The Wonderful Stock Present Under the Christmas Tree

Introduction

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I have seen several headlines to the tune, “Markets Deliver a Lump of Coal for Christmas.” However, if you have been following Coach Investing articles, you will have expected a sell off given the slowdown, overexcitement about technology stocks, high valuation, and the late cycle nature of the economy. During slowing periods, a rotation to defensive stocks is normal. However, when the correction is so strong and quick, they can create opportunities. Instead of a lump of coal, I am very excited about the stock present under my tree – some perhaps great investment opportunities.

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When I first published my warning about the US entering the late cycle phase of the economy (January 2018), few people were in my camp that a recession could occur in 2019 or 2020. Recently, this notion has become mainstream. According to a Duke survey, about ½ of CFOs now expect a recession in 2019. In one survey, 2/3 of economists expect a recession by the end of 2020. Thus, recession fears are now rampant, but this is not all bad. A 2020 recession would be healthy long-term as it could rid the economy from excesses created by the tax policy, low interest rates, and the resulting excessive debt buildup. However, most investors cannot be out of the market, so perhaps we need to hedge our portfolios. Plus, a recession may not occur.

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The Markets Have Reversed in Eleven Months (figure 1)

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(See figure 1.) Eleven months ago, at about the time that I wrote Positioning the Cycle, financial markets were at extreme highs. Everyone was positive: business and consumer surveys of confidence were high, margined equity was rising, the fear index (VIX) was low, equity returns were solid, the AAII bull-bear index spread was high, equity flows were turning up (less negative), earnings revisions were up, and credit spreads were low. This positive sentiment was in front of accelerating and high earnings growth. A negative surprise was likely since expectations were high. Markets responded negatively in January 2018 after a good jobs report jolted the market which became worried that inflation was on the rise and would lead the Fed to become more aggressive and bring the end of the recovery nearer. However, good growth quickly reinvigorated the market and it rose through the summer.

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Now, the environment is almost the opposite. Perhaps earlier ramped up growth has brought the next recession nearer as the Fed continues to normalize interest rates. Growth is slowing, inflation expectations are down, and financial market expectations have fallen. Confidence surveys are still high, but have generally peaked, the VIX has spiked, leverage in equity accounts is declining, the AAII bull-bear spread has fallen, equity markets are off about 15%+ from their highs, revisions have weakened, and credit spreads have widened. Now, few are expecting a positive surprise – exactly opposite of January 2018; however, could one be lurking in our future? Could the Trump Administration try to do something to get the markets and economy rising before the next election? The administration has the incentive. Could resolving the trade war or passage of an infrastructure spending plan get markets excited again? Could Brexit be resolved? Might the riots pass in France, Germany’s growth rebounds, and/or China’s fiscal and monetary policies reinvigorate growth in Asia? Maybe oil comes back? Slowing growth may cause the Fed to pause rate hikes and the markets could cheer and the dollar could decline which would help US multinationals and emerging markets.

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What to Do?

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My base case continues to be that we need a recession in 2020 (to rid of excesses) and it is not unlikely, and since recessions are bad for markets, it is what I am preparing to endure. A delayed recession will probably be more severe recession due to the continued buildup of corporate leverage, government leverage, and a ramp up of consumer and financial leverage. However, I have to prepare to be wrong. There are positive catalysts (see above), and if they materialize, could keep the economy rolling along for a few more years, and if so, lead to a positive return market. The current slowdown could be just a hangover from the tax reduction/earnings acceleration party. Hangovers eventually pass.

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Thus, one may want to de-risk one’s portfolio to hedge for a recession, but still stay in the markets by rotating to good companies that participate in rising markets, protect one during corrections, and build business value over time. Value stocks tend to perform well during market corrections, and this correction is not an exception. However, the stocks I am talking about here are not normally cheap enough to be considered value. These companies grow their business value over time. They tend to have high returns on equity, low levels of debt, are moderately priced, have some type of sustainable competitive advantage, and generate good amounts of cash flow. I just described a Warren Buffett-like stock. Reasonably priced quality growth stocks tend to perform well during down markets.

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FAANG Stocks Have Been Pummeled

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The S&P 500 is down 13.5% since August, and the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) are down 23.7% (figure 2). These high flyers have taken some of the biggest hits; although, small stocks have also been pummeled (the small cap S&P 600 is down 18.1% versus the S&P 500 which is down 14.1% over the last three months through January 2).

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When searching for quality stocks that can weather a storm, it may be best to go looking in the large cap space and toward more established businesses. The P/E average of the FAANG’s has fallen from 84.7 at the end of last August to 48.9 today. Although Amazon and Netflix are outliers (94.7 and 95.9, respectively), all of the FAANG P/Es are down and the stocks are down more than the market.

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Typically, high P/E stocks underperform. Figure 3 is recreated from figure 9 of Is Amazon’s P/E Worth 11X More than Walmart’s? The highest P/E stocks (average 60.2 in the study) have a future five-year return of 7.2%, compared to 10.5% for the low P/E stocks (average 10.7). While the high P/E stocks have above average growth (16.1% 5-year future growth) versus the low P/E stocks (-0.4% growth), their P/E’s fade over time as growth matures (P/E is a function of future growth and risk, see box a below for the math behind the P/E ratio). Thus, the biggest concern for high P/E stocks is that the P/E fades quicker than earnings grow. Past outperformance of the richly priced FAANG stocks is an exception, not the rule.

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P/Es for some of the leading companies are down significantly over the past few months. Maybe FAANG P/E’s are down enough to justify owning them as a group even in the face of empirical evidence (figure 3) that this is normally not a good idea? However, be aware that while FAANG P/Es are down, the average expected future growth rate for them is as well (figure 2). Relative to the market, the FAANGs are only expected to grow mid- to high-teens faster than the S&P 500 over the next two years, compared with 48% to 85% superior growth the last few years.

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Let’s look at another FAANG-like stock, but one in China since the country is out of favor. As Warren Buffett says, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” He also said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” As noted above, now is possibly the time to own a stock as if it was a business and hold it for at least five years.

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Alibaba (a Chinese Company)

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Each fall, I teach my students how to analyze business drivers, forecast financial statements, and value a stock. Professionals have commented that their stock reports are impressive. Along the way, I teach students that a successful stock investment often involves owning a growing company, where expectations are low, surprises are positive, fundamentals are improving, and where risk is well recognized. When selecting their stocks to research, I prohibit any nose bleed P/E stocks (above 35) which are normally high expectations stocks. It is very hard to perform one’s first DCF and relative valuation analysis on these securities. However, the last couple years, near the end of the semester, I reviewed a high flyer to show how it is done. Last year, I discussed Bitcoin, and the students’ encouraged me to write on it (which I did in Don’t Ride the Bitcoin Rollercoaster Blind, Consider Value). This year, we discussed Alibaba.

