Alibaba Group Holding Ltd (BABA)

[FUNMAN]

Alibaba: A Rare Buying Opportunity

Feb. 08, 2021 12:47 PM ET

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Summary

Alibaba’s stock dipped recently due to the postponement of Ant Group's IPO and because the Chinese government opened antitrust investigations against the company.

The Chinese behemoth enjoys a well-entrenched competitive advantage which leads to strong revenues and earnings growth.

According to our valuation model, Alibaba is undervalued, and we expect it to outperform S&P 500 for at least the next 5 years.

Although the company faces significant regulation risks, we believe that its long-term uptrend remains intact and could offer excellent returns to investors that count patience among their virtues.

Investment thesis

In spite of the share price falling almost 30% during the last two months of 2020 due to political and regulatory issues, Alibaba (NYSE:BABA) remains a very attractive long-term investment opportunity. The company continues to enjoy a well-entrenched competitive advantage and to grow its top line at a remarkable pace.

Introduction

Alibaba, often called the Amazon (NASDAQ:AMZN) of China, requires little to no introduction and according to the SEC "Alibaba is the world’s largest online and mobile commerce company measured by GMV." Although Alibaba is mainly an e-commerce company focused on China and South East Asia, the company has also ventured into a wide range of other industries. Its business units are diverse and span across e-commerce, cloud computing, entertainment, logistics, financial services and e-payments with its recent investment in Ant Group.

However, the last three months have not been particularly kind to Alibaba and shares in the company have traded sideways due to reasons such as the suspended Ant Financial IPO, the ongoing U.S.-China tensions, delisting concerns as well as the launching of antitrust investigations. These adverse developments raised huge concerns and frightened numerous investors who decided to dump their shares in pursuit of other opportunities. But the fact is that Alibaba’s fundamentals remain strong and its business units continue to do very well. We believe that fears are overblown and long-term investors have a wonderful chance to buy the dip and enjoy high returns in the next decade.

In order to back our argument, we can simply turn to Alibaba’s strong Q2 FY2021 results where the company achieved a remarkable +30% total revenue growth YoY and its free cash flow increased by 33% in Q2. Moreover, in the same quarter the company increased its monthly active users (MAU) by 15 million. Also, its cloud business, which is crucial for its future growth and profitability, increased revenue by an astonishing 60% versus the previous year. Last but not least, paying customers for its food delivery business increased by 45%. Overall, Alibaba has seen a tremendous growth in both its group revenues and operating profits since its IPO. It is worth noting that from 2016 to 2020 they have grown at a CAGR of 49.8% and 33.1% respectively. It is expected that Alibaba will continue to grow its top line with rates between 20% and 30% for the next 5 years.

In the picture below we can see the September Quarter Financial Highlights.



Source: Alibaba Group September Quarter 2020 Results

Alibaba’s moat and competitive advantage
Across multiple research we can see that a company’s competitive advantage is strongly associated with its total returns from an investor’s standpoint in the long term. So, in this section we are going to try to briefly examine if Alibaba has a competitive advantage and what is it.

Alibaba’s competitive advantage is well noted across analysts around the financial world and we further argue that economies of scale play a vital role for Alibaba’s strong margins. Economies of scale are the cost savings associated with a larger volume of sales. Alibaba is the world’s largest e-commerce company in terms of Gross Merchandise Value (GMV). With such a large amount of transactions processed through the company’s systems we see a notable opportunity for Alibaba to achieve significant cost advantages in multiple operating functions such as operating expenses, cash flow capitalization and logistical efficiencies.

The second advantage is economies of scope which means the cost savings associated with the offering of sale of different products by a single corporation through the same sales channels. Alibaba enjoys economies of scope with its two retail sites, Taobao which features thousands of non-brand name products sold by smaller merchants and Tmall for branded products.

But the primary competitive advantage of Alibaba according to our opinion is network effects. Network effects are the benefits arising from an expanding network of users of a product or service. The larger the network the more valuable the product becomes to each user. As of 30 September 2020 Alibaba, had 881 million of mobile monthly active users (MAUs). Also, as an early starter it was able to attract many vendors which in turn attracted many buyers because of the vast product array of products to buy from. Alibaba has also an extensive ecosystem of services from new retail to food delivery services which keep consumers within Alibaba products and services. With more services offered by Alibaba, consumers are more likely to spend more time using Alibaba’s platforms which will surely lead to more revenue which can be used to further expand its services to more and more buyers. This ecosystem is a very significant competitive advantage Alibaba has over its other competitors such as JD.com (NASDAQ:JD) and Pinduoduo (NASDAQ:PDD) because these companies lack such an ecosystem and is therefore more difficult for them to induce consumer stickiness.

