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Buy Alibaba - A Maturing Yet Under-appreciated Chinese Behemoth

Updated: Jul 1, 2022

Contents



Summary

  • A challenging 18-24 months for Chinese stocks presents a case for overselling and an attractive value opportunity.

  • Alibaba’s revenue streams and cash flow continue to be robust, with a fast-growing international market.

  • Target price is between $149.13 and $202.63, depending on the risk premia used.


Introduction


The last 12-18 months have been extremely challenging for Chinese stocks. The CSI300 is down 28% on its February 2021 high, while the NASDAQ Golden Dragon China Index – a basket of stocks representing Chinese companies listed in the US – has plummeted over 61%. This meltdown – down to China’s crackdown on Big Tech, its political tensions with the US, and other key factors – has caught my attention as it presents a potential value opportunity: Alibaba.


Since its October 2020 high, Alibaba shares have fallen over 65% (see Figure 1). There are three main reasons for this. First, the current US-China political tensions have brought about the threat of delisting Chinese stocks from the NYSE – Chinese ride-hailing app Didi is the most recent example. Its decision to delist its US-traded shares has caused the market cap of the company to drop from $73.5bn to only $11bn in just over a year.


Figure 1: Alibaba's stock has fallen over 65% since its October 2020 high.

Luckin Coffee – a Chinese coffee chain formerly listed on the NASDAQ – was also forced to delist in April 2020 after admitting it had fabricated more than $300m in sales. Since then, however, there has been talk of the company relisting after reporting triple-digit sales growth in Q3 of 2021.


There is no doubt that US authorities have paid attention to and sanctioned the behaviour of listed Chinese companies, but I would argue that this is not that different from how US and European firms are treated and that an action taken against the former is penalised much more in the stock market than the latter.


This year, for example, Alibaba has been added to the “Notorious Markets List” of the Office of the United States Trade Representative (USTR), for facilitating the global trade in counterfeit and pirated goods. This also happened around the same time last year. However, Amazon – also an e-commerce company, more so in the western world – has been on USTR’s list in recent years for its European platforms.


The second reason for recent stock price volatility is China’s regulatory crackdown on big tech, where Alibaba has been subject to antitrust fines, including a $2.8bn slap on the wrist in April 2021, along with other less significant penalties prior. This was because they broke the country’s antimonopoly law by preventing merchants who use their services from operating on other shopping platforms.


Worrying it may seem, this is not dissimilar to what goes on in the Western world: Alphabet has received multiple fines over the years from the EU on the grounds of anti-competitive behaviour, including $2.7bn in 2017, $5bn in 2018, and again in 2019 for $1.7bn; Amazon was most recently fined $1.3bn by Italy for abuse of market power, stating that the logistics giant had leveraged its dominant position in the Italian market to favour the adoption of its own logistics services; and let’s not forget Facebook, whose privacy violations resulted in a $5bn fine from the Federal Trade Commission in 2019 – which, bizarrely, resulted in a 2% stock price increase on the day of the announcement, amid relief that the punishment was not as bad as anticipated – as well as Mark Zuckerberg’s ongoing congressional hearings.


Furthermore, Alibaba has responded to the fines with action. First, they have developed methods of tackling the sale and distribution of counterfeit goods, including a Notice-and-takedown system, giving individuals the power to report products; tech-driven monitoring such as AI-driven Optical Character Recognition to flag fake listings; and offline enforcement, where the company works with local authorities to fish out suspicious manufacturers/dealers. In fact, London-based World Trademark Review (WTR) awarded the company the Asia-Pacific Team of the Year in 2019 for its success in intellectual property protection, and in 2020 the company correctly removed 96% of suspected infringing listings before a sale could be made.


Last year, the company also announced a commitment of $15.5bn in investments in September last year to help spread the wealth of large Chinese corporations to ordinary people. This is in accordance with the government’s ‘Common Prosperity’ agenda, and presumably to ease tensions between the company and the PROC. The money was pledged towards SMEs and improving insurance protection for gig economy workers, and Simon Hu Xiaoming, head of the company’s public welfare group, mentioned that around 80% will “be open for programs that can leverage Alibaba’s advantages as a big platform”. Later, in the valuation section of this report, we treat this commitment as a fixed-capital investment deducted from free cash flow.


