7. Alibaba: The Digital Silk Road Giant in Troubles

Summary:

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This report presents a valuation of Alibaba Group Holding Limited (9988.HK), estimating its intrinsic value. The valuation is based on its financial results reported in Chinees Yuan (FX rate USD/CNY is 7.2).

Our findings reveal an equity valuation of ￥2.2 trillion yuan (equivalent to $305 billion USD), marking a substantial 51% disparity below the prevailing market capitalization, which stands at ￥1.4 trillion yuan ($199 billions USD) on Hong Kong Stock Exchange. This notable discrepancy suggests that Alibaba's current share price might be undervalued by 51%, potentially presenting an interesting opportunity for investment. This however is in the face of serious uncertainty that may pull the stock price still significantly lower form current levels.

*It's crucial to underline that this analysis does not constitute financial advice or a recommendation.

**Prior to making any investment decisions, it is advised to conduct thorough research.

***Full disclosure: We currently hold a position in Alibaba Group Holding Limited.

Introduction:

Alibaba Group, established in 1999, has emerged as one of the most prominent publicly traded companies in China, capitalizing on the nation's burgeoning economy, expanding middle class, and significant technological advancements over the past quarter-century. This strategic positioning allowed Alibaba not only to fend off competition from US-based multinationals but also to secure its dominance in China's e-commerce sector. At its market zenith in October 2020, Alibaba boasted a nearly $900 million USD market capitalization, positioning it among the global tech elite. It was at the forefront across a spectrum of business domains, including e-commerce, cloud computing, logistics, fintech (notably through Ant Group), and various digital services. It magnetized substantial interest from Western investors who were enticed by China's growth narrative and Alibaba's prospective future.

However, this remarkable ascendancy played a part in precipitating its subsequent challenges. The expanding influence of Chinese conglomerates like Alibaba began to be perceived as a potential threat to the centralized authority of China's governance. A pivotal moment was a speech delivered by Alibaba's founder, Jack Ma, in October 2020, where he openly critiqued China's regulatory framework. This led to swift regulatory intervention, notably halting Ant Group's imminent IPO, which was poised to be the largest in history. The aftermath saw Jack Ma withdrawing from the public eye for an extended period.

An anti-monopoly investigation ensued, culminating in a $2.8 billion fine for Alibaba from the State Administration for Market Regulation (SAMR). These regulatory measures have had a profound impact on Alibaba's stock valuation and market perception, compelling the company and its peers to adapt to a more regulated and scrutinized operational landscape.

The loss of governmental favour, coupled with a sluggish recovery from COVID-19, the bursting of the property bubble, and escalating geopolitical tensions between China and the West, including sanctions and trade restrictions, has eroded approximately 80% of Alibaba's value from its October 2020 peak. Currently trading at a Price-to-Earnings (P/E) ratio of 13 (TTM), Alibaba appears significantly undervalued when compared to Western counterparts like Amazon, which boasts a P/E ratio of 59. Yet, this disparity in valuation metrics can be attributed to a confluence of factors that may justify such divergent multiples.

China government:

The People's Republic of China, the world's most populous nation and its second-largest economy, operates under the central authority of the Chinese Communist Party. Over the past three decades, the nation has witnessed extraordinary economic expansion, propelling hundreds of millions out of poverty and rapidly enlarging its middle class.

The influence of the government on China's economy is unparalleled. Its capacity to significantly bolster or impede business operations is unique, with even Western entities adapting to regulations that might be unacceptable in their own jurisdictions to maintain a presence in the Chinese market. In this environment, Alibaba has aligned its operations with the broader objectives set forth by the ruling party. While it may continue to operate relatively freely, reclaiming the dominant stature it once enjoyed seems improbable. Thus, Alibaba's future prosperity hinges more on governmental directives than perhaps any other factor, positioning investors in a de facto partnership with the Chinese state, where the concept of value creation may diverge from traditional investor`s expectations.

China international politics:

Internationally, the geopolitical stance of China is a subject of intense scrutiny. A segment of the investment community views China as "uninvestable," citing the volatility of its geopolitical and economic landscape as a deterrent. Among the gravest concerns is the potential for military confrontation with the United States over Taiwan, a scenario that has gained plausibility in the wake of Russia's aggression towards Ukraine. Such conflicts would not spare any global investor. The intensification of trade disputes is already evident, with the U.S. imposing restrictions on exports of cutting-edge technology, such as the NVIDIA A100 and H100 GPUs, critical to artificial intelligence developments. In retaliation, China has limited the export of rare metals and other components vital for manufacturing of these technologies.

