Alibaba (BABA, Financial) shares are down over 50% from their October 2020 peak of $319 per share. In contrast to the pessimism from investors, the company grew its revenue by 34% over the last year and is now trading at what is one of its lowest valuations ever: 18 times projected earnings for the next 12 months and 15 times projected earnings for fiscal 2023. For reference, an average stock in the S&P index is currently trading at over 20 times forward earnings while growing at a much slower rate relative to Alibaba.
The company is a value play hiding in plain sight, which is why guru Charlie Munger (Trades, Portfolio), a longtime China bull, increased his position in the company by over 82% since July 2021, or about 20% of the Daily Journal’s (DJCO, Financial) portfolio. With a 5.5% free cash flow yield and 22% annual growth, Alibaba is priced to return 20% to 25% a year or more to long-term owners. This represents incredible – and rare – value at a time when even high yield bonds have negative yields after adjusting for inflation.
This situation is best encapsulated by guru George Soros (Trades, Portfolio)’ famous quote “Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected." What’s obvious today is that while the Chinese government has spent the last year yanking the tech sector’s chain, leading to an investor exodus, it will likely do little to impair Alibaba’s long-term value. In fact, despite widespread panic, nothing has actually been done to impair the long-term prospects of the Chinese tech sector, since the government's interests are tied to the sector's prosperity.
Alibaba is the leading player in Chinese e-commerce, payments, fintech and cloud (AliCloud). Alibaba also has several other businesses that are strategically but not financially significant yet. These other businesses lose the company around $4 billion to $5 billion a year, but over time, these losses should be minimized and help the company grow.
Alibaba has over 1.18 billion annual active users, with over 912 million from China alone, and had a net increase of 45 million users quarter over quarter as per the investor presentation for the second quarter of 2021. Despite the competition from other Chinese e-commerce giants such as JD.com (JD, Financial) and Pinduoduo (PDD, Financial), Alibaba continues to enjoy over 50% market share in China. That said, Alibaba’s stock trades at just 18 times forward earnings, vs. JD.com’s forward price-earnings ratio of over 40, showing just how much recent regulatory trouble has depressed the stock.
Outside of China, the company also operates e-commerce brands in Southeast Asia (Lazada), Europe (AliExpress is the most visited e-commerce site in Russia), Turkey (Trendyol), South Asia (Daraz) and North America.
Core commerce consists largely of two marketplace businesses, TMall and Taobao. These businesses are why Alibaba is often described as the Chinese version of Amazon (AMZN, Financial). Core commerce revenues grew 34% in fiscal year 2020 and 35% in 2021. In comparison, Amazon marketplace, a more mature business in a more mature economy, is still growing at 15% to 20% year-over-year.
There are several notable differences between Amazon and Alibaba, however. Amazon’s e-commerce business model consists of a combination of direct sales, as well as providing a platform for other retailers to sell products to consumers. Amazon also offers subscription-based service Amazon Prime and makes money selling it’s Kindle e-reader line of products. Unlike Amazon, Alibaba is asset light, choosing to outsource logistics, acting more as the middleman between buyers and sellers online. On Taobao, sellers pay to rank higher on the site’s internal search engine, and the company makes most of its revenues from advertising. In this respect, Alibaba’s platform resembles eBay's, while its business model is closer to that of Alphabet's (GOOG, Financial)(GOOGL, Financial) Google than Amazon. Because of these differences, Alibaba can earn 30% operating margins vs. 4% for Amazon.
Alibaba’s other main business line is Alibaba Cloud, which is growing 50% to 60% annually and is already the third largest IaaS player behind Amazon’s AWS and Microsoft’s (MSFT, Financial) Azure. Alibaba Cloud turned profitable for the first time ever in the December 2020 quarter, over 11 years after being founded. This division continues to report increasing profitability ($53 million as per the quarter ended June 2021) because of improving economies of scale. With improving scale, Alibaba Cloud can operate at 30% operating margins, the same as Amazon’s Web Services. The business on its own does not even represent 10% of Alibaba’s revenue today but is already worth over half of the company’s current market cap in present value terms.
