Alibaba: Conservatively Undervalued By 20-30%

|
About: Alibaba Group Holding Limited (BABA), Includes: AMZN, FXI
by: Victor Dergunov
Summary

Despite Alibaba's recent 30% move off the lows, at just 25 times forward EPS estimates, the stock remains meaningfully undervalued.

Alibaba has enormous momentum, and the company continues to develop secondary businesses that are likely to become increasingly more profitable in future years.

Product development as well as revenues increased by 41% YoY, while G&A costs increased by just 28%, strongly implying increased efficiency at the company.

Alibaba will likely report modest to moderately higher EPS next year (than current consensus estimates), and the company should go through a multiple expansion as well.

Based on relatively conservative estimates of $7 in EPS, coupled with a slightly higher forward multiple of 30-35 times forward earnings, Alibaba's shares are currently undervalued by 20-30%.

Image Source

Alibaba (BABA) has surged by about 30% ever since the company’s shares hit a triple bottom earlier this year. Nevertheless, the stock is still off by more than 20% from its all-time high, and by relatively conservative estimates, shares remain undervalued by roughly 20-30%.

Alibaba 1-Year

Source: Stockcharts.com

Alibaba is currently trading at 25 times forward earnings, and while this may not seem “cheap” at first glance, it appears like a bargain for a company like Alibaba. Alibaba is in an incredibly dominant market position, operates in one of the most promising market segments in the world, is expected to grow revenues by over 50% this year and nearly 40% next year, and has enormous earnings potential.

Consensus estimates point to EPS of about $6.74 next year, but I believe Alibaba can earn at least $7 per share (my conservative estimate). Moreover, based on the company’s market position, and the fundamental factors surrounding Alibaba, the stock should be trading at a higher multiple, likely at least around 30–35 times forward earnings.

Several factors appear to be responsible for Alibaba’s mispricing, including not enough emphasis on future earnings potential of secondary businesses, and too much emphasis on the supposed China slowdown. Ultimately, future earnings are likely to improve, and could be substantially higher than analysts' forecast.

Provided that Alibaba can earn around $7 in EPS next year (which is conservative in my view), coupled with a 30–35 times forward earnings multiple, Alibaba’s price should be around $210-$245. This is roughly 25-45% higher than the company’s recent share price, which strongly implies the stock is currently undervalued by about 20-30%.

Alibaba Earnings Indicate Extremely Robust Momentum

Alibaba’s stock took off after the company recently reported another stellar quarter.

Revenues

  • Total Revenue came in at $17.06 billion, a 41% YoY increase.
  • Revenues from core commerce came in at $14.96 billion, a 40% YoY surge.
  • Cloud computing revenue came in at $962 million, an 84% YoY increase.
  • Revenue from digital media and entertainment increased by 20% to $944 million.
  • Innovative initiatives and other revenues increased by 73% YoY to $193 million.

Source: Alibaba.com

Users

  • Annual active consumers increased by 5.8% YoY to 636 million users.
  • MAUs increased by 5% to 699 million users (9-month period).

Profitability

  • Operating income: $3.9 billion.
  • Adjusted EBITDA: $5.92 billion.
  • Net income: $4.5 billion, 33% YoY increase.
  • EPS: $1.84, 37% YoY increase.
  • Net cash from operating activities: $9.44 billion.
  • Non-GAAP free cash flow: $7.47 billion.

Spending

The company spent a record amount of $41.6 billion in 2018 on product development, sales and marketing, general and administrative (G&A), and other expenses, an 86% YoY increase. The higher increase in costs relative to revenue growth may not seem like a positive factor. However, much of the increase in spending has to do with expanding and growing future businesses, and does not appear to be related to decreased operational efficiency.

In fact, on a YoY basis, as a percentage of revenues, Alibaba showed a 1% decline in G&A expenses, while showing a 1% increase in product development costs. In total, Alibaba increased product development spending by over 40%, while G&A costs increased by just 28% YoY.

