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Introduction

Investing in China is not for the faint hearted. Read the risk section first, then re-read it again.

If the objective of a value investor is to develop a global portfolio with a basket of reat businesses at great prices, I look for great businesses where significant pessimism is priced in. As the Hang Seng trades at near 2008-09 levels, fear is at a all-time high

At $72, Alibaba’s market cap is $190bn, 77% below its all time highs in Oct 2020. I am specifically focused on the HK listed 9988, but reference BABA since the system defaults to the US ADR. Incredibly, Alibaba stock is flat 8 years since its IPO price of $68 in 2014! Who would have predicted this ? Not even the biggest China sceptics. 

Consider that since IPO, at a high level, revenues have multiplied 15x from $8.5bn to $118bn, net cash and LT investments has gone up 5-10x,  operating cash flow is up 5-6x and free cash up 3-4x!

Below is a rough breakdown down of cash and eq as per BABA’s June 2022 balance sheet:

Cash and cash equivalents $26.4 billion

Short term investments $41.3 billion

Equity securities and other investments $34.2 billion

Investment in equity method investees $32.5 billion

The above including LT investments adds up to $134 billion. If one excludes the long-term investments, this figure is $68 billion. 

As per BABA’s June 2022 balance sheet, below is a breakdown of debt liabilities

Current bank borrowings $1.3 billion

Current unsecured senior notes  $700 million

Non-current bank borrowings $6.5 billion

Non-current unsecured senior notes $14.1 billion

The above debt adds up to $22.6 billion.

It is worth noting that Alibaba’s net cash and LT investments is $112 billion or a staggering 59% of market cap. it is hard to find a dominant business globally, with that sort of asset value.

At $72 a share, and if one assumes a valuation range of 50-100% valuation of LT investments, Alibaba’s enterprise value can range between $78-112 billion. i.e. $112 billion, if one assumes a 50% hair cut on their LT investments on balance sheet. 

Segment Breakdown

The below is a high level revenue by segment breakdown since FY 2010. The figures are in US$, assuming a $1=7.2 CNY. 

As can be seen, China commerce (retail and wholesale) and Cloud computing are the largest revenue segments at over $82bn and $10bn respectively, together accounting for nearly 80% of Alibaba's revenues and over 100% of Alibaba's profits and free cash flow.

Alibaba has over 1 billion active consumers; there are very few businesses globally that reach this milestone. Think Google, Apple, Microsoft, Meta, etc.

To view Alibaba's ecosystem, please see Appendix which highlights the powerful ecosystem that Alibaba has developed around its platforms and businesses that consists of consumers, merchants, brands, retailers, third-party service providers, strategic alliance partners and other businesses. 

For readers unfamiliar with Alibaba, at a high level the business comprises of the below segments:  

 China commerce: China commerce retail, Taobao, Tmall, Taobao Deals, Taocaicai, Freshippo, Tmall Supermarket, Sun Art, Tmall Global and Alibaba Health, as well as wholesale business including 1688.com

• Cloud computing: Cloud segment is comprised of Alibaba Cloud and DingTalk (previously reported under the Innovation initiatives and others segment).

• International commerce: Lazada, AliExpress, Trendyol, Daraz and Alibaba.com etc

• Local consumer services: location-based businesses, such as Ele.me, Taoxianda, Amap (previously under Innovation and others), Fliggy and Koubei

• Cainiao. domestic and international logistics services and supply chain management solutions.

• Digital media and entertainment: Youku, Quark, Alibaba Pictures and other content and distribution platforms, as well as our online games business

• Innovation initiatives and others: DAMO Academy, Tmall Genie and others. Other revenue also includes annual fees received from Ant Group or its affiliates in relation to the SME loans business that we transferred to Ant Group in February 2015. 

At a high level, lets discuss the two segments below

E-commerce

At a high level, Alibaba's China commerce champions small businesses in China to level the playing field by enabling small enterprises to leverage the internet.

The company creates millions of jobs and therefore, is aligned with China’s long-term common prosperity goals of increasing GDP per capita

Alibaba's ecommerce segment derives a majority of its China commerce retail revenue from customer management, which primarily consists of  merchants primarily bid for keywords, bid to market to groups of consumers, merchants pay a commission based on a percentage of transaction value 0.3%-5% depending on product and Taobaoke program, as well as direct sales (Sun Art, Tmall Supermarket and Freshippo,)

Over the past fiscal year, there were more than 124 million consumers on Taobao and Tmall with annual ARPU exceeding RMB10,000 with 98% continuing to be active year over-year. 

As of March 31, 2022, there  were over 320,000 brands and merchants on Tmall, including over 80% of the consumer brands ranked in the Forbes Top 100 World’s Most Valuable Brands for 2021

Cloud computing

Alibaba Group is the world’s third largest and Asia Pacific’s largest Infrastructure-as-a-service provider by revenue. 

