2023-12-11 00:00:00 ET
Summary
- Alibaba's stock price has significantly declined, making it an attractive investment opportunity.
- The company's fundamentals remain strong, with solid revenue growth and positive free cash flow.
- The Chinese stock market has already discounted the worst-case scenarios, making Alibaba undervalued and potentially poised for a rebound.
Would you ever buy a company with these characteristics?
- 5-year free cash flow growth of 11%; free cash flow margin of 19.60%.
- 5-year revenue growth of about 20%.
- Net debt of -$51.48 billion and market capitalization of only $184 billion.
- NTM Market Cap / Free Cash Flow of 7.26x; NTM Price / Normalized Earnings (P/E) of 7.61x.
Probably, if this company was headquartered in New York now you would all run to buy it. Unfortunately, it is located on the other side of the world, in Hangzhou, China. It is exactly this aspect that I want to leverage in this article since the issues of this company are not about the business itself but about the country in which it resides. As you might have guessed, I am talking about the much-discussed Alibaba ( BABA ).
Context
Before assessing the current situation, I think it is useful to give a brief recap of what has happened so far since November 2020, which is when Alibaba's meltdown began. In these three years, virtually everything has happened.
At the end of October 2020, there was great optimism around Alibaba and it was steadily trading around $280-$300 per share. At the time, it was pretty much done for the IPO of Ant Group, which is the company that owns the world's largest mobile payment platform, Alipay. Alibaba owns 33% of the group, so it had every interest in making the biggest IPO of all time go through. However, when everything seemed to be going right, some statements by Jack Ma about the Chinese financial system caught the attention of the Chinese authorities and after a few days, the IPO was cancelled. According to the authorities' statements, the reason was that Ant Group's structure did not reflect the anti-monopoly rules. After years of turbulence, the worst seems to be behind us, but not without consequences:
- Ant Group was fined $985 million , one of the highest fines ever imposed by Chinese regulators.
- The ownership structure has been completely turned upside down: Jack Ma owned 53.46% of the voting shares, today only 6.20%. Thus, no shareholder, alone or in agreement with other parties, will have control.
Overall, after these three years, Ant Group comes out weakened, and indirectly so does Alibaba. Be that as it may, this was only the first hiccup.
Following the suspension of the IPO, Chinese regulators fined the country's major big tech companies for antitrust violations: in 2021 Alibaba was fined $2.80 billion . In addition, a few months later, the company said it would participate in common prosperity initiatives by investing $15.50 billion through 2025. The goal was to benefit from the economic growth of the entire country:
Alibaba is a beneficiary of the strong social and economic progress in China over the past 22 years. We firmly believe that if society is doing well and the economy is doing well, then Alibaba will do well.
Former Alibaba CEO Daniel Zhang
Needless to say, the market saw these investments as yet another fine to pay, and from that point on, the stock began to sink. Although by 2022 the fines were over, the S&P 500 ( SP500 ) in a downward trend was yet another excuse to fuel Alibaba's collapse. From $319 per share in October 2020 today the stock is trading at about $72 per share: an absolute disaster.
Coming to this point, after all this news, you may be wondering why Alibaba is a strong buy. The reason is that the current price per share is so low that in my opinion, it has already discounted the most negative scenario ever. Over the past three years, everything was a pretext to sell Alibaba and we have reached a point where it is really hard to make things worse. Making an analogy with the U.S. economy, this is Alibaba's 2008 and it is much easier to restart from here than to sink further.
At the moment the major problems with Chinese regulators are behind us, but I don't doubt that there may be new complications in the future, and that is what worries the market. While I understand investors' concern, I also believe that one should not be overly pessimistic either. I doubt that it is in China's interest to destroy one of their best companies ever. Tencent ( TCEHY ) and PDD Holdings ( PDD ) have also been fined, but they have already made up some of the lost ground.
My impression is that sentiment is still extremely negative for Alibaba compared to the other Chinese big tech companies, which is why it will have to prove something more to attract investors. Still, it really took very little to go from being one of the best companies in the world to being one of the most avoided: Mr. Market is often too emotional.
Analysis of the Chinese economy
As already anticipated, since Alibaba's performance is affected by any news that has to do with China, I think the first thing to analyze is the macroeconomic environment.
Since the mid-1960s China's economic growth has been unrestrained and GDP used to increase in double digits. Since 2010, year-on-year growth has slowed down but remains higher than European and U.S. growth. The Chinese government's goal is to grow on average between 4.50-5% per year, which has failed in recent years due to a number of issues.