Lastly, we see China’s bleak economic figures as another catalyst for poor share price performance. Amid an umpteenth COVID lockdown imposed on its citizens a few months ago, they reported a 7% decline in industrial production between April and May this year and have seen a much more serious drop in housing activity and other parts of the economy. That being said, this effect is likely to be temporary as the government is now phasing out COVID restrictions, which has resulted in a dramatic recovery in Chinese assets.


The PRC has also tried to add stability to the situation by a) vowing to “boost the economy in the first quarter” and introduce policies “that are favourable to the market”, and b) loosening auditing rules by removing the legal requirement for mainly Chinese authorities to be present at foreign inspections. They also very recently announced the approval of 60 new game licenses, after slamming the sector last year for provoking addiction, and dubbing its products as ‘spiritual opium’. This is perhaps a signal that the crackdown has passed its worst phase and is a step forward for Chinese Big Tech regulation.


There are other more global risks – the most obvious being the Russian invasion of Ukraine, which has exacerbated the already jittery situation concerning inflation and economic slowdown. China recorded 4.8% GDP growth in GDP during the first quarter of this year, but its Premier warned recently that it could struggle to achieve growth in the following.


Recent ADR performance & earnings


Year to date, Alibaba’s shares have continued to drop. The ADR is 12% down, along with smaller declines of just under 11% and 7% for shares traded on the Frankfurt and Hong Kong exchanges, respectively. The difference most likely reflects the American delisting fears mentioned above. The stock was at an all-time low of $76 (-36% since 31/12/2021) on the NYSE back in March but has since recovered due to the FY2022 Q4 earnings beats in May, the easing of China’s covid lockdown restrictions, and further hope for big tech regulation easing.


Alibaba’s FY2022 earnings showed $134bn in sales, along with a net profit of $9.7bn, showing changes on FY2021 results of +22% and -57%, respectively. The company claims that the large decrease in the latter is mainly due to a reverse in last year’s upward valuations of its equity investments. However, both CFO and FCFF have also declined by 36% and 67%, respectively. This is partially reflected by the full payment of the anti-monopoly fine mentioned further above, but mostly due to a sharp drop in earnings power because of a declining operating margin (11% in FY2022 versus 15% in FY2021). This will have to be monitored over the coming quarters.


Further, Alibaba increased its share buyback plan this year to $25bn, a two-thirds increase from the previous yardstick of $15bn. As of 18th March 2022, the company has purchased 56.2 million ADSs for an aggregate of $9.2bn, leaving around $15.8bn in dry powder. With today’s ADS price hovering at about $109, this represents just over 144M ADSs – 5% of all shares outstanding!


About the company


Alibaba Group Holding Limited is a Chinese multinational technology company founded by Jack Ma in 1999. Its chief segments are E-Commerce, Cloud Computing, Digital Media and Entertainment, Innovation Initiatives, and Other ventures. They are involved in every arm of E-Commerce – their main line of business, accounting for 76% of FY 2022 revenue – including consumer-to-consumer; business-to-business; manufacturer to distributor to the small retailer; imports; logistic services, etc.


Trademark platforms include Taobao Marketplace, their domestic online shop; AliExpress, their non-domestic, worldwide platform; Alibaba.com, their export-focused B2B platform, catering to both Chinese and International wholesalers/suppliers; and Lazada, their Southeast Asian market. There is also Trendyol in Turkey and Daraz in South Asia; two platforms that I believe will be instrumental in the future growth of the company. A relatively newer area of the business – Cloud Computing, now just under 9% of total revenue, and just turned profitable in the 6 months up to September 2021 – is gaining headway, with a 65% CAGR sales growth over the last 5 years, compared to 40% for their core online retail. This is very similar to Amazon - Alibaba’s western relative – where Amazon Web Services accounts for just over 13% of net revenues.


Revenue Mix – how do they make money?


For simplicity, I split the business into two segments: E-commerce and non-e-commerce, both of which make up the ‘Alibaba Ecosystem’.


