Summary
Alibaba Group Holding Limited is currently priced at only 8.5x its FY1 pretax earnings.
As such, it provides a very asymmetric return/risk profile according to the so-called Buffett’s 10x pre-tax rule (earnings before taxes, EBT).
An 8.5x EBT multiple is comparable to ~12% bond yields because bond yields are quoted in pre-tax terms even if earnings stagnate.
Any growth is a bonus.
Of course, the assumption is that the business has no existential risk, which is a good assumption here in my view.
Andrii Yalanskyi/iStock via Getty Images
Investment thesis
In the past 1 or 2 years, the stock prices of Alibaba Group Holding Limited $Alibaba(BABA)$ have been largely dominated by news and fear. Despite a large rally since its stock price bottomed near $65 in Oct 2022, my thesis here is that its stock price is still disconnected from the company's fundamental business performance. The stock is irresistibly undervalued according to Buffett's 10x pre-tax rule (earnings before taxes, EBT). According to this rule, if you pay 10x EBT for a business that remains stagnant, you would be essentially buying a 10% yielding bond because bond yields are quoted in pre-tax earnings.
In the next section, you will see that BABA is currently trading far below 10x EBT. It is trading around 8.5x of its 2023 pre-tax earnings and about 7.7x of its 2024 pre-tax earnings. Yet at the same time, BABA is very unlikely to be a stagnating business in my view. I view it as the best-positioned company to benefit from the e-commerce movement, particularly in the Asian-Pacific region.
As such, my thesis is straightforward here: owning BABA at its current EBT multiples is already a good deal according to the 10x EBT rule. And any growth would be a plus to push your annual return into double digits.
BABA and Buffett's 10x EBT Rule
If you are a follower of Warren Buffett like me, you may have observed many of his most significant and successful investments were made at or below 10x EBT, including Coca-Cola $Coca-Cola(KO)$, American Express $American Express(AXP)$, Wells Fargo $Wells Fargo(WFC)$, and more recently Apple $Apple(AAPL)$. As detailed in my earlier writings, I do not see this as a coincidence. Buffett understands that pre-tax earnings are more fundamental because tax rates do not reflect business fundamentals and there are always ways for a company to manage its taxes. And pre-tax earnings yields are much easier to benchmark against risk-free rates, as bond yields are quoted in pre-taxed terms.
Against this background, you can see that the market now presents BABA at a valuation far below 10xEBT at its current price of around $95 as of this writing. For a business like BABA, its multiple should be far above 10xEBT, as it has been in the past, as seen. However, due to recent market overreaction out of fear, its current valuation is hovering close to 8.5x FY1 EBT and only 7.7x FY2 EBT.
In particular, its stock price bottomed near $65 in Oct 2022, corresponding to a multiple of only ~5x EBT, a reflection of extreme and irrational fear as I see it. Even though the stock prices have rallied substantially since then, a 7~8x EBT multiple is still disconnected from the company's fundamentals and growth potential.
Next, I will elaborate on the above results and their implications for expected returns.
Source: author based on Seeking Alpha data
BABA’s financials and valuation multiples
All my following analyses are made based on a per ADR basis, and there are eight ordinary shares in each BABA ADR. All the data used in my analyses were taken from Seeking Alpha unless otherwise specified. Consensus estimates project BABA’s EPS to be $7.83 in 2023 and $8.84 in 2024. And BABA’s effective tax rates are ~21% in recent years (taken from the most recent Value Line report). As such, the EBT of BABA is projected to be $9.91 in 2023 and $11.12 in 2024, as shown in the next chart.
Source: author based on Seeking Alpha data
In the meantime, bear in mind that BABA has a good amount of cash on its ledger as shown in the next chart. To wit, BABA has a cash position of $10.94 per share. To better contextualize things, the table also shows the financial positions of the other Chinese tech giants: JD.com, Inc. $JD.com(JD)$ and Tencent Holdings Limited $Tencent Holding Ltd.(TCEHY)$. All of them have superb balance sheets, and BABA has the highest amount of cash ($75.28B) and the lowest amount of debt (-$47.57B).
Now if you take the cash position out of the stock price, you will get the valuation multiples that I quoted above. And again, these multiples are 8.5x FY1 EBT and 7.7x FY2 EBT, translating into a pre-tax earnings yield in the range of 11% to 13%. As mentioned above, such yields are directly comparable to an 11%~13% yield bond even if BABA’s earnings stagnate forever.
And next, I will argue that instead of stagnating, BABA’s earnings have an excellent prospect to grow at a robust pace.