China’s economy is poised for structurally higher growth moving forward, following the announcement of their new five-year plan. Given this, it’s highly likely that Alibaba’s core commerce can grow at least 20% for a decently long time. Despite being battered by China’s regulatory crackdown, Alibaba’s commerce arm generated a record $84.5 billion in sales on Singles Day this year (Nov. 11, 2021), surpassing last year's totals during which the company doubled its record from the year before. Singles Day is the largest shopping day in China.
One of the highlights from this new five-year plan was a focus on developing capabilities in hard technologies, such as semiconductors. On that note, Alibaba recently unveiled a new chip of its own, one of the most advanced to come out of the country and one that could dramatically alter the narrative around the company in Beijing. Alibaba will not sell the chips it produces, but instead use them to run the servers for Alibaba Cloud. With the global chip shortage showing no signs of resolving anytime soon, Alibaba’s own chip could give it a major strategic advantage in both the short and long term.
The regulatory situation
Big businesses operating in China always have to play a delicate balancing act. But as corporate influence grows amid a slowing Chinese economy, Beijing is exerting its power to remind companies exactly who really wields control.
The early manifestations of this power play began in earnest last year when Chinese regulators stopped the IPO of Ant Group, of which Alibaba owns 33%. This was originally believed to have been retribution for comments from Alibaba CEO Jack Ma stating that regulators were stifling innovation. However, as the crackdown grew, it is now clear that this was about far more than Jack Ma's comments. It was more about keeping big tech companies from gaining more power unchecked.
Ant Group originated loans to half a billion people, most of them unsecured, and accounts for 20% of the country’s consumer debt. Despite its position as one of the country’s biggest originators, the company had no capital requirements, unlike a regular bank. Essentially, Ant Group was offloading risk from itself onto the growth of the Chinese economy. Given the systemic risks involved to the country’s financial system, a case could be made that stopping the Ant Group IPO was appropriate. Charlie Munger (Trades, Portfolio) also believed that regulators did the right thing in stopping the IPO. Beijing recently turned to the Alipay platform, with a plan to bring in the government as an investor, turn over its proprietary consumer data and force it to open to Tencent’s WeChat Pay (and vice versa).
In response to these measures, Alibaba recently announced a “social equity” fund to tackle societal challenges, committing $15.5 billion over the next five years. Many believe this initiative has the implicit backing of the Chinese government and is expected to reduce the regulatory pressure on the company.
Value investing guru Li Lu (Trades, Portfolio) says it best when it comes to understading China long-term. He has written extensively about China and his framework is worth quoting. Li believes that “China is at interim stage between Civilization 2.0 and Civilization 3.0,” or at 2.5. He said, “If you have a good understanding of China’s culture, people and history, you will agree that China will forge forward,” and that “There is almost no chance of China leaving the common market, and the probability of China changing its market rules is also very small.”
In Li's October 2015 lecture at Peking University’s School of Management, he said:
“Given this new landscape, the scale of development, institutionalization and maturity of the financial market will be greatly improved in the near future. Many with short-term vision may complain that the government has been too heavy-handed in market intervention, or that it should not bail the market out, in addition to other criticisms. However, with longer-term vision, we find the Chinese capital market is continuing to move towards a more market-oriented, institutionalized, and mature system. It will play a more important role in China’s economic development.”
In sum, I believe fears about the Chinese economy and tech sector are overdone and a massive opportunity has opened up as a result. China’s five-year plans in the past have achieved monumental feats, such as lifting 800 million people out of poverty, and it is obvious that China is attempting something similar with its new plan.
Valuation and opportunity
In the upside case, Alibaba will likely grow revenues 20% a year or more over the next five years. Due to its operating leverage as well as asset lite business model, this growth would translate roughly to $45 billion to $50 billion in levered free cash flow.
Levered free cash flow of $45 billion at an owner's earnings multiple of 25 equates to over a $1.1 trillion market cap. When discounted from 2025 to today and factoring in net cash and the stake in Ant Group, that gets us to over $320 per share, which equates to 100% gross upside to the current price level.
While the outlook may look bleak for Chinese tech stocks right now, Alibaba’s business fundamentals potentially make it a oppportunity for investors who are willing to overlook the challenges the company faces in the short term. By 2025, if Alibaba finds itself back in the government’s good graces, investors could find themselves owning a piece of a $1 trillion company.
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