E-commerce (76% of FY 2022 revenue)


Alibaba runs the largest retail commerce business in the world with respect to gross merchandise volume (GMV), which made just over $103 billion in turnover in FY2022. Most of this is derived from customer management, consisting of:


  • P4P (pay-for-performance) marketing: an algorithmically determined bidding process for key search words, which governs where a listing will show up on their platform and charges on a cost-per-click (CPC) basis. The moment a consumer clicks on a merchant’s product or service listing, Alibaba makes money.

  • In-feed marketing services: like P4P, but on a consumer-group basis, whereby sellers will bid for certain groups of consumers with similar profiles based on their search results. Again, this is done on a CPC basis.

  • Display marketing services: where merchants bid to display advertisements on a cost-per-thousand impression, or CPM, basis. This is typically not as clever as word or consumer group-based marketing but is still highly effective.


The company also provides the above services via a third-party ‘Taobaoke’ program, which generally involves entities such as search engines, video and media platforms, and mobile apps. An agreement is entered into between Alibaba and these third-party affiliates (the Taobaoke) to connect the former’s marketing infrastructure to the online resources of the latter. Once a sale is made through the merchant’s listing being on the third-party platform, both Alibaba and the Taobaoke make money. A western example of this could be when an advert for an eBay listing shows up on Google Ads.


In addition, the company makes a chunk of its e-commerce revenue from commissions on transaction value, from the likes of Tmall and other Alibaba marketplaces. Turnover from their own sales of goods is also done on these platforms and has become a significant cash generator for the company in recent years – almost tripling from a mere 12% of revenue in 2019 to 31% in 2022.


Non-e-commerce (24% of FY2022 revenue)


Other streams of income include membership fees from wholesale sellers, enabling them to have a better reach to customers on Alibaba.com/Aliexpress; logistics services, mostly for the international platforms like AliExpress and Lazada, promising a 72-hour delivery window; cloud computing, their service for managing, storing, and using computers/data on the internet, including DingTalk, an all-in-one mobile workplace that provides services very similar to Microsoft Office; and big data & AI services.


Cloud computing accounted for just 4% of total revenue in 2017 and has doubled to more than 8% for FY2022. Total revenue from the cloud within this period has surged from just $968M to $11.8bn – an increase just shy of 1115% (65% CAGR)!


There are also much smaller ventures such as online games; fees from SMEs via Ant Group, which incidentally had its IPO canceled in late 2020 due to China’s tech crackdown; Amap, a provider of real-time navigation and traffic information in China; Tmall Genie – akin to Amazon’s Alexa; and premium services for Youku – essentially the Chinese version of YouTube.


See Figure 2 below for all the company’s business lines – the ‘Alibaba Ecosystem’.


Figure 2: All of Alibaba’s business segments, dubbed the ‘Alibaba Ecosystem’.

Further business development


Alibaba continues to develop its services. Specifically, on the e-commerce front, their New Retail strategy seeks to integrate the two main methods of buying products and services: online and offline (in-store). The idea, backed and coined by Alibaba’s founder Jack Ma 6 years ago, is that while shopping has drifted mostly online, there is still a place for brick-and-mortar/physical shops.


Freshippo – more commonly known as ‘Hema’ in China – is the most prominent example. This is a supermarket that allows people to have greater access to fresh food and other FMCGs by grouping together both the online and offline operations into one single distribution/shopping center. There are many features to this, including the ability to deliver food to customers within 30 mins of when a shopper chooses to buy, if they live within a 3km radius – Alibaba claims that some Chinese citizens have in fact opted to live within ‘Hema Locations’ to have permanent access to this service. In addition, for those who prefer to shop in-store, the customer can find out everything one needs to know about, say, a lobster; whether they would like it to be cooked in their in-store restaurant; and finally pay for it via face recognition on the way out!


Another focus for the company is to empower retailers through modernisation. Take a small convenience store in rural China. Normally these places – also in the UK/US – are associated with a ‘mom and pop’-Esque business operation: most payments made in cash, a pencil-lead stock take, followed by finger-in-the-air estimates on upcoming product demand. Now, with Alibaba’s tech, these stores have opted to go digital. This includes analytics on what customers are buying, as well as access to simpler distribution channels, enabling the shop to be more dependable in having what the consumer wants and to ultimately make more money.


