The thesis is to illustrate the current situations of Alibaba (NYSE:BABA) and JD.com (NASDAQ:JD) as yet another demonstration of the irrationality of the stock market (and hence the opportunities such irrationality creates). The comparison and contrast between BABA and JD are so dramatic that it seems to me that the market has entirely disregarded the business fundamentals – again. Admittedly, both are well poised to tap into the e-commerce growth in the Asian-Pacific regions, where the remaining e-commerce resolution will be centered. And both also face similar macroeconomic risks, including much of the regulatory and geopolitical risks.
However, just taking a quick glance at the following simple comparison, you can probably already see that BABA now is completely dominated by fear yet JD is still by greed. As shown in the table, JD and BABA are valued at about 30+ and about 10x PE based on non-GAAP TTM. So BABA is at a discount by almost a factor of 2x compared to JD. As we look a bit deeper, BABA valuation is also at a significant discount in terms of forward metrics. When the growth projections for the next three years are considered, BABA’s PE would still be at an almost 50% discount compared to JD.
Looking forward, I see BABA’s growth rates as underestimated because its R&D efforts and new investments are not properly factored in. On the other hand, JD’s growth rates and R&D efforts are on the side of being overestimated, as detailed next.
As mentioned in our earlier writings, when analyzing tech stocks, we tend to focus on A) the recurrent resources available to sustainably support new R&D endeavors, and B) the yield of the R&D process. The following chart shows how well and sustainably BABA and JD can fund their new R&D efforts.
As seen, the chart shows the R&D expenses of BABA and JD over the past decade. Both have been consistently in R&D and BABA has been spending more aggressively. Since 2015, JD on average has been spending only about 2% of its total sales on R&D efforts. And BABA, in contrast, spends on average 10%, about 5x more than JD.
Then the next question is, how effective is their R&D’s process? The next chart shows a variation of Buffett’s $1 test on R&D expenses as detailed in our earlier writings and in summary:
- The purpose of any corporate R&D is obviously to generate profit. Therefore, this analysis quantifies the yield by taking the ratio between profit and R&D expenditures. We used the operating cash flow as the measure for profit.
- Also, most R&D investments do not produce any result in the same year. They typically have a lifetime of a few years. Therefore, this analysis assumes a three-year average investment cycle for R&D. And as a result, we used the three-year moving average of operating cash flow to represent this three-year cycle.
As you can see, BABA's R&D yield has been stable, albeit with some degree of variance, around an average of $3.3 of output per $1 of R&D expenditure for the past decade. It's a competitive level even among the FAAMG group. In recent years, the FAAMG group has had an average R&D output of roughly $2 to $2.5 per $1 of R&D expenditure. JD's R&D yield was quite in the early part of the decade. It started below $1 and gradually improved to the current level of $2.2.
Looking forward, I see BABA as better positioned for future growth given the above contrast of R&D inputs and yield. Specifically,
As you can see from the following chart, BABA’s profitability is far superior to JD (and Amazon too) across many metrics. Take the net income margin as an example. BABA earns about 7.86%, drastically higher than JD and also almost 2x of that earned by Amazon. Another key metric is the FCF margin. As seen again, BABA’s FCF margin is almost 10x higher than JD. And for Amazon, its FCF has been suffering dramatic deterioration in recent quarterly (especially when lease obligations are considered) and its FCF margin is currently negative.
The metrics supplied in the above table provide a multifaceted snapshot of their current profitability metrics. For us, we also want to see a more fundamental measure over a longer period of time.
And as explained in our earlier writings, to us, the most important profitability measure is ROCE (return on capital employed) because:
ROCE considers the return of capital ACTUALLY employed and therefore provides insight into how much additional capital a business needs to invest in order to earn a given extra amount of income – a key to estimating the long-term growth rate. Because when we think as long-term business owners, the growth rate is “simply” the product of ROCE and reinvestment rate, i.e.,
Long-Term Growth Rate = ROCE * Reinvestment Rate
And I consider the following items capital actually employed A) Working capital (including payables, receivables, inventory), B) Gross Property, Plant, and Equipment, and C) Research and development expenses are also capitalized.
As you can see, both JD and BABA were able to maintain a remarkably high ROCE over the years. In BABA’s case, its ROCE has been at an astronomical level above 200% between 2014 and 2017. JD’s ROCE spiked to above 150% in 2017 also. Then both begin to suffer decay in their ROCE due to a variety of reasons (heightened competition, Chinese government regulations, the de-acceleration of China's overall economic growth, etc.). Despite the decays in ROCE since 2017, both still enjoy superb ROCE in recent years. In JD’s case, its average ROCE in the past four years is on average about 75 percent. And BABA is even higher, about 95 percent. To put things in perspective, the S&P 500’s average ROCE is around 20% and the FAANG group is about 55% to 65% in recent years by my estimation.
