Alibaba: Valuations Too Conservative – A Transparently Bullish Analysis (NYSE:BABA)

Introduction:

Tom Hayes, of Great Hill Capital and hedgefundtips.com, has been bullish on Alibaba (NYSE:BABA) for months now. Despite being an avid listener to his podcast, I didn’t take a close look at the stock. I recently did and am glad I did so.

If Alibaba’s margins and earnings were to normalize and historical multiples paid for those earnings to return by 2026, Alibaba stock would be worth at least $500, an immense difference from the ~$100 it’s trading at now. I argue this is not nearly as unlikely or foolish a suggestion as some may suggest; it is simply getting back to normal.

Such a disconnection between value and price is usually only seen amongst low-quality stocks, small-cap stocks or in the aftermath of a financial crisis. For this to occur in a business as large and quality as Alibaba is almost unbelievable.

This is why an investment in Alibaba is not comparable to undervalued FAANG names, or any other quality large-cap out there: the risk-reward is exceptional, some might say once in a generation.

If you could buy Amazon in the early 2010s, would you? I would.

The Red Scare: Risks, Catalysts and Counter-Points

When considering investing in companies outside western liberal democracies, we must consider country risk. With China, there is (or was) plenty to be concerned about.

Most of the worry has to do with the non-democratic government in Beijing. For the last few years they’ve led a tech crackdown that forced Alibaba founder Jack Ma underground and postponed the IPO of Ma’s Ant Financial, implemented questionable Covid policies that not only didn’t stop the spread of Covid but put the entire economy on pause, consistently provoke western governments by not hiding their ambitions regarding Taiwan and flying spy balloons over North America, and have potentially lax auditing standards (particularly of state-owned enterprises) that have caused all Chinese stocks listed in the USA to be considered for delisting.

Though the overhang from these events and actions lingers, Beijing has been acting quite differently as of late. Jack Ma has been allowed to re-emerge, Ant Financial had to pay a fine and restructure its business but the IPO looks to be back on track, Zero Covid policies were suddenly reversed meaning the economy is back open, the response to and lack of success in Ukraine for the Russians will strongly dissuade China’s territorial ambitions, quality Chinese businesses like Alibaba and Tencent passed US audits so won’t be delisted, and the value of the US dollar is trending down, making the yuan more valuable in relation. The headwinds have stopped gusting.

It’s worth reminding ourselves that just because China is not a democracy doesn’t mean the people in power can’t be replaced or can’t be held accountable. Beijing seems to have realized that and is responding accordingly. Tailwinds stir.

The government bought shares in Alibaba and Tencent and have initiated consumption-led economic stimulus. The government is no longer on the opposing team; they seem to have joined the home squad. Policymakers have repeatedly stated their intention to boost the consumer’s spending power since December, targeting 5% GDP growth in 2023. Alibaba, whose focus is the consumer, can only benefit from these developments.

The situation is like the West in 2020-2021. Rates are being cut and stimulus is being dished out. A Federal Reserve report estimated that during the peak of Covid restrictions in the US, households accumulated $2.3T in savings. US GDP is around $23.3T, meaning savings were around 10% of GDP. The results were seen in the massive market and economic rebound of 2020-2021 as excess savings were spent.

Currently, Chinese household savings are nearly $2.6T while GDP is $18T. 15% of GDP is sitting in people’s bank accounts; that’s 50% more than peak savings in the states. The nation’s savings rate has fully doubled since Covid began; pent-up demand is immense. With people finally being let outside their homes and with wallets (Alipay accounts) full of money, 2023 could be a monster year for China’s economy (and Alibaba).

A strong counter to this “revenge spend” thesis is that Chinese consumers have faced a grim last few years and may be unwilling to spend their savings. Indeed, much of the excess savings has come from people removing money from underperforming investments (like property and mutual funds) and putting it in bank accounts. Perhaps this is why Premier Xi Jingping said in December that China should take steps so that consumers, “dare to spend without worrying about the future.” Fortunately, this is in their power to change.

In my view, with consumption at all time lows and savings at all time highs, probabilities are high that spending will increase. The rally may not be what was seen in the US, but it won’t be immaterial either. We also have a government dead-set on growing the economy through consumer spending and a company through which 60% of all Chinese e-commerce is done. BABA investors don’t need to have all $2.6T of those savings spent to see a rally, even just a fraction will do.