Other cases of New Retail include car vending machines, to make the process of choosing an automobile more autonomous and less tedious; virtual shelves for high-street retailers, to satisfy demand even when an item is not in stock; and even Snapchat-like virtual makeover mirrors for women’s bathrooms, so one can try on cosmetics without doing so physically.

I believe this continuous improvement and innovation of its services will help the company increase its revenue per customer, and ultimately enhance the value of the business.


Share structure – BABA US or 9988 HK?


Alibaba has shares listed on three exchanges, two of which have been the main focus in the media – New York and Hong Kong – due to the delisting fears discussed earlier. If Alibaba does delist from the former, the shares do not just magically disappear but become tradable via over-the-counter (OTC) markets. This is a much less liquid way of trading securities and would a) limit further foreign investment into the company and b) make it much harder and more expensive for investors to sell quickly if/when the need arises. Whilst it is probably not a financial death penalty for the company in the long run, it is worth avoiding, and for individual investors, it is advised that one transacts on the Hong Kong exchange, where possible.


Valuation – how much is the company worth?


To calculate the value of the company we have used DCF modeling, where cash flows are calculated from revenue growth; profitability; tax; D&A and CAPEX; change in NWC; and the Alibaba ‘Common Prosperity’ (CP) investment. Note that the discounted cash flow time horizon runs up to 2034, by which point we calculate the terminal value based on an expected long-term growth rate of 3%.


Cash flow components


Revenue growth – number of users


Since 76% of its turnover comes from E-commerce, this will be our main focus. We will then also discuss the trajectory of the non-e-commerce part of the business, which accounts for the rest (24%).


As there are several services the E-commerce business offers, as described at the beginning of this article, we shall simplify it into two main ways in which Alibaba can make future revenue growth: 1) An increase in users, and 2) An increase in money made per user. We will use Annual Active Consumers (AACs) as a proxy for users, as they are customers that have placed one or more orders during the financial year, and therefore generate revenue for the company.


The increase in users will come from both China and Alibaba’s international platforms, where the latter will have more of an impact as it is untapped compared to their domestic market. CEO Daniel Zhang announced in February this year that the company has “substantially captured all consumers with purchasing power in China“.


Businesses – especially e-commerce, with its nationwide reach – rely on people to buy their goods and services. Therefore, to calculate potential future customers, we focus on the population of each country for which Alibaba has an E-commerce platform. Of course, the likelihood of the company capturing the entire population of a country is low, and so the addressable market is calculated by multiplying the population of each of these countries by a 'market penetration' percentage. Then, we add together all these countries to the existing customer base to come up with an aggregate pool of potential users and multiply this by the expected revenue per user to get the total revenue the company will make from e-commerce.


Starting with China (see the top of Figure 3 below), the business has already brought in 63% (903 million) of its citizens as AACs. The country has a current population of just over 1.4 billion people, 914 million who live in urban areas, and 498 million rurally. Going forward, we will assume it can bring in no more than 85% and 60% of people living in cities and the rural areas going forward, respectively. Then, by multiplying 914 million by 85% and 498 million by 60% and then adding both together, we arrive at 1.076bn AACs – the addressable Chinese market.


Note that we also include Alibaba’s equity stake in the center of the diagram when multiplying for the potential AACs as not all of Alibaba’s platforms are 100% owned by the company itself.


Figure 3: Current Annual Active Consumers (AACs) in China, versus potential AACs, based on the country’s 2020 population (according to the World Bank).


For Alibaba’s international arm, we use the exact same method (see Figure 4 below). Naturally, the international market is more diverse than the domestic one, hence the slightly more complex treelike journey towards our final answer. We also expect more competition to take place in these domains, from the likes of Amazon and other platforms, which is reflected in our lower market penetration rate of 60%. That is, the company will be able to capture no more than 60% of the population of each country. Each platform has its current number of users at the top of the diagram, along with the aggregate and individual populations of its respective countries towards the middle. For instance, Daraz – their South Asian business – (on the right-hand side) targets 5 countries in South Asia, whose aggregate population is 502 million people. Multiplying by 60% gives us 301 million potential users for Daraz. Lazada also serves multiple countries with a total population of 878 million, but this has not been split out for presentational reasons.

