Description

Alibaba hasn’t been written up in 2.5 years. In the meantime, the shares are down 45% from their peak of $307 in October 2020. Alibaba grew revenue 30% last year and is now trading at what must be its lowest valuation ever: just 16x FY2023 earnings. For reference, the average stock in the S&P 500 has historically traded at 16x earnings and put up 6% annual EPS growth. Alibaba, by contrast, is poised to grow 20% a year for a long, long time.

This writeup will include no earth-shattering insights into Alibaba’s business because it doesn’t need any. Alibaba is an “inevitable” hiding in plain sight, which is why Charlie Munger put 20% of Daily Journal’s portfolio in it last winter. With a 6% FCF yield and 20% annual growth, Alibaba’s priced to return 26% a year or more to long-term owners. This represents incredible—and rare—absolute value at a time when even junk bonds have negative yields after inflation.

Ultimately the situation is best encapsulated by George Soros’ famous quote: “Money is made by discounting the obvious and betting on the unexpected.” What’s obvious today? The communists in China, who’ve just yanked their tech sector’s chain, are heavy-handed. What’s unexpected? They will do little to impair Alibaba’s—or any of the tech sector’s—long-term value. In fact, despite widespread perceptions, nothing has been done to impair the long-term prospects of China’s tech sector—in which the CCP has a lifeblood interest.

As a result, Alibaba’s shares are worth $350, 105% upside from the current price.

THE BUSINESS

Everyone at this point has at least a passing familiarity with Alibaba’s business. I’ll run through it quickly anyway for people like me who never thought a company with such obvious value would ever be cheap enough to own.

Alibaba is essentially two businesses—core commerce and AliCloud—combined with other businesses which are strategically but not financially significant. Those other businesses lose $4-5 billion a year, but over time those losses should be minimized. They’ll also shrink proportionally as core commerce and AliCloud continue to grow at a rapid pace.

Core commerce is comprised largely of two marketplace businesses—Tmall and Taobao—and is why Alibaba is often described as the Chinese Amazon. Unlike Amazon, however, Alibaba outsources logistics and is asset-light. Because of this, it’s able to earn 30% operating margins versus 4% for Amazon. Core commerce revenues grew 34% in FY 2020 and 42% in FY 2021. To give you an idea of core commerce’s growth runway, Amazon marketplace, a more mature business in a more mature economy, is still growing 20%. China’s economy meanwhile is poised for structurally higher growth, so it’s likely that Alibaba’s core commerce can grow at least 20% for a long, long time.

Alibaba’s other main business is AliCloud, which is growing 50-60% annually and is already the third largest IaaS behind Amazon and Microsoft. It isn’t profitable yet, but when it reaches scale, it will have 30% operating margins like those at Amazon Web Services. This business on its own, which doesn’t even yet represent 10% of Alibaba’s overall revenue, is already worth half the company’s current market cap in present value terms.

It’s said that business analysis is ultimately destination analysis. Both core commerce and AliCloud are businesses whose destinations are enormous, future-proof and high-percentage to the point of inevitability. And at 16x 2023 earnings, they’re trading at a once-in-a-decade price.  

THE SITUATION

When Chinese regulators stopped the IPO of Ant Group, of which Alibaba owns 30%, it was originally believed this was retribution for comments from Jack Ma that regulators were stifling innovation. However, as the crackdown grew, it was clear this wasn’t just about Jack Ma. It was about the Chinese Communist Party (“CCP”) reasserting control over the economy and society.

Measures taken by the Chinese government include:

—Nationalizing the for-profit tutoring industry and erasing $100 billion in market cap.

—Shortly after ride-hailing giant Didi went public on the New York Stock Exchange, Beijing banned it from app stores over cybersecurity concerns. This humiliated the company and tanked the stock, which still remains far below its IPO price.

—Suspending registration of new users of WeChat, one of the most important social and economic touchstones in daily Chinese life.

—Limiting gaming for children under the age of 18 to just 3 hours a week. (Side note: I found it humorous that when this was announced, an article described a Chinese woman pumping her fist at work and bursting into tears of joy.)

This is where I’m supposed to tell you that investors’ fears about these measures are irrational and foolish. But they’re not. What happened is a harsh reminder that China is a top-down society run by a strict government whose values often differ from our own. Accepting this difference—and its downsides—is the “iron price” an investor must pay for getting a piece of China’s incredible growth.

While current fears about China reflect an unpleasant truth, the problem is that they take a limited crackdown and extrapolate it into the CCP rejecting capitalism, as some have claimed. Now the perception is that the CCP is on a rampage, and everything is in flux. George Soros has even penned an op-ed declaring China uninvestable. Currently Alibaba is priced as though there’s a 50% chance the CCP will destroy its business. The same holds for Tencent, which is equally undervalued.

