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Alibaba Group Holding (NYSE:BABA) stock recently soared 36% in a single day. Following the Chinese government’s move to support the markets, investors bid the stock up, sending it back over $100 following a low of $72. Earlier in the week, China revealed a rash of economic data, most of which beat expectations. Retail sales–the metric most relevant to BABA’s performance–rose 6.7% year-over-year, doubling expectations. The combination of China’s dovish stance and its strong economic data thrilled investors, as they bought up BABA shares in big quantities when the news came out. Not only did BABA rally 36% in a single day, it followed up that performance with another 10% rally on Friday. It was one of Alibaba’s best weeks in years.
Many people were surprised to see Alibaba rally so much in such a short period of time. The sentiment toward BABA and other Chinese ADRs was pretty negative prior to the rally, as China was perceived as being aligned with Russia in the Ukraine war.
Those who were surprised at the rally shouldn’t have been. The “one two punch” of good news this week helped lift Chinese stocks out of their slump, as did a two hour phone call between Presidents Biden and Xi on Friday. The fact that all of this positive news lifted BABA was completely predictable. The stock is not trading on fundamentals but on politics. If people think the political situation is improving, then BABA stock is free to float upward to where its fundamentals are. Several positive news stories could therefore lift the stock by extreme percentages in a very short period of time. As I wrote in a Tweet recently:
What I was getting at was that a series of events like the ones I mentioned could lift BABA dramatically. Potentially by more than the 36% it rose on Wednesday. The higher BABA goes, the more money it takes to lift the stock by high double digits in a single day. But if the market cap remains not much higher than $250 billion when the news gets flooded with a deluge of good news, then more 36%+ rallies are very much possible.
Reasons for the Rally
Before getting into why more big rallies are possible for BABA, it helps to look at reasons why the first one happened. The big picture is that many investors agree BABA is undervalued by conventional metrics, but think there’s too much political risk in it. It follows from this that when the political risk appears to subside, a lot of money is likely to flow into BABA. Today, the political risk surrounding BABA appears to be fading. A few points below should suffice to demonstrate that.
China’s Dovish Stance
China took a dovish stance toward stocks in a recent statement, saying that it will:
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Pursue policies favourable to the financial markets.
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Not adopt contractionary monetary policy.
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Cooperate with the U.S. on listings.
In one fell swoop, China addressed at least two main concerns investors have had with BABA. It has long been felt that China’s economic growth was slowing, and that its government was hostile toward big tech firms. The recent statement seemed to provide good news on both fronts. Obviously, China making a statement is not the same as it actively pursuing market-friendly policies. But it’s a step in the right direction.
Strong Economic Growth
Another factor that may have lifted BABA this week was strong economic growth. On Monday, China put out a number of economic measures that beat expectations. These included:
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6.7% retail sales growth (3% est).
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7.5% industrial output growth (3.9% est).
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12.2% growth in fixed asset investment (5% est).
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3.7% growth in real estate investment.
The only negative number released in the report was commercial real estate floor space sold, which fell 9.6%.
These strong numbers–particularly retail sales–were all good news for BABA, which sells primarily to the Chinese market. So, investors may have bought stock on the good economic news.
Xi Jinping’s Phone Call With Biden
Chinese President Xi Jinping held a phone call with U.S. President Joe Biden on Friday, when BABA’s second large rally of the week was taking place. On the call, Xi indicated to Biden that he would not send weapons to Russia. Investors breathed a major sigh of relief. Ever since the Russia/Ukraine war began, there have been concerns that China would supply Russia with arms and then be targeted by sanctions just like Russia was. If Xi stays true to his word, then China will not be doing so. This reduces the likelihood that China will be hit by sanctions, which have destroyed the value of Russian stocks.
The Government Buying Stocks
Last but not least, there is the possibility that the Chinese government is itself buying stocks to prop up the market. On Wednesday, Hang Seng Index rallied across the board, with most of the big names rising by double digit percentage points. It almost looks as if someone with extremely deep pockets was buying up the entire index. It has long been rumored that China would go so far as to buy up stocks to support its market. In February, BNN Bloomberg reported that it had done exactly that. I wouldn’t take these reports as gospel, but there’s a decent chance that they’re true. It would explain, among other things, the uniformity of the rally in Chinese stocks on Wednesday.
The Financials-Driven Case for BABA
Having established the various political factors that could be pushing BABA higher, we can turn now to the financials. Alibaba is a highly profitable company that, until last quarter, had been growing very rapidly. With China’s scorching hot retail sales, it may return to fast growth later this year. For the trailing 12 month period, BABA’s earnings metrics were:
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Revenue: $131 billion, up 29%.