Figure 4: Current Annual Active Consumers (AACs) internationally, versus potential AACs, based on each country’s population (according to the World Bank). Lazada, catering to Southeast Asia, consists of the addressable markets of Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Vietnam. Data on the number of users for platforms Trendyol and Daraz was not in Alibaba’s latest 20F, and so had to be retrieved from different sources. Therefore, the sum of the individual parts does not add up perfectly to the total amount.


The company has 305 million international users currently, between 4 main platforms: Lazada (100m), AliExpress (60m), Trendyol (circa. 19.3m), and Daraz (circa. 35m). I believe the latter two show huge potential. We expect Trendyol – the main e-commerce platform in Turkey, acquired by Alibaba in 2018 – to almost double, as well as Daraz – also acquired in 2018 – which we expect to increase by almost 10-fold! This is mainly due to its reach in highly populous and developing markets such as Pakistan and Bangladesh where the five South Asian markets in which Daraz operates have a combined population of over 502 million, 60 percent of whom are under the age of 35.


AliExpress operates entirely internationally, where it is difficult to use a country’s population as anyone in the world can order from this site. Therefore, we assume this platform will max out at 120 million users.


Finally, with an eye on the bottom of Figure 4 (bold green), we expect the number of international users to max out at just over 792 million, over 2.5 times the current amount!

Next, we figure out how this growth in users is going to play out over time. Looking at the right-hand side of figure 5 below, we begin with the current number of users of both domestic and international markets, along with the aggregate of the two at the bottom. We then assume the former will grow at 12%, while the latter grows at 25%. We then use this to make a forward estimate on how many they will have over the coming years, and when the company will arrive at the maximum number of users which was determined above in Figures 3 and 4.

Figure 5: Forward estimate of growth in Annual Active Consumers, using the maximum number of AACs calculated in Figures 2 & 3 and FY 2021 growth rates.

For the domestic market, we assume growth in users declines to 6% in 2024, after which the company hits its maximum number of AACs and the Chinese market no longer grows.

As the international market is much less mature than the Chinese one, we expect growth to stay at around 25-35% from 2022 all the way up to 2026, where their AAC number matures completely at the 792 million mark determined in Figure 4.


Summing together national and international AACs, we arrive at a total amount of AACs in 2026 to be approximately 1.8bn (in blue).


Revenue Growth – revenue per user


The second pillar of revenue growth is turnover made per person. Observing the middle row of Figure 6 below, we assume a 15% growth rate up to 2026. This comes from the high economic growth rates of each of the countries in which Alibaba operates, along with how much user revenue has grown historically due to business developments described in the Further Development section of this report above.


To illustrate, looking at Revenue per Consumer in 2026 on the left-hand side of the diagram, we can expect Alibaba to be making just over $149 per user per annum. Multiplying this revenue-per-user figure by the total number of users expected in Figure 5, we end up with a total revenue figure of $279bn by 2026. We do the same with all other preceding years. We can also see from this that the growth rate for revenue hovers between 33% and 24% during this time.

Figure 6: Total revenue from e-commerce up to 2026, calculated using Revenue per consumer (growing at 15% annually) multiplied by total users in the final row of Figure 5.

Revenue Growth – Non-e-commerce


We then add in the non-e-commerce revenue from Figure 7 below which, as of FY2022, accounts for around 24% of money made. In recent years, this segment has shown growth rates ranging from 63% to 31%. This is because Cloud Computing – their largest part of non-e-commerce revenue – has grown at astronomical levels in recent years. Therefore, we assume this segment will grow by 28% in FY2023 and will teeter off by 2 percentage points each year until 2026 when total revenue expected is $76.6bn.

Figure 7: Non-e-commerce revenue up to 2026, calculated by applying a 28% growth rate for 2023 which diminishes by 2 percentage points thereafter.

Summing the e-commerce and non-e-commerce revenue streams, we have the total revenue Alibaba will make up to 2026 (see Figure 8).