Despite efforts to foster indigenous semiconductor technologies and lessen its dependence on the U.S., the symbiotic relationship between China and Western economies is profound. An escalation of conflicts would be detrimental to all involved, suggesting that a competitive yet cooperative global stance is more likely to prevail.

China economy:

On the domestic front, China faces significant challenges. The protracted aftermath of COVID-19 lockdowns and the fallout from the real estate sector's downturn, triggered by the "three red lines" policy introduced in 2020, have led to a liquidity crisis for developers like Evergrande Group, the world's most indebted property developer. This crisis has rippled through the sector, causing defaults, stalled construction projects, and necessitating government intervention or restructuring.

China also confronts other issues common to Western nations, such as an aging population, high levels of public debt, and the rapid pace of technological change, particularly in AI and robotics, reshaping its manufacturing landscape. Moreover, the propensity of Chinese consumers to save poses additional challenges to revitalizing the economy and heightens the risks associated with deflation. Some analysts draw parallels between China's current economic situation and Japan's experience in the 1990s, leading to its "Lost Decade."

Despite these challenges, the Chinese government projects a 5% growth rate for the upcoming year. While this figure is modest by China's historical standards, it remains positive relative to Western economies. However, as the size of China's economy increases, a moderation in growth rates is to be expected. Nonetheless, with the continued expansion of its middle class, China's narrative as an enduring success story remains intact.

Alibaba Business Structure:

Alibaba Group stands as a multifaceted conglomerate, boasting a current market capitalization of $184 billion (on NYSE) and generating revenue of $130 billion. In an ambitious move in 2023, Alibaba announced plans to restructure by dividing the corporation into six independent units, a strategy aimed at unlocking value and enhancing operational efficiencies across its diverse portfolio. However, this strategic plan has recently been paused. In a pivot from its initial restructuring strategy, Alibaba has chosen to emphasize the pursuit of synergies and cost-saving efficiencies across its existing framework, signalling a nuanced approach to its expansive ecosystem.

Despite the broader reorganization being put on hold, the company still appears poised for significant actions in the near term. Notably, an Initial Public Offering (IPO) for Cainiao, Alibaba’s logistics arm, is on the agenda for 2024. Additionally, there's speculation that Alibaba's Cloud Computing division might also explore a public listing. These moves underscore Alibaba's strategic recalibration towards leveraging its core strengths while still exploring avenues for growth and value realization within its expansive corporate structure.

Six main Alibaba division:

1.?????? Cloud Intelligence Group: This division focuses on cloud and artificial intelligence activities.

o?? Local and International competitors: Amazon Web Services (AWS), Microsoft Azure, Google Cloud

2.?????? Taobao Tmall Commerce Group: Encompasses online shopping platforms like Taobao and Tmall.

o?? Local and International competitors: Amazon, JD.com, Walmart, eBay

3.?????? Local Services Group: Covering services like food delivery and mapping.

o?? Local and International competitors: Meituan in the food delivery sector

4.?????? Cainiao Smart Logistics: Focusing on logistics services.

5.?????? Global Digital Commerce Group:

o?? Local and International competitors: Amazon, JD.com, Walmart, eBay

6.?????? Digital Media and Entertainment Group: Led by CEO Fan Luyuan, involving streaming and movie businesses

o?? Local and International competitors:

Revenue distribution of Alibaba in 4th quarter of 2023, by segment

Corporate Governance:

Alibaba Group, despite its vast size and recent efforts at restructuring, exemplifies the complex and often opaque nature of corporate governance that characterizes many Chinese corporations. The entity that investors engage with on the NYSE and Hong Kong Stock Exchange is essentially a shell company domiciled in the Cayman Islands. This arrangement facilitates a profit-sharing agreement with the operational entity based in China, which the offshore company does not actually own.

This structure was devised as a workaround to circumvent China's stringent regulations on foreign ownership, particularly concerning companies deemed of significant national interest. While it's a remote possibility, the Chinese government could, at any moment, declare such arrangements illicit, potentially nullifying the entire market value of these entities.