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The goal of the exercise was to determine whether growth is sufficient to justify Alibaba’s high P/E. Too often, investors buy the high P/E stocks without quantifying their true earnings opportunities (this is probably why high P/E stocks underperform, see figure 3). Alibaba was also chosen because it has an established business with an economic moat, growth that is independent of the US economy, and has high cash flow and low debt. As noted above, this is the type of firm one may want to own, if it is cheap enough, if one believes the US economy is heading to a recession. Personally, I prefer to own companies during recessions that grow their business values throughout the difficult times as, eventually, that value should be recognized, even if it is during the market recovery following a recession. Maybe Alibaba fits the type of company one wants to marry as if owning the business (at least five years) instead of date like a stock.

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Like the FAANGs, Alibaba has a very high P/E and the stock is down much more than the US market and its home market (China) (figure 4). Through 1/2/19 or about, MSCI China is down 23.0% for 52 weeks versus MSCI USA which is down 5.2%. BABA closed at $130.60 on 1/3/19, or down 24.0% since August 31, 24.3% since 12/31/17, and 37.5% since its high of $208.95 on June 4. Unlike the FAANGs, consensus (FactSet) Non-GAAP EPS growth for Alibaba is expected to accelerate to 29% in 2019 (fiscal 2020, year-end March) from 2% in 2018 (fiscal 2019). Its fiscal 2018 P/E is 32.7, or an 78% premium to the S&P 500 (price of $2,447.89 on 1/3/19) which is at 18.3 in calendar 2017. If we use fiscal 2019 non-GAAP consensus numbers for Alibaba, the stock has a P/E of 24.9 ($130.60/$5.25) versus the market at 15.1, or a smaller but still large 64% premium.

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The high P/E premium tells you that the investors are counting on higher growth for Alibaba than for the overall market. Equation 4 (see box for the math of the P/E ratio) shows that a higher growth rate reduces the denominator of the P/E equation and pushes up the multiple. Will growth be sufficiently high to justify Alibaba’s high P/E?

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My conclusions are explained at the end of the report and the details are described in the following pages; however, let me summarize here. Alibaba is one of the strongest competitors in its diverse set of businesses. Thus, it is moat-like. It also has substantial opportunity for internal growth and for acquisitions as it builds its ecosystem. It generates substantial cash flow to pay for this growth, and it has low amounts of debt. This growth appears to fully justify the premium P/E. Plus, as shown in figure 5, Alibaba’s FCF yield is about the same as the S&P 500’s in fiscal 2022 despite its above average growth opportunities beyond that year, which implies it is more than fairly priced. The correction over the last six months may be a nice gift to investors who do not yet own the stock.

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Disclaimer: I do not own shares of Alibaba, but I am thinking about purchasing the stock. The work discussed here is just a highlight and performed over the last week+ to show an example of quantifying growth opportunities in a high P/E stock. I do not claim to be, and I am not an expert, on the company, and thoughts expressed herein should be independently confirmed and more research should be done before purchasing the stock yourself. You should also consider how a security fits in your overall portfolio before buying any stock.

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The Opportunities

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In my opinion, Alibaba is a combination of Amazon, eBay, Netflix, YouTube, a financial service company, and many others as it builds its ecosystem, according to its mission, “To make it easy to do business anywhere (in this digital era).” At the end of fiscal year 2018, the firm had 552 million annual active customers in China and 90 million outside China (source: Alibaba 2018 Investor Day). Figure 6 shows that all of its profits are derived from the core commerce segment, and figure 7 shows Alibaba’s businesses. Cloud computing is still unprofitable, and the company leaks profits like crazy from digital media and entertainment and its other businesses. However, perhaps that will not always be the case.

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Most of the following pages are spent analyzing and quantifying opportunities to grow earnings in each segment over the next three years. This is needed to determine whether Alibaba’s premium P/E is justified.

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Core Commerce

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BABA’s mostly retail business generated RMB214,020 in fiscal 2018 (year ended March 31, 2018). RMB214,020 is about $34 billion. This was up from just RMB92,335 in 2016, or 132% growth in just two years. Over this period, the firm’s EBITA/operating margin fell from 63%/55% to 53%/48%, but these are still huge numbers. For comparison, in 2017, Amazon’s North America retail business made $106.1 billion in sales, up 67% over the last two years. However, it only made $2.8 billion in operating income, or 2.7% of sales. eBay’s operating margin in 2017 was 23.7%; however, keep in mind that its business is divided between StubHub and Marketplace, with Marketplace at $6.5 billion or 67% of sales. StubHub’s transaction take is 22.4%, whereas Marketplace’s is 7.7%, so I expect that eBay’s operating margins from its Marketplace business is at most 23.7%, making Alibaba’s core commerce business perhaps much more profitable than both comparable firms.

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Like eBay, Alibaba generally does not hold inventory (an example of an exception is Intime, a leading department store in China, which it purchased for $3 billion). This means that it can grow its online retail business without large investments in capital (warehouses) that a firm like Amazon must spend. Thus, Alibaba’s commerce business is highly profitable and needs little cash to grow. It is a huge cash cow. With this being said, AMZN has ramped up sales from highly profitable third-party retailers, which now make up 21.8% of its 2017 $146.0 billion in worldwide online retail sales.

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Some of Alibaba’s commerce businesses are described below (source: July 2018 20-F).

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1. Taobao Marketplace (means “search for treasure” in Chinese, see taubou.com) is the starting point to direct users to various marketplaces. It is personalized, a way to interact with retailers, offers live video streaming, etc. Merchants are primarily individuals and small businesses.
2. Tmall caters to consumers looking for branded products and a premium shopping experience. Tmall pioneered the “Singles Day,” the most important shopping event in China.
3. Rural Tabau serves rural areas (about 600 million) in China.
4. Alibaba Health sells healthcare products, provides e-commerce platform services, operates product tracking platforms, and develops intelligent medicine and health management services. Alibaba’s strategy involves expanding beyond physical goods to entertainment, healthcare, travel, and local services.
5. Wholesale: 1688.com is the largest wholesale marketplace in China and Alibaba.com is China’s largest international online wholesale marketplace.
6. Cainiao Network provides logistical services. Its vision is to fulfill customer orders with 24 hours in China and 72 hours anywhere else in the world.
7. Consumer services includes Ele.me (means “are you hungry” in Chinese) which allows consumers to use an app to order meals, etc., Koubei that generates traffic to restaurants through content discovery to finding a store with discounts, and Fliggy which is a leading online travel platform for tickets, accommodations, tours, etc.
8. International and Cross Border
   1. AliExpress is a global marketplace which targets consumers around the world and enables them to buy directly from manufacturers and distributors in China.
   2. Taobao Global helps Taobou merchants outside China to engage Chinese consumers.
   3. Tmall Global allows overseas brands and retailers to reach Chinese consumers.
   4. In fiscal 2018, Alibaba completed the acquisition of most of the outstanding interest in Lazada, a Southeast Asian leading e-commerce marketplace with its own inventory and third-party retailers. In 2016, Google issued a report that it expects e-commerce in Southeast Asia to grow at a 35% CAGR for the next 10 years to $88 billion in 2025, driven by the young population, lack of big-box retailers, difficult access in remote islands, a rapidly growing middle class, and the fastest growth of internet users in the world. Lazada and AliExpress had 90 million annual active consumers as of March 31, 2018.
   5. BABA is investing over $1 billion in Tokopedia, another online marketplace for retailers to sell into Indonesia.

