like eBay, Yahoo had struggled to tailor its global model to China, where it battled not only its U.S. nemesis Google but also a sophisticated local upstart, Baidu.com. At the time, the deal, which gave Ma full control over Yahoo China, seemed tilted in Alibaba's favor. But in the wake of Alibaba's IPO, it looks like one of the shrewdest venture capital moves of all time: Analysts figure Yahoo's $1 billion investment may now be worth ten times that amount.

Handing Ma the reins at Yahoo China also wins Yang a bit of political cover in Washington, where, on the day of Alibaba's IPO, Yang was summoned to appear before the House Foreign Affairs Committee over Yahoo's role in the arrest and conviction of two Chinese pro-democracy advocates who had Yahoo e-mail accounts.

In April, families for the two men, each now serving 10-year prison sentences on subversion charges, filed suit in San Francisco alleging that, in supplying Chinese authorities with information leading to the arrests, Yahoo China had violated universal human rights.

After the hearing, at which Yahoo executives were denounced as a "moral pygmies," Yang settled the suit and issued a statement promising to make sure Yahoo's "actions match our values around the world." But Ma, not Yang, now runs Yahoo in China, and he says corporations have no choice but to comply with a lawful order from government authorities.

One thing the deal with Alibaba hasn't accomplished is an improvement in Yahoo China's market position. Since the merger, the company has slipped to No. 3 in search, from No. 2 when Alibaba took over, and continues to lose ground to local portals NetEase.com and Sina.com.

Ma vows Yahoo's China strategy will focus on search for high-end users interested in commerce, investing, and personal finance. But it's unclear how or when that strategy will be implemented, let alone whether it can succeed.

Just as uncertain are Alibaba's plans for making use of the capital raised in the IPO. Ma, who has asserted that the key to Alibaba's success was its ability to remain private, now argues that Alibaba needs outside capital to deploy its business model on a full scale. "This is a golden opportunity, one we probably won't see again for another 20 years," he says.

"Sure, we could just be like an easy guy and enjoy life. But by going public now, we have a chance to be a focus of attention - not just from China but from the rest of the world - to say, 'Hey, e-commerce in China can make money; it can help China get to the next stage.' When the time comes, you have to grab it."

Alibaba says it plans to use 60 percent of the IPO proceeds to fund acquisitions and 20 percent to build up existing businesses. Over the past year, Alibaba has added heft to its management team, hiring David Wei, who ran British home improvement retailer B&Q's China operations, as CEO of Alibaba.com, and Andrew Tsuei, Wal-Mart's former head of global procurement, as a nonexecutive director.

Wei says the group is eyeing overseas markets, including India, South Korea and Taiwan. In Japan, it launched a Japanese language service with advice from Softbank, which owns a 29 percent stake in the Alibaba group. Ma vows Alibaba will become China's first truly global corporation. But he insists that for the next five or 10 years, the main focus will be on China. "We will be global," he says. "But we must lay a solid foundation."

If nothing else, the influx of capital will make it easier for Alibaba to continue building its customer base by offering the bulk of its services at no charge. And that may prove a winning strategy. If Ma can refashion the rest of China in the image of Zhejiang, the nation's entrepreneurial heartland, Alibaba might live up to the promise of its sky-high valuation.