Moreover, Alibaba's internal governance mechanisms lack the transparency commonly observed in Western corporations. The reliance on financial audits conducted by prestigious accounting firms does not entirely eliminate the risks of inaccuracies or misrepresentations, as evidenced by the controversies surrounding Luckin Coffee's audit by Ernst & Young and China Medical Technologies' audited by KPMG. Although the potential for such discrepancies exists globally, the risk is markedly more pronounced within the Chinese business landscape, highlighting a unique challenge for investors in navigating the complexities of corporate governance in China.

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Alibaba Risk & Opportunity:

On one hand, Alibaba is navigating through turbulent economic waters and stringent government regulations, while on the other, it is contending with escalating competition. Despite these hurdles, Alibaba continues to stand out as a remarkably successful enterprise. Its e-commerce market penetration in China is approximately 30%, a figure that's on an upward trajectory.

In a strategic move in June 2023, Alibaba underwent a significant management reshuffle, with co-founders Chung (Joe) Tsai and Eddie Wu ascending to the roles of Chairman and CEO, respectively. This dynamic leadership duo is now poised to steer Alibaba towards further growth while harnessing synergies across its diverse divisions to enhance efficiencies and drive cost savings.

Alibaba's commitment to innovation, particularly in artificial intelligence (AI), is evident in its hefty investment exceeding $2.5 billion in AI companies like Moonshot AI and MiniMax, alongside substantial allocations towards internal R&D. Amid these advancements, Alibaba is also executing share buybacks, capitalizing on the historically low share price to augment its earnings per share (EPS), reflecting a strategic move to enhance shareholder value.

Demonstrating their commitment to Alibaba's success, co-founders, including Jack Ma, have made recent stock purchases, further solidifying their commitment to the company's future. Additionally, there's optimistic speculation surrounding Ant Financial's IPO, which, unlike previous attempts, may now receive the green light from regulatory bodies.

As Alibaba voyages through these challenging times, the opportunities ahead are evident, albeit accompanied by significant risks. To assess the investment risk and potential, we'll review Alibaba's current financial standing and develop a forecast aimed at estimating its intrinsic value, offering investors a perspective on the company's future prospects.

Financial View:

All amounts in the reports are presented in Chinese Yuan unless specified otherwise. The current exchange rate is $1 USD = ￥7.2 CNY.

Share price history:

The performance of the share price has been notably disappointing for investors. It has plummeted by nearly 80% from its peak in October 2020 and by 68% from its pre-Covid peak in January 2020.

The company has encountered significant setbacks from both macroeconomic and microeconomic challenges. On the macroeconomic front, China is perceived by a notable segment of investors as politically and economically "uninvestable." On the microeconomic level, Alibaba is grappling with intense competition and shifting consumer behaviours. Investor confidence has hit all-time lows, even though the majority of professional analysts maintain a "BUY" recommendation.

However, it should be noted that the substantial price depreciation is partly attributed to the optimism that propelled the market price to unprecedented highs in late 2020. This phenomenon is not unique to this instance but is shared by numerous Western technology companies

Financial Stability:

Balance sheet:

Alibaba maintains a robust financial standing:

The ratio of total debt to capital is a healthy 37%.

Its cash reserves amount to approximately ￥614 billion ($85B), against a total debt of ￥678 billion ($94B).

The interest coverage ratio stands at a very safe 15, indicating strong financial health.

Revenue & Growth:

Over the past decade, Alibaba has experienced significant revenue growth, which saw a slowdown to 2% in 2022. Looking ahead to the 12-month period ending in March 2024, the growth rate is projected to improve, reaching approximately 7%. It is anticipated that the growth trajectories for Alibaba's diverse business divisions will vary, with even the company's management likely facing challenges in making highly confident forecasts.

Given China's GDP growth target of 5% for 2024, I believe, it's reasonable to predict that Alibaba's group sales will increase from 7% in 2024 to 10% by 2027. This anticipated growth is expected to be fuelled by the expanding middle class population and the ongoing expansion of e-commerce within China. Beyond the initial 10-year forecast period, I apply a perpetual revenue growth rate of 3.5%.

Revenue Growth in the last decade:

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Margins:

The trajectory of Alibaba's margins reflects a similar theme of compression. Both Gross Margin and Operating Margin have experienced decreases. Further to that, Earnings Before Tax (EBT) inclusive of Unusual Items have fluctuated, with Investment Income and Losses showing significant variance year over year, further compounded by the more recent impairment of Goodwill.