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Consumer spending grew at over 9% in the first half of 2018 in China, with growth from rural areas above 12% and overall retail spending growth above 6-7% GDP growth. Consumption accounted for 78.5% of the country’s economic growth, up 14.2% in a year, and I expect consumer growth to continue at a 9-10% pace as China transitions from infrastructure growth to a consumer-driven economy. This move has been fueled by rising productivity and wages along with it. Although, retail sales growth slowed in 2018.

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Due to growth in consumer spending in China and a growing online marketplace (discussed next), I expect Alibaba’s sales could rise 72% by 2022 (year ending in March). If margins are maintained, this means that operating income can grow from RMB102,743 million to RMB177,450, for a net change of RMB74,707 million. Assuming an 18% tax rate, the 2018 share count (basic), and an exchange rate of 6.27 yuan to the dollar, this could boost BABA’s EPS by $3.83, or nearly 100%!

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Online retail spending was RMB6,278.5 billion in 2018 through September, or 22.9% of total retail sales in China. This figure represented 27.7% annual growth, so online sales are growing much more rapidly than overall sales (9.3%). The online market share of 22.9% in China compares to 10% estimated for 2018 in the US. Alibaba’s June 2017 20-F notes that mobile revenue per mobile monthly average user rose from RMB123 to RMB179 from the March 31, 2014 to March 31, 2017. If we assume China’s online retail sales grows to 27.5% of total retail sales by 2022 and Alibaba’s share is stable, this boosts BABA’s sales by over 20%.

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China may generate a higher proportion of online sales versus the US since more people live in rural areas in China than in the US; therefore, they have a greater need to purchases over the internet. Also, Asians are generally more willing to purchase online, perform banking online, etc. than Americans. Perhaps this is because Chinese infrastructure for retail sales and banking grew up in the current age of the internet, whereas the bulk of US consumers grew up around brick and mortar stores and banks. Over 42% of total e-commerce sales in the world is in China (the US is 24%), and it will probably rise as only ½ of China’s population uses the internet and 68% of mobile internet users utilized mobile payments in 2016 (up from 25% in 2013). Mobile payments in China were 11X that of the US in 2016. Furthermore, Alibaba facilitates business to business transactions (RMB13.8 billion of RMB214.0 billion in 2018) and I expect this to continue. In the US, perhaps because businesses trust in the banking system, corporations have not needed another intermediary to make transactions between each other.

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We also should consider Alibaba’s competition. BABA’s Tmall division currently has about 60% of online B2C sales, according to Analysys. Its main competitor is JD.com with about 25% market share. JD.com is like Amazon, which sells from its own inventory. While this means that JD has more investment capital tied up in the business, it also means that it has fewer issues with counterfeit goods. Alibaba’s Taobau site is a behemoth in C2C sales, somewhat like eBay but with differences (fixed prices, chat rooms with sellers, etc.). My sales forecasts assume that Alibaba’s market share is unchanged.

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In addition, international commerce is taking off. It rose from RMB2.2 billion to RMB14.2 billion from 2016 to 2018. This far outpaces Amazon’s growth rate ($35.4 billion to $54.3 billion). Thus, even if Alibaba loses some market share, my estimate above does not necessarily incorporate the international opportunity. It also does not incorporate the company’s plans to add more consumption categories, so my estimates could be conservative. On the other hand, margins have been declining. Perhaps this continues as the firm grows larger, matures, and competition rises, so maybe my expectations of the boost to earnings is aggressive. Although, one would expect that as Alibaba grows larger that this will lead to gains in operating efficiencies.

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Cloud Computing

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Alibaba’s revenue for cloud computing has been rising very rapidly (RMB13.4 billion (about $2 billion) in fiscal 2018, up from RMB3.0 billion in 2016).

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IDC expects the public cloud business to grow at over 20% CAGR through 2021 to $277 billion by 2021. Discrete manufacturing, professional services, banking, process manufacturing, and retail industries will all spend more than $10 billion in 2018. Cloud computing goes beyond storage to big data and analytics, Internet of Things (IoT), and many other services (see Alibaba’s, Amazon’s, IBM’s, Google’s, and Microsoft’s product pages). Microsoft describes cloud computing as “the delivery of computing services – servers, storage, databases, networking, software, analytics, intelligence and more – over the Internet (“cloud”) to offer faster innovation, flexible resources, and economies of scale. You typically pay only for cloud services you use, helping lower your operating costs, run your infrastructure more efficiently, and scale as your business needs change.”

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The public cloud (see forecasts in figure 9) differs from the private cloud. The private cloud is internal to an organization, whereas with the public cloud a firm is not responsible for the management of the solution. Private clouds perhaps offer higher security, but the public cloud reduces costs significantly since all firms benefit from economies of scale that cloud providers pass along to customers as they grow their business (David Fildes, Director, Investor Relations, Amazon, noted in the October 3Q 2018 conference call, that Amazon lowered AWS prices 67 times since its launch). There are no huge up-front costs, one pays just for what one needs, and public cloud is quick to implement. This allows even small companies to stay at the forefront of what is available technology-wise. RightScale’s 2018 State of the Cloud Report notes that 98% of the survey’s respondents (997 people with 54% in North America) now use the cloud. 92% use a public cloud, 75% utilize a private cloud, and 81% have a multi-cloud strategy. Plus, organizations run about 5 clouds on average.

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According to IDC, the US is the largest country in calendar 2018 with $97 billion of the $160 billion cloud market. China is tiny with $5 billion. Remember, Alibaba has about $2 billion in cloud sales in fiscal 2018 ending in March, so depending on how IDC and BABA categorize cloud sales, Alibaba may make up 50% of the Chinese market ($2 billion in fiscal 2018 is mostly 2017 figures, and given BABA’s estimated fiscal 2019 growth, Alibaba should at least have 50% share in calendar 2018). Alibaba’s dominant Chinese share, along with its small worldwide market share, provides the firm with a long runway for growth. Synergy estimates that Amazon’s AWS has nearly 35% world market share of IaaS, PaaS, and hosted private cloud (note that this is a subset of cloud as depicted in figure 9). Alibaba is in 5^th place with perhaps less than 5% share, behind Microsoft, IBM, and Google.

