The investment thesis
The thesis of this article is really simple: the share price of Alibaba Group Holding Limited (NYSE:slime, OTCPK:BABAF) has recently decoupled from business fundamentals. As such, it has become a good opportunity to buy a good business on the trading table. As will be detailed later, there is no double that faces a series of risks, and its profitability is no longer as strong as before. But I will argue that these risks are already more than discounted. Performance remains remarkable when put in context, but valuation is so compressed by negative sentiment that the potential for recovery far outweighs the risks. Before diving into more details, here I will first summarize the gist of my thesis in two bullet points.
First, a simple comparison between BABA and JD.com, Inc. (NASDAQ:JD) is enough to illustrate the current absurdity of the market. JD.com trades at a significant valuation premium compared to Alibaba (and also the broader market) despite comparable profitability, a lack of diversity in its revenue streams, and also a lack of high-growth areas.
And second, for unusual stocks like BABA at unusual times like ours, it’s much better to follow independent thinkers like Charles Munger than the market in general. As everyone knows, Munger doubled his stake in Alibaba twice during 2021 and then recently halved it in May 2022. Despite the reduced position, his Daily Journal Corporation (DJCO) still holds BABA’s largest position among super investors tracked by dataroma.com, as you can see in the first graph below. BABA’s position currently stands at over $34 million and represents over 19% of DJCO’s equity portfolio.
Plus, Munger isn’t the only one who’s been shopping for BABA lately. The chart below shows the top 12 super-investors who have placed the largest position in BABA in terms of their weight in their portfolios. As you can see, only 3 of them reduced their position during the most recent 13F disclosure. Three of them kept their exposure. And one of them started a new position and five of them increased their exposure. Of the two who increased their position, two almost doubled it (Prem Watsa and Bruce Berkowitz). The JD activities of super investors are a completely different picture, as you can see in the second chart below.
Of course, super investors don’t always make the right bet at the right time. And I’m not suggesting you follow them blindly (I’m not). But after studying several of them in depth (Charles Munger, Guy Spier, and also the Tweedy Browne lineage), I can speak responsibly and confidently that they tend to be more original and critical thinkers, and they all follow very disciplined investment approaches. .
With this, let’s try to redesign their reasons.
BABA’s profitability decreased
There is no doubt that BABA’s profitability is no longer what it used to be after the recent regulatory crackdown on tech in China. The chart below shows your return on capital employed (“ROCE”) over the past few years with a highlight of this year. ROCE measures the return on capital ACTUALLY employed in a business, and is the most important and fundamental measure of profitability in my mind as detailed in my blog article here. As you can see, BABA was able to maintain a remarkably high ROCE level in the past: it has been above 100% through 2020 with an average of 143%. However, his ROCE began to decline substantially after the crackdown began. Even just in the last few months, its ROCE has decreased from 76.7% based on TTM finances as of January 2022 to the current level of 62.8% based on TTM finances as of September 2022.
In absolute terms, profitability has also suffered considerable falls as shown in the table below. Again, these numbers are based on TTM financials as of January 2022 and September 2022. Namely, operating cash flow is down by about 22%. In terms of earnings before taxes (“EBT”) and net earnings, financials declined even more than operating cash flow. Earnings before taxes were down about 50% and net profits were down about 43%. In the future, the business also has remaining shares of contributions to the prosperity pool and will also be subject to higher tax rates.
But BABA’s profitability remains competitive
Here I want to put past performance into perspective. Its ROCE is much lower compared to its astronomical past, but it’s still very well rounded compared to other companies, as you can see in the chart below. This chart compares the ROCE of some other highly profitable stocks like AAPL, JD, et al. And as you can see, BABA’s current ROCE of ~63% ranks third even among this group of achievers. JD’s current ROCE is around 75%, higher than BABA’s. But as I’ll argue later, I don’t see how such a narrow lead in ROCE can justify the huge valuation premium the markets have over JD.
Capital allocation flexibility and growth rate
BABA’s capital allocation picture used to be very simple not too long ago (let’s say 2020). You get a lot of cash organically from your trades, but you don’t need to spend a lot. It is true that its financial position and capital allocation flexibility have weakened somewhat for now. However, the operative word is again relative. It is weak relative to its own past, but still quite strong compared to other businesses.
