Michael Loccisano
Alibaba Group Holding (NYSE:BABA) just released earnings for its fiscal first quarter. The release beat estimates on revenue and on EPS. Revenue declined, but by much less than analysts thought it would, while free cash flow actually saw positive growth. The core e-commerce segment was weak, as expected, but the 10% year-over-year growth in the cloud made up for it.
The first quarter was a tough one for Alibaba, and for Chinese companies in general. Much of the second quarter coincided with a two month lockdown in Shanghai and a few other Chinese cities. The lockdown contributed to sluggish 0.4% GDP growth and declining manufacturing activity in the quarter. Retail sales were one bright spot for the quarter, growing 3.1%. Apart from that, though, it was a tough time. Nike’s (NKE) Chinese business reported a 20% revenue decline in its fiscal first quarter, which partially overlaps BABA’s first quarter. So we knew in advance that Q1 was going to be tough.
Alibaba delivered a fairly solid performance in Q1 in light of all the headwinds it faced in the period. Its revenue was $530 million ahead of estimates, and its earnings were very strong. The highlight of the quarter would have to be the 7% growth in free cash flow, as few people thought that BABA could crank out positive growth amid China’s lockdowns.
The question for investors is, where do we go from here? Alibaba just delivered a solid performance in one of the toughest macro environments it ever faced. The possibility of stronger performance in the upcoming quarter is very real. In light of this, it’s reasonable to believe that BABA stock will be on a good trajectory in the months ahead, as China’s macro issues fade.
Earnings Recap
In its fiscal first quarter, Alibaba reported:
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$30.68 billion in revenue, stable year-over-year, and ahead of estimates.
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$3.7 billion in operating income, down 19%.
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$1.24 in GAAP earnings per share (“EPS”), down 30%.
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$1.75 in adjusted EPS, down 29%.
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$3.3 billion in free cash flow, up 7%.
Overall, it was a solid quarter. Yes, all of the earnings metrics declined, but remember that Alibaba owns a portfolio of Chinese tech stocks. Those stocks were down in the quarter just reported, so net income was virtually guaranteed to decline. Free cash flow is probably the better “earnings” metric to look at here, and it grew by nearly double digits.
Balance Sheet and Valuation
Having looked at BABA’s most recent quarter, we can turn to its balance sheet and valuation. These factors give a picture of what an investor is actually buying, irrespective of short term earnings results. Viewed alongside quarterly results, they can add a lot to a thorough analysis.
Balance Sheet
As of the most recent quarter, Alibaba’s balance sheet included the following:
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$255 billion in assets.
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$91 billion in liabilities.
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$162 billion in equity.
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$96 billion in current assets.
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$56 billion in current liabilities.
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$20.5 billion in long term debt.
From these metrics we get a 0.126 debt to equity ratio and a 1.71 current ratio, suggesting strong liquidity and solvency. Alibaba’s debt is truly miniscule compared to book value, so the company is not at risk of financial distress. Additionally, BABA has $26 billion in cash on its balance sheet, a sum that can be used to fuel future buybacks and boost shareholder returns. In fact, Alibaba’s cash position is $1 billion greater than the $25 billion worth of buybacks the company authorized earlier this year!
Valuation
Now, let’s jump into the valuation.
At Wednesday’s market close, BABA stock traded at:
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25 times GAAP earnings.
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11.3 times adjusted earnings.
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1.86 times sales.
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10.9 times operating cash flow.
Given that first quarter earnings shrank compared to the first quarter of last year, the earnings multiples increased. For example, at the moment I was writing this, BABA was at $99.9 pre-market. At that price, and factoring in the Q1 results, we get an adjusted P/E ratio of 19. That’s still pretty cheap, and if BABA can resume its positive growth trajectory in the second half of the year, then the “E” part of the P/E ratio will increase. Additionally, the positive cash flow growth means that the cash flow multiple has gotten even smaller. Using the first quarter’s operating cash flow, along with the three quarters before that, I got a price/cash flow ratio of 10.76. That is, using the $99.9 pre-market quote. So even with the stock price rising from Yesterday’s close, BABA’s cash flow multiple got smaller!
Discounted Cash Flows
In addition to multiples, we can value BABA using a discounted cash flow (“DCF”) model. Normally this involves discounting five or ten years’ cash flows during a “growth” period, and adding a terminal value, based on a presumed slower growth period in the future.
