MELI - Alibaba Q2: If You Are Not Buying Now When Will You?

2023-08-15 09:00:00 ET

Summary

• Alibaba Group Holding Limited had a superb second quarter, surpassing expectations and showing re-accelerated sales growth and free cash flow generation.
• BABA stock is by far the cheapest in its peer group and trades at a free cash flow yield of 12%.
• The company's balance sheet is a fortress, with 31% of the market cap in cash and short-term investments larger than that of Amazon.
• Free cash flow is silently moving closer to a new all-time high, while the stock price is back at prices of 6 years ago.

Alibaba Group Holding Limited ( BABA ) has had a hard time ever since the failed IPO of the Ant Group in November 2020. Following the long-standing Covid-19 restrictions, the world's second largest economy, China, slowed down temporarily. However, Alibaba showed re-acceleration of sales growth in the second quarter, signaling a rebound in consumer spending. The stock price is yet to recover, while free cash flow is closing in on a new all-time high. As a result, extreme undervaluation is present in one of China's wide moat businesses.

Business Overview

Alibaba is a multinational conglomerate based in China and one of the world's largest e-commerce and technology companies. Founded in 1999 by Jack Ma, Alibaba has rapidly grown into a wide moat business with various segments, making it a prominent player in the global digital economy. Here's an overview of Alibaba's key businesses and operations :

1. China Commerce :

• Taobao : Taobao is a consumer-to-consumer (C2C) online marketplace, akin to eBay. It allows individual sellers and small businesses to set up online shops and sell a wide range of products directly to consumers. Taobao's user-friendly interface and extensive product variety have made it immensely popular in China.
• Tmall : Tmall is a business-to-consumer (B2C) platform that hosts official storefronts for well-known brands and retailers. It ensures product authenticity and quality, which has helped build consumer trust. Tmall's setup is more structured and regulated compared to Taobao, making it a preferred choice for established brands looking to tap into the Chinese market.
• ??1688 : 1688's platform serves the Chinese domestic market and is focused on wholesale transactions.

2. International Commerce:

• Alibaba.com serves as a global platform connecting businesses from around the world. Alibaba.com facilitates business-to-business (B2B) trade by connecting manufacturers, wholesalers, and suppliers with buyers internationally. The platform streamlines international trade by providing tools for communication, negotiation, and secure transactions.
• AliExpress : AliExpress is one of Alibaba's primary platforms for international commerce. AliExpress connects Chinese sellers with buyers from around the world, offering a wide range of products at competitive prices. Similar to Taobao, AliExpress primarily serves individual consumers and small businesses
• Lazada : Lazada is another e-commerce business with the largest part of customers in Southeast Asia.

3. Local Consumer Services:

• Ele.me : Ele.me is Alibaba's online delivery platform, connecting users with food and beverages, groceries, flowers and pharmaceutical products. Ele.me focuses on efficient last-mile delivery to ensure that orders reach customers quickly and fresh.
• AMAP : AMAP provides a range of location-based services, including digital maps, navigation, real-time traffic information, location-based search, and location-based advertising. AMAP's data and services can be integrated into other Alibaba services such as e-commerce platforms, ride-hailing apps,...

4. Logistics and Supply Chain :

• Cainiao Network : Alibaba's logistics affiliate focuses on improving supply chain efficiency and providing advanced logistics solutions to support the company's e-commerce operations.

5. Cloud Computing :

• Alibaba Cloud : Alibaba's cloud computing arm offers a comprehensive suite of cloud services, including computing power, storage, databases, analytics, and AI capabilities. It's a major player in the global cloud services market, competing with companies like Amazon Web Services ((AWS)) and Microsoft Azure.

6. Digital Media and Entertainment :

• Alibaba Pictures : This segment focuses on film production, distribution, and entertainment-related investments.
• Youku Tudou : A prominent online video platform in China, often referred to as the "YouTube of China." Alibaba acquired Youku Tudou to expand its digital media offerings.

7. Digital Finance and Payments :

• Alipay : Initially launched as an online payment platform for Alibaba's e-commerce sites, Alipay has evolved into a comprehensive digital financial services platform. It offers services like mobile payments, money transfers, investment options, and credit services.
• Ant Group : Ant Group, which is for 33% owned by Alibaba, operates Alipay and provides a wide range of financial services, including wealth management, insurance, and lending.

The first 6 business segments are soon to be split into 6 companies and will IPO separately, where each company will be run by its own CEO and board of directors. The size of Alibaba has increase a lot of over the last years and to let each segment run on full performance more agility is needed in the business.

Superb Second Quarter

Analysts were skeptical about the results of Alibaba and got blown away by a large double beat. The company increased revenue by 14% year-over-year to $32.29 billion, which beat estimates by $1.08 billion. Earnings per share came in at $2.40 (up 48% year-over-over), compared to the estimates of $2.01.

Alibaba saw re-accelerating growth in all of their segments. The Chinese market recovered from a 3% year-over-year decline to a 12% increase year-over-year. Noteworthy, international commerce grew 41% compared to 29% in the previous quarter. The cloud business also changed growth direction from a 2% decline in sales to 4% sales growth in Q2.

