Summary
- Alibaba shares now trade below their March 2020 low amid increased regulatory scrutiny.
- Risk is high but so is the reward. We present a DCF forecast so you can value BABA yourself based on what your required discount rate is.
- Some exposure to BABA and other Chinese stocks might be warranted given these heavy price discounts.
Thesis Summary
Alibaba Group Holding Limited (BABA) has depreciated almost 40% in the last year. On the surface, this seems unfair to BABA investors, who were attracted by the strong fundamentals and growth prospects. But investing in BABA has always carried particular risks associated with the business structure and geographical location. These risks have materialized like never before, destroying billions in wealth, not only for BABA but for the whole Chinese financial market. The question now, after such a drop is: Does this present a time to add and is holding still the best option?
In this article, we analyze BABA using a classic DCF model. We find this forecast to be the most fitting because a DCF model allows you to determine the value according to your desired discount rate. Therefore, each investor can assess what return he/she requires to invest in BABA, to see if the return is worth the risk, which we will also discuss in-depth in this article.
A Quick Recap
So much has happened in the last 12 months to BABA that it helps to visualize this in context with the company’s share price:
Source: TradingView
In October of last year, things were looking up for BABA after the company got the green light to IPO Ant Financial. The stock peaked at near $300 and has since plummeted to under half that value. Soon after the IPO was announced, regulators began “talks” with Ant Financial. A few weeks later, BABA was slapped with fines and increased scrutiny. Ultimately, Ant Financial was “restructured” and it is still not clear when the company will IPO.
A $2.8 billion fine came in April, and things continued to get worse after that. Since June-July, China has tightened up its laws on data, taken down apps, like the recent IPO’d DiDi Global Inc. (DIDI) and even shut down whole industries, such as after-school teaching centers. Even when BABA isn’t the direct target of these regulations, the stock price still gets hit. It is only normal to assume that the country’s largest business will also be the one most closely regulated.
If we look at BABA’s financials or business, not that much has changed, though the company took a hit with the Ant restructuring. The biggest concern for investors though is the unpredictability and sudden path the CCP has taken in the last few months.
The question on everyone’s mind is: How far will the CCP go and just how bad could things get for BABA investors?
The China Risks
The risks associated with China and the CCP, as well as the VIE structures that Chinese companies use to trade abroad, are easily misunderstood. It is a complex situation, and many things could happen, so I’m going to try to boil it down to three possible scenarios:
BABA delisting
A word that has been thrown around a lot lately is “delisting”. To trade in the US, companies have to follow certain rules and the accounts have to be audited by the SEC. Chinese companies were exempt from this to an extent, but the US and SEC are now imposing the same rules on China. This would mean that Alibaba would have to expose its accounts to US auditors, which it doesn’t do now. As things stand, these Chinese companies have around 2-3 years to comply with this.
Will BABA get delisted? I feel like this is unlikely. BABA is the largest Chinese company, and, although under different standards, it has been publicly reporting its accounting since its IPO. Even if China/BABA wants to hide something nefarious, there’s no reason to believe they couldn’t still do it even after being audited by the SEC. Fraud happens within the US borders, so there’s little chance of stopping it abroad.
Nonetheless, could the US just delist, and ban OTC trading of BABA as a political move even if they “comply”? Of course, anything is possible, but it is hard to see how this move would make sense geopolitically. Financial institutions in the US have significant exposure to BABA, with 42% of shares owned by institutions, and it would not serve the country’s image very well.
Chinese nationalization
A much more prevalent threat, in my opinion, is the idea that China might nationalize Alibaba. How likely is this? Still unlikely but much more likely than a year ago. The CCP has already taken a stake in other private companies, such as ByteDance. Furthermore, the Ant Financial restructuring was mostly done to allow the CCP more control over the company’s activities in the fintech space.
If China did nationalize BABA, then it is possible that owners of VIE shares would be left holding the bag. The VIE structure is considered illegal in China, which would give the CCP the perfect excuse to disregard the “rights” of these investors. Alibaba wants to use the VIE structure to obtain funding, but a company owned and funded by the CCP would have no such need.