Figure 8: Total Alibaba revenue up to 2026, calculated by summing e-commerce and non-e-commerce revenue calculated in Figures 6 and 7, respectively.

Finally, since the DCF model we are using has a terminal value in 2034, we must work out the revenue growth in the years after 2026, all the way up to 2034. From 2026 to 2034, we assume revenue growth will diminish by 3 percentage points each year until finally hitting the terminal growth rate of 3%. We illustrate with Figure 9, where we start with the 2026 growth rate of 27% which decreases to 24% in 2027. Alibaba’s revenue is then expected to grow by 21% in 2028, 18% in 2029, and so on.

Figure 9: Revenue growth declining by 2 pps every year from 2026. First 4 years of this.

Profitability


The next component of the company’s cash flow is operating profit. That is, we predict how profitable the company will be in the future.

Figure 10: Alibaba gross, operating and, net profit margins from 2013 to 2021.

As we can see in Figure 10, margins have clearly declined on every level. This is mainly due to an increase in investment in marketing and promotional spending, along with additional costs that have come with the consolidation of acquired businesses such as Lazada and Sun Art, as well as continued support for their New Retail segment described earlier on.


These are most likely responses to increased competition from other e-commerce companies in China, with the likes of JD.com and Pinduoduo, and others. We can also confirm this by observing Alibaba’s e-commerce market share, which has declined from 78% in 2015 to just over half of the market today.


Something unusual about their net margins in Figure 10 is that they sometimes exceed their operating counterpart, most notably in 2016 and more recently. Their spike in the net margin in 2016 even eclipsed their gross margin. This is due to a large increase in investment valuations of their acquisitions such as UCWeb – fully acquired in 2014 mostly through a stock deal, and now partially used for the company’s P4P Taobaoke services described in the Revenue Mix section of this report – as well as disposal gains from Alibaba Pictures, their formerly owned Chinese film company which now trades on the HKSE.


The more recent incidence of this between 2019 and 2021 is also due to large increases in the valuation of the company’s equity investment portfolio. In 2020 and 2021 alone, they saw net gains of $10.3bn and $11.1bn, respectively. However, the already glowing fragility of the 2022 equity market has already reversed some of these gains, resulting in a return to margin normality.


Using the trajectory of Alibaba’s profit margin and multiplying by expected revenue which was calculated above, we will forecast their expected operating profit (EBIT). Their operating margin was 11% in 2022 and looking at Figure 11 we assume an 11.53% margin for FY2023 ($20.4bn in operating income) and that this will decline steadily to 5% in 2034 ($48.5bn), totaling an aggregate decrease in margin of 6 percentage points. Notice that we see a large decrease in operating profit in 2034 due to the drop from just under 7% to 5% in margin.

Figure 11: Alibaba operating profit and margin from 2023 to 2034.

Tax


The corporation tax rate is now 25% in China. However, Alibaba’s average effective rate over the last 9 years has been 19%, which is due to their operations in other jurisdictions and part of their business being domiciled in zero-tax countries such as the Cayman Islands. Therefore, we will give an estimate of 20%.


Depreciation & amortization and CAPEX


D&A is a non-cash charge (NCC) in the income statement and affects overall earnings. However, we are only interested in the raw cash generated from the business, and so must add this amount back to after-tax operating income (calculated from the forecasted EBIT and tax rate above, and known as net operating profit after tax – NOPAT).


Note that Alibaba’s D&A in FY2022 was $6.2bn and is mainly from plant and equipment of their core commerce platforms and includes operating lease costs related to land use rights.


CAPEX follows the same process as D&A, but in reverse – it is not deducted from the income statement, because any money spent on PPE/capital investment is capitalised. Recognising that this is still money going out from the business, however – that it is a cash charge – we deduct this from the NOPAT. CAPEX was $8.4bn in FY2022.


To forecast the two components above, we look at how they behave relative to revenue earned and then see if this tells us anything about how they will play out in the future. Figure 12 shows Depreciation and CAPEX as a percentage of revenue, alongside Alibaba’s cash from operations (CFO) growth.

Figure 12: CAPEX and depreciation as a percentage of total revenue, plotted alongside CFO growth.