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Alibaba is growing quickest of its competitors, which may be fueled by three forces. First, cloud is a smaller business in Asia than the US, so it is playing catch up. Second, as Chinese companies expand internationally, Alibaba serves many of them and benefits. Third, companies wishing to do business in China may adopt Alibaba’s tools. Alibaba is the only real global cloud since China does not allow foreign companies to run cloud computing infrastructure there. Amazon runs two regions in China through other firms, Microsoft runs Azure through another company, and Google has no plans to offer a product in China.

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The negative to signing up with Alibaba is perhaps trust. Do you really want a Chinese company with access to your data? However, the offset is access to Chinese markets and Alibaba’s capabilities (BABA’s success during its Singles Day, or Black Friday in China, shows its strong cloud capabilities).

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Let’s size up the opportunity (figure 10). By making some highly debatable estimates for market growth, market share, and margins, we can estimate that the cloud business may boost Alibaba’s EPS by $0.73 by fiscal 2022 (calendar 2021).

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• Normally, I like more reliable numbers to estimate market growth, but the cloud business is a developing field so good estimates are just extremely wishful thinking. As noted earlier, most firms in the RightScale survey have some sort of a cloud, so it seems likely that growth will be from finding more uses for it, at least in the US, than more people adopting it for the first time. Let’s assume the market grows 92% from 2017 or 58% from 2018 as Gartner suggests in figure 9.
• Since China is starting from a small position ($5 billion in calendar 2018 compared to the US at $97 billion, according to IDC), let’s assume that its growth will be at least triple worldwide growth, or 300% from 2017 to 2021 or 200% from 2018 (or Alibaba fiscal year 2019). This equates to a Chinese market of $20 billion in 2021 (or Alibaba fiscal year 2022) as shown in figure 10. This growth rate is still conservative versus IDC’s forecasts of over 40% CAGR. We can assume that Alibaba will capture 40% of the Chinese market, a little less than 50% that I estimated for its current share (discussed above), so its Chinese sales could rise to $8 billion.
• Alibaba currently holds 4% of the worldwide IaaS, PaaS, and hosted private cloud market. Let’s assume that it can capture 10% of the IaaS, PaaS, and hosted private cloud (this would be larger than IBM and Google’s current share). IaaS and PaaS are estimated to be $90.7 billion in calendar 2021 (figure 9). Public cloud is about double the size of private cloud according to IDC’s estimates of cloud infrastructure spending and McAfee’s 2017 estimate of application workloads, so this means the private cloud market is about $45 million higher than $90.7 billion, or IaaS, PaaS, and private cloud will be $136 billion in calendar 2021. Thus, including China (projected above at $8 billion), I estimate Alibaba to have sales of $13.6 billion (10% of $136 billion). This means Alibaba captures $5.6 billion sales outside China. This may be conservative; although, I expect that Amazon, Microsoft, IBM, and Google are tough competitors.
• Note that my estimates do not include Alibaba capturing sales outside of IaaS, PaaS, and private cloud services. These sales may only make up 50% of the total cloud market, so I am perhaps quite conservative. The largest omission is software as a service (SaaS), which is about 40% of the market, and Alibaba does have SaaS products.
• Right now, the firm loses 6% (EBITA margin, 23.0% EBIT margin which does not add back share-based compensation and amortization) on cloud services. This compares to a 2017 margin of 24.8% for Amazon ($4.3 billion in operating income on $17.5 billion in sales in 2017) and 31.1% in 3Q 2018. Let’s assume that as BABA increases in size it gains operating efficiencies and bridges 2/3^rd of the gap from -23% to 31%, or EBIT margins rise to 13.0%. As the infrastructure is built, additional sales drop to profits.

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Note that this analysis is very back of the envelope type work. It is not meant to be exact, so feel free to adjust the estimates. For instance, my comparison is to Amazon, and what Amazon includes in operating expenses to arrive at operating income may vary from what Alibaba subtracts to determine operating income.

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Digital and Media Entertainment

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Alibaba’s 2018 20-F notes that this division primarily includes revenue from Youku and UCWeb and includes sales from P4P (pay for performance advertising) marketing services, display marketing services, and subscriptions.

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Youku

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Youku is essentially a cross between Netflix and YouTube. YouTube is the leader in video-sharing with 1.8 billion in monthly logged-in users (a billion hours per day, or three times Netflix in a record-breaking day in January 2018), up from 1.5 billion monthly users in June 2017. China blocks YouTube, so this has allowed other video-sharing portals to evolve. The top three in China include Tencent Video, Baidu’s iQiyi, and Alibaba’s Youku (24.0%, 22.9%, and 22.0% market share, respectively). Even with a #3 position, Alibaba is in the red with an operating margin of negative 42%. Plus, it really has not improved over the last few years (see figure 12).

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Google does not release YouTube’s revenue and profit figures. However, some people estimate it generates $10 billion to $15 billion in annual revenue. This compares with an estimate of $1.5 billion (the rationale for the estimate is discussed later) for Youku. Youku is a substantial opportunity, though. Business Insider reports that minutes spent on YouTube per month was 1,163 in 2017, which compares to 510 for Netflix, 5,400 for television, and 744 for Facebook. One person claims that YouTube could be worth up to $100 billion. Offering premium subscription services helps YouTube monetize those minutes. However, original content that comes with it eats into profit margins.

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By comparison, Netflix’s 2017 revenue was $11.692 billion, and the firm had 117 million streaming memberships. Its operating margin was $839 million, or just 7.2% of sales. Its net margin was only 4.8%, which is its highest since 2011 when the net margin was around 7% (sources: 2016 and 2018 10Ks). Netflix trades at a market cap of over $110 billion.

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In 2018, 229 million Chinese watched video via a subscription. There are 1.4 billion people in China. Youku reports 580 million monthly unique visitors, which is more than 1/3 the users of YouTube. While Youku may have about 1/3^rd the users of YouTube (580 million monthly users versus 1.8 billion), I doubt it has 1/3^rd of YouTube’s revenues as Youku’s users are in China, who have much lower income per capita than the average YouTube user. Assuming Youku is currently 1/8 of the size of YouTube and Netflix at maybe $1.5 billion in revenue, this would give it a value of at least $12.5 billion using today’s revenue figures (approximately $100 billion value for YouTube or Netflix divided by 8 = $12.5 billion). Alibaba is worth about $350 billion at today’s market prices. This includes an estimate of Youku’s current value, but more likely an expectation of its future worth.

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However, Youku, YouTube, and Netflix are perhaps barely profitable. Netflix trades at about $271 and its earnings are expected to be $2.65 (FactSet consensus estimates) in 2018, for an enormous 102 P/E. Thus, these estimated and real, in the case of Netflix, equity market values are all based on the hope that viewership will lead to substantial profits.

