Investment Case: Alibaba Group Holding
A Sleeping Giant
Listen to this write-up:
Hello friends,
Welcome back! As Alibaba Group Holding is the largest position in our fund, we feel it deserves a proper write-up. The below analysis is for informational purposes only and not intended as investment advice. With that disclaimer in mind, let’s get started…
Business Overview:
Alibaba is a large internet retail business with multiple divisions that facilitate different aspects of commerce such as payments, logistics, advertising, big data analytics, and cloud computing. The company owns two of the most popular online shopping sites in China (Taobao and Tmall) and is the world’s largest e-commerce business by gross merchandise value of $1.3 Trillion USD. The company went public in 2014 and has since experienced massive revenue growth while having a profitable business model. The company in recent years has been investing heavily into its value-added services such as smart logistics, generative A.I. and cloud computing, while expanding its services geographically into Southeast Asia, Europe, and the Middle East. The business is well capitalized with a large net cash position and a private investment fund that spans the globe.
Why We Like the Business:
Alibaba’s core strategy is centered around customer obsession and inclusive growth. As such, throughout its history, the company has experienced a natural business evolution, adding services to address customer pain points. As Alibaba’s platforms grew, so did their capabilities in network coordination and data intelligence. The two-sided ecosystem that Alibaba controls creates a vast amount of user data that the business uses to improve functions for both sides of the network (buyers and sellers), creating a flywheel effect. We believe that the flywheel effect is one of the most powerful concepts in modern business and look for it when analyzing businesses.
While Alibaba is sometimes grouped with its large tech peer, Tencent, we do not think of Alibaba as a pure tech company. The business throughout its history has invested in advanced technologies to improve their business capabilities as it relates to commerce. This tech-enabled business model where decisions are made via machine learning in real time, allow companies like Alibaba to adapt rapidly and dynamically to changing market conditions and customer preferences. The economic value of this capability is twofold for a marketplace business; (1) the company is able to maintain a low-cost structure through vertical integration and (2) the company can simultaneously build services to be monetized as their merchants scale and move to more advanced data intelligence requirements.
The Capacity to Reinvest:
Alibaba’s excessive cash flow from its mature core commerce segment allows it to invest into their value-added segments, which in turn strengthens their competitive positioning within the e-commerce industry. The company in their most recent quarter reported free cash flow of roughly $11.2B. To put this figure into perspective, Alibaba earned more than double the amount of free cash flow in a single quarter than their top competitor earned for their entire year. This advantaged free cash flow generation allows Alibaba to out invest their competitors and grants the company greater flexibility in managing the competitive landscape.
One of our preferred metrics when analyzing a companies capacity to reinvest is through their research and development spending relative to their rivals. While accountants have historically categorized R&D as an operating expense, we believe that R&D should be capitalized, as this spending is designed to create benefits for the business over many years. Alibaba has invested ~$8.00B into R&D over the trailing twelve months. This compares to $2.5B for JD and $1.5B for Pinduoduo. We believe that Alibaba’s capacity to reinvest puts them in an advantaged competitive position for the foreseeable future.
High Value Proposition:
Alibaba currently charges the lowest take rate for merchants while having the largest active customer base in China. This high value proposition makes Alibaba the marquee e-commerce destination for merchants. The company holds a 44% share of the largest internet retail market in the world along with dominant positions in secularly growing industries such as cloud computing and digital payments throughout Asia. By owning Alibaba in its current state, we are effectively collecting a toll of $.44 cents for every dollar that passes through the market. With the Chinese e-commerce market expected to grow at a compounded annual growth rate of 12.4% through 2027, we expect to be happy toll takers in the years ahead.
Alibaba currently generates most of its revenues from the Chinese consumer market. As such, we are keenly interested in consumption trends in China. The Chinese government has a stated goal of shifting China’s economy from being mainly export driven to a more consumption driven economy, much like the United States is currently. (For reference, China consumption relative to GDP is roughly 40% while U.S. is 70%). The trend in China has been favorable pre-covid as household consumption has been growing as a percentage of GDP steadily since 2010. With a current savings rate of 45.8% (compared to 19% in U.S.) and an internet penetration rate of 70% (compared to 90% in U.S.) we believe there is tremendous untapped potential in the Chinese internet consumer market.
