Alibaba: Fair Value Approaches (NYSE:BABA)

On Wednesday, Alibaba (NYSE:BABA) stock rallied 13% in a single trading day on news that Ant Group had received government approval to expand its payments business. The news was a big deal because it showed that the Chinese government was softening its stance toward tech companies.

Alibaba’s 2021/2022 selloff got started when the Communist Party of China (“CPC”) cancelled Ant’s planned IPO. Investors thought that the scuttling of the IPO signaled hostility from the government. Some went so far as to say that the IPO cancellation was more about Xi Jinping’s personal anger at Jack Ma for criticizing the government, than Ant Group’s financials. Shortly after the IPO was cancelled, Alibaba was slapped with a number of regulatory measures, including a $2.8 billion fine. That would seem to confirm the theory that Xi Jinping was personally upset with Jack Ma and Alibaba.

That was then, this is now. Following three gruelling years of Zero COVID, China is re-opening, and a big part of its growth strategy is promoting the stock market. China has been furiously working to retain its New York Stock Exchange listings, support stock prices, and facilitate economic growth. The latest Ant Group news just confirmed that China was heading in a dovish direction on stocks, so it’s not surprising that Alibaba rallied when that news became public.

Personally, I was disappointed to see BABA stock rally 13% in one day. The stock went as low as $62 just a few months ago, I only got a couple small buys in at that level. I was hoping to get the opportunity to buy at $62 again, but my hopes were dashed. C’est la vie.

In my opinion, Alibaba stock is still a buy at today’s level. However, it’s not the slam-dunk buy it was just a few months ago. Analysts’ consensus fair value for BABA stock is $134, my own personal estimate is $168 to $258. Whether I’m right or the analyst community is right, there is no doubt that Alibaba is rapidly catching up with its fair value. It will only take one more rally like the one seen this week for the lower end of analysts’ price targets to be hit. The stock is still a great value, but it could soon hit a level after which it will market-perform, rising only incrementally after earnings releases. In this article I will make the case that that level is approximately $200. Once that level is breached I’ll stop buying BABA stock.

Alibaba – The Opportunity Defined

Alibaba has been getting a lot of attention online over the last two years. It has been all over Seeking Alpha ever since its bear market started in late 2020, it’s also pretty popular on Twitter and Reddit. In the last few months the stock hasn’t been getting as much attention as it did a year ago, but it still punches above its weight.

Why all this attention for a company that most Westerners don’t deal with on a regular basis?

A lot of it has to do with who owns it. The social media phenomenon surrounding Alibaba was kicked off when Charlie Munger took a position in it, later other big investors followed him into the trade. Charlie Munger highlighted Alibaba’s cheapness. At the time Munger bought, BABA was trading a rock bottom multiples compared to U.S. tech stocks, which were then in the middle of a bubble.

At the lows, Alibaba was a remarkably cheap stock. It still is today; it currently trades at just 12.5 times earnings and 11.2 times operating cash flow. However, the recent rally made the stock more expensive than it once was, as it did not coincide with any new earnings. At $62, BABA was barely trading above book value, today it has a 1.8 price/book ratio. The opportunity here is not as great as it used to be.

Of course, the opportunity is still very real. At today’s prices, BABA trades at just over half the NASDAQ-100’s P/E ratio. If Chinese stocks’ valuations converge on those of their American peers, then Alibaba will eventually rise just from multiple expansion alone. However, the stock is not likely to remain a “pick money up off the floor” opportunity for long. My models have generally yielded fair value estimates between $168 and $258; once the lower end of that range is reached, I expect Alibaba’s price moves to become much slower.

Alibaba – Valuation

In the previous section, I said that I estimated Alibaba’s fair value at between $168 and $258. Given that this range of estimates is well above the analyst consensus, I should explain how I arrived at it.

First, let’s look at Alibaba’s most recent 12 month cash flow statement. I’ll use the version on Seeking Alpha Quant, which compiles the company’s financial statements into a convenient ttm format.