Alibaba's Cloud businesses primarily generate revenue from the provision of public cloud services and hybrid cloud services to our domestic and international enterprise customers. There are more than 4 million paying customers, which include more than 60% of the A-share listed companies in China

By 2025, the size of China’s cloud computing market is expected to reach RMB1 trillion, which is 3x the size of the current market. Therefore the growth potential continues to exist for cloud computing.

As perspective, Amazon's cloud business was a $10 bn business in 2016 and today AWS is a $75bn business

Microsoft cloud $60bn+ and Google is $20bn+. BABA's cloud business should grow at 15-20% a year in normal circumstances. 

Significant Repurchase Program 

Alibaba instituted a new share repurchase program upping it from $15 billion to $25billion. 

This year, Alibaba has bought more stock than Amazon has in its entire hitsory inception. In Alibaba's own words

"The Board is confident about the Company’s continued growth in the future and has authorized the upsize of the Company’s share repurchase program to US$25 billion from US$15 billion. The Share Repurchase Program will be effective for a two-year period through March 2024.

As of March 18, 2022, the Company has purchased a total of 56.2 million American depositary shares under the previously announced share repurchase program, for a total consideration of approximately US$9.2 billion" 

The above repurchase program is significant in that it is nearly 13% of its market cap. 

It is worth noting that Apple has a $315bn repurcahse program, which at its current market is also an astounding 13% of its market cap. I believe this is one very good reason why Mr. Buffett has been attracted to Apple.

Alibaba's large repurcahse program is comforting in that it has the ability to allocate its free cash if the company's stock is far below its intrinsic value. 

Valuation

Below are Alibaba’s high level financials since 2014 in US$ terms (at current FX rate of US$1 = 7.2 RMB)

At $72 a share, and if one assumes a valuation range of 50-100% valuation of LT investments, Alibaba’s enterprise value can range between $78-112 billion. i.e. $112 billion, if one assumes a 50% hair cut on their LT investments on balance sheet 

As noted previously, Alibaba’s net cash and LT investments is $112 billion or a staggering 59% of market cap. it is hard to find a dominant business globally, with that sort of asset value.

As highlighted earlier, China commerce (retail and wholesale) and Cloud computing are the largest revenue segments at over $82bn and $10bn respectively, together accounting for nearly 80% of Alibaba's revenues and over 100% of Alibaba's profits and free cash flow.

In March 2022, the China commerce segment earned adjusted EBITDA margins of 30%+ which means approx $25bn in adjusted EBITDA, which translates to operating cash flow. Even if one assumes 10% growth in the China commerce business, the segment should generate $20-25bn in free cash flow.

In March 2022, the cloud computing division earned adjusted EBITDA margins of 2% and was profitable for the first time. This translated into $159mm in adjusted EBITDA. I believe the cloud computing business should grow at 15-20% in normal circumstances. 

One can make their own adjustments to Alibaba's free cash. My conservative estimate is $10 billion a year under current dire circumstances. If the economy opens up, $15 billion. There are less than 10 companies in the world that generate nearly $15bn in free cash.

This would mean that Alibaba is trading at roughly 7-10x free cash conservatively. If you assume 100% of their LT investments, and a EV of just $80bn, this could mean just a 5x FCF multiple.  

Since inception, Alibaba has reported higher cumulative free cash than Amazon and both are still in "reinvesting" mode

Alibaba is repurchasing shares aggressively as well. Alibaba is a net cash balance sheet; Amazon is net debt

Considering the revenue, profit, operating cash and high level free cash figures, Mr. Market is valuing the below companies with much smaller revenue, profits and cash flow higher than Alibaba

Starbucks $120bn enterprise value ($30bn revenue, $3-4bn FCF)

Intuit $117bn enterprise value ($13bn revenue, ~$1.5-2bn FCF)

Adobe $138bn enterprise value ($17bn revenue, $4-5bn+ FCF)

Netflix $131bn enterprise value ($30bn revenue, negative free cash)

While the above are good businesses, the revenue, growth, profits and free cash are not close to Alibaba and in my view reflects the very significant pessimism in China - perhaps warranted 

Risks

Investing in China is not for the faint hearted. There are significant risks, which means investors could lose all their money.

1. To earn life changing returns, one needs a system where capitalism, albeit higher quality companies can flourish.

Admittedly the events in the last few years have put a question mark to whether profit, cash generative businesses like Alibaba can flourish with current policies.  

At current prices, investors believe the opposite and therefore this is reflected in the price of Alibaba stock

This is the biggest risk to the thesis as without growth in revenue or profits, earning IRR is capped.

In the past, the party's legitimacy has been uplifting the lives of the Chinese people. If the party takes a U turn and economic growth and GDP per capita are not lifted, and entrepreneurs restrained, investing in Alibaba even at depresesd prices may lead to a fixed income like return, or significant losses. 

Munger had this to say at the previous DJCO meeting:

" China is a big modern nation. It's got this huge population, and this huge modernity that's come in the last 30 years. And we invested some money in China because we can get more value in terms of the strength of the enterprise and the price of the security than we could get in the United States. Other people, including Sequoia, the leading venture capital firm in the United States, have made the same decision we have.

