To The Moon

Summary

• Alibaba's stock appears to be lost amidst heightened geopolitical tensions.

• The company is executing on cost optimization initiatives and the results are showing through strong growth in adjusted EBITDA.

• The company maintains a strong balance sheet with $58 billion of net cash plus a sizable equity portfolio.

• Management continues to make progress towards its planned spin-offs of various business segments.

• The catalysts are already in motion for a big upside - but will you notice?

CeBIT 2015 Technology Trade Fair

Sean Gallup

The bearish thesis against Alibaba (NYSE:BABA $Alibaba(BABA)$ ) is well known at this point, centering around the regulatory risk in the event of rising US-China tensions. But the market seems to be ignoring the clear signals being sent from management that they are focused on extracting shareholder value. BABA has seen its valuation reset to arguably distressed levels amidst the rising interest rate environment, and management continues to work towards spinning off various business units in order to address the conglomerate discount. This is a company which has net cash and investments equivalent to nearly 60% of the market cap, and trades at around 10x earnings even before accounting for that fact. At this point, any successful execution on spinning out the various business units, starting with its cloud division, is likely to lead to substantial upside - downside scenarios seem to focus on management being unable to accomplish those goals. While risks have not declined for this name, I am increasing my aggression in buying the stock and have made it a core position in my portfolio.

BABA Stock Price

The valuation reset in the tech sector has led many tech stocks to trade at pre-pandemic levels. The adjustment has been even more severe at BABA as it is still trading at the same levels as it did in 2014 when it came public.

Chart

Data by YCharts

I last covered BABA in May, where I discussed the potential upside from the proposed spinoffs. The stock has not gone up as expected, as Wall Street has suddenly lost interest in these events that in theory should help realize considerable shareholder value.

BABA Stock Key Metrics

In its most recent quarter, BABA saw strong growth in most of its various business categories, but overall revenue growth hovered at 2% YOY as its most critical commerce operations declined 3% YOY. The big story was clearly the boost in profitability, as adjusted EBITA grew 60% YOY. This marks the company’s return to a double-digit adjusted EBITDA margin after it dipped to 8% last year.

financial snapshot

March 2023 Quarterly Presentation

BABA was able to generate such strong growth in adjusted EBITA largely due to its cost reduction initiatives, as it was able to reduce losses substantially at almost every loss-generating unit, as well as boost margins by 500 bps in the core commerce operations.

business segments

March 2023 Quarterly Presentation

BABA generated $4.7 billion in free cash flow in the quarter, making up 124% of adjusted EBITA. The company spent $1.8 billion repurchasing stock, an arguably modest amount given the extent of the undervaluation and solid free cash flow generation, but still impressive considering that share repurchases are still a newer development for this company.

free cash flow

March 2023 Quarterly Presentation

BABA ended the quarter with $63.4 billion in net cash plus $66 billion in additional equity investments.

balance sheet

March 2023 Quarterly Presentation

Together, those made up roughly 59% of the market cap. On the conference call, management noted that while the Chinese economy continues to recover following the easing of pandemic restrictions, “consumer confidence and spending power still need further momentum.” Management also noted that there is fierce competition from the various consumption platforms. Such commentary might confuse American investors, given that BABA is often called “The Amazon of China.” But one must remember that the cost of living is much lower in China, making any logistical advantage less relevant as compared to the United States.

I suspect that many investors are now focused mostly on management’s efforts to split up the business units and spin off as many of them to shareholders. Management reiterated plans to fully spin off the cloud intelligence division and complete a public listing in the next 12 months. Management also noted that their board of directors has approved both Freshippo (BABA’s retail grocery segment) and Cainiao (their logistics groups) to explore an IPO over the next 18 months. BABA owns a 67% equity interest in Cainiao. Management stated that the business reason for splitting up these business units (outside of realizing shareholder value) is that their Taobao and Tmall businesses would no longer have to direct cash to fund those losses, but could instead reinvest in growth.

Management also reiterated their commitment to share repurchases, disclosing that the company had repurchased another $2.3 billion in ADSs in the 1.5 months subsequent to the quarter. I would caution against extrapolating that management has increased their aggression of the share repurchase program, but it is a good sign to know that this upcoming quarter already has a sizable amount of repurchases executed. With BABA stock being so cheap, management alignment with shareholders is a quality that can not be understated.

Is BABA Stock A Buy, Sell, or Hold?

As of recent prices, BABA was trading hands at just around 10x earnings.

consensus estimates

Seeking Alpha

Yes, that is non-GAAP earnings, but it should be noted that share-based compensation (the most typically protested non-GAAP adjustment) is only around 22% of non-GAAP net income.

non-GAAP reconciliation

March 2023 Quarterly Presentation

As noted previously, BABA has net cash and equity investments making up over 50% of the market cap - this is not reflected in that valuation and reflects additional upside.

The anticipated spin-offs may create value due to investors beginning to value the company on a sum-of-the-parts basis. When valuing BABA on a price to earnings basis, only China commerce is offering positive value contribution as that is the only segment generating positive net income. If we “zero out” the losses from these other segments (arguably a reasonable decision considering that these segments must have at least positive value), then we would need to adjust earnings by around 25% higher. $22.7 billion in China commerce net income valued at 10x earnings implies $227 billion in equity value from this segment alone.

Based on a 6x sales multiple for the cloud division (yielding $73 billion in equity value), a $20 billion value for Cainiao (at a 67% equity interest), we arrive at another $86 billion in equity value. If we include only $58 billion in net cash (ignoring the equity investments on the balance sheet) then we arrive at $371 billion in projected value, implying a stock price of $144 per share. That is already suggesting ample upside, and we have neither assigned value to many other proposed spin-offs nor increased the 10x earnings multiple on the China commerce operations.

What are the key risks? The risks should not be understated. The Chinese government remains a wildcard here, not just due to what kind of negative actions they might do in the future, but also due to the perception of it placed on the valuation. Even if BABA management follows through with these spin-offs, it is possible that the total valuation remains compressed if Wall Street remains concerned about regulatory intervention. I am of the view that the share repurchases go a long way towards helping to improve this sentiment, but the share repurchases admittedly can be increased further, and a dividend might be more efficient at this point. It is also possible that management is unable to execute on the proposed spin-offs, or the spin-offs result in bloated cost structures that somehow come back to become a net negative for the company. There isn’t really a price at which these risks are “priced in” but I see tremendous potential upside for the stock and the near term catalysts are in motion. I rate the stock a buy, but caution that this position requires monitoring (and ideally hedging).

Source: seeking alpha