A Painful Two Years:
Alibaba’s shares have had a difficult couple of years (to put it mildly). The shares have plunged from a high of $309.92 in October 2020 to a low of $63.74 in October 2022: an 80% loss in two years, peak to trough. This destruction of shareholder value has been driven by the challenging operating environment in China with restrictive zero covid policies reducing economic activity, an ongoing debt-fueled property crises, and hostile government regulations targeting large tech companies. CEO Daniel Zhang recently said in the 2022 letter to shareholders that, “This may be the year in which changes in the external environment has been most severe in decades.”
Aside from the operating environment, sentiment for Chinese equities has plummeted due to geopolitical fears regarding U.S/China relations, Taiwan independence, delisting risk, and national security concerns related to supply chains and technology investment. As the operating business has largely been resilient throughout this time period (revenues remained relatively stable while free cash flow remained positive, albeit with a 40% haircut) we are left to conclude that the loss of value has been mainly driven by sentiment related fears and uncertainty around political risk. In our investment decision in Alibaba, we are focused solely on the long-term business results and their competitive positioning in the markets they operate in. We believe the negative sentiment has been largely priced in as uncertainty surrounding geopolitics has increased. However, our investment decisions are based on the quality of the assets and the valuation, not on predicting the future geopolitical landscape or government actions related to the VIE structure.
Valuation:
At the time of writing Alibaba has a market capitalization of $235B. This value is backed by a Net Asset Value of $159B as audited by PWC. (Total Assets-Total Liabilities). As such, roughly 68% of the total market cap is protected by net assets. This is unusual for such a large, growing, and profitable business. As shareholders, having such a large percentage of our investment protected by net assets gives us comfort that we are not overpaying for the operating business.
After backing out a net cash position of roughly $40B from the market cap, we arrive at an enterprise value of $195B. Alibaba generated roughly $23B in free cash flow in the trailing 12 months, translating to a FCF yield of 12%. Furthermore, the $23B in FCF was generated through cost optimization, during the most difficult operating environment in the company’s recent history. We see this figure growing significantly as economic conditions normalize in China, cloud adoption accelerates in Asia, and their loss-making divisions continue to scale and trend toward break even margins.
Alibaba currently has a share repurchase program in place for $25B and we believe they can increase these buybacks even further through their strong FCF generation and excess cash on the balance sheet. As shareholders, we are happy to see management using capital to repurchase shares at lower valuations than our purchase price. By doing so, they are increasing our ownership in the company without us having to spend another dollar. We expect share repurchases to accelerate as free cash flow grows in the years to come.
Using a DCF model, with conservative growth assumptions, and a 10.20% WACC, we arrive at a fair market value for the business of roughly $450B or $177 per share. This would indicate that Alibaba is currently trading at a discount of ~45%.
When analyzing Alibaba’s valuation on a relative basis, we come to a similar conclusion. The peer group for comparison include their main competitors, JD 0.00%↑ and PDD 0.00%↑ , and the Brazilian e-commerce business MELI 0.00%↑ We have avoided using Amazon Inc. for direct comparison due to differences in corporate governance between businesses in developed versus emerging markets. Focusing on the metrics of Sales, EBIT (Earnings before interest and taxes) and FCF, we arrive at the respective average multiples of 3.34x sales, 38.35x EBIT and 17.54x FCF, giving us a blended relative valuation for Alibaba of $200.77 per share. This would indicate Alibaba is currently trading at a discount of ~56%.
Catalysts for share price appreciation:
· Earnings growth over time
· Continued Share Repurchases
· Easing regulatory environment
· Ant IPO
· Improving U.S./China relations
Thanks for reading! We hope you enjoyed the analysis. If you did, please feel free to subscribe and share with a friend.
Much appreciated,
Jack Beiro, MBA
JB Global Capital
The information contained herein represents the author’s opinion and is for informational purposes only. Nothing in this newsletter should be construed as legal, tax, investment, or financial advice. No opinion expressed by the author should be construed as a specific inducement to make a particular investment or follow a particular strategy. The author may hold positions in securities mentioned in the newsletter and may buy or sell securities at any time. The author may express opinions based on information he considers reliable, but no guarantee or warranty is made with respect to such information’s completeness or accuracy, and the author is under no obligation to update or correct any information provided. Please consult your own financial or investment advisor before acting on any information provided herein.