Furthermore, the fact that the company’s revenues increased by 41%, while G&A costs increased by only 28% firmly implies that the company is becoming more efficient with scale, and should continue to become increasingly more profitable going forward.

Earnings Takeaway

We can see that Alibaba continues to grow and expand operations at an epic pace. Its core commerce business remains immensely profitable and is allowing the company to sustain and grow multiple other businesses under its increasingly expanding umbrella. The company also reported very strong profitability metrics across the board, once again, underscoring Alibaba’s incredible momentum and future earnings potential.

The Big Picture

One thing investors should not lose sight of is the big picture. Right now, Alibaba generates nearly 88% of its revenues from its core commerce segment. This segment is incredibly profitable, and delivered a 45% adjusted EBITA margin last quarter.

However, much of the record profits is not funneling through into the company’s net income column right now. Instead, it is going towards expanding numerous businesses in cloud, digital media, entertainment, and other segments.

Alibaba is essentially building an online empire, the likes of which have never been seen before. The company owns what is widely considered to be the best and biggest cloud service in China. Furthermore, Alibaba owns numerous online media and entertainment platforms, as well as significant gaming interests, and numerous other online enterprises.

An important factor to consider is that many of these businesses are still in their developmental stages, and are not yet profitable. However, this does not mean that they will stay unprofitable for long.

In fact, if we take a closer look at Alibaba’s “secondary” segments, we see that despite bringing in nearly $1 billion in revenues last quarter, cloud is not yet profitable. The segment had a negative 4% EBITA margin last quarter. Now, it’s likely because Alibaba continues to grow the unit very aggressively, with last quarter’s growth coming in at 84% YoY.

This business alone will likely generate about $5–$7 billion next year, and it will very likely become very profitable over the next several years. A similar argument can be made for Alibaba’s other businesses in digital media and entertainment, and in innovative initiatives and others.

Just because these units are unprofitable now, does not mean that they will lose money indefinitely. Instead, it suggests that Alibaba’s secondary businesses will continue to grow, and when they reach a certain level of maturity, they should begin to generate significant profits for Alibaba’s shareholders.

Watch For More Upside As Sentiment Improves

Chinese stocks in general have been out of favor since early 2018. In fact, China’s large Cap (FXI) ETF had declined by about 30% through November of last year. This is due to various factors, including trade tensions with the U.S. as well as an overall slowdown in the Chinese Economy.

However, it is important to put the Chinese slowdown into context. What we are talking about here is a “slowdown” to about 6.2% this year, and the next, possibly lower to 6% in 2021, and slightly lower (above 5%) after that.

China GDP Past Growth And Forecasts

Source: Statista.com

Also, it is important to note that this slowdown is largely a naturally-occurring phenomenon, as China’s economy continues to mature. Additionally, 6.2% or 6% GDP growth is still extremely strong, especially if we compare it to the sub 3% growth we’ve seen in the U.S for more than a decade now.

Finally, with all this growth, Chinese stocks are about 30% cheaper than their U.S. counterparts on a P/E basis. If we use a CAPE ratio analysis, Chinese stocks are trading at a discount of nearly 50% to U.S. equities.

Ultimately, Alibaba’s business is not likely to be substantially impacted by the slowdown in China, and any negative effects would very likely prove to be transient in nature. Furthermore, the company has enormous momentum, and once the U.S./China trade deal gets signed, shares are likely to see substantial upside as sentiment improves.

Valuation Appears Relatively Depressed

At 25 times forward earnings, Alibaba remains moderately undervalued. If we compare this valuation to an analogous company like Amazon (AMZN), which trades at 42 times forward consensus estimates, Alibaba’s price would need to be at $285, 68% higher than today’s price to compare on a similar P/E basis.