Source: Seeking Alpha data
BABA near- and long-term growth catalysts
First, much of the fear surrounding BABA is driven the by so-called “China risk.” However, my view is that the risk has been overblown. BABA plays a critical role in the overall Chinese economy and is too big and also too good to fall. The company's platforms, such as Taobao and Tmall, connect millions of consumers with merchants and have become a fundamental part of the country's infrastructure now. It is true that the Chinese government has indeed been tightening its regulatory control on its tech giants in recent years. However, there are many signs that China is easing the pressure now. Recent developments surrounding BABA alone include:
China's central bank, the People's Bank of China, recently issued a statement that it would support the stable development of Ant Group.
According to this Reuters reports, Chinese regulators are likely to reduce the fine and charges against Ant Group. The fine, which was originally projected to exceed $1 billion, is now expected to be $728 million. Admittedly, it is a small amount under the overalls scheme of things. But the symbolic aspect is more fundamental than the financial aspect.
In the longer term, Alibaba Group Holding Limited’s growth is simply unstoppable given the world's progress toward e-commerce. Despite the impressive success of e-commerce giants such as BABA and Amazon $Amazon.com(AMZN)$ so far, it's important to note that the e-commerce revolution is still in its early stages. The chart below shows the steady and rapid increase in global e-commerce penetration in recent years, nearly doubling from 10.5% in 2016 to 20.2% in 2020, with a CAGR of approximately 19%. However, ~80% of commerce was still conducted offline and the total global retail e-commerce sales have “only” reached $4.2 trillion in 2020. This figure is projected to almost double by 2026, reaching $7.4 trillion. In other words, the bulk of the e-commerce penetration is yet to come.
Source: Digital Commerce 360
And the Asia-Pacific region will be the epicenter of the remaining e-commerce revolution, and BABA is best positioned to benefit in my view. By 2023, retail e-commerce sales in Asia-Pacific are projected to surpass the rest of the world combined as shown in the chart below. To wit, retail e-commerce in the Asia-Pacific region is estimated to reach $1.4 trillion by 2023, while the rest of the world will only have around $1.3 trillion. By 2023, the Western continents will contribute only 16% of the total B2B e-commerce volume, with the remaining 84% coming from the non-Western world. The greater China region is likely to see the most growth due to its large population base, the rapid urbanization process, and also the rise of its middle-class.
Source: Shopify.
BABA is in a prime position to benefit given its geographical, language, and cultural proximity in this region. And it certainly has the means to play the long game, and a quick glance at its recent capital allocation snapshot could easily confirm this. As seen from the chart below, BABA generates significant operating cash flow its operations (“OPC”). And at the same time, it does not have a debt burden as previously noted and does not need to spend too much on CAPEX either. To wit, in recent years, BABA has generated around $30B of OPC annually. Its debt interest expenses have been essentially zero (on average $0.5B per year). And its business is so capital-light that it only needs to spend about 14.5% of its OPC as maintenance CAPEX. The majority of its OPC (more than 85%) of its can either be spent on growth CAPEX or other purposes (e.g., share repurchases or paying a cash dividend).
Source: author and Seeking Alpha.
Risks and final thoughts
BABA faces several risks, too. As mentioned above, the fear of the “China risk” is for good reasons. Even though these are signs that China is easing its regulatory tightening, the pressures on tech giants can be fluid and change rapidly. Besides such regulatory risks, BABA also faces competitive risk and geopolitical risks. Domestically, BABA faces intense competition from rivals such as JD.com and Pinduoduo $Pinduoduo Inc.(PDD)$. And globally, it competes with other giants like Amazon. BABA also operates in several countries around the world, and its business could be impacted by geopolitical tensions and trade disputes, such as the ongoing tensions between China and the United States.
Finally, specific to the 10x EBT applied here, a strong warning is also in order. As detailed in my earlier writings,
The rule does NOT suggest you go out and start buying every/any stock that is below 10x EBT. Investors face two major risks: A) quality risk or value trap, i.e., paying a bargain price for something of horrible quality, and B) valuation risk, i.e., paying too much for something of superb quality. The 10x pre-tax rule is mainly to avoid the type B risk AFTER the type A risk has been eliminated already.
And the assumption in my thesis here is that BABA faces no existential risks either in the near term or long term. An existential risk is unthinkable, at least at this point. But it is an assumption, nonetheless. Under this assumption, Alibaba’s current valuation multiple provides double-digit pre-tax earnings yields (11% to 13%) even if it stagnates indefinitely.
Source: Seeking Alpha
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