Last but not least every e-commerce platform needs reviews, comments and rankings from buyers to determine the credibility of the site. As such, they will choose a site with an abundance of these 3 factors. Taobao and Tmall meet these criteria so consumers will continue to trust them and not want to switch platforms. Furthermore, their sites are formatted so that consumers get comfortable with a simple layout and based on this increase their fidelity to the platform

Valuation
In order to reach to a price target for Alibaba we will perform some calculations using basic assumptions. From a revenue perspective we will use the last revenue estimates as they are presented in the Seeking Alpha website by Integrator which points to the amount of $208.36 billion as a target March 2025 revenue expectation. Management has provided guidance for EBITDA margins well above 40% but we want to be a bit more cautious since we don’t know when and if Alibaba will achieve these margins, a prudent choice considering the recent regulatory events. So, we will opt for a margin of 30% from now until March 2025. In our calculations we’ll set EV/EBITDA at 25 because we believe that Alibaba should be considered a growth stock. We also assume that Alibaba’s debt will be a little bit higher at $35 billion at the end of period. So, using a 25 EV/EBITDA multiple we get an equity value of $1,527.7 billion. With a share count of 2.71 billion shares outstanding our valuation model gives a target price of $563.73 over the next five years with an upside potential of 120.89%. In the picture below you can see our model.

Alibaba
Source: Author's calculations

Risks
Despite the significant competitive advantages that Alibaba enjoys and its relatively protected position in the global e-commerce ecosystem there are also some risks involved with investing in this stock. These risks are mainly of political and regulatory nature and in our opinion most of them are short-term.

To begin with, at the 18th of December 2020, President Trump signed the Holding Foreign Companies Accountable Act, which threatens to remove Chinese companies from US markets if they fail to comply with US auditing regulations within a time period of 3 years. This has scared many investors but we believe that it doesn’t pose a significant threat for Alibaba because Alibaba’s auditors since its IPO have been PwC which lends to a higher level of confidence in the sturdiness of their books. Furthermore the 3-year time frame would be more than enough for any company to make necessary adjustments and thus comply fully. Also, in an event of delisting the investors would probably be able to transfer their holdings to Hong Kong. But according to our opinion this is not going to happen under a Biden’s Administration.

The second major threat comes from the postponement of Ant's Group IPO. The regulators were worried about Ant Financial’s rapidly growing consumer lending business and Ant’s "lax" lending practices which raised fears that would cause a significant increase in debt levels. Our position is that we cannot know exactly how this situation will affect Ant’s Group valuation and consequently Alibaba’s share price. Also, we are not sure if finally, Ant will even achieve its IPO.

Another area of concern is that of U.S.-China relations which, as covered extensively in the press, haven’t been particularly warm during the years of Trump Administration. This is a long-term threat and there is nothing much that investors can do about it but we believe that this will not have a huge impact on Alibaba’s business as they are largely focused on China and South East Asia. Moreover, we remain confident that under the new administration the relations between the two countries will dramatically improve.

Rules against anti-monopolistic practices may also unfold new obstacles for Alibaba as on 24th of December, Alibaba was hit with an antitrust probe over its "choosing one from two" policy, in which merchants had to exclusively sell products on Alibaba platforms. We still don’t know how aggressively the regulators will interfere but we remain confident that the company’s long-term outlook will remain bright. Our overall feeling on this matter is that the company will most likely fully cooperate with any regulatory requirement and thus emerge relatively unscathed.

Last but not least we would like to highlight two risks that come from the business landscape, the first of which being competition from Tencent which has dominant positions in many markets that Alibaba is eyeing for expansion. This could lead to a significant deterioration to Alibaba’s operating margins. Alibaba is also investing heavily across business lines and countries. Investments overseas, such as these in India could be a significant risk for Alibaba shareholders.

Conclusion
Alibaba has shown that it can sustain strong above – average growth over many years. We remain confident that the company will continue its strong growth trajectory in the years to come due to the expected market growth for its e-commerce and cloud business. But of course, no investment in stocks is without risk and that is also true for Alibaba. There are significant political and regulatory risks associated with an investment in Alibaba but those exists for U.S. tech companies as well. Moreover, our feeling is that the Chinese government will not take steps to destroy its most promising tech company. With all that said we believe that Alibaba is severely undervalued and well-poised to offer huge returns to long-term investors. Our recommendation is a buy with a target price of $563.73.

Disclosure: I am/we are long BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.