I'm sympathetic to Gundlach. He's nervous. He doesn't have to join us. Different folks have different opinions. I feel about Russia the way he feels about China. I don't invest in Russia. So I can't criticize Gundlach's point of view. It's just I reached a different conclusion" 

Given the first risk, I would not have a 100% China portfolio. The risks of opportunity costs loss is too high. At the same time, I would maintain a small allocation in a global portfolio of businesses that will endure for the next 10 years. If that is the case ,the returns should follow 

2. Geopolitical risks between the US and China 

I expect geopolitical risks will continue to stay front and center and US China remain in a technowar for a decade. This should be of no surprise to anyone, as this is a battle for #1 and #2. Incentives. 

Two points here: 

Over the last few years, U.S. regulators have continued to express their concerns about challenges in their oversight of financial statement audits of U.S.-listed 

companies with significant operations in China.

In addition, a number of companies have been blacklisted, particularly in critical areas including security, telecom, surveillance, defence, etc. 

In the last few months, Washington and Beijing reached an agreement for U.S. accounting regulators to inspect China-based audits, laying the groundwork for a monthslong process that could prevent numerous Chinese companies from being booted off American stock exchanges.

Given the de-listing risks, Alibaba has already started to pursue a primary listing in Hong Kong.  The expected effective date is by the end of 2022, the document said. Gaining primary status in Hong Kong would make Alibaba eligible for inclusion in a stock connect program with mainland China.

For investors that are invested in Alibaba, owning the H-shares make more sense, than the ADRs at this point. Both securities are convertible to each other.

3. Covid lockdowns, what? in 2022? 

We have all seen the empty airport pictures in China. To lockdown a billion people, when the entire world including its mighty neighbour, India with a 1bn people has opened up is crazy. This has stifled economic growth and its reflected in the price of Alibaba stock

The legitimacy of the CCP was built around uplifting the lives of hundreds of millions of people. Lest it not be forgotten, under that party, they have now made China's GDP per capita $12,000 in 2021 when in 1980 it was less than $200 (India was ahead in 1980).

Do the powers that be want to reverse this ,and let their friendly neighbour India march ahead with economic success. This ultimately, will pose a threat to their own power. So my perhaps naive view is that post the China party congress, there will be signs of opening up, which is critical for economic growth.

4. VIE structure

Due to legal restrictions on foreign ownership and investment in, among other areas, value-added telecommunications services, which include the

operations of ICPs, Alibaba, similar to all other entities with foreign-incorporated holding company structures operating in China, operate Internet businesses and other businesses in which foreign investment is restricted or prohibited in the PRC through various contractual arrangements with VIEs that are incorporated and 100% owned by PRC citizens or by PRC entities owned and/or controlled by PRC citizens

The question is when foreign investors buy Alibaba, what do they really own. This has been a issue ever since IPO. Below is Munger's response to the VIE risk.

Munger: "When you buy Alibaba, you do get sort of a derivative. But assuming theres a reasonable honor among civilized nations, that risk doesn't seem all that big to me."

5. Regulatory risks 

In China, regulatory risks abound. The authorities halted Ant’s $34 billion-plus IPO in 2020 at the 11th hour and restructuring it as a financial holding company regulated by China’s central bank.

Jack Ma's disappearance post his speech in 2020 which then further had him relinquish control of Ant Group Co have unnerved investor, even if Jack Ma is not involved day to day with Alibaba's business any longer. 

6. Sentiment is terrible 

Sentiment around China is the worst it has been, even for a "long-term" investors, lets say 5 years.

• The KraneShares CSI China Internet ETF is down 61% in the last 5 years.
• Tencent is down -32% over the last 5 years 
• Alibaba is down -58% over the last 5 years
• New Oriental is down -76% over the last 5 years and so on..

On a separate not, BYD is +170% over the last 5 years (well done Mr. Buffett and Munger)... 

The Texas pension Fund recently halved its China equity allocation. It is hard to find a bull.

Mr. Munger still owns I believe 300,000 shares of Alibaba through DJCO. Greg Alexander has sold his stock in BABA, and JD. 

the bright news is that sentiment is so bad, that any catalyst, is going to send stocks soaring. I have no clue when that happens. But for investors in Alibaba or Chinese stocks, be prepared to be lonely for sometime. 

7. Other risks

There are other risks that investors must be prepared to contend with, anti-monopoly measures capping profits, litigation with competitors (JD, etc), etc. 

Appendix

Alibaba Ecosystem

Alibaba’s businesses are comprised of China commerce, International commerce, Local consumer services, Cainiao, Cloud, Digital media and entertainment, and Innovation initiatives and others. Below is a diagram of the powerful ecosystem that Alibaba has developed around its platforms and businesses that consists of consumers, merchants, brands, retailers, third-party service providers, strategic alliance partners and other businesses.

Catalyst

1. Covid lockdowns ending and economy opening up 

2. Easing of local regulatory risks 

3. Repurchases 

4. Value is its own catalyst

and more..