Alibaba Stock: Fear Is Gripping The Market Now (NYSE: BABA)

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Thesis article

Alibaba (BABA) continues to perform in a solid manner when it comes to its operations. Its stock, however, has dropped dramatically in recent weeks. This was caused by macro worries related to a potentially escalating China-Taiwan conflict, new lockdowns in China, delisting fears, and so on. In this environment, BABA’s future stock performance depends less on how the company fares operationally. Instead, China-related macro themes and their perception by investors from the US and elsewhere will decide how BABA will do over the coming weeks and months. From a valuation perspective, Alibaba is ultra-cheap, but fear is gripping the market right now.

Alibaba’s Ongoing Operational Success

Alibaba is one of the largest e-commerce players in the world, and a dominant force among Chinese tech companies. COVID tailwinds for e-commerce, due to less brick-and-mortar shopping, have waned in 2021. But Alibaba nevertheless managed to grow its business at a solid pace in recent quarters.

During the company’s Q3, which ended December 31, the company grew its revenue by 10% versus the previous year’s quarter. That is actually marginally ahead of the growth recorded by Amazon (AMZN) during its most recent quarter (9.4%). This comparison shows that Alibaba’s growth is not slowing down in an unprecedented manner. Instead, the company is experiencing a slowdown in line with other major e-commerce players, on the back of lapping a very strong pandemic period during which sales rose considerably more. Investors should also note that the law of large numbers dictates that no company can grow at extraordinary rates forever, thus some slowdown over the years is to be expected – for BABA, AMZN, and all other large players.

Alibaba’s revenue growth was driven by several contributing factors. First, the company continued to add new users to its ecosystem. Active consumers rose by around 4% during the quarter, which was a stronger-than-expected user count growth rate. When we consider that Alibaba has more than 1 billion consumers on its platforms already, an annualized growth rate in the teens range is quite compelling. It should be noted, however, that user count growth has not been this strong during all quarters in the recent past, and some deceleration in the coming quarters seems possible. Still, even a somewhat lower user count growth rate would likely allow Alibaba to continue to grow its core commerce business at a healthy pace going forward.

When one combines this solid, but not spectacular growth for BABA’s core business with faster growth at newer business units such as Alibaba’s cloud computing franchise, the company’s overall business growth gets lifted. BABA Cloud grew by around 20% during the most recent quarter. Considering the fact that cloud computing in China is not as developed as in the US yet, the unit should have a strong long-term growth outlook. The fact that Chinese companies are oftentimes inclined to partner with Chinese providers for critical solutions such as cloud computing should also help BABA’s prospects in the cloud computing space. Western or US-based providers, such as Amazon, Microsoft (MSFT), or Alphabet (GOOG) (GOOGL) will have a harder time growing their cloud computing business in China versus Chinese peers such as BABA or Tencent (OTCPK: TCEHY).

Alibaba’s profits declined quite a lot during Q4, by more than 80% compared to the previous year’s quarter. This was not caused by a deteriorating core business, however. Instead, a one-time goodwill impairment charge related to digital media assets of $ 3.95 billion was responsible for the weaker-than-expected profits. This was a non-cash item, and it seems unlikely that similar goodwill impairments will become the norm. It thus makes sense to adjust for that one-time issue (with no impact on cash flows or cash balances). Adjusted income from operations was $ 5.06 billion, or more than $ 20 billion annualized. That is, for reference, more than Amazon’s Q4 operating income run rate of $ 14 billion – and yet, Amazon’s market capitalization of $ 1.5 trillion is close to 7x as high as BABA’s market capitalization of $ 225 billion.

BABA’s adjusted net income, once again backing out the one-time charge and additionally factoring in results from equity investments that are not included in operating income, totaled $ 7.0 billion during the most recent quarter. Annualized, that makes for $ 28 billion of net income – quite a lot for a company growing at a double-digit rate and trading for just $ 225 billion.

Macro Risks Rule The Market

Of course, a low valuation alone does not make for a great investment. In BABA’s case, not even the combination of a low valuation and solid business growth is able to attract many new buyers. Instead, the market has sold off BABA massively in recent weeks, as shares dropped by an unprecedented 40% over the last month alone. This isn’t explainable by the company’s underlying results or near-term business outlook. Instead, China-related macro fears are responsible for the steep sell-off that has hit many other Chinese tech companies at a comparable level:

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Data by YCharts

We see that BABA’s performance over the last month was basically in-line with how the Chinese tech sector fared. Tencent is down 33% over that time frame, Baidu (BIDU) is down 32%. JD.com (JD) is down an even wider 44%, and the KraneShares CSI China Internet ETF, which also includes a range of smaller, more volatile companies, has dropped by an enormous 44%. Alibaba’s in-line performance proves that the current selloff is not caused by company-specific issues.