To be sure, investing in China is riskier than investing closer to home but given recent events it is not nearly as risky as some make it out to be. Indeed, short-term, with the government pivoting on controversial policy decisions and stimulating the consumer instead of locking and cracking down means China’s economy, and thereby BABA, are set up unbelievably well for the next couple years.

Longer-term, assuming Beijing continues to be friendly to markets and consumers, the domestic case for Alibaba is strong as it benefits from significant trends in Chinese society and economy. A report from McKinsey highlights 5 trends in China:

As the dominant, Chinese, online marketplace and infrastructure operator in the private sector catering to consumers, all these trends will benefit Alibaba. We discuss them in relation to the business itself next.

Alibaba – An Ocean for a Moat

Domestically, Alibaba’s moat is immense. Nearly every single of-age Chinese person is an annual active consumer on an Alibaba product, 60% of all money spent online in China is done on an Alibaba platform, the burgeoning cloud infrastructure market is 37% captured by Alibaba, and 54% of all payments in China are done on Alipay, which BABA owns a third of through its stake in Ant Financial.

Competitors like JD.com in e-commerce, Huawei in cloud and Tencent’s WeChatPay are all playing catch up. Notably, none of them compete in all three, while BABA is the dominant player in all three. Alibaba is a tier above when it comes to Chinese tech names.

This relates to McKinsey’s Trend 3, “Rising Competitive Intensity,” a title which seems to suggest that Alibaba’s dominance could be topping out, even trending down. Indeed, I’ve read many articles suggesting this could be the case. Charlie Munger even recently pointed it out in a CNBC interview, that internet retailing is competitive in China. Looking closer however, McKinsey suggests that “technology and agility drive winners to capture the lion’s share of industry value.” In other words, the big players are going to push the smaller players out and take their slice of the pie.

This is already happening, as 89 smaller e-commerce players closed during Covid in China. Contrary to what many suggest, competition will lead to consolidation. BABA, the biggest, strongest gorilla around, will benefit, or at least not lose as much as some apocalyptic analyses suggest.

Digitization (Trend 1) clearly benefits Alibaba as well. Most of its properties are digital. For example, Alibaba owns and operates Taobao, essentially e-Bay but with many more features, Tmall, a site that is a blend of Amazon.com, the shopping channel, and TikTok, Taobao Deals, a discount online retailer, 1688.com, a wholesale e-commerce platform, Taocaicai, a discount delivery/pick-up shopping service in more rural areas, Freshhippo, a high-tech health-conscious grocery chain which also opened a Costco-style wholesaler known as Store-X, and Alibaba Health, an online store and service for medical products and needs that BABA owns a majority stake in. Notably, all these businesses are profitable. The last two, Freshhippo and Alibaba Health, even tap into Trend 4, the health-conscious consumer. Alibaba’s domestic operations are well-positioned for the future.

In Alibaba’s financials this group of businesses is collectively “China Commerce,” the revenue of which make up the majority of Alibaba’s sales and most of its operating income. Concerningly, the China Commerce segment’s revenue dipped by 1% year over year, but this is largely due to zero Covid policies in 2021 effectively shutting the economy down. Personally, considering many businesses closed during what was a long and trying year, I think it is quite impressive that revenue hasn’t dipped more. This year’s numbers are more a reflection of the government’s Covid policies than any inherent flaw in the business; one might say this year demonstrated the resiliency of BABA’s core businesses.

A more astute criticism is that Alibaba can’t really gain more users in China, as almost everyone already is one. Instead of getting more users, they must encourage those users to use their platforms more, which is a much harder task. The days of 40% top-line growth may be past.

But that shouldn’t lead us to believe that secular growth isn’t happening. For example, Alibaba Health has multiplied revenues 10x since 2018, while Freshhippo, in an internal memo from its CEO leaked to the press, made clear the goal was to have $150B of sales in 2033. For reference, that’s more revenue than Alibaba had in the last twelve months; sales could double in the next ten years from this little-known branch of the company alone. Initiatives like these don’t get much publicity, and perhaps should. Alibaba’s domestic growth story is a lot more than just “revenge spending.”