So here I see both JD and BABA enjoy superb profitability in recent years. However, BABA’s profitability is even better, which enables it to better fund its R&D efforts and position it for future growth as discussed next.
Looking ahead, I believe both are well positioned to profit from the secular growth trend of e-commerce penetration. It's easy to form a misconception that the e-commerce revolution is reaching a saturation point when we're so acclimated to North American shopping habits. Taking a broader view, the worldwide e-commerce penetration rate is presently only about 20 percent. In absolute numbers, worldwide retail e-commerce sales just hit $4.2 trillion in 2020 and are expected to nearly double in size by 2026, hitting $7.4 trillion in sales. The e-commerce revolution is only getting started and both JD and BABA are well-positioned to tap into the remainder of the revolution – which is the remaining 80% since most of it will be centered in the Asian-Pacific regions.
As seen from the following chart, retail e-commerce sales in Asia-Pacific are expected to surpass those in the rest of the globe by 2023. This will be mostly due to three factors: Increasing urbanization, catching up on the technological curve, and the fact that more than 85 percent of the new emerging middle-class will be from the Asian-Pacific region. The potential on the B2B front is even more enormous considering the current B2B gap as seen below. With their size, reach, government support, and cultural and geographic proximity, both JD and BABA are best positioned to gain in the Asia-Pacific region.
However, I see BABA as better positioned for tremendous growth opportunities in other areas besides e-commerce. BABA is a leader in the cloud computing space in China.
Our world is entering a "pay per use" paradigm for its insatiable computing needs. BABA is best positioned in this space in China as private companies, government divisions, universities, and research institutions all transfer their computing needs to this new model. Another notable advantage that BABA enjoys is its logistic arm, Cainiao. Cainiao is BABA’s delivery platform that handles shipments around the globe. The logistic system interacts seamlessly with its local and international e-commerce activities. Its recent demonstration of the Xiao G delivery cart has the potential to reshape the future of e-commerce logistics. It's a fully autonomous cart that has shown great promise during its demonstration in Hangzhou, a metropolis of 10 million people. It has been demonstrated to pick up items from Cainiao's Hangzhou depot, navigate the city traffic using its 360-degree sensors, and deliver to local areas.
Finally, the following table summarizes all the key metrics discussed above. My thesis is that the risks surrounding BABA have been fully priced in already and JD seems to be still dominated by greed. BABA spends 5x of its sales on R&D than JD, harvests 1.5x of the R&D expenses, and enjoys 1.27x of profitability as measured by ROCE sustainably in the long-term. Yet, it’s for sale around 10x PE, compared to 30x of JD – which is not only higher than BABA but also higher than the overall market.
I do not think there's a need to repeat BABA’s risks anymore. Other SA authors have provided excellent coverage already. And we ourselves have also assessed these risks based on a Kelly analysis.
Both JD and BABA face macroeconomic risks and geopolitical risks. The Russia-Ukraine conflict has already led to extreme volatilities in Chinese and global equity markets. And the conflict is far from over and China’s involvement (if any) remains highly unpredictable.
Specific to JD, it has been facing the Chinese regulatory crackdown (same as BABA). It has become harder for it to gain market share and its user growth has slowed in recent quarters because of the increased competition, especially against BABA. After all, BABA enjoys a much larger scale and much deeper pocket. BABA’s operating cash flow is currently more than 4 times of that JD (more than $27B vs $6.6B).
The stock market is known for ignoring business fundamentals at sentimental extremes. The contrast between JD and BABA suggests such market psychology is currently at play.
Both JD and BABA are well poised to tap into the e-commerce growth in the Asian-Pacific regions. However, in direct comparison against BABA, JD underspends on R&D. Its R&D yields and profitability are also both lower than BABA by a large margin (though healthy when compared to the general economy and other good businesses). Yet, JD is currently valued at around 30x PE TTM, compared to ~10x of BABA, creating a mispricing situation too large to ignore.
Check out our marketplace service
As you can tell, our core style is to provide actionable and unambiguous ideas from our independent research. If your share this investment style, check out Envision Early Retirement. It provides at least 2x in-depth articles per week on such ideas.
We have proven and perfected our methods with our own money and efforts for the past 15 years. For example, our aggressive growth portfolio has helped ourselves and many around us to maximize return with minimal drawdowns.
Lastly, do not hesitate to take advantage of the free-trials - they are absolutely 100% Risk-Free.
This article was written by
** Disclosure** I am associated with Envision Research
I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between.
My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community!
Disclosure: I/we have a beneficial long position in the shares of BABA either through stock ownership, options, or other derivatives. 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.