The cloud business growth slowed down a lot, but the CEO Daniel Zhang mentioned this in the latest earnings call :

I think if you look at the cloud landscape in China, I think the total cloud infra as a percentage of the IT infra still in a lower -- actually, in a relatively low percentage as compared to the U.S. peers. So we still -- we see still the huge potential first in this cloud infra penetration.

Secondly, I think with this AI revolution, I think that this brings incremental opportunities, and because today, all the companies want to use our AI capabilities to upgrade their services and in their own application. So -- but they need a high computing -- high-performance computing power to support this operation, not only in today's training, but also in the influence services to be provided. So I think these two are, we believe, the primary growth engine for the long term.

Although I am not a big fan of EBITDA or EBITA (also called earnings before everything), this is the only way to compare the profitability of the different segments provided by Alibaba. Alibaba's profitability is improving across the board with the Logistics and Digital Media business as two new contributors to positive EBITA. Furthermore, the Cloud business grew EBITA 106% year-over-year and the International Commerce is finally closer to becoming a profitable business.

The most outstanding news in the earnings report was the comeback of free cash flow growth. Partly boosted by lower CAPEX, the free cash flow increased 76% year-over-year, nearing the all-time high of free cash flow in 2021. The company remained focused on returning value to shareholders through $3 billion in share buybacks.

Valuation

I have chosen three other prominent players in the e-commerce business worldwide, that are similar to Alibaba, to compare various valuation metrics. The first metric covers the price-to-sales ratio. JD.com ( JD ) is easily beating their peers, followed by Alibaba at 1.9x price-to-sales.

Further, when we move on to my favorite metric the free cash flow yield, we can see who has the strongest profitability and efficiencies. Alibaba is above and beyond the others with a free cash flow yield of 12%. The next peer is MercadoLibre ( MELI ), whose free cash flow yield is standing at a solid 6%. The worst performer by far is Amazon ( AMZN ), with a free cash flow yield of 0.2%.

When I was writing my article around Meta Platforms ( META ) in November 2022, the free cash flow yield was at 8.5%. This was really exceptional for a business of that caliber. Since my article, Meta is up 170%, so who knows what will happen to Alibaba.

In addition, Alibaba is even more undervalued compared to the peers based on EV-to-free cash flow. EV stands for enterprise value and this takes into account the market cap combined with total debt minus cash and cash equivalents.

Despite, JD's large number of sales compared to their market cap, it is underperforming in profitability by quite a margin. Alibaba is once again the leader with profit margins of 9%, followed by 6% for MercadoLibre.

Balance Sheet

Although Amazon has 5.8x times the market cap of Alibaba, Alibaba's cash and short term investments top those of the e-commerce king Amazon. Alibaba's cash and short-term investments were $75 billion in the latest earnings report and accounted for 31% of the current market cap. This liquidity can further enhance investments in business opportunities.

Alibaba's current ratio is almost reaching 2x and the total liabilities ($86 billion) are even lower than the current assets ($100 billion), showcasing the fortress balance sheet the company has amassed.

The balance sheet makes it possible to buy back shares of their own company at the discounted value it is trading at. During the fiscal year 2023, Alibaba repurchased almost $11 billion or 4.5% of shares outstanding. After the second quarter, the company has $16.3 billion remaining under the current share buyback program, or 6.6% of shares outstanding.

Risks

However, investors need to keep in mind that Alibaba has been identified by the SEC under the Holding Foreign Companies Accountable Act . This means the company will be delisted by 2024, if they do not show the right auditing under the rules of the United States.

In the annual report of Alibaba, you can find the following positive statement:

Following that, on December 15, 2022, the PCAOB announced that it was able to secure complete access to inspect and investigate PCAOB-registered public accounting firms headquartered in Chinese mainland and Hong Kong in 2022. The PCAOB vacated its previous 2021 determinations that the PCAOB was unable to inspect or investigate completely registered public accounting firms headquartered in Chinese mainland and Hong Kong. For this reason, we do not expect to be identified as a Commission Identified Issuer following the filing of this annual report.

The dual listing in Hong Kong lowers the risk of losing money must a delisting ever were to happen. Your shares could be converted into Hong Kong listed shares or you can re-buy your shares at the Hong Kong exchange yourself for a similar price, because the dual listing trades around the same price on the New York and Hong Kong exchange.

Takeaway

Few understand that the COVID-19 era has only recently ended in China, but more and more signs come in that China is ready to bounce back. The drop in Alibaba's share price was not completely risk driven and also partly justified in the drop of profitability and free cash flow after the incredible years of 2020 and 2021. The free cash flow generation is back on trend and is likely to go higher. Investors are known to exaggerate risks in a downtrend and Alibaba is no exception at all. Once the price recovers, supported by business performance and share buybacks, the risks we heard so loudly in 2021 and 2022 will play on the background.

I rate Alibaba Group Holding Limited stock a "Strong Buy" around $100 a share. The company is fundamentally exceptional and undervalued compared to the closest peers. The management is shareholder friendly with strong support of share repurchases. Furthermore, Alibaba's restructuring is likely to lead to more focus, efficiencies and profitability in all the different segments. China is easing up regulatory moves on businesses, has cut interest rates and is expected to boost the economy with another stimulus. Positive momentum is building up, which seems to me like a great opportunity to start a position in one of China's best businesses out there.

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