The most publicized growth opportunity for Alibaba is its cloud computing services. In addition to cloud computing simply being convenient and value-additive, AliCloud benefits strongly from trends in the Chinese economy, namely the growing role of the private sector (Trend 5), digitization (Trend 1), deglobalization (Trend 2), and competition leading to consolidation (Trend 3). Like AWS for Amazon, AliCloud for Alibaba will be a major domestic growth pillar moving forward.

Two separate studies on the growth of the public cloud in China suggests the presently $30B industry will become close to $90B by the end of 2025. That’s a tripling in as many years. Alibaba currently controls 37% of the Chinese cloud market, and 12% of the company’s revenues are derived from it. AliCloud currently breaks even, but with scale is expected to generate significant profits, like Amazon’s AWS. Cloud is a promising domestic growth business that will grow top and bottom line.

Tom Hayes notes that if Alibaba’s cloud offerings maintain market share (as trends suggest), the market grows as forecast, and margins scale like those of AWS, Alibaba’s cloud offerings could be adding $10B in operating income by 2025, increasing Alibaba’s total operating income by 66% from the present (or 15-20% annually), without any help from an economic recovery or organic growth in other parts of the business. Cloud growth is a great reason to own BABA stock.

Another area of organic growth for BABA stock that may be overlooked, because it is essentially a footnote in the financial reports, is Alibaba’s one-third ownership of the embattled Ant Financial. Ant Financial owns AliPay, the world’s largest digital payments platform with more payment volume than Visa, 730 million monthly active users and 54% of the Chinese payments market. In addition to offering numerous other financial services, like insurance and auto loans, Ant also operates the world’s second largest money-market fund, Yu’e Bao. Through its one-third stake in Ant, Alibaba dominates Chinese payments and finance.

When Ant first looked to IPO it was valued at over $300B, but this was scuttled by the CCP. Since then, Ant was forced to spin-off part of its business and become a holding company for a variety of companies to wall off AliPay from its other services, as Ant could leverage its significant amount data on consumers’ spending which, according to the government, doesn’t follow Chinese laws. They have also had to pay a fine over $1B, which investors actually cheered, as it means the crackdown is coming to an end.

The result likely means a lower valuation and lower profitability, but still a huge, dominant business. The last year of reliable data for Ant was 2019, where it recorded revenue of $18B and profits of $2.7B. We can infer its profits for more recent years from Alibaba’s earnings reports where it reports its share of income from Ant:

As we can see, Ant’s profit has declined substantially, by about 40% since this time last year. Covid zero policies likely did not help, along with the fine and restructuring. But still, if we multiply Alibaba’s share of Ant’s earnings by three to get an estimate of total earnings, Ant seems to have earned around $2.3B in the last six months, an impressive feat considering the circumstances. If this were to continue for the next six months, Alibaba would reap $1.7B from its stake in Ant Financial, which is more net income than Alibaba’s wholly owned companies reported in the last twelve months. The one-third stake in Ant Financial could meaningfully add to earnings, growth and valuation of BABA going forward, especially if conditions normalize.

Alibaba has other parts of its business that are growing top line but remain unprofitable. I brush over them as they aren’t part of the thesis, but they perhaps shouldn’t be overlooked. For example, International e-Commerce properties are growing quickly and positioned well in their respective markets while Cainiao, Alibaba’s fulfilment network, is following suit, albeit slightly unprofitably and not without hiccups. There are other snazzy sounding projects (like a superpowered map app), but they aren’t part of my thesis for BABA. If they work out, great, if they don’t, I won’t be upset.

In the short term, the main non-macro reason to own BABA is its dominance in China’s e-commerce market allowing it to consolidate market share and revert to more typical operating performance. In the medium term, underrated non-macro reasons to own BABA are the profitable growth potential in AliCloud, Ant Financial, health, and grocery, in addition to continued incremental growth of domestic e-commerce properties, all of which are underpinned by powerful societal trends, including demographics. Whether I’m a long-term holder or not will depend on how promising (and profitable) BABA’s international ambitions end up being. Excluding macro events and valuation, I view Alibaba as a very high-quality company, the Microsoft, or Apple of China.