For BABA, I am not going to try to model five years’ worth of cash flows, because the Chinese macro environment is so volatile that it’s basically impossible to predict with accuracy. However, it’s still possible to calculate a terminal value for the stock. If we assume that BABA never grows again, doing $5.23 in free cash flow per share forever, and discount the stock at the current treasury yield (2.73%), we get $191 in terminal value. That suggests significant undervaluation. If we up the discount rate to 5% to account for risk, then we get $104–which is a little upside but not much. So, taking into account both multiples and terminal value, Alibaba looks undervalued.
What’s in Store for Q2
Having looked at BABA’s Q1 results, we can now turn our eyes to Q2. The next quarter is probably BABA’s best chance at really impressing investors this year, as the comparisons are going to be soft. The previous second quarter release was extremely bad, and it won’t be too hard for BABA to grow from such a weak base period. In last year’s second quarter, Alibaba’s GAAP and adjusted earnings both declined. Free cash flow declined as well. Revenue growth was pretty solid in the period, but the company was in the process of losing valuable tax credits and stepping up its investments in unprofitable subsidiaries. Additionally, the guidance contained in the release was quite pessimistic, forecasting 20% full-year growth, which implied single digit growth for the third and fourth quarters.
In light of the weakness in the base period, it won’t be hard for Alibaba to deliver positive year-over-year earnings growth in the next quarter. It won’t necessarily beat estimates, but it will probably resume its previous trajectory of positive growth. Therefore, we could see BABA’s results begin to improve as soon as this Fall.
When a company is dominant in a growing industry, we expect that company to grow over time. Alibaba enjoys a solid competitive position in China’s e-commerce industry, so it stands to reason that its current earnings downturn is temporary. BABA is China’s biggest e-commerce firm by profit, and second only to JD (JD) on total revenue. JD’s growing sales put pressure on BABA’s core retail business, but BABA has much higher margins, which gives it the ability to invest in new businesses like the Cloud. Cloud computing was a game changer for Amazon (AMZN), and Alibaba’s own cloud business is growing at a rapid pace. So, we should expect BABA’s total business to grow in the coming years, even as JD and other competitors put pressure on the core commerce business.
The Big Risk to Watch
This year has seen some of Alibaba’s risk factors fade, while new risks have appeared afresh. The Chinese Communist Party’s (“CCP”) regulatory crackdown has been pretty quiet lately, and Jack Ma is taking the steps needed for Ant Group to go public. There is room for optimism on the regulatory front. However, public health issues are currently flaring up in China, in a way that we hadn’t seen since 2020. As we saw in today’s earnings release, COVID lockdowns took a big bite out of BABA’s first quarter sales. The company directly attributed its flat revenue growth to the lockdowns, and there’s no reason to think that they’re lying about that. Apple (AAPL) and Nike both posted negative revenue growth in China in the same period, so BABA’s weak Q1 revenue was likely a direct consequence of the lockdowns.
This means that the COVID situation in China is a major risk factor. China still formally adheres to a “zero COVID” policy. In recent months, they’ve changed the wording to “dynamic Zero COVID,” but they still have a policy in which localized lockdowns can be implemented over just a handful of cases. So far, small numbers of cases here and there haven’t caused new lockdowns in Shanghai, but Wuhan recently locked down over four asymptomatic cases. So, there is still the possibility of economic disruption from China’s COVID policies.
The Bottom Line
The bottom line about Alibaba is that it’s still a solidly profitable company even with all of the challenges that have been thrown its way. Its first quarter release blew away all estimates, which is more than we could have expected given the challenges BABA faced in the quarter. Even with all of these challenges, Alibaba still had high margins and positive growth in some segments, such as cloud computing. Taking the macro environment into account, that is a win.
The next quarterly release is likely to be a much bigger win. In the second quarter, Alibaba will be comparing itself to a weak base quarter, which will make it easier to deliver positive year over year earnings growth. In the quarter just reported, that wasn’t really possible, as the equity portfolio was too much of a drag on results.
There are still risks facing Alibaba shareholders. COVID remains a concern, and delisting could create liquidity issues a few years down the line. However, these risks appear small compared to all of the positive things BABA has going for it. I know I’ll be holding for the foreseeable future.
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