In the last 12 months, Alibaba had:

• $120 billion in revenue.
• $76.6 billion in direct selling costs (“COGS”).
• $44 billion in gross profit.
• $29.9 billion in operating expenses.
• $14.1 billion in operating income (“EBIT”).
• $1.075 billion in interest expense.
• $3.9 billion in depreciation and amortization.
• A $1.33 billion increase in working capital.
• $7.4 billion in net capital expenditure.
• $4.4 billion in cash income tax (note: the reported amount on the last four income statements works out to $2.75 billion, I got the cash amount from Seeking Alpha Quant).
• $-1.024 billion in net borrowing.
• $7.42 billion in levered free cash flow.

Some of the items on this list are very difficult to predict going forward; namely, depreciation, working capital, capital expenditure and net borrowing. These are partially at management’s discretion; for example, depreciation is based on assumptions that management can change, and net borrowing ultimately comes down to how much debt management chooses to repay, a decision that’s not normally announced at the start of a quarter. For this reason, I’ll leave these items out of my Alibaba model. Effectively this means I’ll be modelling net income rather than free cash flow, but at any rate, the two should correlate with one another over time.

Alibaba’s revenue growth rate in the last two quarters was 0%. The low growth was due to China’s COVID lockdowns. Now that Zero COVID is permanently over, I’d expect growth to pick up again. However, Alibaba is big enough now that it probably won’t roar back to its previous 40% year-over-year growth. So, I’ll model revenue growth at 5% per year for five years.

COGS directly correlates with revenue, so I’ll assume that grows at 5% too.

Next up, we have operating expenses. Those declined 12% last year. That was a positive development, but I wouldn’t expect these costs to keep falling. So, I will assume that they plateau at this year’s level and stay there for the next five.

I’ll make the same assumption about interest expenses, which are declining but probably won’t continue to decline forever.

With these ingredients in place, I can forecast five years’ worth of Alibaba’s cash flows/earnings:

	Base year	Year 1	Year 2	Year 3	Year 4	Year 5	CAGR
Revenue	$120B	$126B	$132B	$139B	$146B	$153B
COGS	$76.6B	$80B	$84.5B	$89B	$93B	$98B
OpEx	$29.9B	$29.9B	$29.9B	$29.9B	$29.9B	$29.9B
Interest	$1.075B	$1.075B	$1.075B	$1.075B	$1.075B	$1.075B
Tax	$2.75B	$3.75B	$4.13B	$4.75B	$5.5B	$6B
Earnings	$9.6B	$11.2B	$12.39B	$14.3B	$16.5B	$18B
Per share	$3.60	$4.2	$4.65	$5.37	$6.20	$6.76	13.4%

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My model yields a 13.4% CAGR growth rate in earnings per share. If we assume that growth slows to 0% after these five years are up, then we arrive at the following fair value estimates, depending on the discount rates chosen.

Discount rate	Fair value	Rationale for discount rate
3.72%	$174	10 year treasury yield
5%	$128.6	Fed’s goal for terminal rate
5.72%	$111.62	Treasury yield plus 2% risk premium

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At all of the discount rates above, Alibaba has some upside. Now, if you push the discount rate to 8%, my model shows downside; however, note that the model was for net income rather than free cash flow. I chose that metric because it requires fewer assumptions, but it results in low estimates for Alibaba, which has more free cash flow than earnings. If I had started with the $5.32 in ttm free cash flow per share and grown that at 13.4%, the range of estimates would have been from $168 to $258, and upside would have remained with discount rates as high as 9%. However, for the sake of intellectual honesty, I must say that I consider things like working capital and net borrowing impossible to predict, so I can’t say for sure that free cash flow will grow at such a rate. I’m fairly confident that earnings per share will.

The Bottom Line

The bottom line with Alibaba is that it still has upside, even under fairly conservative growth assumptions. However, as my model shows, the “low hanging fruit” are rapidly being picked. If the range of estimates in the table above is accurate, then Alibaba stops being easy money at around $150. It’s a buy, but maybe not for much longer.