Alibaba: Amazon´S Success Or eBay´S Misery?

Summary

• Price depreciation of Alibaba´s share did not reflect very good number from last couple of quarters when excluding fine and Ant share compensation.
• How operational costs could affect future potential with comparison to Amazon and eBay.
• In my opinion, company represent very good opportunity for mid and long-term investors.

Alibaba – current view

Alibaba (BABA) is the largest Chinese and one the largest technology companies in the world. But not sure if „technology “is the best word for description of Alibaba´s business. The core lies in retail and e-commerce business (the largest e-commerce company in the world, despite fact, that people think it´s Amazon), with exposure to financial services, logistics, technology sector (such as cloud) and digital media & entertainment. In combination with huge market share Alibaba represent very attractive investment.

Source: Forbes.com

Nevertheless, share price is falling from November´s 316 USD to current 211 USD mainly due to dispute with Chinese regulatory authorities, which begun with not fortunate Jack Ma´s speech at Bund summit in 2020 and ended with postponed Ant financial IPO and the highest Chinese regulatory fine ever (2,8bn USD or 18,2bn RMB), which should end regulatory scrutiny - for now.

Financial results in nutshell

Let´s take a look at financials first. Company delivered extraordinary 64% revenue growth in comparison to Q1 20 and 41% revenue growth on yearly basis (which is more than most of FAANG companies). Quarterly loss from operations of 7,6bn RMB were impacted by fine imposed by Chinese regulators on Alibaba for violating anti-monopoly rules. When excluding this one-time item, the outcome will be more than superior – 48% increase. On yearly basis, a decrease of 2% year-over-year, was little bit surprise, but affecting primarily by the above-mentioned Anti-monopoly fine as well as a 16bn RMB increase in share-based compensation expense related to Ant Group. When excluding these items, we can see approximately 35% increase – still below previous revenue growth, but in line with FAANG.

Cloud computing delivered revenue growth of 50% year-over-year, to 60bn RMB, primarily driven by revenue from customers in the Internet, public sector and finance industries. The „slower “37% revenue growth in last quarter was primarily driven by loss of ByteDance due to requirements not related to product (pressure from US to keep data outside of China and ByteDance involvement in cloud business).

Net income attributable to ordinary shareholders was 150bn RMB and net income was 143bn RMB, which reflected the above-mentioned anti-monopoly fine and the increase in share-based compensation expense related to Ant Group. Excluding these impacts non-GAAP net income was 171bn RMB, an increase of 30% year-over-year. In current environment, still solid outcome, but expectations were set up much higher at the beginning of the year.

Source: March Quarter 2021 and Full Fiscal Year 2021 Results

Cost or profitability direction

I noticed, while doing due diligence, that operational expense/ revenue ratio is keep rising year over year. I was not sure if it´s Alibaba related specific or it´s usual for companies with same or similar business focus? As benchmark I used Amazon (AMZN), one of the best companies in the world, which share few similarities with Alibaba and eBay (EBAY), which was one of companies used as template for business model. Based on outcome, we can assume how future company price appreciation can look like.

Amazon were investing heavily in first 5-6 years of its existence, when expenses represented in average 132% of revenue and in following years Amazon were able to keep percentage around 96%, but till 2017 were not able to unwind revenue growth into more significant profit increase.

eBay were able to keep expenses below 90% of revenue and producing more than decent growth till 2013, but after divesture of PayPal were not able recover in terms of revenue, growth or net income.

In case of Alibaba, percentage of operational expenses/revenue ratio were below 73% in period of 2012-17, but then growing steadily to 87% till current year (numbers are limited by fact, that statements are available only from 2012), supported also by net income growth (with exception of current year, mainly by reasons mentioned earlier).

Amazon is keeping ratio near 100% level and producing significant profit. Mainly due to scaling (in line with low operating margin – 6,6% for 2020). In past Walmart was bringing stores closer to the customer to scale the revenues, Amazon is doing the same, with last mile shipping. Keep doing business this way, keeping leadership position and expanding into new markets and areas, all these, in order to secure future revenue growth, is cost demanding. High ratio in such case make sense and could bring significant appreciation as I mentioned later in article.

On the other hand, eBay was more profitable company since beginning, but has never repeat Amazon´s success. Not releasing all revenues into future growth in early years were not a good idea. Which at the end costed eBay more significant market share at the expense of Amazon.

Alibaba´s case is specific, as it has better profitability and very high revenue growth as well (almost leveled Amazon´s profit for 2020, despite three times lower revenues). Necessity for emerging market like China, especially with highly fragmented retail and tough competition. Alibaba is not focusing solely on Chinese market and core business (e-commerce and new retail), but keep investing internationally too – especially in south-east Asia (could be huge win with improving economic conditions). Following Amazon, company is investing heavily into cloud and turned into profit first time in last two quarters of financial year of 2020.

It is usual for high growth companies invest heavily to support future growth not only in early years, but also later, but keeping operational revenue/cost ratio significantly below 100% level do not guarantee significant price appreciation in future. Quite the opposite, keeping ratio near the 100% most probably result into price increase in future. Of course, this is not only factor – vision, management executions are important as well.

Amazon

Source: Morningstar.com

Alibaba

Source: Morningstar.com

Source: Morningstar.com

As you can see on chart below, Alibaba´s appreciation is on the same level as eBay despite fact, that company is producing profit as Amazon. More aggressive spending could bring revenue´s increase at the expense of profitability, thus more significant price increase. Nevertheless, I prefer more organic growth before chasing additional revenue (which is mostly tied with not very effective cash allocation). With 473bn RMB of cash on balance sheet it´s not a problem for company to pull a trigger in case of interesting investment opportunity.

Source: seekingalpha.com

Retail ecommerce sales will be growing in next couple of year based on graph below, so with unwinding China´s potential and firm foothold at international markets, significant price appreciation is expected.

Source: shopify.com

My investment in Alibaba

My intention is to keep Alibaba as long-term core investment. Apart from that my initial encounter with company was not very fortunate, I bought shares at the time of infamous Jack Ma´s speech and had get rid of them after 10% loss of my initial investment. Revisited company lately, after couple of months when situation around company settled down and price levels/financials were hard to ignore.

Based on simplified extrapolation, Amazon share price is worth of 3 203 USD, while producing almost the same profit as Alibaba, therefore Alibaba´s price should be around 589 USD with the PE of 61 (current PE of Amazon). With Alibaba´s historic PE at 33, I´m expecting price around 319 USD.

I get same price based on DCF calculation, with gradually decreasing revenue growth from 40% to 30% in next 10 years and cost of capital around 10%. This represent 47% appreciation from current levels.

“Hard to ignore” investment was also supported by Charlie Munger, who disclosed open position of 37 million USD for Daily Journal Corp., followed by Mohnish Pabrai with similar amount. With these two gentlemen on the board, my conviction is even stronger.

Conclusion

Operational cost/revenue basis matters not only in early stages, but later as well (as noticed with Amazon example). Suggesting that this is only thing which can bring future success is little bit stretched. It can give you indication where focus of companies lies and what you can expect from share price in future, but management vision and execution matter as well.

Share price is heavily affected by dispute with Chinese regulatory authority and more scrutiny is expected going forward, but intention of government is not to bring Alibaba down. On contrary, government mission is to build or support Chinese companies, which will represent counterweight to foreign companies like Amazon, Google, Microsoft or Facebook. So, I´m more than convinced that eventually superb financial and growth values prevail, and political risk will disappear.

I don´t expect any significant movement downwards (in case of unchanged market conditions), but if so, I will be adding more shares to my portfolio, till 10% level of overall portfolio.