In attempting to stabilize these figures, I have adjusted the earnings to what I deem a conservative EBIT margin of 13%, situating it at the lower spectrum of Alibaba’s historical performance. The ongoing pressure on margins is anticipated to persist, largely because the company levies relatively modest commissions on transactions processed through its platform. Concurrently, Alibaba is poised to enhance its margins through other avenues, notably its cloud services, which harbour substantial growth potential.

Historical margins:

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Reinvestment:

Alibaba allocates approximately 6% of its revenue towards Research & Development (R&D), an expense directly reflected in its Profit & Loss statement. Arguably, this expenditure is akin to capital expenditure (capex) since it is expected to yield benefits over the subsequent 3-4 years. A more apt accounting treatment would involve capitalizing these costs and amortizing them over their beneficial period, which would enhance Alibaba's reported profitability during its growth phases (lower cost vs higher depreciation).

Regarding working capital investment, Alibaba exhibits a net negative investment as it strategically leverages Accounts Payable to finance both its Inventory and Accounts Receivable. This operational tactic underscores Alibaba's efficient capital management although my be changing as Alibaba develops its B2B segment.

The company's investment in Property, Plant, and Equipment (PP&E) is significant, addressing both maintenance (wear and tear) and facilitating growth. Historical analysis suggests a balanced investment rate, averaging 3:1, where ￥3 in revenue growth necessitates an investment of ￥1. This ratio appears to be a rational and sustainable approach to supporting Alibaba's expansion and operational needs.

Upon reaching maturity, I will project that the reinvested capital in Alibaba will generate a net return of 14.5%. This assumption is based on the company's strategic investments and operational efficiencies, anticipating a robust return on capital as Alibaba continues to solidify its market position and optimize its revenue streams.

Cost of Capital:

Given the current global market dynamics, characterized by inflation-induced high interest rates and the looming threat of an economic downturn, I have opted to apply a 10% cost of capital over the upcoming decade.

This decision is driven by a calculated approach: starting with a beta coefficient of 1.3, multiplied by a market premium of 6%, to which the risk-free rate of 4% is then added. Although the prevailing risk-free rate in China hovers around 2.4%, my calculation employs a rate more closely aligned with that of the United States for a broader perspective.

Published Alibaba's beta is currently estimated at 0.5, reflecting the stock's price decline in recent years. Despite this, Alibaba's actual market risk (and opportunity) is perceived to be higher than the market.

I further factor in lower cost of debt and tax shield, reducing the overall Weighted Average Cost of Capital (WACC).

Valuation:

Valuation Using Discounted Cash Flow:

Using the earlier defined variables, the equity intrinsic value calculated is ￥2.2 trillion yuan. This is 51% below the current market value of ￥1.44 trillion yuan.

The annual rate of return forecast is as a result close to 14%.

If we were to reduce the growth factor and assumed a very conservative 3.0% annual growth the company would still look 16% undervalued.

*Values are in Chinese Yuan

Conclusion:

Alibaba’s journey from its inception in 1999 to becoming a giant in China’s tech and e-commerce landscape is noteworthy. It has navigated China’s economic upsurge, technological advancements, and the expansion of the middle class. Despite facing regulatory headwinds and market volatility, particularly with the Ant Group IPO saga and subsequent regulatory fines, Alibaba has shown business resilience, albeit experiencing significantly lower growth and margins. The company's strategic pivot towards operational synergies and the potential public listing of its divisions like Cainiao signals a forward-looking approach to unlocking value and sustaining growth.

As we summarise Alibaba's valuation narrative, it's imperative to underscore the broader spectrum of internal and external factors influencing its market valuation. The intricate balance between Alibaba’s commercial ambitions and China's regulatory landscape, coupled with the global geopolitical tensions, presents a complex backdrop for investors. Yet, the company's solid market position, robust financial health, evidenced by its cash generation, debt-to-capital ratio and cash reserves, alongside strategic investments in R&D and future tech like AI, positions Alibaba on a potentially upward trajectory.

In conclusion, Alibaba represents a confluence of opportunity and risk, magnified by its apparent undervaluation in the current market. Investors considering Alibaba must weigh the high-growth potential against the backdrop of regulatory scrutiny, market volatility, and geopolitical tensions. As Alibaba sails through these multifaceted challenges, its journey portrays the delicate balance between seizing growth opportunities and navigating the deep waters of global and domestic uncertainties.