We have raised our fair value estimate of Chinese e-commerce giant Alibaba (BABA) on account of the firm’s stronger than expected earnings and faster pace of top-line expansion relative to our previous future forecasts.
Through the first nine months of its fiscal 2015 (ending March), the company’s revenue has expanded at a 45% year-over-year clip thanks in part to strength in mobile, where sales expanded roughly 5-fold in the calendar fourth quarter. Non-GAAP EBITDA margins were an impressive 58% during the three months ending December 2014, and we expect profit margins to remain robust as expenses are scaled with robust revenue expansion. Through the first nine months of its fiscal 2015, Alibaba has generated RMB35.45 billion ($5.7 billion) and RMB31.4 billion ($5 billion) in cash from operations and free cash flow (CFO less capex). The firm’s cash flow profile remains robust. Our five year forecasts within our enterprise free cash flow (free cash flow to the firm) valuation model now reflect a 5-year forward revenue compound annual growth rate of ~31% (was ~23%) and an average non-GAAP EBITDA margin of ~59% (was ~63%), more consistent with its growth and profitability trajectory. Our fair value estimate for Alibaba is now $128 per share (was $104 per share).
As a result of the sell-off in shares, Alibaba’s Valuentum Buying Index rating has been revised to 3 from 6. The Valuentum Buying Index is not a step-function rating system because the methodology takes into consideration not only valuation dynamics but also the information contained in technical/momentum indicators. This is unlike other systems (e.g. star rating systems) that may only take into account the valuation of a particular entity. Said differently, multi-step moves are not uncommon with the Valuentum Buying Index (e.g. 6 to 3), unlike a step-function system where companies move gradually from 3 stars to 4 stars, for example. The combination of in-depth discounted cash flow valuation, comparative multiple analyses, and market information leads to a more informative outcome with greater conviction, in our view.
The flow chart shows how we derive the Valuentum Buying Index rating for each firm.
Alibaba’s Investment Considerations
Investment Highlights
• Alibaba’s business quality ranks among the best of the firms in our coverage universe.The firm has been generating significant economic value (ROIC less-WACC) during the past few years. The company benefits greatly from a network effect and will continue to benefit from favorable demographic trends in China.
• Alibaba is widely known as being synonymous with e-commerce in China.The firm owns Taobao.com, the country’s largest online shopping destination, Tmall, China’s largest third-party plaform for brands and retailers, and Juhuasuan, China’s most popular group buying marketplace.
• Alibaba has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm’s free cash flow margin to average about 47.1% incoming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 43.8%. Yahoo and Softbank own a nice slice of the firm.
• Alibaba has a robust marketplaces operation and is a mobile commerce leader. Total gross merchandising volume (GMV) on its China retail marketplaces is $270 billion, a staggeringly large figure. The firm has 163 million mobile MAUs and controls more then 75% of the total mobile retail GMV in China.
• The underwriters on this deal had priced the firm very attractively. We think shares are worth north of $100 each. Though risks are abundant with operators in China (regulatory/legal), the company is underpriced.
Business Quality
Economic Profit Analysis
The best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm’s economic profit spread. Alibaba’s 3-year historical return on invested capital (without goodwill) is 77%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Alibaba’s free cash flow margin has averaged about 37.1% during the past 3 years. As such, we think the firm’s cash flow generation is relatively STRONG. At Alibaba, cash flow from operations increased about 184% from levels registered two years ago, while capital expenditures fell about 120% over the same time period.
Valuation Analysis
We’ve updated our discounted cash flow model following fourth-quarter results. Our updated fair value range is $102-$154 per share. The margin of safety around our fair value estimate is driven by the firm’s LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $128 per share.
Our enterprise free cash flow valuation model reflects a compound annual revenue growth rate of 30.7% during the next five years, a pace that is lower than the firm’s 3-year historical compound annual growth rate of 37.9%. Our model reflects a 5-year projected average operating margin of 56.5%, which is above Alibaba’s trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 8% for the next 15 years and 3% in perpetuity. For Alibaba, we use a 10.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $128 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show the probable range of fair values for Alibaba. We think the firm is attractive below $102 per share (the green line), but quite expensive above $154 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
We continue to believe Alibaba is an underpriced equity. Shares are trading just shy of $90 each at the time of this writing.