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EBIT: $14.2 billion, down 16%.
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GAAP diluted EPS: $3.76, down 59%.
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Adjusted diluted EPS: $5.30, down 21%.
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Levered free cash flow: $17.4 billion, down 38%.
As you can see, revenue grew dramatically in the period, but most profit metrics declined. The declines in some of the earnings metrics do appear genuinely concerning at first glance. However, they were influenced heavily by non-recurring factors. Two noteworthy non-recurring or non-cash factors holding back BABA’s trailing 12 month earnings include:
The fine is a one-time cost that has been fully absorbed. The decline in the stock portfolio may or may not reverse, but at any rate, it doesn’t affect cash flows. Free cash flow itself declined, but that was largely due to the fine.
There was one extra cost BABA took in 2021 that WILL recur:
The higher tax rate.
In 2021, BABA lost its Key Software Enterprise status. This was a government designation that entitled it to several tax credits. While BABA had these credits, its tax rates ranged from 10% to 18% depending on the quarter. In September and December, the tax rate was 24%. There is no reason to believe it will go down again.
So, of the three factors that held back BABA’s earnings in 2021, only one of them is set to recur. That suggests that the company can return to solid earnings growth later this year. The higher tax rate will hold back earnings somewhat, but in the March quarter, BABA will be comparing itself to a prior-year quarter in which a fine caused earnings to swing negative. So, year-over-year growth in that quarter should be strong.
If BABA can successfully overcome the costs it took in 2021, then its growth could return to historical norms. Those norms are pretty strong. According to Seeking Alpha Quant, some of BABA’s 5-year CAGR growth rates are:
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Revenue: 34%.
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EBIT: 15.7%.
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Net income: 11.3%.
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Free cash flow: 13.7%.
Pretty solid numbers. They were all much higher prior to this year, of course, as the decline in earnings this year was dramatic enough to noticeably impact the entire five-year period. Still, these numbers are strong enough to justify an investment in a low-multiple stock.
If BABA can get back to its previous growth rates, it will prove to have been a steal at today’s prices. Today, BABA trades at just 11.7 times adjusted earnings, 2 times sales, 9.85 times operating cash flow, and 1.76 times book value. These are all very low multiples. If BABA were to resume positive earnings growth later this year, and the stock price didn’t change, then the multiples would come down further. Eventually it could get to a point where BABA was trading below liquidation value. That would make the stock an absolute no-brainer buy.
Risks and Challenges
As I’ve shown in this article, Alibaba stock is extremely cheap, has strong historical growth, and now even has momentum on its side! Things are certainly looking good. But we’re not done yet. In order to truly finalize any bullish thesis, we need to consider the contra position. So, here are some risks and challenges BABA investors need to keep in mind:
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Competition. Competition was one of the big themes of China’s 2021 tech crackdown, and BABA will face more of it going forward. Last year, BABA was forced to scrap its “choose one of two” policy, share payment methods with Tencent (OTCPK:TCEHY), and potentially unwind its Ant-Group subsidiary. All of these measures will make competition tougher for BABA. The forced payment sharing results in payment processing fees going to Tencent, the end of “choose one from two” gives competitors like JD (JD) a leg up, and the unwinding of Ant Group would take BABA out of the payments business. Collectively, all of these measures could make life harder for BABA and comparatively easier for its smaller competitors. So, competition is a risk for investors to watch.
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An invasion of Taiwan. In the immediate aftermath of Russia’s invasion of Ukraine, Russia was hit with unprecedented sanctions. Its stock market immediately collapsed and was eventually closed. If China pursued similar moves in Taiwan, then investors might perceive its stocks as too risky, and sell them just like they did Russian stocks.
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Deceleration. Alibaba’s revenue growth decelerated severely in the fourth quarter. Coming in at just 10%, it was very low by the company’s standards. Prior to the fourth quarter earnings release, BABA had been growing revenue at more than 30% year-over-year. Now it’s barely in the double digits. If the deceleration continues then it could eventually get to a point where BABA isn’t growing at all. At that point the only way to deliver value to shareholders would be cutting costs.
These are all risks worth keeping mind. But on the whole, BABA appears to be worth it. With a valuation that prices it at barely above liquidation value, it’s one of the cheapest stocks in the market. Even with just modest earnings growth from here on, it could deliver considerable value to shareholders.
