Alibaba: The Cheapest Chinese Tech Stock (NYSE: BABA)

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Alibaba Group Holding (BABA) is once again trending downward. Following an earnings release by JD (JD) and another delisting scare, BABA went as low as $ 87 on Friday. Prior to JD’s release, BABA had been selling off modestly for other reasons. The reaction to its own earnings release (which missed on revenue but beat on adjusted EPS) was muted. More significant selling occurred after the start of the Russia / Ukraine war. After Russia invaded Ukraine, people began to express fear that China might make a similar move on Taiwan.

The overall atmosphere of international instability may have dimmed sentiment toward Chinese ADRs, which have always been plagued by delisting fears. It has long been speculated that, if Chinese stocks were to be delisted in the US, a Chinese invasion of Taiwan could be the catalyst for it. The recent demand for accounting disclosures by the US added to the concerns about delisting. As I’ve written in past articles, Alibaba isn’t at risk of being delisted. It is already in full compliance with US accounting laws, and was not among the companies named in the SEC’s list of companies not in compliance with the law. Nevertheless, investors sold off BABA along with its delisting-plagued peers.

We can never be 100% sure what caused a stock to move the way it did on a particular day. Despite financial reports that confidently proclaim “stock and moved on event x,” investors are under no obligation to report why they bought or sold a given stock, and most of them don’t. With that said, the three events described above – the earnings releases, the war in Ukraine and the delisting scare – coincided with the most recent selloff in Chinese ADRs. The correlation suggests that these events may have weighed on investors’ minds this month.

Whatever the cause, the most recent round of selling in Chinese stocks has pushed BABA to a valuation that few would have considered possible just a few months ago. At today’s prices, BABA trades at just 10.82 times earnings, 1.6 times sales and nine times operating cash flow. These are among the lowest multiples you’ll find among large cap tech stocks today. You can find even lower multiples among bank stocks and US automakers, but it is rare to find stocks with BABA’s growth potential that trade at such low valuations. In fact, Alibaba is one of the cheapest tech stock of its size in China. In this article, I will make the case that BABA is, in fact, THE cheapest Chinese big tech stock going by “classic” multiple-based valuation methods, as I will show shortly.

BABA’s Valuation Compared to Peers

Alibaba stock is by far the cheapest of its peers when going by “traditional” valuation multiples. This doesn’t necessarily mean that it’s the cheapest in a discounted cash flow model – using that kind of analysis, a higher-growth company may be cheaper. But it is the cheapest using a purely multiples-based approach.

To demonstrate this, I pulled the multiples on the seven largest Chinese tech companies from Seeking Alpha Quant, in no particular order. The table of these multiples is shown below:

Adjusted P / E

Price / sales

Price / book

Price / operating cash flow

Tencent (OTCPK: TCEHY) 15.61 5.3 3.4 16.7
JD 28.7 0.5 2.3 11.2
Meituan (OTCPK: MPNGF) N / A 4.3 5 N / A
BYD Company (OTCPK: BYDDF) 141 2.3 5.6 9.6
Baidu (START) 14 2 1.24 13

Alibaba

10.1

1.78

1.52

8.51

NetEase (NTES)

17 3.8 3.4 13

As you can see, BABA has the lowest multiples out of all of these names. Some of the names mentioned have one or two multiples lower than BABA’s, but BABA has the lowest metrics on the most scores out of all of them.

So, among China’s top 7 tech companies by market cap, BABA is the overall cheapest. JD and Baidu can each claim P / Sales ratios lower than BABA; BABA gets 4 out of 4 in head-to-head comparisons with all of the rest. That would tend to argue that BABA is a cheap stock, compared to the rest of the Chinese tech universe.

However, all other things are not the same. Low valuation multiples mean little if a company is going to deliver lackluster growth going forward. In the past two quarters, BABA delivered negative growth in net income, and its revenue growth shrunk considerably. Given this fact, it is reasonable to ask whether BABA will return to positive earnings growth in the near future. I will dedicate the next section to evaluating the likelihood of that happening.

Growth

Until recently, Alibaba was an extremely high-growth company. Its five year CAGR growth rates in revenue, adjusted earnings and free cash flow were:

  • Revenue: 42.2%.

  • Adjusted EPS: 9.82%.

  • Free cash flow: 13.7%.

As you can see, we have very strong growth on the top line and moderate growth on the bottom line. The earnings picture is much worse if we zoom in to the trailing 12 month period: over the last 12 months, BABA’s net income declined 59% and its FCF grew only 6.6%. The question, therefore, is whether BABA can return to its previous growth rates in the near future.

The answer is partially yes, partially no. Or more accurately: future growth will be higher than 2021 growth, but not as high as in the period up to and including 2020.

