Why Alibaba Is A 'Strong Buy'

Summary

• Alibaba has a competitive moat and is a cash machine.
• The company is severely undervalued when compared to eBay and Amazon.
• However, there is a decent risk in the company's corporate structure. Thus, we recommend allocating a small percentage of your portfolio to this stock.

Alibaba (NYSE:BABA) is one of the world's fastest growing companies. Not only it has a strong competitive moat, which is scale and a strong ecosystem, Alibaba is a cash machine. However, its stock price is not reflecting the company's real position.

We believe that BABA stock is strongly undervalued and a comparison with both; eBay (EBAY) and Amazon (AMZN), proves that. It's worth noting that both of these comparisons are based on the idea that a company which has a higher growth rate and a higher FCF margin shouldn't be valued less on a price to FCF basis.

Alibaba is undervalued when compared to eBay

Both, Alibaba and eBay, share a similar business model as they connect buyers and sellers directly without requiring in-house storage of the products exchanged. This enables both companies to generate a decent amount of cash flow. But, the market is valuing eBay's free cash flows just 41% cheaper than Alibaba's free cash flow valuation, while in fact, Alibaba's growth is 13x higher than that of eBay's.

But, the market is valuing eBay's free cash flows just 41% cheaper than Alibaba, while in fact, Alibaba's growth is 13x higher than that of eBay.

BABA Free Cash Flow (TTM) data by YCharts

And, not only is Alibaba's growth much-much higher, its TTM free cash flow margin is almost double that of eBay. This means, for every $1 of added revenue, Alibaba generated double the amount in FCF that eBay generated (24.7% vs. 43%).

Thus, it's unreasonable for Alibaba to be valued just 70% higher than eBay taking the huge discrepancies in growth and FCF margin into account.

Not to forget, eBay itself is undervalued as we stated in the articles linked below. Which means that Alibaba should be valued much higher than current levels.

eBay: A Safe Investment with a Possible Acquisition Target

Alibaba is undervalued when compared to Amazon

When compared to Amazon, Alibaba is severely undervalued. Amazon has a price to FCF valuation that is 66% higher than that of Alibaba's.

BABA Revenue (TTM) data by YCharts

However, besides having more than double the growth rate, Alibaba has a higher cash-from-operations margin (CFO/sales). For instance, over the LTMs Amazon generated 11.7% of its sales (after deducting all expenses) in cash while Alibaba generated ~51% (!) of its sales (after deducting all expenses) in cash.

Not to forget, Amazon gets the vast majority of its CFOs from Prime subscriptions and by postponing paying for its expenses while Alibaba gets its cash purely from direct sales. For more info, you can read the article linked below.

The Red Flag that Amazon Investors Should Worry About

Also, if we were to judge on FCF basis, the situation gets worse for Amazon and better for Alibaba. Not only Alibaba's FCFs are higher, the company has no capital leases obligations. Unlike Amazon which acquired last quarter $6.7 billion of assets under capital lease contracts (capital leases are not included in FCF calculation in Ycharts)

AMZN Free Cash Flow (TTM) data by YCharts

(Source: Amazon's latest 10Q)

(Source: Alibaba's latest 20-F)

If we included capital leases in FCF calculation for Amazon, Amazon's FCF would be slashed by more than two-thirds, which means that Alibaba's adjusted FCF is more than 5x that of Amazon.

For more info about the type of capital leases acquired by Amazon, read the article linked below.

Calculating Amazon's FCF in a Different Way

Amazon's FCFs are depressed due to high capital spending that includes building warehouses, leasing shipping planes and servers. However, that doesn't change the premise that Alibaba is better positioned to translate revenues into FCF due to its business model which doesn't require huge capital spending. And we all know, less capital intensive industries deserve a higher valuation.

For instance, Samsung's (OTCPK:SSNLF) operating profit might surpass that of Apple (AAPL) this quarter, but its valuation is somehow 3x less due to the high capital spending the company's operations require (and thus lower FCF).

Yet, the market is valuing Amazon, which has half the growth rate of Alibaba and 77% less the adjusted FCF, 66% higher on a price to FCF basis.

We believe that's ridiculous. If Alibaba is valued the same way as Amazon, which it should be, the company would be worth $615 billion (~$240/share), 67% higher than current valuation.

Final thoughts

Alibaba is undervalued when compared to both Amazon and eBay. The stock deserves a higher valuation as the company is doing exactly what Amazon is doing but in its own market. Alibaba is now in the cloud business, and unlike the US cloud market, the Chinese cloud market is controlled by fewer companies, which translates to higher profits and faster growth.

The only risk we see in investing in Alibaba is its corporate structure. Orange Peel Investments regards this as a "Black Box", while Earnings Forecast Focus removes the possibility of Alibaba being close to "Enron".

In both cases, there is a decent risk in investing in Alibaba's ADRs. That's why we recommend having just a small position in the company. Also, we recommend reading Liang Zhao's analysis on Alibaba as she adds great additional insight.

Bottom line: We rate Alibaba as a "strong buy".

Analyst’s Disclosure: I am/we are long BABA, EBAY. 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.