To sum, in the long-term my views are dependent on new projects working out; in the medium-term I am confident the domestic growth is not over; and in the short-term I am tremendously excited about BABA’s rebound potential, especially at current prices.

Business Valuation

Having established that Alibaba is a company of quality that investors should desire to own a part of in a country that is providing significant catalysts to its operations, we need to determine if the current price is an attractive entry point. The quality of a stock doesn’t matter much if the price paid is lofty.

We don’t have to overthink the valuation on BABA. Make an educated guess on what normalized earnings could be at a time in the future, apply a reasonable multiple to those earnings and discount count that value appropriately. For me, historic averages are a great place to start. Below I value a BABA share according to a variety of profitability metrics.

I assume sales increase 10% annually (in line with analyst estimates, which may be way too low), apply BABA’s average historic margin and multiple for each metric, then divide the result by the number of shares in 2026 to arrive at the price of a BABA share in 2026. I discount that value to the present by 20% annually because I usually require a 15% minimum return on equities to justify the risk, but for a Chinese equity I want more minimum return as there is country risk in addition to equity risk. Here are the results:

As we can plainly see, if BABA can get anywhere near to its historic averages, we have a multi-bagger on our hands. Even with an aggressive discount rate and a large margin of safety, BABA could be substantially undervalued.

Some readers may think I’m out to lunch, but I don’t consider it absurd to take normalized multiples on normalized earnings as a baseline estimate for valuation. Unless we think Alibaba is a dying business, the Chinese economy is gone for good, and investors will forever consider China “un-investable,” the above valuation is within the realm of possibility. Alibaba’s profitability, China’s economy and China investors are going to come back, the question is just to what extent.

To see what the current price suggests about investors’ expectations as to the extent of the rebound, I present the following “what if?” analyses. They show the fair value of BABA in a variety of different margin and multiple situations to see what expectations are being priced in at different levels.

The green cell is the fair value if BABA were to revert to historical means for EBIT and EBIT margin (assuming 10% annual sales growth to 2026 and a 20% discount rate). Notably, in all scenarios where the fair value is below the current price of ~$100 (the red cells), BABA would have to trade below all time low EBIT multiples and/or have all-time low EBIT margins three years from now. Considering that the sky has essentially already fallen on Alibaba in the last few years, I don’t see these scenarios as probable. Downside risk is as low as we can hope for in a stock.

The yellow are scenarios currently being priced in. As we can see, the market seems to be expecting BABA’s EBIT margin to revert to around 15% and it’s multiple on that EBIT to increase to 20. This is almost half of historic averages. Investors are clearly extremely bearish on the stock.

For a different perspective we can look at free cash flow.

This sensitivity analysis tells a similar story to the prior. To get less than a 20% return (the red cells), BABA would have to trade at FCF multiples and/or have FCF margins below current all-time low levels. I view this as unlikely. The market seems to be pricing in ~20% FCF margins and multiple of 15x on that FCF generated (the yellow cells). Both these expectations are extremely undemanding, as historically this is far below the mean.

In sum, the current price of BABA builds in 10% sales growth with 2026 margins and multiples to be almost half what they’ve been historically. Considering the positive macro environment in China (especially in relation to the West), Alibaba’s substantial business moat, and its profitable growth opportunities (most notably the cloud), I find it difficult to imagine a situation where the present price is even remotely justified.

While it is prudent to be conservative when valuing a company, when we find one of this quality so compellingly valued, we shouldn’t let our caution, however astute, cause us to miss the big picture. There is immense opportunity in BABA stock, and I don’t plan to miss the ship as it sails.

I’m an enthusiastic buyer at current prices of around $100 a share and would even be comfortable up to $200. I’d begin selling when the price has reached $500-$600 a share.

Conclusion:

At present, I admit these conclusions may look ridiculous. Hindsight could say differently, however. Markets can be remarkably inefficient, and investors can take advantage. I try to keep in mind that attitudes change, and events pass; the world rarely ends. Those who can be greedy when others are fearful will more than likely be making money on Alibaba.

Tom Hayes has a great way of putting BABA into perspective. In 2014, Alibaba IPO’d at $92.70 a share. We can buy it at near IPO prices except with 15x the revenue, 5x the EBITDA, 4.5x the free cash flow, and 3.5x the operating income.

BABA is gold priced like pyrite.