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As the online streaming organizations compete, they are paying up to add content, and original and other paid content is not cheap. For instance, Youku secured rights to stream the 2018 FIFA World Cup. It is the #1 movie maker in China, has co-produced feature films, has a deal with Disney to stream movies and TV episodes, etc. Netflix may spend $12 to $13 billion in 2018 on content, with 85% on original series and movies, a number bigger than any Hollywood studio (note, FactSet consensus estimates for Netflix’s sales in 2018 are $15.8 billion, so content spending is a large part of sales).

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UCWeb

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UCWeb is a web browser. In November 2018, it had 4.2% worldwide market share, 11.5% market share in China, and 20.8% market share in India. This compares to worldwide share of 62%, 15%, 5%, 2%, and 3% for Google Chrome, Safari, Firefox, Opera, and IE, respectively.

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Google does not break down its sales and profits from Google Chrome. However, we can try to get there…

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• Google properties generates revenues from advertising on Google Chrome, Gmail, Google Maps, Google Play, and YouTube. According to the February 2018 10K, revenues from Google properties was $77.788 billion, or 70.9% of Alphabet’s Google segment. Let’s assume that Google Chrome makes up at least $62 billion of this segment’s advertising revenue. Here is my logic:
  • Earlier, I suggested that sales for YouTube are $10-$15 billion. Thus, subtracting this from $78 billion total for Google properties brings the number to $63-68 billion for Chrome, Gmail, Google Maps, and Google Play. Do you click on ads in email? I don’t. I have an iPhone so I am unfamiliar with Google Play; however, there aren’t ads in the Apple Store app so I assume there are few ads in Google Play as well. Maybe people click on ads in Google Maps. Anyway, it makes sense that Google Chrome makes up the vast majority of advertising spending outside YouTube for Google properties. Maybe Chrome is $62 billion of this $78 billion in revenue.
• Next, let’s try to figure out how profitable Google Chrome is for the company.
  • Google has two segments, the Google segment and Other bets. The Google segment includes Ads, Android, Chrome, Commerce, Google Cloud, Google Maps, Google Play, Hardware, Search, and YouTube. It had combined sales of $109.652 billion in 2017, and operating income of $32.908 billion, for an operating margin of 30.0%. Google properties, discussed above, is $77.788 billion of the total. The rest of the Google segment includes Google Network Members’ property revenues (advertisements on members’ websites, etc.) for $17.587 billion and Google other revenues (app purchases, Google Cloud, and Hardware) of $14.277 billion.
  • Each business is bound to have very different profit margins depending on the needed investment. I expect advertising on established platforms such as Chrome, Gmail, Google Maps, and Google Play is not too costly compared with needed investments for Google Cloud, Hardware, Android, and perhaps YouTube. Advertising on members’ sites must also have high margins. Given that the vast amount of advertising is on Chrome, and it is probably one of the services requiring the least new annual investments, I expect its operating margin to be much higher than the average for the Google segment (30% noted above). Let’s assume it is 50%..

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UCWeb’s revenue per user is probably much less than Google Chrome’s since its main markets are in China and India. Let’s assume that UCWeb makes 1/6^th as much per user as Google Chrome (keep in mind that Chrome is also in China and India).

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If UCWeb had 8% of the world market share in fiscal 2018 (calendar 2017), Google Chrome was 54%, Chrome makes $62 billion in revenue, and the revenue take per user is 1/6^th for UCWeb versus Chrome, then we can back out that UCWeb’s revenue of about $1.55 billion (this equals 8% UCWeb share / 54% Chrome share * 1/6^th revenue per person for UCWeb versus Chrome * $62 billion in Chrome revenue).

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Sizing Up the Opportunity (see figure 12)

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Earlier, I estimated Youku’s revenue at $1.5 billion in fiscal 2018. Adding $1.55 billion from UCWeb to $1.5 billion results in $3.055 billion. The total revenue for Alibaba’s Digital and Media Entertainment business is $3.119 billion. This means that revenue from P4P marketing services, display marketing services, and subscriptions is less than hundred million and my estimates above, while having the potential to be off by a substantial margin, are probably reasonable, and at a minimum, logical.

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OK, the hard part is done. Now, let’s figure out how much money Alibaba can make from Youku and UCWeb if it starts to bridge the profit margin gap with Netflix and Google Chrome, respectively.

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The details:

