The premise of this essay is straightforward: Alibaba Group Holding Limited’s (NYSE:BABA) stock price has recently been disconnected from company fundamentals. As such, acquiring a solid firm on the operation table has become a wonderful opportunity. As discussed more below, there is little doubt that it confronts many difficulties, and its profitability is no longer as robust as it once was. However, I would argue that these risks have already been priced in. When the profitability is contextualized, it is still amazing. Still, the value is so compressed by the negative emotion that the recovery potential significantly surpasses the dangers. Before I go into further depth, I’ll summarize the main aspects of my argument in two bullet points.
To begin, a simple comparison between BABA and JD.com, Inc. (NASDAQ:JD) demonstrates the current market ridiculousness. Despite comparable profitability, a lack of diversification in income streams, and a lack of high-growth areas, JD.com trades at a large value premium to Alibaba (and the broader market).
Second, in odd times like ours, it is far preferable to follow independent thinkers like Charles Munger than the entire market for peculiar stocks like BABA. As you may know, Munger raised his position in Alibaba twice in 2021 before cutting it in half in May 2022. Despite the decrease, his Daily Journal Corporation (DJCO) still has the highest Alibaba holding among super investors tracked by Dataroma.com, as seen in the first figure below. The BABA stake is worth more than $34 million and accounts for more than 19% of DJCO’s stock portfolio.
Super-investors, of course, do not always make the correct bet at the right moment. And I do not recommend that you mindlessly follow them (I do not). But, having studied some of them in depth (Charles Munger, Guy Spier, and the Tweedy Browne lineage, to name a few), I can say with authority and confidence that they are more innovative and critical thinkers. Moreover, they all adhere to extremely disciplined investing methodologies.
Let’s try to re-engineer their reasoning using this.
Alibaba’s Profitability Decreased
There is little doubt that BABA’s profitability is no longer what it once was following China’s recent regulatory assault on digital companies. The figure below depicts its return on capital employed (“ROCE”) in recent years, focusing on this year. ROCE gauges the return on capital ACTUALLY utilized in a firm, and it is, in my opinion, the most significant and fundamental profitability metric, as discussed in my blog piece here. As can be seen, BABA has always maintained an extremely high level of ROCE: it has been over 100% through 2020, with an average of 143%. However, as the crackdown began, its ROCE began to fall precipitously. Even in the last several months, its ROCE has fallen from 76.7% in January 2022 to 62.8% based on TTM financials in September 2022.
Again, these figures are based on TTM financials as of January 2022 and September 2022. Specifically, operating cash flow has been reduced by around 22%. The finances declined even more than the operating cash flow in profits before taxes (“EBT”) and net earnings. Earnings before taxes fell by roughly 50%, while net earnings fell by around 43%. In the future, the company will be liable for increased tax rates and remaining payments on contributions to the shared prosperity fund.
But BABA’s Profitability Is Still Competitive
I’d want to put the profitability above into context. Its ROCE is much lower than in the past, yet it is still very competitive compared to other firms, as seen in the figure below. And as can be seen, BABA’s current ROCE of 63% ranks third even within this exclusive group. JD’s ROCE current is around 75%, which is greater than BABA’s. However, even a modest lead in ROCE does not justify the large value premium the markets on JD charge.
BABA Vs. JD: Valuation and ROCE-Adjusted Valuation
Without adjusting for cash position, Alibaba ‘s current TTM P/E is 12.5x, whereas JD’s is 33.8x. As a result, JD is worth nearly three times more than BABA (2.7x, to be exact). When adjusted for cash, BABA trades at 11.1x, whereas JD trades at 29.6x. The premium is slightly smaller due to JD’s big cash position but is still 2.6x greater. As previously said, I believe such a premium is nonsensical considering the relatively same ROCE (63% vs 75%), much alone BABA’s higher growth efforts, such as its cloud and the likely resuscitation of its Ant Group IPO, as I discuss in my earlier post.
Final Thoughts and Risks
To conclude, there has been a negative development in both BABA’s profitability and financial status. However, such bad events are mostly compared to the company’s track record. BABA’s profitability remains very competitive when compared horizontally to other highly successful enterprises like JD or AMZN. Despite this, the stock is trading at an incredibly low level. Compared to JD, its P/E of 11x 12x is just around one-third of JD’s, despite similar ROCE (63% vs 75%) and strong growth categories like the cloud business. It is far better to follow independent thinkers like Charles Munger than the broader market for odd stocks like BABA in strange times like ours.
JD is vulnerable to all these macro and geopolitical concerns from every perspective I can think of. Nonetheless, it is trading at a premium valuation relative to Alibaba and in absolute terms. An immediate concern that I see is a revival of COVID instances in Chengdu (an important Chinese city), the prospect of a lengthy shutdown, and the possible impact on BABA, JD, and the Chinese economy as a whole.
Featured Image- Megapixl @Hisdx15