- The first was the pandemic. In China, the lockdowns lasted longer and were also much more stringent.
- The second is that China's real estate market is facing a tough time, which is extremely relevant since it contributes about 30% of GDP. China's housing boom seems to have come to an end and is now paying for the excessive borrowing and construction done over the past decades. The population has stopped growing as it did in the past, and demand for new housing has dropped dramatically to the point where it has created ghost towns.
The beginning of the real estate crisis dates back to 2021 when the China Evergrande Group (EGRNQ), once the second-largest real estate developer in the country, declared bankruptcy. Later, it was the turn of other prominent real estate developers such as Country Garden (CTRYF). In any case, we have been talking about this crisis for at least two years, and in my opinion, the Chinese equity market has already discounted this issue. This is nothing new.
Federal Reserve Bank of St. Louis
In fact, it has been since 2021 that the price of Chinese residential property has been plummeting, but as of mid-year, there seems to be a basis for a recovery. Proportionally, the slump in recent years has been greater than during the great financial crisis.
Moreover, taking a look at the average price of Chinese properties in RMB/sq m, after a violent slump starting in 2021, a new bullish trend has already begun since the beginning of the following year. In short, I believe that overall the worst of the real estate bubble has now already been discounted by the market and China has faced its 2008. We often forget that the Hang Seng ( HSI ) has collapsed more than 50% from its all-time high: how much further down can it go?
The median of the Hang Seng P/E ratio is 10.20x, today we are at only 7.80x, more than one standard deviation below. In the last 20 years hardly has this index been so depressed.
So, in addition to the problems with Chinese regulators, Alibaba's price per share has also been affected by the tightening of the Chinese economic environment, which is why I think it has also discounted a potential recession in China. In general, at current prices, I think the Chinese stock market is much more attractive than the U.S. stock market, and Alibaba is probably one of the companies that will benefit most from China's economic rebound.
While the United States is struggling with high interest rates, rising default rates, and banks reluctant to lend money, China is currently in the opposite situation: interest rates are declining and the Chinese government is also poised to increase fiscal spending.
The Prime Rate Loan has already decreased twice since the beginning of the year and China's budget deficit ratio will be raised to about 3.80% of GDP following the issuance of CNY 1 trillion sovereign bonds ($137 billion).
Since China is currently fighting deflation , I would not be surprised if rates were reduced further and fiscal spending increased. During the 2008 crisis, the Chinese government made immediate efforts to avoid a financial meltdown, and about two months after the Lehman Brothers bankruptcy it had a stimulus package worth CNY 4 trillion ready.
Since China remains one of the main economic powers with the lowest debt-GDP ratio, about 77%, I expect that in case of a worse-than-expected real estate crisis, a decision will be made to increase economic stimulus: there is room to do so. Finally, at least for the time being, GDP growth estimates in 2023 and 2024 are sound, 5.20% and 4.10%, respectively.
In light of all these considerations, I believe that the Chinese stock market has already discounted the worst and as early as next year may begin its comeback. Typically, the market bottom is reached when the following conditions occur:
- Pessimism is extreme.
- There are deflationary pressures.
- The government begins to stimulate the economy.
- Interest rates fall.
China currently meets all the conditions; the U.S. does not even have one since it is coming from years of strong expansion. Therefore, I would not be surprised if in 2024 the performance of these two countries is opposite: Hang Seng rising and S&P500 declining.
Alibaba was among the hardest hit companies in the Hang Seng Index, so I expect it will be one of the companies to benefit the most when the trend reverses. After all, its fundamentals are still solid.
Alibaba is not dead
When a company loses 77% in three years, we expect at the very least that its core business has been disrupted for the worse. Other times collapses of this magnitude raise assumptions of bankruptcy or permanent damage to the company. In the case of Alibaba, the company has simply encountered two years of stagnation after a decade of strong growth. Even the best companies in the world have difficult times to overcome: take a look at Apple between 2012 and 2014.
Chart based on Seeking Alpha data
As we can see, until FY2021 growth never had any problems; they started the following year. As already widely discussed, pandemic, fines, and real estate crisis made FY2022 and FY2023 hell, and yet Alibaba came out with its head held high. The company in the last 12 months generated a net income of $18.16 billion, cash from operations of $29.21 billion, and revenues declined minimally. In addition, it should be noted that these figures were impacted by an unfavorable exchange rate effect. Since the Fed is implementing a restrictive monetary policy and China's central bank an expansionary monetary policy, the CNY/USD exchange rate has changed significantly. In any case, performance over the past 12 months has been significantly better than in FY2022 and FY2023, suggesting that a comeback is underway.