An interesting dynamic has occurred. From 2013 to 2016, we see the company’s CAPEX remaining above depreciation, while growth in its cash from operations is within the range of 30-85%. Then, from 2017 onwards, the relationship completely reverses, with CAPEX now trailing depreciation, and CFO growth dropping to almost an entirely new paradigm.


This is perhaps indicative of a company transitioning from its growth to maturity phase. Earlier on in the 2010s, more capital investment was needed to pump up the business to a sustainable level, with earnings also growing at a very high level. Later in the decade, Alibaba naturally began to soften its push on the accelerator pedal as they then reached a size where a 30-85% growth in earnings is no longer sustainable. Thus, we see a slowdown in CAPEX relative to depreciation, as well as lower growth rates for operating cash flow.


We shall therefore assume that depreciation will remain slightly above CAPEX and that the two will decline in parallel by 0.5 percentage points annually. We then multiply this by the expected revenue to get expected nominal figures for depreciation and CAPEX. See Figure 13 for expected depreciation and CAPEX between 2022 and 2030.

Figure 13: Expected Depreciation and CAPEX between 2022 and 2030.

Changes in net working capital (∆NWC)

In basic terms, NWC represents current assets minus current liabilities (i.e., whether the company can meet its short-term obligations with its short-term assets). However, when used for a DCF valuation, we must deduct cash and short-term borrowings from the asset and liability components, respectively, for two reasons. Firstly, if most of a company’s current assets is cash – as is the case with Alibaba – then the theory that an increase in NWC decreases cash falls on its head because, in this case, the opposite takes place. The second reason is that NWC is supposed to represent the indirect cash movements of the company’s operations, and neither cash nor short-term debt is an indirect cash movement. To illustrate, see the NWC formula we use below.


Note that the change in NWC is what we are after, which is calculated by taking the NWC for each year and deducting the preceding one.


In this case, both NWC and the change in NWC are mostly negative. This is because a) most of Alibaba’s current assets are cash and short-term investments, which are far greater than its current borrowings, and so this mathematically creates a shortfall when not included in the formula; and b) it is not uncommon among tech companies – whose capital outlay is typically very low compared to other sectors – to have negative NWC. At the 2015 World Economic Forum in Davos, Jack Ma jokingly claimed in an interview that Alibaba will be “bigger than Walmart on sales” in 10 years. His reason was that for a business like Walmart, "if you want 10,000 new customers you have to build a new warehouse and this and that. For me: two servers." Whilst this sales aspiration is unfortunately still a jest, with Walmart’s FY2022 revenue at $572bn and Alibaba’s just over $134bn, the point was that e-commerce is much less capital/inventory intensive compared to brick-and-mortar retail, and thus requires much less working capital. We also see the same for Amazon, where NWC is negative throughout its entire financial history.


Once NWC is calculated on a historical basis, we then use this to predict its behaviour in the future. To do this, we calculate NWC as a percentage of total revenue, since we assume total revenue is indicative of how much activity is taking place for the company, which will directly affect its NWC. This, from 2013 to 2021, turns out to be 28% (or -28% since NWC is negative in this case). We, therefore, multiply all expected revenue streams from 2023 to 2034 by -28%, to give the expected NWC for each of those years. Finally, we calculate the change in NWC for each of these years to give the overall cash flow. Since this is negative throughout, we can expect the overall cash flow to come from this to be positive. See Figure 14 for clarity.

Figure 14: Change in NWC.

‘Common prosperity’ (CP) investment


As mentioned earlier, last year, Alibaba pledged $15.5bn over the next 5 years towards ‘common prosperity’ investments. Since the details of the transactional terms of this pledge have not been disclosed, we will assume this is being paid by the company in cash, and that it spans equally over the 5 years. That is, we will see an extra $3.1bn in cash outflows from 2023 to 2026, inclusively.


Unlevered Free Cash Flow (Free Cash Flow to the Firm – FCFF) and Terminal Value


After forecasting all components of future cash flow above, we now have what we need – FCFF.