Instead, several macro worries have caused the market to panic-sell all kinds of Chinese tech equities. The first macro issue is a huge increase in COVID infections in China. The country has followed a No-Covid approach and case numbers were pretty low for many months. But in recent days, case counts exploded upwards, hitting new 2-year highs. Politicians have reacted with new lockdowns, including in and around Shenzhen – which is a tech hub for the Chinese economy. This will cause disruptions for many tech players, even US-based ones such as Apple (AAPL).

The market is also selling Chinese equities due to renewed fears about a potentially escalating China-Taiwan conflict. The current Russia-Ukraine war shows that brewing tensions can flame up and lead to a hot war, and that might also be the case when it comes to Taiwan eventually. I do not believe that this is particularly likely in the foreseeable future, especially since Russia is faced with massive sanctions, which might deter China from escalating the Taiwan conflict. But markets seem to be in risk-off mode, therefore reducing exposure to Chinese equities that would be hit hard in an escalating China-Taiwan conflict.

China is also exposed to the current Russia-Ukraine war. Due to its links to Russia, there is the potential for sanctions against China as well. China naturally seeks to avoid such sanctions, but a harsher trade environment between the US and Europe on the one hand and China on the other side cannot be ruled out. In such a scenario, Chinese equities could be impacted, which has been priced into Chinese stocks in recent weeks and days.

BABA Is A Great Value – If Everything Goes Right

Alibaba has seen its shares sell-off massively over the last couple of years. Meanwhile, as indicated above, its operational progress has been solid. This has made the stock incredibly cheap based on a range of metrics.

The company’s forward earnings multiple, for the year ending March 31, is just 9.1 based on current earnings per share estimates. Looking towards the upcoming fiscal year, which starts in about two weeks, BABA looks even cheaper. Analysts are predicting that BABA will earn $ 9 next year, which means that shares are currently trading for an incredibly low 8.3x next year net profits. Even if Alibaba were a no-growth company that never managed to grow its profits by a single cent, an 8x multiple earnings would be attractive – just returning all of the company’s profits via dividends or share buybacks would translate into annual returns of around 12 %, which should be enough to handsomely beat the market in the long run.

Alibaba likely won’t turn into a no-growth company in the near term, which means that potential total returns could be way higher. If we assume that BABA manages to grow its earnings per share by just 10% a year (which would be below the consensus growth estimate) in 2022 to 2023, and if BABA were to trade at a very undemanding 15x net profits at the end of 2025, shares would climb to $ 180 by the end of 2025. Relative to the current share price of $ 75, that would allow for total returns of 140% over just a couple of years. Have BABA earn the $ 13.40 per share in 2025 that analysts predict, and put an 18x multiple earnings on that, and BABA could rise to $ 240 – 220% higher than the current share price.

There is no guarantee that any of that will happen, of course. But if the China tensions ease, and if BABA continues to generate at least some growth, investors could generate very strong returns over the coming years. It is thus not surprising to see famed value investors such as Buffett’s partner Charlie Munger double down on Alibaba at its current bombed-out valuation.

Takeaway

Alibaba has been a very bad investment in recent years – I personally am down quite a lot as well. But that has not been caused by operational issues, declining revenues, cash flow problems, or similar issues. Instead, BABA has been the victim of multiple compression in a massive way, as investors keep selling BABA at any price due to China-related macro fears.

No one knows whether the China-Taiwan conflict will escalate any time soon. But I believe it is unlikely – and even if it were the case, Chinese equities would not be the only hard-hit investments. BABA has the potential to deliver massive returns over the coming years if tensions between China and Taiwan, and / or China and the US ease. If the market’s panic mode ends and investors become keener on being exposed to China’s long-term growth story, BABA (and many of its Chinese tech peers) could generate huge returns.

I keep exposure to Chinese tech, although at a small level, as I always have. Going all-in on Chinese stocks seems inadvisable, but some exposure at bombed-out valuations could juice portfolio returns in the coming years, as long as we don’t see a China-Taiwan war. In that case, portfolio returns might be the least of our problems.

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