THE OPPORTUNITY

For the below reasons, I think fears about China are overdone and the opportunity there is still massive:

1. Stopping the Ant Group IPO was appropriate.

Ant Group originated loans to half a billion people and accounted for 20% of the country’s consumer debt. Despite its size—and the systemic risk it posed—it was extremely leveraged and had no capital requirements. It’s unclear how much personal animosity toward Jack Ma influenced regulators’ decision to stop the IPO and force the company to reconstitute itself as a bank holding company. Nonetheless Ant Group’s incredible economics were enhanced by being able to offload risk from itself and onto the Chinese financial system. It’s an example of privatized gain and socialized cost.

The regulators were right to regulate the company. Moreover this will still probably be an incredible business after the regulations have taken effect.

2. The network is everything.

Current fears about China overestimate the strength of the CCP’s hand, and they ignore the country's "nature"—i.e. the national character that China's actions have cohered around over the last 20 years. One of the most valuable things I’ve learned while investing is that over time industries show you their nature. And what you typically see is that it’s difficult, if not impossible, for them to deviate from that nature for long. The same can also be true of nations, particularly one whose ambitions have been reiterated so publicly as they have in China.

And in China’s case, both the strength of its hand and its nature can only be understood in reference to the most powerful economic force of the last 30 years: globalization. Globalization is what’s made China as it currently exists possible. And only through the lens of globalization can we get some idea of what China will do in the future.

The global chessboard is set up as follows:

—Globalization has created a global network of trade, and the network is so vital and existentially important that membership is a matter of national life and death. Joining the network isn’t just a path to prosperity. It’s the only path. Conversely not joining the network—or being kicked out—consigns a nation to the dustbin.

—A corollary to this is that the power of the network encourages unprecedented conformity from each member-nation to the network’s values (free trade, respect for property rights). We’ve seen the same phenomenon play out on the internet, which went from the Wild West in 2000 to centrally-controlled by social media giants today.

—At present the US enjoys outsized control over the global network of trade. It has the world’s reserve currency, military leadership and its values largely determine the network’s membership. Cuba has been kicked out out, and as a result it’s an impoverished mess. Russia has been half-kicked out, and as a result its economy continues to be a backwater. The penalty for offending the moral, political and economic values of this network are severe.

—China seems like an autocracy indifferent to global opinion, but this isn’t the case at all. China has increased its economy 15x because it’s been the most enthusiastic contributor and beneficiary of this network in the world.

—China would love to influence this network the way the US does. However, it lacks the power to do so. For the time being, it’s a price taker and will toe the line for a long time because staying plugged in is everything and getting unplugged—or even partially unplugged—would be a national disaster.

—On top of this, China is obsessed with winning what it calls the Fourth Industrial Revolution. It simply cannot accomplish this without being a member of the network. And that means it must adhere to network values. It can’t have it both ways.

What’s so confusing and concerning to us all is that China is only partially “globalized.” Imagine a spectrum with the US and Europe on one end and Russia on the other. On this spectrum, China would fall somewhere in between the two poles. Li Lu has written well about this dynamic. And his framework is worth quoting:  

“I believe China is at interim stage between Civilization 2.0 and Civilization 3.0. Let’s call it

Civilization 2.5. China has come a long way but still has a long road ahead. Therefore, I think

there is a high probability that China will continue on the main track of Civilization 3.0, as the

cost of deviation is very high. If you have a good understanding of China’s culture, people and

history, you will agree that China will forge forward. This is particularly the case now that you

have a better understanding of the essence of modern civilization. There is almost no chance of

China leaving the common market, and the probability of China changing its market rules is also

very small. Thus, it is highly probable that, in the next 2 to 3 decades, China will remain in the

global market system, and adhere to free market principles, in addition to promoting science &

technology development.”

His point about China being at Civilization 2.5 does a good job of putting the current situation in perspective. If China stays at Civilization 2.5, the value proposition there is tepid. Returns could be decent. But like Russian equities, Chinese stocks would deserve a substantial discount. If, on the other hand, China really is on the path to Civilization 3.0, then the opportunity in China at current valuations is huge. His most important point though is this: The only path that can get China close to its national milestones is staying on the track of Civilization 3.0. There is no other way.

In other words, you don’t need to believe the CCP are beings of pure goodness and light to invest in their country. You just need to believe they’re serious about their nation’s trajectory and respect the ground spring which makes it possible.

3. The US and China can dislike each other without destroying each other.

Perception: China and the US are on a collision course. That puts foreign investors in the crosshairs.

