I've been eyeing Alibaba (NYSE:BABA) for quite a while, since the IPO in fact. I was previously unable to secure stock at levels that were attractive to me.
Last week, Alibaba's stock price hit $68. I made an initial purchase at this level, with a view to adding more should the stock continue to fall. In my view, Alibaba is an even better business now than it was at IPO. Alibaba currently trades at a trailing P/E of 18x earnings and has now approached a level that looks attractive.
A dominant moat that will drive strong returns
I like dominant businesses with natural barriers to entry that help ensure long-term profitability. Alibaba has the characteristics of a wide moat business. The company benefits from strong network effects, courtesy of being the dominant e-commerce play in China.
At latest count, BABA had roughly 367M buyers across its marketplaces. This represents close to 20% of the Chinese population. TaoBao in particular enjoys strong brand loyalty among a younger generation of Chinese consumers. A platform with the greatest number of buyers attracts the greatest number of sellers and provides strong monetization for Alibaba.
Having such a dominant platform makes it hard for competitive platforms to find a place. Others either need a clear value proposition to supersede BABA, such as better pricing, or offer services in a small niche that Alibaba doesn't cater to.
Profitable, high margin business with strong cash flows
Alibaba is a business with a high level of profitability that produces significant levels of cash. BABA's gross margins hover near 70%, and the business manages to retain 30% of revenues as operating margin. Such a level of operating profitability is much better than Amazon (NASDAQ:AMZN) and eBay (NASDAQ:EBAY).
The net impact of such strong economics is free cash flow generation that hovers between 40%-50% of revenue, which again is not only much better than Amazon and eBay, but is significantly better than other high quality technology franchises such as Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Apple (AAPL) and Facebook (NASDAQ:FB).
Growth drivers are in place for the foreseeable future
Alibaba is in the midst of a growth spurt. Revenues have grown at a strong pace over the last five years, averaging just under 30% annually. Operating income and EPS have shown similar levels of growth over the last five years.
BABA's growth potential remains immense. China's e-commerce sales still only represent about 10% of total retail sales, implying that there is still a long way for digital commerce to go. Increases in per capita consumption and a shift toward a services oriented economy will see increasing purchasing power for Chinese consumers. This should result in higher disposable incomes driving more discretionary spending. Ultimately, this all augers well for Alibaba.
Risk factors likely manageable
An investment in Alibaba isn't without risks, but in my view these risks are quite manageable. The biggest risk is the mere fact that the business operates in China, which implies an economic and regulatory risk profile that is very different to most businesses.
The e-commerce landscape in China also is in a state of flux as new players develop new value propositions. JD.com (NASDAQ:JD) and Vipshop (NYSE:VIPS) in particular are two players that are carving out markets for themselves. JD is emphasizing authentic merchandise coupled with a strong distribution and fulfillment model. Vipshop's model of flash sales targeted at consumers in Tier 2 and Tier 3 cities also will be an interesting one to watch. Ultimately, I think these players and others will occupy small niches in China's e-commerce landscape rather than challenging Alibaba's dominance.
Valuation looks compelling
In my view, it is clear that BABA is a great business. In fact, it is a great business with a strong set of growth drivers that should propel growth for quite some time.
I'm interested in investing in a business with a robust market position that has strong growth drivers which will allow superior growth. I think Alibaba represents that kind of a business. Analysts are forecasting Alibaba will grow earnings close to 25% annually over the next five years. Given the historic rates of growth that the business has achieved, I think this looks very achievable.
With a TTM P/E ratio of 18x earnings, this suggests a likely rate of return going forward for investors of at least 15% annually if BABA achieves the level of growth that analysts expect. Morningstar currently rates the business 4 stars.
While Alibaba's stock price may show a high level of volatility in the near term, those who are willing to hold for an extended period of time should see good investor returns.
Disclosure: I am/we are long BABA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.