Of course, such a move would severely limit BABA’s international expansion efforts. But again, this might not concern the CCP that much, especially given the latest political moves which show that China is trying to distance itself from the outside.
BABA activities curtailed
Lastly, the most significant risk, and something that is taking place right now, is the idea that BABA’s growth and profitability might suffer as a result. This has indeed already happened with the Ant Financial restructuring, which could have reduced the value of the company by 20-30%. Capital restraints and the newly imposed data privacy laws will also curtail BABA’s profit-making abilities.
For years, BABA has been hailed as an eCommerce monster, which also had incredible upside thanks to higher profit businesses in Cloud and Fintech. Now, Alibaba’s CEO has come out to talk about the slowdown in Cloud growth as well as regulatory concerns.
BABA might continue to trade and operate for years to come, but just how profitable will the company be for investors, when their needs are second to those of the CCP? This is perhaps the biggest concern, in our opinion, that investors face today.
Valuation
Let’s take a look at Alibaba’s step-by-step valuation from a free cash flow perspective. We will take into account ongoing trends in revenue and profitability and construct a 10-year forecast, respecting the balance sheet structure to estimate free cash flows for the period and discount the cash flows to find a target price.
Revenues have increased about 20-fold in the last 9 years, meaning a CAGR of 39%. The CAGR for the last 4 years is 48%. It seems that, so far, there is no evidence that growth is slowing down. If we look at the YoY revenue growth rate for the last 5 years, it doesn’t seem to be on a downward trend.
Source: Author’s work.
If we were to assume that revenue growth will not slow down in the future, we would have to use an exponential model to forecast the next 10 years, concluding that yearly revenues will be around $4.5 trillion. However, the reachable market is limited, and giant companies don’t sustain these growth rates forever, which is why we like to use polynomial models to forecast revenues. Such as the one below:
Source: Author’s work. Revenues in $millions
Our forecasted revenue for the next 10 years is as follows:
| FY | Revenues | Growth YoY |
| 2022 | 134,237 | 22.63% |
| 2023 | 168,012 | 25.16% |
| 2024 | 205,751 | 22.46% |
| 2025 | 247,455 | 20.27% |
| 2026 | 293,124 | 18.46% |
| 2027 | 342,758 | 16.93% |
| 2028 | 396,356 | 15.64% |
| 2029 | 453,919 | 14.52% |
| 2030 | 515,447 | 13.55% |
| 2031 | 580,939 | 12.71% |
Source: Author’s work. Revenues in $millions
If you look at Seeking Alpha consensus estimates, we are very close to them for the first 3 years, where there is a substantial number of analysts and we are a little more optimistic beyond that, where the estimate is based on 1 to 3 analysts. If you look at the diminishing growth rate and compare it to what we have seen so far, it hardly looks optimistic. The fiscal year 2022 is looking to beat this estimate, with revenue in its first quarter having grown 46% year on year.
Moving on to the balance sheet, we have classified all assets and liabilities into Net Invested Capital and Debt. All cash, long-term investments, short-term investments, and of course debt, are considered financial assets and therefore not included in the net invested capital, which is the remaining assets minus the remaining liabilities. If we look at this classification over the last 9 years, we find that revenue has been growing faster than invested capital. This implies an increase in asset turnover and is good news for cash flows going forward. You can see this in the following chart with invested capital on the vertical axis and revenue on the horizontal.
Source: Author’s work. Items in $millions
Following this trend, we have constructed our forecast for the next 10 years, respecting the linear relation between net debt and revenues (negative values for net debt indicate more cash and financial investments than debt).
