A large publisher ran a negative article on Alibaba (BABA) last weekend, “Alibaba: Why It Could Fall 50% Further (1)” As the article has successfully struck fear into the hearts of US investors in light of ongoing Chinese market collapse, it has also successfully hurt Alibaba’s stock. There are a few things that we think are worth emphasizing that were lacking in the piece.
1) Alibaba is significantly free cash flow positive.
Unlike the many Internet sensations of the late 1990s and early 2000s that were burning through millions and millions of cash every quarter, Alibaba is significantly free cash flow positive (cash flow from operations less all capex). In the June quarter alone, assuming a USD-to-RMB exchange rate of 6.2, the company hauled in $1.54 billion in free cash flow. Annualizing the quarterly tally gets to a run-rate free cash flow stream of ~$6.16 billion. For a company that is growing as fast as Alibaba, generating positive free cash flow at all (in the context of a net cash-rich balance sheet, which it has) is a large dent to the bear case outlined in the publisher’s piece over the weekend. In the case of most young, fast-growing companies, investments tend to overwhelm cash flow from operations. This is not the case with Alibaba, which remains a cash-flow rich enterprise.
2) Alibaba’s valuation is not stretched.
Aside from the absence of the most important financial aspect of business evaluation (free cash flow), an in-depth assessment of the company’s valuation was missing in the piece. For example, if we assume a mere 5% annual growth rate in Alibaba’s traditional free cash flow and add back Alibaba’s net cash balance of $10 billion and its various other holdings in Alibaba Pictures, Alibaba Health, Ant Financial, YoukuTudou and Weibo, we can implicitly back into the firm’s current share price and market capitalization (~$160 billion) with a value – and that’s only with a 5% long-term growth assumption.
Alibaba’s revenue has grown nearly 7-fold since 2011 and its net income has advanced 15 times over the same period. We think a 15 times multiple that is stipulated as “fair” on Alibaba’s shares is far from it. Companies such as Coca-Cola and Procter & Gamble, for example, where growth is under pressure for various reasons, are trading at near-20 times forward earnings and Apple which is trading at an incredible ~9 times, less net cash, show the tremendous pitfalls of using any kind of multiple analysis across different companies–or even for similar companies for that matter, as in the case of the publisher’s comparison of Alibaba to eBay. A discounted cash-flow model is the only true way of uncovering an entity’s intrinsic worth.
3) Why no long-term focus?
As we have outlined before, our affinity with Alibaba is a function of what the company will look like 10, 20, 30 years from now–not how the firm’s shares will perform over the next few quarters, which we admit may be rough in light of macroeconomic issues in China. The points that the publisher makes about slowing “growth in volume” from (~50% to ~34%), for example, are semantics, in our view. Where we’d grow concerned is if growth in revenue and gross merchandise volume (GMV) slowed to a single-digit pace; only then would we have to take a hard look about whether one of the largest economies in the world will face what most may call a “hard landing.” From our perspective, it’s unreasonable to expect ongoing revenue acceleration for a company that is as large as Alibaba. The company has a lot of room to the downside in the growth of key value-driving metrics (revenue, earnings, free cash flow) before shares would be considered expensive.
4) Why is precision important?
In light of the tangible free cash flow generation, should investors really be concerned about the precision of how many online users are in China at present—whether it is 367 million or 400 million or 450 million. Does it really matter?
Such estimates are incredibly difficult to make, in any case. What we think is important is to acknowledge that there are currently ~1.4 billion people in China at the moment, the growth run-way is long, and online penetration rates are still low. If Alibaba’s user numbers should be lower than reported, as the publisher argues, it would then mean that future growth potential is larger! This is actually a good thing.
What we’re skeptical of is not the average annual spend per online user in China of $1,215, which the publisher points to as being suspect, but the US measure of “$963 annual average for US online shoppers.” We have a difficult time believing that the average US online shopper spends ~2-3% of the median household income of ~$40k online? Does that include business spending online? We think a sub-$1,000 number in the US is actually the one that is too low.
5) Businesses are their future free cash flow streams.
We think Alibaba gets it.
Businesses are their future free cash flow streams – and the view that “the fruits of the businesses, including cash flow and profits, are transferred to the holding company,” that US shareholders own is a tribute to the very idea and focus of the intrinsic qualities of any business.
As Alibaba has stated many a time before, “Alibaba shareholders own shares in a holding company that holds 100% equity stakes in its Chinese operating subsidiaries…Through ownership in the shares of Alibaba…shareholders own these assets and have direct access to the cash flows generated from operations of the wholly-owned subsidiaries through dividends.”
We think the publisher’s fear mongering will be successful, but there is a very important silver lining. The article has brought to light important information for the investment community to continue to hash out, thereby improving transparency, and counter-intuitively increasing the confidence investors will place in Alibaba. At the moment, the company accounts for less than 3% of the Best Ideas Newsletter portfolio, a rare short-term miscue and black eye, but something that shouldn’t pose a material headwind to growing outperformance in the Best Ideas portfolio.
The long-term picture at Alibaba remains bright, in our view, but that doesn’t mean shares won’t suffer in the near term, much like large cap peers Tencent (TCEHY) and Baidu (BIDU), as economic malaise in China proliferates. Alibaba’s response to the magazine’s article is worth reading first.
It can be found here.