In particular, the first six months of FY2024 are showing improvement in all business segments.
Alibaba Group September Quarter 2023 Results
Taobao and Tmall generated revenues of RMB 212.60 billion, up 8% from the previous year. This may seem like a slightly disappointing result, but one must consider the macroeconomic environment in which Alibaba is operating. It is not easy to grow during a deflationary period; in fact, even competitor JD ( JD ) has struggled.
International commerce had sensational growth, +47% or RMB 14.86 billion more than last year. This growth comes mainly from the retail segment. This is in my opinion a strong result and a proof of the ease with which Alibaba is expanding overseas through AliExpress.
Local Services, Digital media, and Cainiao all grew more than 20% over H1 FY2023.
Cloud had only 3% growth and generated revenues of RMB 52.71 billion; Alibaba continues to have the third largest cloud computing platform globally. The market did not take management's decision to give up the spinoff well, but I personally find it a correct choice. How much capital could Alibaba have gotten from a business segment growing at low-single digits today? For the time being, the focus is to get the Cloud growing again and only then to think about the IPO.
Alibaba Group September Quarter 2023 Results
Anyway, in terms of profitability the Cloud has improved: compared to H1 FY2023 EBITA improved by 26%. Cainiao is no longer at a loss and Local Services and Digital Media have significantly reduced losses. Overall, income from operations improved by 52%.
In light of these results, it is clear that Alibaba is not a dying company contrary to what the price per share would have you believe.
Street Estimates, despite pessimism toward this company, are in favor of steady growth in the future, albeit not at the same rate as in the past decade. After all, Alibaba today is a behemoth and logically cannot sustain the growth rates of the past.
Finally, the last aspect I would like to cover in this section is shareholder remuneration.
Alibaba has also officially become a dividend company since a dividend of $2.50 billion will be issued in 2024. The current dividend yield is very low, only 1.38%, but think of its growth potential. This company can easily generate an annual free cash flow of $30 billion over the next few years, so its growth rate could be substantial. The increase in dividend per share will be fueled by the huge buybacks that management is implementing. In the last quarter, treasury stock worth $1.70 billion was purchased and another $14.60 billion remains on hand.
Personally, on shareholder compensation, I slightly disagree with management's choices: that $2.50 billion I would have preferred if it had been used to increase the buyback. In any case, I understand that this choice was made more to attract new investors than anything else. I expect the buyback to be leveraged as much as possible at the current price.
Valuation
We came to the centerpiece of the article, which is the valuation of Alibaba. I have written hundreds of articles on Seeking Alpha but honestly, I have never found a company so undervalued. At the current price, Alibaba does not make sense and now I will explain why.
First of all, net debt is -$51.48 billion and free cash flow for the past 12 months was $24.51 billion (and Alibaba has not yet fully recovered). Subtracting net debt from the current market capitalization of $184 billion, in five and a half years free cash flow (assuming 0% growth) manages to cover the entire capitalization. For comparison, it is as if Apple ( AAPL ) were trading at $35 per share.
By creating a discounted cash flow model this undervaluation is even more evident. This model takes into account the following assumptions:
- 2023-2028 free cash flow was calculated from previous Street Estimates and multiplied by the free cash flow margin for the last 12 months, 19.60%. From 2029-2032 I applied a CAGR of 5% and finally a perpetual growth rate of 2.50%.
- The discount rate used is 12%. Using the CAPM the rate would have been under 10%, so to make my estimate more conservative I arbitrarily increased it.
With these assumptions, Alibaba's fair value is $157.27 per share, more than double the current price. But there is more.
For the fair value to align with the current price, the RRR would have to be about 25%, effectively making Alibaba almost 10x in 10 years. Thus, investing $1,000 today in 2033 will become $10,000. Anyway, 10x or not, unless the financials are distorted (and I have no reason to believe that) at today's price Alibaba I think is a bargain, potentially the best in 2024.
With Alibaba, we can have fun making even the most absurd assumptions, but there is no way to make it overvalued.
Let's assume that all analysts are wrong and Alibaba will never grow again for some strange reason. So, the expected free cash flow in 2023 will have a growth rate of 0% and a perpetual growth rate of 0%.
