Alibaba: Update From Our Latest Letter
The following is an excerpt from Eagle Point Capital’s most recent letter to clients. Every six months, EPC writes to clients to explain what they own and why they own it. The portfolio-specific portion of each letter is for clients and prospective clients only. If you’d like to read EPC’s entire letter, please contact us.
The reports of my death have been greatly exaggerated.
— Mark Twain
To say investing in Chinese businesses has been out of favor recently would be the understatement of the decade. Fears of regulatory crackdowns, American delistings, and uncertain economic growth thanks to COVID have pressured Chinese stocks for the last 18 months.
In early 2022, pessimism started to snowball. Major sell-side analysts deemed China the pariah of the investment world. Negativity peaked as Russia invaded Ukraine. Investors feared China would side with Russia and sold without regard to price.
On March 15th JP Morgan declared China “uninvestable.” This proved the ultimate contra-indicator. The next day the Chinese government reassured investors that they would support its markets. Alibaba, which had been down 37% year to date, surged nearly 40% that day. Currently Alibaba shares are down less than 4% year to date.
The market is currently pricing Chinese equities emotionally, not rationally. Times like these often present opportunities and are to be welcomed, not feared. As always, our focus is on Alibaba’s fundamental earnings power, not its short term stock price. If Alibaba’s earnings power continues to grow, its stock price is sure to follow.
Alibaba’s largest business is e-commerce. Taobao and Tmall have nearly one billion annual active users (AAC). They are the Chinese-equivalent of Amazon, eBay, and Etsy. Lazada, which operates in Southeast Asia, has more than 300 million AAC.
Chinese AAC grew 15% year over year in Q4. International AAC grew 37% and overall revenue grew 10%. Earnings declined 25% as anticipated investments in growth, user acquisition, and merchant support cut into margins.
Alibaba’s increased spending is reminiscent of Facebook. Facebook has periodically made heavy investments through its income statement which temporarily depress margins but which ultimately strengthen the company’s competitive position.
We estimate that Alibaba’s e-commerce segment currently has underlying earnings power of more than $20 billion per year.
Alibaba benefits from an emerging Chinese middle class. While the company faces competition from JD.com and Pinduoduo, among others, we expect that the overall Chinese pie will expand enough to provide everyone with growth. We expect Alibaba’s network effects to remain intact and for revenue and profitability to grind meaningfully higher over the long run.
Alibaba’s second largest business is Cloud. Alibaba’s Cloud segment is similar to Amazon Web Services (AWS) and Microsoft Azure. It delivers on-demand computing resources like servers, databases, and applications over the internet to businesses all over Asia.
In 2021 the cloud segment grew sales 20% and earned a profit for the first time. Cloud requires significant up front investment in data centers but has minimal marginal costs. We expect Cloud to experience significant operating leverage as it grows and customers consume more data.
Economies of scale are critical in Cloud and here Alibaba has a clear advantage. Alibaba Cloud is the largest cloud platform in China and Asia several times over.
The Asian cloud market is less mature than in North America and ought to continue growing for the foreseeable future. Last year Alibaba Cloud generated $11 billion of sales. That’s the same size as AWS in late 2015. Today, AWS is 4x larger and earns $19 billion.
Investors main concerns regarding Alibaba are that:
Tech regulations will stunt growth or call for Alibaba’s breakup.
American stock exchanges will delist Chinese equities over audit disclosures.
China will cooperate with Russia and subject the country to sanctions.
We think Alibaba’s valuation and competitive position more than compensate for these risks.
To begin, the Chinese government has no incentive to destroy the country’s tech sector. The Chinese government’s recent actions suggest that they agree. In mid-March, the government stated that they would:
Ease pressure and sanctions on the tech sector;
Support the Chinese economy and stock market; and
Support foreign-listed Chinese equities, including those in the U.S., and seek to ensure compliance with local regulators, including the S.E.C.
Alibaba and other Chinese internet companies rose nearly 40% on this news. Despite the rally, we continue to think Alibaba is selling for far less than its intrinsic value.
We estimate that Alibaba trades for approximately 10x earnings today. The company is worth about $300 billion. From that we subtract its stake in Ant Financial, which is worth at least $25 billion. We also subtract its $60 billion of net cash and investments. That leaves $215 billion of value for the e-Commerce and Cloud segments. We think e-commerce has normalized earnings power of more than $20 billion, which implies a ~10% earnings yield. Such a low valuation implies expectations for zero growth along with zero value for Cloud. Someday, we think Cloud could be even more valuable than e-Commerce.
Cloud is on track to generate more than $12 billion of sales in 2022. Margins for AWS and Azure are around 30%, which means Cloud could someday produce over $3.5 billion of profits. If Cloud is worth 8x sales, then it is worth $80 billion. Accounting for this, Alibaba’s e-commerce segment trades for just 6x earnings.
Alibaba executives appear to recognize the company’s bargain valuation. Last week Alibaba authorized a $25 billion share repurchase. The repurchase will allow Alibaba to buy back 9% of its current market cap.
Howard Marks recently compared China to an economic adolescent – likely to be temperamental and prone to erratic behavior – but whose best economic years likely lie ahead. We think he’s right. Alibaba stands to benefit as a toll road on the expansion of the Chinese middle class and an explosion in cloud computing across Asia.
Although Alibaba shares are down significantly from our cost basis, our conviction in the business is unchanged. We maintain that Alibaba’s fair value is multiples higher than its current price. Eventually the company’s cash flows will speak for themselves and the market will fairly value Alibaba. Until then, we’re content to be patient.
If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com. Thank you for reading!
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.
with you! So cheaper! The retails stability