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• Youku competes against three strong competitors in China, but the total market in China may be only $7 billion (Youku’s estimated revenues divided by its share at 22%), which is a little more than half as large as YouTube and half of Netflix. Youku and the competitors are adding content (Youku’s in-house production spending is up 2.3 times from fiscal 2016 to 2018), which should attract users (cumulative growth of daily average paying subscribers is up 200+% from fiscal 2016 to 2018) (source: September Investor Day).
  • Let’s assume Youku grows 75% (15% per year compounded for four years) from fiscal 2018 at $1.5 billion through fiscal 2022 to $2.625 billion.
• UCWeb had a worldwide market share of 8.6% at the end of 2016, dropping a little in 2017, and falling off a lot since May 2018 and was 4.2% at the end of November, so its userbase may have gone backwards.
  • For example, its India share fell from 43.4% to 20.8%. Internet usage in India is up by about 20% over this period (432 to over 500 million), which would imply a loss of 80 million users (20.8% of 520 million – 43.4% of 432 million). On the other hand, share rose from 10.0% in 2016 to 11.5% in China. China’s total number of users rose from about 720 million to 800 million over this period. So, taking into consideration its market share, this implies a pickup of 20 million users. Worldwide, internet usage was expected to rise from 3.696 billion to 4.208 billion from 2016-2018, and incorporating its change in share suggests a loss of 141 million users (318 million to 177 million) for UCWeb, or about 44%.
  • Loss of market share does not mean sales fell if people are using the internet more often and clicking on ads more often when they are online. For instance, paid clicks for Google properties rose 43% in 2016 and 54% in 2017 during a time when worldwide internet users rose a cumulative 14%. Keep in mind that Google has been adding platforms for clicks and growing those platforms (e.g., YouTube), so maybe its growth rate is 10% per year for Chrome. We can probably assume double that click growth rate for UCWeb as more Chinese come online and as wages rise quicker than in other places in the world. This means that even if UCWeb’s number of users declined 44%, sales may have been nearly flat for UCWeb over that time.
  • In 2016, UCWeb was reported in a different segment called Other revenues, which was $958 million. Other revenues also included AutoNavi, over-the-top TV services, and YunOS. Let’s assume UCWeb is $800 of this amount (the Feb 2016 20-F says other revenues is primarily from UCWeb).
  • Global internet penetration is about 55%. The highest is in North America (95%) and Europe is at 85%. Asia is at 49%. Penetration has been growing at about 2% per year and we can expect that trend to continue. If clicks per user grow at 10%, then in four years (through fiscal 2022) I can estimate UCWeb to grow revenues by perhaps 60% (12.5% per year compounded) to $2,480 million.
  • Currently, we can assume that Youku is unprofitable. The entire digital media and entertainment segment bleeds red with a 42% negative EBITA margin. I expect this is primarily due to Youku as its investments in content have grown larger.
  • Recall, I estimated earlier that Chrome’s operating margins are about 50%. However, it is well established and is the largest browser. Opera, which had 5.2% share at the end of 2016 and 3.2% at the end of November may give us better insight to UCWeb’s profitability. Opera is a Norwegian company that had a public offering in 2018. According to its prospectus, it had $10.2 million in operating income on $128.9 million in revenue, or a margin of 7.9%. There are a couple important contrasting points to make. First, with just 1% more market share for UCWeb (about 1/3^rd more total share), the estimated revenues for UCWeb (above at $1.55 billion) is 11X+ higher than Opera. Either my estimate is way too high or Opera does a horrible job at monetizing its business. I expect it is the latter but cannot be sure. However, even if Opera does not do a good job of generating revenue, it is still profitable. Given the assumptions that UCWeb is much bigger than Opera and that there is huge operating leverage in this business (once technology is developed, sales drop to the bottom line), we can then assume that UCWeb’s margins are moderately higher than 7.9% (Opera) but still much below 50% (Chrome). Sales per customer could be lower for UCWeb if the cost per click is less in China, and this can keep margins down if more sales people are needed for UCWeb per dollar of sales (Opera only has 410 employees, with 278 (67.8%) in R&D and 23 in sales and commercial).
    • Let’s assume that UCWeb’s operating margin is 15%, but this is far from certain. As the UCWeb grows larger, I expect the margin to rise, so let’s assume 20% in fiscal 2022. 20% of estimated sales of $2.480 billion is $496 million.
  • I estimate the loss for fiscal 2018 from Youku is $2.494 billion on only $1.5 billion in revenue. If UCWeb makes 15% on $1,550, then this means it made about $233 million in operating income in 2018. If P4P marketing services, display marketing services, and subscriptions makes 10%, then this equals $7 million operating income. The entire division lost $2,254 million, so this means that Youku lost $2.494 million ($2,254 loss + $233 + $7).
    • Does this make sense? Earlier, I noted that Netflix may be spending $12-$13 billion on content this year. In 2017, Netflix spent about 66% of its revenues on “cost of revenues,” which I assume is mostly for content. Since Youku is a cross between Netflix and YouTube, where the latter does not spend as much on content, maybe we can guess that half of Youku’s costs are for content. The above analysis, if 50% difference between revenue and loss ($1.5 billion – a loss of $2.494 billion) was for content, means Youku is spending $2 billion on content, or 1/6^th that of Netflix. Remember, earlier I estimated that it is 1/8^th the size of Netflix/YouTube, so this means that it is a heavier spender (1/6^th the spending for 1/8^th the size), which makes sense since it is nearer to the start up phase of its life cycle than Netflix and YouTube.
    • To verify these profit levels further, I considered 2016 financials. In 2016, Youku was not consolidated and the firm reported its share of equity income of -$61 million for its 16.5% ownership (the best I can ascertain). Thus, on a fully consolidated basis, the loss would be -$61 million / 0.165 or -$370 million in 2016. The operating loss that year for the entire division was $638 million. This would mean that Youku was a little bit more than half of the losses, and my estimate in figure 12 is that it was also a little more than half of the sales on a consolidated basis. The estimate of 15% operating margin for UCWeb in 2018 compares to perhaps negative 34% (($638-$370 loss)/$800 sales) in 2016.
    • Going forward to fiscal 2022, we can assume that the firm increases its spending on content from $2 billion. Let’s say it goes to $2.5 billion. If other costs do not rise (they stay at about $2 billion), then total costs rise to $4.5 billion. If sales rise to $2.625 billion (noted above), then operating income is negative $1.875 billion in fiscal 2022. This is an improvement from negative $2.494 billion in fiscal 2018.

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The net impact of the 67% growth in sales and improvement of operating margins (-72% to -26%) from fiscal 2018 to 2022 is $0.28 higher EPS.

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Other Businesses

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Innovation Initiatives and Other

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Alibaba’s final segment is called Innovation Initiatives and Other, and includes AutoNavi, DingTalk, Tmall Genie, and other businesses. It also includes the SME annual fee from Ant Financial (discussed later). The businesses generated RMB3,292, or $524 million, in sales in fiscal 2018. This is just 1.3% of sales; however, it drives down operating income by RMB6,901 million ($1,098 million), or 8.8% of operating profits (RMB78,617 or $12,514 million).

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The firm does not break down how much sales and profits are derived from each business, but we can make an educated guess at AutoNavi’s sales. AutoNavi is a Chinese web mapping, navigation, and location-based service provider. Alibaba completed its acquisition in 2014 and believes it will help enable its mobile commerce user base. Before 2017, the firm had an “Other” division that primarily included the SME annual fee, and revenue from UCWeb and AutoNavi. In 2016, Other revenue was RMB6,174 million (note 5, February 2016 20-F), the SME fee was RMB708 million in fiscal 2016 (note 23, February 2016 20-F)), and UCWeb generated an estimated $800 million (estimates provided above in figure 12) or RMB5,156, which leaves only RMB310 for AutoNavi. While this seems minor, the firm fits in its overall strategy in building a one-stop mobility platform.

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In 2018, the SME annual fee was RMB956, which leaves RMB2,336 (total for Innovation Initiates and Other is RMB3,292) for AutoNavi and other initiatives. In 2017, AutoNavi launched a ride-hailing service, in March 2018 a carpooling option, and it connects to China’s biggest bike rental company and Alibaba’s Fliggy travel and booking platform. While Alibaba does not collect commissions from all of these services (e.g., carpooling), it connects the firm with the country and offers opportunity. Some even suggest that the additional data can help develop autonomous vehicles (that is being tested by Alibaba, Baidu, and Tencent). It may also help Alipay (part of Ant Financial discussed below) to expand.

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Other initiatives include DingTalk, Tmall Genie, and others. DingTalk provides video and audio conference calling and organizes contacts with 100 million users and 7 million employers in China. Although, users may not be happy that employers can contact them and know their whereabouts at all times. WeChat, from Tencent, is a main competitor. Tmall Genie is a smart speaker, like Amazon’s Echo. Its new product sold 1 million units in its first four months.

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In general, the firm loses a lot of money from these initiatives (RMB6,901 million on only RMB3,292 million in sales in fiscal 2018), but this is not stopping it from making investments. These businesses can grow to becoming sustainable on their own and will help the firm create its end goal ecosystem. The ecosystem will enable people to meet (e.g., commerce), work (e.g., cloud infrastructure), and live (e.g., entertainment).