Namely, it generated over $21 billion TTM operating cash as mentioned above. You are effectively debt free considering your debt interest expenses are only $0.5B. And its total long-term debt is about $20 billion, while its total cash position is about $69 billion. And depreciation on it is only $4.1B, less than 20% of its operating income.
So overall, it’s still a very cash-generating business but doesn’t require a lot of cash to sustain and grow. In the long run, the growth rate is given by:
Long-term growth rate = ROCE * Reinvestment rate
With an ROCE of the order of 63%, even if BABA only reinvests 10% of its profits in the business, it can grow around 6.3% per year (long-term growth = 63% ROCE * 10% reinvestment rate). % = 6.3%). And you can afford to reinvest much more than 10% as discussed above. By contrast, JD’s ROCE is around 75% and assuming a reinvestment rate of 10%, the growth rate would be around 7.5%. It is higher, but not enough to justify the valuation premium as detailed below.
BABA vs. JD: Valuation and ROCE-adjusted valuation
The chart below shows BABA’s P/E multiple adjusted for cash compared to some other similar stocks like JD, Amazon (AMZN), Apple (AAPL) and Alphabet (GOOG, GOOGLE). All cash per share data, P/E data and pricing data are taken from SA as of September 5th. As can be seen, all companies have a positive cash position behind their stock. And in the case of BABA and JD, they both have a large cash position at $9.95 and $7.54 per share, respectively. Such cash position represents about 10.8% and 12.4% of its current share price.
Unadjusted for cash position, BABA’s current TTM P/E is approximately 12.5x, compared to 33.8x for JD. Therefore, JD is valued at a premium almost 3 times higher than BABA (2.7x to be exact). When adjusted for cash, BABA is only trading at 11.1x and JD at 29.6x. The premium is slightly lower due to JD’s large cash position, but still 2.6 times higher. As mentioned above, I view such a premium as absurd given the very similar ROCE (63% vs. 75%), let alone the biggest growth initiatives at BABA, such as its cloud and potential IPO revival. from Ant Group as detailed in my another item.
The chart below puts the valuation into a more visual and also revealing format. Instead of comparing just the P/E, it compares both the P/E and ROCE of BABA to some stocks that are large holdings in BRK’s stock portfolio (V, AAPL, AMZN, et al). And the green line is what I call a Buffett value line because it is a line that joins: A) the origin (a business that has 0 ROCE should be worth 0x P/E); and B) Buffett’s largest holding, AAPL (which has the highest ROCE among this group of stocks, as shown above).
So, intuitively, it doesn’t make sense to own something much above this line. Because stocks above this line represent a worse trade-off between company valuation (reflected by P/E) and company quality (reflected by ROCE) than stocks below this line.
And as you can also see, BABA is in this line. And it’s very close to AbbVie (ABBV), showing that they have a similar valuation when adjusted for profitability despite their totally different line of business. And JD is well above this line, due to his marginally better ROCE compared to BABA but a very high rating.
Final Thoughts and Risks
In summary, it is true that there has been a negative evolution both in BABA’s profitability and in its financial position. However, such negative developments are largely comparative to its own historical track record. When compared horizontally with other highly profitable businesses like JD or AMZN, BABA’s current profitability remains highly competitive. However, its shares are trading at an absurdly compressed level. Compared to JD, its P/E of 11x ~ 12x is only about 1/3 of JD despite the fact of similar ROCE (63% vs. 75%) and its high-growth segments such as the cloud. For unusual stocks like BABA at unusual times like ours, it’s much better to follow independent thinkers like Charles Munger than the market in general.
The risks surrounding BABA have been detailed in other SA articles (and some of mine). These risks include VIE risk, delisting risk, and also the all-encompassing “China” risk. And I won’t go into more detail here. To me, these risks only add to the absurdity of the market when considering JD. From every angle I can think of, JD is subject to all of these same macroscopic and geopolitical risks. However, it still trades at a higher valuation, not only in relative terms compared to BABA, but also in absolute terms. An immediate risk that I see is the new resurgence of COVID cases in Chengdu (a key city in China), the possibility of a prolonged lockdown and the potential impact on BABA, JD and also the Chinese economy in general.