The biggest issue on the minds of most investors is the recent trade negotiation between the US and China. Alibaba (BABA) has seen a major downturn due to the bearish sentiment surrounding the trade rhetoric. However, the recent bearish performance by the broader market increases the probability that we will see a middle ground in the trade talks. Analysts are already pointing towards 'modest progress' in these negotiations.
Chinese PMI data has also been very soft for December which has led to widespread contagion in many regions. The Shanghai Stock Exchange Composite Index has contracted by 30% in 2018. These swings in both the US and Chinese markets should reduce the probability of extreme positions during trade negotiations. Alibaba has seen a 35% fall in its prices since hitting the highs in June 2018. The fundamentals of the company are still very strong with an increase in diversification to non-core commerce segments. The low valuation multiple and long runway for growth provides substantial upside for long-term investors.
All eyes on trade talk
For the next few weeks, the trade negotiations between the US and China will decide which way the market moves. Many experts are already projecting a brutal start as Apple announced the poor sales figures in China. However, there are several reasons why we should expect an optimistic result from the trade talks.
Negotiators on both sides would need to keep an eye on the overall economy and the markets. SSE Composite Index in China has shown significant correction in 2018. Other metrics are also pointing to a slowdown in the broader economy if there is a breakdown in trade negotiations.
The current White House administration would also like to prevent a complete rout in the market due to trade talks. This should prevent the negotiators from taking an aggressive position. The markets and the broader economy are acting as a safety valve during the trade negotiations, which increases the probability that a middle ground would be found by both the sides.
Impact on Alibaba
Alibaba's stock has taken a big hit due to the ramping up of trade rhetoric in the past few months. Despite showing good revenue growth rate, the stock is down by 35% since June 2018.
Fig: Fall in trailing twelve month pe ratio and forward pe ratio of Alibaba since June 2018. Fall in next year revenue estimate of Alibaba compared to depreciation in Yuan.
The revenue estimate for the next fiscal year fell by 9.46% while the Yuan depreciated by 6.66%. We can easily see from the above chart that most of the decline in the next fiscal year revenue estimate for Alibaba is due to the depreciation in Chinese Yuan. A weaker Yuan reduces the dollar-denominated revenue of Alibaba. On the other hand, the fall in valuation multiple during this period has been much more drastic. Both the trailing twelve months and forward pe ratio of Alibaba have seen close to 30% decline.
This shows that Alibaba is being priced according to a worst-case scenario in the trade talks. However, as pointed above, a complete breakdown in talks and the increase in tariffs is a very small probability. The response of the broader market will act as a check which should prevent extreme negotiating positions.
Upside for Alibaba
Alibaba has taken one of the biggest correction in the major stocks which are dependent on trade talks. The company has also aggressively moved into diversifying its revenue base away from core e-commerce segment in China. Alibaba has made massive investments in South Asia and Southeast Asia. These should give huge benefit in the next few years as it increases the overall ecosystem of Alibaba and also provides a ready market for the cloud segment.
Alibaba is rapidly increasing partnerships and investments in Europe. It recently made a broad partnership with Spain's El Corte Ingles. This is the biggest department store in Europe. The partnership includes Alibaba providing logistics, new retail, cloud, and e-commerce support to the company. Such a strong partnership also increases the moat for Alibaba and would help the company attract other big retailers in Europe.
Currently, Alibaba has a market cap of less than $350 billion. However, Alibaba's cloud segment alone could end up having a stand-alone valuation of over $100 billion. The cloud segment is currently showing an annualized revenue rate of $3 billion with 90%-100% growth in the past few quarters. At this rate, this segment should hit $10 billion by next year. Alibaba should be able to deliver at least 20% operating margin from this segment as it reaches higher scale (Amazon's (AMZN) AWS showed 31% operating margin in the recent quarter). A $2 billion EBITDA from cloud segment should easily have a valuation multiple of over 50 times, considering the fact that it has much higher growth rates than other cloud players.
Fig:Alibaba is trading at close to 25 times its forward pe ratio
In the short term, Alibaba stands to gain a lot from even a modest trade deal between US and China. On a longer term basis, Alibaba is diversifying into new regions and segments which gives the company a long growth runway. In addition to this, Alibaba's cloud segment will end up becoming a key profit driver. This should improve the bullish sentiment for the stock.
It is difficult to see how we will have a worst-case scenario in the recent trade negotiation between the US and China. Both sides would like to prevent a complete rout in their individual markets which is highly likely if the trade talks fail. A modest understanding in the trade negotiation should help Alibaba's stock come out of its current bearish trend.
The company is aggressively diversifying away from e-commerce segment in China. This should further provide downside protection and improve the future growth possibility for the company. I have a strong buy rating from Alibaba.
Disclosure: I am/we are long SAVE, 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.