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While losses may decrease for AutoNavi, DingTalk, and Tmall Genie over time, I expect the firm will continue to make new investments that will drag down earnings. Let’s assume that earnings from AutoNavi, DingTalk, and Tmall Genie rise to break even by fiscal 2022, but losses from new investments will equate to the current loss, so by 2022 there is no change in losses from the segment Innovation Initiatives and Other. However, sales could more than double from RMB3,292 in 2018 to RMB7,000 by 2022 (a CAGR of 21%, slower than the 35% sales growth rate (from RMB1,817 to RMB3,292) over the past two fiscal years).

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Ant Financial

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The firm has many equity investments.

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Ant Financial owns Alipay, which is important to the e-commerce business. Alipay is the most popular mobile payment solution in China (it is like Apple Pay, Android Pay, and PayPal). Footnote 21 of the July 2018 20-F filing discusses Ant Financial’s financial impact on Alibaba and footnote 4 (a) discusses its history.

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• Alipay was part of Alibaba until 2011.
• In 2014, the firm sold its SME loan business and other services to Ant Financial. The firm then receive an annual fee based on average daily balance of SME loans. This was RMB956 million in fiscal 2018.
• The 2014 agreement gave Alibaba the right to receive 33% ownership under certain circumstances. This occurred in 2018, and under the agreement the firm’s right to profit sharing payments terminated (37.5% of Ant Financial’s pre-tax profits). These payments were RMB3,444 million in fiscal 2018, or $0.18 per share (RMB3,444 / (RMB6.27/$1) * (1-tax rate of 18%) / 2,533 shares).
• Ant Financial recently earned a valuation of $150 billion, based on a round of funding. The firm facilitates transactions with Alipay, makes loans to individuals and businesses, and operates the world’s largest money-market mutual fund. Given Alibaba’s 33% stake, its ownership could be worth $50 billion. A tradeoff of $0.18/share or $450 million in earnings for $50 billion sounds like a really good deal. Of course, Ant Financial could be quite overvalued. Total profits in fiscal 2018 equated to $1.201 billion ($450 million in Alibaba’s profits / Alibaba’s 37.5% share), so the P/E would on these earnings is 125 ($150 billion/1.201 billion)!

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Share of Results of Equity Investees, Interest and Investment Income, and Net Loss Attributable to Noncontrolling Interests

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Share of results of equity investees was a huge negative of RMB20,792 million in fiscal 2018, while interest and investment income was an even larger RMB30,495 million gain. These big numbers, and often big swings in these amounts, are expected to continue, but they are not necessarily cash flow impactful. The large numbers and swings are caused by impairment losses and revaluations upward.

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• In 2018, the impairment loss (mostly for Alibaba Pictures) was RMB18,153 of the RMB20,792 loss for share of results of equity investees.
• Of the RMB30,495 million interest and investment income, RMB24,646 was from the revaluation gain of Alibaba’s interest in the Cainiao network for RMB22,442, RMB1,861 came from a revaluation gain of Intime Retail, there was a disposal gain of RMB2,096 for Didi Chuxing (a transportation network company), and there was a loss of RMB1,753 million for impairments of cost method investments.

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The firm has RMB43,007 in fair value of investment securities and RMB139,700 in equity investees on the balance sheet for a total of RMB182,707 million. Cash and cash equivalents and short-term investments were another RMB205,395 million. On a dollar basis, these amounts add to $61.873 billion, or 18.0% of its equity market value on 1/3/19 of about $344.3 billion.

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Let’s assume that the run rate for share of results for equity investees is a loss of RMB2,500 million (about the same as last year excluding the impairment loss from Alibaba Pictures) and interest and investment income is RMB4,000 (less than the approximately net RMB6,000 last year excluding the revaluation and impairment losses discussed above), and about 1.6% of the fair value of investment securities and cash, and cash equivalents and short-term investments (1.9% on just the latter). Note that interest and investment income also includes gains and losses on interest rate swaps.

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In addition to results for equity investees and interest and investment income, the firm has a loss attributable to noncontrolling interests in fiscal 2018 of RMB2,681. Let’s assume that this continues because of the firm’s growth ventures, but losses are only RMB2,000 in fiscal 2022 (they were RMB171 and RMB2,449 in 2016 and 2017).

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The net impact on earnings of other businesses discussed above is a reduction of income of $0.13/share from fiscal 2018 to fiscal 2022 as shown in figure 14.

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Earnings and Cash Flow Summary (figure 15)

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The firm has ample cash flow to fund losses from investments and a robust acquisition strategy. Figure 15 (last row) shows that cash flow from operations has more than covered investment spending on acquisitions, etc. The firm currently has a long-term debt to asset ratio of 16.7% (RMB119,525 million in non-current bank borrowings and non-current unsecured senior notes / RMB717,124 million total assets). Cash and short-term investments (RMB205,395) is nearly twice as much as debt.

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The firm’s core commerce business is a cash cow. Using FactSet’s figures, the firm produced FCF/share of $5.51 in fiscal 2018 on $14.47 in sales per share, or 38%. This compares with 10% for the S&P 500 in calendar 2017 (121.8 FCF/share / $1,203.6 sales/share). Recall, the firm has very high operating margins in its commerce business, and since it generally does not hold inventory, it has a low physical asset level. Alibaba can grow sales without large investments in its core commerce business, which gives it cash flow to invest elsewhere without needing to raise debt (the last line of figure 15 shows that cash needed for investments is negative, which means its cash flow more than fully funds it).

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FCF/share in fiscal 2018 is $6.20, or 4.7% on a $130.60 (1/3/19) price. FCF/share in fiscal 2022 is estimated at $10.72, or a 8.2% yield. The following bullet points explain my calculations of FCF/share.

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• To determine cash flows from operations in 2022, I started with 2018 cash flow from operations, added new earnings projected for each division from 2018-2022, and then added 50% growth in 2018 non-cash charges such as depreciation and amortization of property and equipment and land use rights (RMB8,789, CAGR 78% 2016-18), share-based compensation expense (RMB20,075, CAGR 12% 2016-18), and amortization of intangible assets and license copyrights (RMB13,231, CAGR 101% 2016-18). I chose 50% growth in these non-cash figures since they grew at about ½ the rate of sales from 2016-18 (their growth was 35% CAGR versus a sales CAGR of 57%) and sales are expected to rise a cumulative 98% from 2018-2022.
• It is possible that my cash flow from operations (CFO) forecast for fiscal 2022 is too low or too high. CFO is generally net income plus depreciation minus changes in working capital. In my estimate described above, I did not account for changes in “assets and liabilities, net of effects of acquisitions and disposals.” Generally, this includes receivables and payables, or working capital. Cash flow from these figures was positive and growing the last several years (RMB6,953 to RMB22,082 from fiscal 2016 to 2018). This exclusion, if this growing trend continues, makes my cash flow numbers conservative.
• To arrive at FCF/share, I subtracted cash flow from investments in “Other property and equipment, intangible assets and licensed copyrights” from CFO and then divided this by the number of shares. FCF/share rises from $3.24 in fiscal 2016 to $6.20 in fiscal 2018 and is projected to be $10.72 in fiscal 2022.