| Year | Net Invested Capital | Net Debt | Total Equity |
| 2022 | 50,089 | -143,202 | 193,292 |
| 2023 | 53,987 | -178,705 | 232,693 |
| 2024 | 57,506 | -218,376 | 275,883 |
| 2025 | 60,712 | -262,215 | 322,926 |
| 2026 | 63,653 | -310,221 | 373,874 |
| 2027 | 66,370 | -362,394 | 428,764 |
| 2028 | 68,893 | -418,735 | 487,628 |
| 2029 | 71,248 | -479,244 | 550,492 |
| 2030 | 73,456 | -543,920 | 617,376 |
| 2031 | 75,533 | -612,764 | 688,297 |
Source: Author’s work. Revenues in $millions
We have made our EBIT forecast also following linear relations of all the expense items with revenues, and we have included unusual items (mainly fines), as these are likely to happen in the future as well. The large sum of negative debt has been bringing interest income to Alibaba, which has improved its bottom line, and this ought to continue in the future. You can see this in our forecast, with the predicted negative interest expense values which are. We have also used linear relations to forecast interest and tax as a function of net debt and EBT, respectively.
| Year | EBIT | Net Interest Expense | Income Tax | Net Income to Common |
| 2022 | 24,354 | -16,822 | 6,619 | 32,698 |
| 2023 | 29,970 | -20,359 | 8,090 | 39,967 |
| 2024 | 36,279 | -25,407 | 9,916 | 48,986 |
| 2025 | 43,281 | -31,047 | 11,947 | 59,024 |
| 2026 | 50,974 | -37,279 | 14,186 | 70,083 |
| 2027 | 59,359 | -44,105 | 16,631 | 82,162 |
| 2028 | 68,437 | -51,522 | 19,282 | 95,261 |
| 2029 | 78,207 | -59,532 | 22,140 | 109,380 |
| 2030 | 88,669 | -68,135 | 25,205 | 124,520 |
| 2031 | 99,823 | -77,330 | 28,476 | 140,679 |
Source: Author’s work. Revenues in $millions
Making all these assumptions, we can calculate our final free cash flow to common shares forecast, as you can see below. For this definition of free cash flow, we are assuming that it is necessary for the company to continue keeping a proportional amount of financial investments and cash as stated earlier, so the amount by which these increase every year is excluded. However, thanks to healthy earnings and a decreasing need for investment in operations, there will be plenty of cash left over to compensate shareholders if our forecast holds.
| Year | Net Income to Common | Cash Flow from Invested Capital | Cash Flow from Debt | Free Cash Flow |
| 2022 | 32,698 | -4,358 | -24,880 | 3,460 |
| 2023 | 39,967 | -3,898 | -35,503 | 566 |
| 2024 | 48,986 | -3,519 | -39,671 | 5,796 |
| 2025 | 59,024 | -3,205 | -43,838 | 11,980 |
| 2026 | 70,083 | -2,941 | -48,006 | 19,136 |
| 2027 | 82,162 | -2,717 | -52,174 | 27,272 |
| 2028 | 95,261 | -2,523 | -56,341 | 36,397 |
| 2029 | 109,380 | -2,355 | -60,509 | 46,516 |
| 2030 | 124,520 | -2,208 | -64,676 | 57,636 |
| 2031 | 140,679 | -2,077 | -68,844 | 69,758 |
Source: Author’s work. Items in $millions
To convert these cash flows into a target price, we are going to propose a range of discount rates. We will use the 2031 cash flow of $70bn as a growing perpetuity for the terminal value. The following graph shows our target share prices for given discount rates (horizontal axis) and long-term growth rates (vertical axis). Values below the current price of $159 are shown in red and higher values are in green. These prices are calculated using the latest quarterly report’s figure for total shares outstanding, 2.7 billion.
Source: Authors work. Items in $.
The current Wall Street target price is $274, which fits the 7% growth-11% discount region, which is about what I believe analysts are thinking. Look a few spaces up or to the right for what the market is thinking (either growth is going to slow down significantly, or the level of risk warrants a higher discount or a bit of both).
Takeaway
It’s easy to understand BABA’s current price decline when we put it into terms of the discount rate. The higher risk means investors require a higher return. There’s always a risk to investing, but successful investors make calculated risks where they believe the expected return is higher than the possible loss. Is this the case for BABA? At today’s price of $158/share, it’s hard to ignore this opportunity. However, we would not advise committing a large part of your portfolio to BABA. A more prudent approach would be to invest in BABA and other Chinese stocks, which are also very discounted. These smaller stocks will provide exposure to China, and many are less likely to suffer from regulatory scrutiny because of their smaller size.