While some of the costs BABA took last year were one-time, at least one of them will recur indefinitely.

The “one time” costs BABA took included:

  • A $ 2.8 billion anti-trust fine.

  • A collection of smaller $ 75,000 fines totaling a few hundred thousand dollars.

  • Contributions to China’s common prosperity fund, the financial implications of which are still unclear.

These measures held back Alibaba’s earnings last year, and for the current fiscal year. They will not recur indefinitely. The fines were all fully paid as of the third quarter, and the common prosperity fund contributions will last for five years. With the fines out of the picture, Alibaba will see some easing of expenses next year. However, it still has to contend with:

  • A doubling of its effective tax rate.

  • The common prosperity contributions still to be paid out.

The first of these factors is essentially permanent, the second will last four more years. To expand on them in a little more detail:

Alibaba’s tax rate doubled in the September quarter last year. Prior to this year, BABA had been benefiting from being a “Key Software Enterprise” – a tech firm seen as vitally important to China’s interests. This status was revoked in the September quarter. Prior to losing KSE status, BABA had been reporting effective tax rates between 10% and 18%, depending on the quarter. In the September quarter, it reported a 24% effective tax rate, which is where it will remain unless it can get some of the tax credits back.

The common prosperity fund contributions are more vague. BABA has never disclosed exactly where it would spend its pledged money. What we do know is that the initial pledge was for $ 15.5 billion over five years. That would be a big cost increase if the money was simply being donated. However, it came out last year that a large part of Tencent’s common prosperity contributions was its ongoing investments in environmentally friendly data centers. This signals that actual business investments can be included under common prosperity if they have a ‘social’ angle to them – so the true “cost” of BABA’s contributions may be less than $ 15.5 billion.

Financial

Having looked at the factors influencing BABA’s performance last year, we can turn to how things are likely to look next year.

In the most recent quarter, BABA reported:

  • $ 38 billion in revenue, up 10%.

  • $ 1.1 billion in GAAP operating income, down 86%.

  • $ 7 billion in adjusted net income, down 25%.

  • $ 2.65 in diluted EPS, down 23%.

  • $ 11.1 billion in free cash flow, down 26%.

The extreme decline in GAAP net income was due to BABA’s stock portfolio declining in value, and depreciation. The adjusted EPS and free cash flow metrics do not include these costs, which is why they were higher.

You can see the effect of BABA’s higher tax rate on adjusted net income. That earnings metric declined 25% even though revenue increased. Some of the Q3 revenue came from unprofitable segments; the core commerce segment (the one that typically contributes positive earnings) grew 7%. Had net income grown in line with revenue, it would have increased. Instead, it declined, driven by increased CAPEX and higher taxes.

With this established we can come up with some forecasts for the future.

Let’s assume, to begin with, that revenue grows at only 10% going forward. An acceleration in China’s GDP growth could produce higher top line growth than that, but it pays to be conservative.

In fiscal 2021, BABA’s revenue was $ 109.4 billion. Its EBIT was $ 13.7 billion. Total costs were $ 95.7 billion. Income taxes were $ 4.4 billion. If in fiscal 2022, BABA’s sales grow 10% and non-tax costs don’t change, then revenue grows to $ 120.3 billion and EBIT grows to $ 24.34 billion. That’s 79% EBIT growth. It sounds promising, but keep in mind the tax hike. 24% of $ 24.34 billion is $ 5.9 billion. That results in a net income of $ 18.44 billion; without the tax hike it would have been $ 20.2 billion. So we’re seeing about $ 1.72 billion lost to higher taxes, resulting in negative net income growth year-over-year.

That’s the bad news. The good news is that starting in the September quarter of this year, BABA will be “lapping” past quarters that already had the tax hike in the picture. That will make growth much easier going forward. The March quarter of last year will also be easy to beat, as that was the quarter when the $ 2.8 billion fine was recorded on BABA’s financial statements. The million dollar question in all of this is revenue. If revenue growth accelerates this year, then we could see strong earnings growth much sooner than the September quarter. For now, though, it’s best to figure conservatively and assume 10% growth for the foreseeable future.

A Concluding Note

As I showed in this article, Alibaba took a real hit last year, but not all of the new costs it assumed will be permanent. The tax hike will recur indefinitely, but the fines have been fully absorbed. For this reason, it appears likely that BABA will return to solid growth later this year, when it “laps” past quarters that included the tax hike. When we consider that fact alongside the stock’s near-single digit P / E ratio, it gives room for optimism. 10% earnings growth is quite decent for a stock trading at 11 times earnings. Particularly when you consider that BABA’s cloud business has only just begun its long march to profitability.

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