Free Cash Flow is the raw cash that goes to all owners in the business. In this instance, we are using Unlevered Free Cash Flow (FCFF) which is the total amount which goes to both debt and equity holders. We then calculate the terminal value from the perpetual growth rate formula using the final interim cash flow (2034). Later, once we have calculated the enterprise value from these cash flows, we will deduct debt to get the equity value of the business. This should come out with an answer that is similar to if we had used Levered Free Cash Flow (FCFE – Free Cash Flow to Equity).


Using all components calculated above, we calculate expected FCFF from 2023 to 2034 using the formula below.

Looking at Figure 15 below, we see this in action. Cash flow hits a peak at $113.4bn in 2033 before the business begins to hit its declining phase from 2034 onwards.


Figure 15: FCFF from 2023 to 2034.

We then calculate the terminal value for the year 2034, where a 3% perpetual growth rate is used, yielding a value of $225bn.


Discount rate and value per share


The last part of our valuation of Alibaba is, of course, calculating the value per share. Having worked out the FCFFs and terminal value in the previous section, we now need to compute and sum the present value of all of these, which will give us the enterprise value – the value of all debt and equity in the business. To get the present value, we need to determine the discount rate.


Since there are many ways of calculating the discount rate – such as CAPM, which is strongly believed by valuation guru Aswath Damodaran to follow unrealistic assumptions (and I tend to agree) – we use a range of such. That is, we use all discount rates ranging from 1 to 25% – 25% being extremely risky, 1% being little to no risk at all – and plot this against all corresponding values per share for the company. That way, we can see how under/overvalued the company is at many different levels of risk and ensure that we are not captive to just one final figure for the intrinsic value per share. This is almost like conducting valuation inversely; finding all appropriate parameters except for the discount rate and then determining for what range of risk the company is truly undervalued.


To get the equity value of the company, we add cash, deduct debt, and deduct minority interest, as the latter is the proportion of the equity that is not attributable to common stockholders. We then divide this by the total number of ADRs (2.7bn).

Figure 16: A range of discount rates used to calculate a range of intrinsic values per share. This is compared with the current price. The dotted lines show the upside.

Looking at Figure 16 above, we can see that for alllevels of reasonable risk up to 21%, the company is undervalued. This is impressive from a valuation standpoint and tilts our stance strongly in favour of a bull case. The point at which the intrinsic value and current price curves intersect is the discount rate for which the company is fairly valued. In other words, if we think the company is extremely risky and deserves a 21% discount rate, we should not buy the stock as there is no reward in doing so.


To narrow our final answer down, we will assume the correct rate to be anywhere between 10% and 15%. This considers the company to be very risky due to all the geopolitical and economic factors outlined in the Current Affairs section earlier on, but not extremely risky as it is in reasonably good shape financially – cash and ST investments far exceed debt. At 10%, we can expect the stock to be undervalued by $93.59; and at a rate of 15%, $40.09. Including and between these two rates, the average amount Alibaba is undervalued by is roughly $65.23, offering an implied 60% upside.


Therefore, at a current price of $109.09, we have found the stock to be moderately undervalued, and buying now is considered a good opportunity.


Conclusion


There is no doubt that Alibaba has been a challenging stock over the last 18 months, with uncertainty persisting into this year and possibly beyond. Much of the market sentiment rests on China’s slowing economy, its relationship with the US, and other company-specific factors such as the success of its international business lines and cloud computing segment.


As long as the company continues to leverage its platform to take advantage of the fast-growing population and economies of its foreign businesses, whilst also steadily increasing its revenue per consumer in China, it will continue a trajectory of growth well into the 2030s and be positioned for a smooth business maturity. Additionally, if the Chinese authorities are to do what they say, by cooperating sufficiently with the US authorities on auditing rules and helping to promote a business-friendly environment within their strict domestic market, companies such as BABA will eventually command a lower risk premium for investors which will ultimately increase the valuation to its sustainable level.


For now, though, we have found that even after applying a large discount rate to account for this challenge, the company remains under-priced relative to its intrinsic value, and still has a place in the long-term investment portfolio.


Disclaimer


This post is not intended as investment or financial advice, and should be used for recreational purposes only. Any financial actions taken using the content of this post are done so at your own risk, and I am not liable for any gains or losses incurred.


I currently hold no shares in any of the stocks/companies mentioned in this post.



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