Reality: A collision course with the US isn’t inevitable at all. The most likely outcome of China’s rise isn’t outright hostilities with the US but separate zones of influence.

The truth is Chinese and US interests overlap more than they conflict. Moreover it’s unclear what exactly it is they have to fight over. The communists of old sought global conquest for both ideological reasons and economic ones. In terms of ideology, they had a religious drive to convert the world. In terms of economics, their movement could only survive by taking slaves and plundering external sources of wealth. China’s incentives, on the other hand, are different. When it comes to ideology, the Chinese communists lack any missionary zeal at all. They view other cultures in the same way China has for a thousand years: with disinterest. There’s little interest in changing other cultures because there was never much interest in them in the first place.

Meanwhile economically the game of thrones has totally changed. Nations are no longer trying to acquire territory or subjects. They’re trying to acquire markets. What’s so unique about the situation between the US and China is that they’re each other’s biggest market. These countries have true skin in the game with respect to each other, and that’s tremendous moderating influence on both. A prominent example of this was China ponying up $1.3 trillion to purchase US treasuries after the financial crisis. They were helping an “ally” and signaling their eagerness to become a member in good standing in the global community. Could you ever imagine the Russians making a similar gesture? Me either.

On top of this, the US and China have huge overlapping financial interests. China still owns $1 trillion in US treasuries. Meanwhile, as Soros pointed out in his op-ed, US pensions have invested hundreds of billions of dollars in Chinese companies. The situation isn’t quite one of mutual assured destruction. But it’s one of mutual assured recession. The US needs China’s growth, and China needs the US to purchase its exports.

It ignites our imaginations to envision something cataclysmic coming from US-China tensions. But the more likely outcome isn’t hysterical misery but ordinary unhappiness. Neither side ever achieves the final heroic victory it wants. Instead life does what it usually does and goes on.

4. Jack Ma’s fate isn’t our fate.

Perception: Jack Ma’s comments against the Chinese government have doomed the company.

Reality: Jack Ma isn’t Alibaba. And it’s unlikely the CCP views the situation otherwise. For years now the CCP has implemented a widespread practice of forcing founders to leave their companies, sometimes for engaging in wrongthink, often for no discernible reason at all. The CCP does this specifically because it doesn’t view founders and their companies as synonymous.

China’s most abiding national concern is with winning the Fourth Industrial Revolution. It’s something Chinese officials and their proxies speak of frequently: the fact that power today comes not from land or population but from technological prowess. Tech prowess, however, can only be achieved by promoting and empowering tech companies and the people who make them possible. And  in today’s world China needs these people more than they need it. Ultimately I can’t put it better than David Goldman did in a recent article on Asia Times: “Beijing can’t accomplish its economic objectives without encouraging thousands of semiconductor engineers to get rich.”

They can’t get rich is if the CCP bans success.

5. China will not respect property rights.

Perception: The fact that the CCP destroyed the for-profit tutoring industry shows it has no concern for investors’ capital.

Reality: For-profit tutoring was a threat to a bedrock Chinese institution: its national exam system. This system—in which test scores, not wealth or connections mean advancement—has offered “equality of opportunity” in China for hundreds of years. Only half of the test takers gain acceptance into college. The rest go on to trade schools and diminished career prospects. For-profit tutoring was an issue because it allowed children of wealthy families to acquire an edge over others whose families couldn’t afford the services. This in turn threatened the fundamental fairness of the system and couldn’t be allowed to stand.

In the meantime, the Chinese government seems to appreciate that it’s spooked investors and is taking steps to calm their fears. Chinese state-run newspaper Securities Times published an article July 28 stating among other things:

“Investors should have confidence in the market.”

“A short-term shock does not change the nature of the long-term positive trend.”

These statements suggest an appreciation by the government that the plunge in stock prices is a problem. They also suggest that the crackdown is of limited scope and duration.

SUMMARY

China isn’t uninvestable. To the contrary, what’s happening there is one of the greatest feats of industry in human history. China deserves an allocation. And Alibaba is one of the highest-percentage opportunities within that allocation. What we’re being offered here is a trade potentially on par with Buffett’s investment in Apple at 10x FCF in 2016. Which in total dollars of profit might be the greatest trade in history.  

VALUATION

Alibaba will likely grow revenues 20% a year or more over the next five years. Due to its operating leverage, the business could achieve 35% EBITDA margins by 2025 and put up $90 billion in EBITDA, which would translate roughly to $46 billion in FCF.

$46B at a 25x earnings multiple equates to a $1.15 trillion market cap. When you discount that from 2025 to today and add in the net cash and the Ant Group stake, that gets you to $350 a share, which equates to 105% upside.

Catalyst

An end to the crackdown.