Additionally, Alibaba’s revenues are projected to increase by 36% next year, double that of Amazon’s 18%. This essentially means Alibaba should be trading at a higher multiple, perhaps as high as 50 or 60 times next year’s earnings to compare well on a valuation basis with Amazon.

At 50 times current forward estimates, Alibaba would be worth $340 a share, exactly double from where the stock is trading at today. Furthermore, higher-end revenue estimates point to growth of as high as 53% next year, which implies Alibaba could easily surpass its projected 36% YoY growth estimate, which makes for an even stronger case to put a higher multiple on the stock.

However, to remain conservative, let’s assume Alibaba’s multiple will expand to just 30–35 times forward EPS. Also, while Alibaba’s consensus EPS estimates point to a figure of just $6.74 for next year, it is probable that due to continued improvements in efficiency and increased profitability, the company will report at least $7, possibly higher even.

In fact, higher end estimates shoot all the way up to $8.71, and if the company can earn anything this high, the stock may be trading as low as 19.5 times forward EPS right now (however, I believe this is too optimistic).

Nevertheless, if we just use the relatively modest figure of $7, and apply a seemingly humble 30–35 times earnings multiple, we arrive at a price target of $210-$245 for the stock, roughly 25–45% higher than where the shares are trading today.

What Wall Street Thinks

If we look at the analysts’ opinions, they mostly share a similar view to my thesis. The current 12-month price target range ranges from $178 all the way up to $260, with a consensus price target of $202.5. This implies the stock would need to appreciate by roughly 20% to achieve analysts’ consensus figure, and by about 53% to get to higher-end estimates.

Technical Image Improving Substantially

We see that Alibaba made a distinct triple bottom recently. The first low was made in November at the $130 level along with the broader Chinese stock market, then the stock retested the same level when the U.S. stock market bottomed, and then Alibaba came back and successfully retested the $130 level for a third time in early 2019.

Alibaba 2 Years

Since then, the stock has been on a tear, up by about 30%. Multiple successful retests of the $130 level imply that the stock likely found a lasting support level and is likely to continue to appreciate going forward.

Furthermore, the $130 level represented about a 38% retracement from Alibaba’s all-time high, likely creating a substantial long-term buying opportunity. However, the stock remains about 20% below its all-time high, and may go on to make new all-time highs before the next significant correction occurs.

Bottom Line: Alibaba Remains Notably Undervalued

Alibaba has enormous momentum, the company is likely going to continue to aggressively grow revenues, while expanding its growing line of businesses. Moreover, Alibaba should start to become increasingly more profitable as its secondary enterprises begin earning more income over time.

Furthermore, China’s slowdown is not likely to impact Alibaba’s business drastically, and any negative effects will likely be transient in nature. Additionally, once the trade deal is announced, Alibaba and Chinese stocks in general should benefit from an overall improvement in sentiment.

Alibaba’s stock price will likely benefit from two factors going forward. One, the company’s EPS will likely surprise to the upside, and two, the company will likely experience a multiple expansion.

Alibaba is currently expected to grow revenues by more than 36% next year. This is by consensus estimates, but top line estimates go as high as 53% for YoY revenue growth. This is compared to Amazon’s 18% expected (consensus analysts estimate) YoY revenue growth next year. Despite the much better growth picture, Alibaba only trades at 25 times forward earnings, while Amazon commands a multiple of around 42.

Alibaba will likely earn about $7 a share next year, and given all the factors this may be a conservative estimate. Furthermore, as sentiment continues to improve and strengthen, the company’s P/E multiple should expand to at least 30–35 times forward earnings.

At just $7 in EPS, and with a relatively conservative multiple of just 30–35 times forward earnings Alibaba’s stock would trade in a range of $210-$245, which implies the current stock price of $170 is about 20–30% undervalued. Hence, Alibaba remains a conviction long-term strong buy in my book, and the company remains one of the largest holdings in my portfolio.

Disclaimer: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please consider consulting a professional before putting any capital at risk.

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.