Again, Alibaba is undervalued since the fair value is $106.28 per share, a 47% difference from the current price. All this, still considering an RRR of 12%, is so quite high.
Let us now assume that Chinese regulators wake up one morning and decide for no reason to fine Alibaba $30 billion. Also, let us assume that the growth rate is -2% as well as the perpetual growth rate.
Once again, Alibaba is undervalued since its fair value would be $82.17 per share. In short, even in the face of a doomsday scenario, this company continues to be undervalued. Based on its financial results there is basically no way for it to be overvalued.
After all, this is to be expected given that its valuation ratios are incredibly low. No company with such high growth prospects and margins is trading at an NTM market cap/FCF of 7.26x; the same goes for the NTM P/E of 7.61x. Their average values since 2015 are 22.54x and 23.97x, respectively, 3 times as high as they are today.
An unusual comparison
With due differences, in terms of valuation, the current situation of Alibaba reminds me of that of Meta ( META ) last year. Since mid-2022, I started writing a series of strong buy articles on Meta even though the price kept collapsing. The rhetoric at the time was that Meta was wasting money on the Reality Labs segment and that no one was using Facebook anymore. That distorted perception of reality is what left many panicked investors without earnings. Even, staying on the Meta/Alibaba parallel, in one of my articles I hypothesized a 0% growth scenario for Meta, just as I did earlier with Alibaba.
Even then Meta was undervalued, yet the price collapsed another 50% before recovering all the lost ground in about a year. I also wrote strong buy articles when the price was around $100 per share, but at that point, pessimism was at its peak and few wanted to buy.
With these remarks, I do not want to create false hope since Meta and Alibaba are different companies, but I want to point out how in the market "nonsense prices" sometimes exist and can affect even established and internationally dominant companies. In my opinion, Alibaba's current price per share is completely irrational, just as Meta was at $90 per share. Sometimes the market takes big oversights, and when the numbers are on our side it may be the right time to take advantage of them.
Risks and final considerations
The fact that Alibaba seems undervalued based on its numbers does not necessarily mean that it will be a bargain and everyone should buy it. It is obvious that there are risks to be evaluated and, in this case, they are quite high given the potential returns.
Certainly, there is competition that could make future performance less rosy. JD is the main competitor, but when you invest in a Chinese company you have to do some different thinking. Typically, we are used to thinking that the competitors are just other companies, but in this case, there is mainly the Chinese authorities to factor in.
Chinese big tech companies do not have the same flexibility as Western ones and have to adhere to a set of rules designed for the common good. For example, previously we saw that Alibaba, in addition to being fined, decided to invest $15.50 billion in common prosperity out of thin air. Although wise, this choice seems rather questionable. Just imagine if Apple had done the same: shareholders would not have been happy.
So, investing in Alibaba means being aware that from one day to the next news could turn the company upside down and that shareholders will not always be put first. At the same time, however, you are buying a company that has no debt, generates $24 billion a year in free cash flow, and has a PE of about 8x. In other words, you must accept some compromises if you want to buy one of the best companies in the world at a ridiculous price: there are no free meals in finance. Finally, the extent of the real estate crisis within the country is still unknown, and this could lead the Chinese stock market to collapse further. In my estimation, even in the event of revenue decline Alibaba is undervalued, but this does not detract from the fact that the situation should be monitored.
In light of these considerations, it is clear that Alibaba is not an investment for everyone but only for those who believe in China's long-term growth without being influenced by the daily news. If you continually watch the performance of your portfolio and volatility scares you, Alibaba is the last company to invest in. Above all, you need some confidence in the Chinese government's choices and that it will not limit the growth of its big tech too much. The dividend issue could attract new investors, but even then, you need a long-term view since the dividend yield is still too low.
I realize that many people are not willing to accept that a company operates in such a complex environment, but as far as I am concerned Alibaba is so undervalued that I am willing to pass on it at $72 per share: I think the potential upside is definitely greater than the potential downside. Of course, one should not make the mistake of overweighting it within the portfolio. For the more risk-averse, it might make sense to consider some ETFs where Alibaba occupies one of the prominent positions. After all, China's goal is generalized growth and an ETF would greatly reduce specific risks while still remaining exposed to the country's growth. There is no right or wrong choice a priori, it all depends on how much you are willing to risk and what your goal is.
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Alibaba: At $72 Per Share Makes No Sense