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Remember, as discussed earlier, Alibaba owns 33% of Ant Financial, which is perhaps worth as much as $150 billion. Since Alibaba’s stock has approximately a $350 billion market value, this ownership is worth about 1/7 of the company. This means that the FCF yields above could be adjusted up by 1/7^th since the firm owns part of the business that is not counted in cash flows here (I reduced earnings for the lost income of 37.5% of Ant Financial’s pre-tax profits (RMB3,440 million) that was converted for the 33% ownership position).

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Let’s compare Alibaba’s FCF yields to the S&P 500’s.

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FactSet notes that 2017 cash flow per share (operating) was $191.7 for the S&P 500 and FCF per share was $121.8. To compare this apples-to-apples with Alibaba’s FCF per share before acquisitions as discussed above, some of the drop of the S&P 500’s operating cash flow per share to FCF per share ($69.9 per share drop from $191.7 to $121.8) has to be excluded. Let’s assume that acquisitions are ½ the size of capital expenditures, so FCF per share for the S&P 500 ex acquisition spending is $191.7 – 2/3 * $69.9 = $145.1. Assuming a $2,447.89 1/3/19 price for the S&P 500, this means the FCF yield of the S&P 500 is 5.9% ($145.1/$2,447.89). The same analysis for 2018 estimated (FactSet) derives FCF/share of $168.0 (FCF yield of 6.9%). If FCF grows with earnings, and earnings rise 7% in 2019, 2020, and 2021, then FCF per share in 2021 (approximately Alibaba’s 2022 fiscal year) is $205.8. $205.8 / $2,447.89 is a free cash flow yield of 8.4%.

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Let’s now look at EPS.

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Basic GAAP EPS was $4.00 in fiscal 2018 (fully-diluted GAAP was $3.91). I expect this to perhaps rise to $8.71 by 2022, or 118%.

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This is fueled by 98% increase in sales from RMB250,266 to RMB494,703. While this may appear optimistic, I am actually quite pessimistic (on sales) versus consensus. Consensus (33 estimates) has sales rising to RMB679,193 by fiscal 2021. There are only three estimates for 2022 (RMB863,719). In general, consensus is much more optimistic on core commerce than me (RMB 566,841 in fiscal 2021 with nine estimates and RMB723,318 in fiscal 2022 with two estimates, versus my RMB369,687 estimate in 2022).

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However, my EPS estimates are much higher than consensus in 2022. I am at $8.71 (approximately GAAP) versus consensus at $6.87; although, there are only two estimates. Still, for 2021 there are 18 estimates and the average for consensus, $6.05, is far below my 2022 number of $8.71. Non-GAAP consensus for 2021 is $8.47 (34 estimates) and $9.39 (two estimates) for 2022. Assuming GAAP consensus is the correct comparison, then consensus expects margins to be much lower than my estimate of 15.2% (RMB75,411 in net income / RMB494,703), which is already down from 25.6% in 2018. Given the firm’s very strong cash flow position, I can imagine a scenario where Alibaba grows sales quicker than my estimates as it acquires or invests in more new businesses to build its ecosystem; oftentimes, these business ventures are not profitable. The firm emphasizes its focus on the long-term – “Consistent with our focus on the long-term interests of our ecosystem participants, we may take actions that fail to generate positive short-term financial results or invest in businesses that have lower margins… (source: 2018 20-F)” It even has a partnership structure of 36 people that has a long-term focus.

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The P/E based on fiscal 2018 (essentially calendar 2017) numbers is 32.7 ($130.60/$4.00). However, GAAP EPS is expected by consensus to fall to $3.42 in 2019 (essentially calendar 2018), which gives the stock a P/E of 38.2. These numbers are much higher than the S&P 500 based on a $2,447.89 price (18.3 in calendar 2017 and 15.1 in calendar 2018 estimated). Assuming EPS for the S&P 500 grows 7% per year from calendar 2018 (Alibaba fiscal 2019) to calendar 2021 (Alibaba fiscal 2022), EPS will rise to $198.03 which yields a P/E of 12.4. The S&P 500 2021 calendar 12.4 P/E compares to Alibaba’s 2022 fiscal P/E of 15.0 ($130.60/$8.71).

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Conclusion

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Clearly, Alibaba has many opportunities for growth. It is building a dominant business in China and expanding outside the country, and it is a market share contender or leader in its businesses. The stock is trading richly, with a P/E of 32.7 on fiscal 2018 EPS and a FCF yield of 4.7%. However, if one looks to 2022, the P/E ratio drops to 15.0 and the FCF yield rises to 8.2%. 15.0 is less than three points above the S&P 500 (12.4), and 8.2% is essentially the same yield as the market (8.4%). Thus, in fiscal 2022, BABA and the S&P 500 look much more similarly valued.

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Of course, earnings and free cash flow in the future is not worth as much as it is today so a similar multiple in 2022 is not as important as Alibaba’s much more expensive multiples today. On the other hand, keep in mind that the ratios do not take into consideration the firm’s position in Ant Financial (up to 1/7^th of Alibaba’s value without corresponding earnings accounted for in the multiples). Total cash, cash equivalents, investment securities, and investments in equity investees is about 18.0% of market value, compared to perhaps less than 10% for cash and cash equivalents as a percent of value for the S&P 500. Right now, since Alibaba’s equity investments produce losses, they are accounted for as a negative to value in the multiple comparisons. Realistically, they should be worth something. Let’s say these considerations – time value of money and investment values – approximately offset.

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Assuming the multiples are the same in 2022 for Alibaba and the S&P 500, this implies that Alibaba is a very good deal. Post 2022, I’d expect Alibaba to have much better growth than the S&P 500, and more extra growth should more than make up for its lack of a dividend (the S&P 500 is at 2.07% (FactSet data) and Alibaba is at 0%).

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Valuation also depends on risk. While Alibaba probably has much higher growth opportunities than the S&P 500 post 2022, I also expect it to have much higher business risk. The firm may not be successful with its ventures. It has many large competitors (Tencent, Google, Amazon, Baidu, etc.), is making enormous investments that may not pay off, and operates in China where the government has much control. Although, the Chinese government would probably be careful to not harm Alibaba given how tied it is with the economy and the functioning of businesses. Furthermore, is Alibaba’s business risk greater than the risk of the US falling into a recession before 2022? I expect not. If the US enters a recession, then the P/E and FCF yield comparisons for the S&P 500 could be off substantially and the market would look much more expensive.

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In conclusion, it appears we have a Christmas gift. Alibaba and perhaps other high-quality growth companies have gotten much more reasonably priced.

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