My previous article about Alibaba Group (BABA) was titled “not selling a potentially $300 stock”, which was written when the stock price was $217. In that article, I concluded that BABA had plenty of room to run, and it was likely to reach the $300. By October 2020, Alibaba passed the $300 mark and went all the way up to $319, setting a new all-time high.
However, because of complications with the Ant Group’s IPO, which will be discussed in some depth in the article, Alibaba stock declined by 20% from its all-time high. As of this writing, BABA is trading at $254.
This article evaluates the prospects of BABA going into 2021, along with a valuation update. The conclusion is that at a valuation of 22.5x EV/EBITDA, with the core business growing at double digit rates as well as the Ant Group IPO catalyst still in play, BABA looks like a great stock to own in 2021. Let’s dive in.
Ant Group – Quick Overview
Most investors that have been following Alibaba know Ant Group well (and can skip this section). But for readers who don’t, here’s a quick overview.
Ant Group is a rapidly growing financial and technology company offering payment and digital financial services. It serves over 1 billion users. Its main product is Alipay, which is the main payment system supporting Alibaba’s e-commerce websites. Ant Group also has other rapidly growing product lines such as insurance, wealth management, credit line products and micro financing.
In short, Ant Group is a well-rounded fintech company that’s highly disruptive to the international banking establishment as well as modernizing Chinese payment systems.
The Ant Group IPO and why it’s important
Alibaba owns 33% of Ant Group and stands to gain enormously if Ant Group goes public and the stock debuts with skyrocketing prices, which many feel is highly likely.
Determining and quantifying the value of Ant Group is difficult because it is classified as an equity method investment in Alibaba’s financials, which means a whole lot less information is disclosed about it. To make things more complicated, Ant Group isn’t the only investment that’s classified as an equity method investment, which means its results are not shown on a stand-alone basis.
That’s why the IPO was so important for BABA, because it would have clearly determined the market value of its Alibaba’s 33% stake.
Excitement for Ant Group’s IPO was not a well-kept secret as this company has truly changed the way Chinese consumers pay for transactions. The IPO was likely going to be a huge hit, and most likely would have been accretive to BABA stock price. That was until the IPO was delayed.
The IPO was delayed as a result of a regulatory change in China, which many believe stemmed as a result of Jack Ma’s (Ant Group and Alibaba’s founder) comments against financial regulation in China. To me, it is not clear what drove the regulatory change, and it doesn’t really matter. The implications of such change are what really matters, not the driver of it.
The implications of the recent regulatory changes are that Ant Group will be viewed as a systemically important financial institution, which will require it holds more capital buffers against loans and other credit products. That simply means Ant Group needs to hold more cash (or cash equivalents) on its balance sheet. Ironically, that makes an IPO even more likely as the public markets are one way for Ant Group to raise such capital, in my opinion. And it’s not clear that this new regulation directly impacts the digital payment side of the business, which is a huge part of Ant Group.
Considering that the equity markets are a great avenue to raise some of the capital buffers that Ant Group needs, it seems that an IPO will eventually happen. Perhaps it will be delayed until Ant Group reorganizes the business to conform to new regulatory standards and make the Chinese government comfortable, but my expectation is that it will happen sooner or later. Bloomberg reported that Ant Group and Chinese regulators have reached an agreement on capital requirements, and that IPO talks have resumed. That doesn’t mean everything is clear for an IPO, but it’s an important step forward.
For those reasons, fears that Ant Group won’t go public seems to be a bit overblown, in my opinion. If those fears are misplaced, it means that Ant Group IPO still counts as an important catalyst for BABA to go higher. As time goes by and the dust settles, those fears are likely to disappear, and be replaced by optimism towards a renewed IPO.
It is the uncertainty of whether the IPO will occur or not that creates the opportunity to buy BABA at price that’s ~20% below its all-time high. My bet on that uncertainty is that the IPO will occur, and that BABA will recover its recent losses. Furthermore, that bet is hedged by all other Alibaba businesses, which are performing strongly.
Alibaba’s core businesses
As mentioned earlier in the article, Ant Group is classified as an equity method investment. That means Alibaba doesn’t report Ant Group’s revenues and profits like it does for all its core businesses. Those are the core e-commerce sites and digital platforms.
Alibaba core commerce and digital platforms continue to shine. In the latest quarterly results, Alibaba reported total revenue growth of +38% and EBITDA growth of +22%. That growth rate is derived from results in RMB (Renminbi), which is the reporting and functional currency of Alibaba’s core businesses.
That’s a strong rate of growth, and has not slowed compared to previous quarters. As Chinese consumers continue to migrate towards e-commerce, Alibaba revenues are likely to keep growing at double digit rates.
When that growth rate is taken into consideration along with valuation, the story looks even better.
My preference is to value Alibaba using an EV/EBITDA ratio because it measures the company irrespective of leverage and tax base, which allows me to make apples-to-apples comparison with other US companies.
When converting the TTM (trailing twelve months) EBITDA into USD at the latest conversion rate of RMB 6.53 per USD $1, I arrive at USD $29.5B of EBITDA.
Based on an EV of $664B, I arrive at an EV/EBITDA of 22.5x, which is not cheap by any means, but a reasonable multiple to pay for a business that’s growing both revenues and profits at double digit rates.
Alibaba is not a riskless investment by any means. There are some important risks to consider:
- There are risks that the IPO of Ant Group won’t happen anytime soon, or happen at all. It is important to recognize that the IPO is not guaranteed and it remains a risk
- As mentioned in the valuation discussion, Alibaba functional currency is the Chinese renminbi, not the US dollar. US investors are taking currency risks by investing in a foreign company whose revenues are not generated in USD
- There is also risk in the valuation multiple discussed above as well as the growth rate of the core business. If Alibaba’s core businesses do not generate strong revenue and profit growth, it is highly likely that its EV/EBITDA multiple will shrink. History has shown that Alibaba can trade around 12-13x EBITDA when sentiment is poor
In my opinion, these are risks worth taking as the rewards could be significant.
Alibaba core business continues to shine and grow at double digit rates, which in and on itself is a great reason to own BABA. A business that’s growing organically at more than 30% per year is usually a great investment, as long as it is not massively overvalued. As shown in the calculations above, Alibaba is trading at 22.5x EV/EBITDA, which in my opinion is a reasonable multiple to pay for such a strong business. What’s more, I expect that multiple to rise towards 30x as BABA has a history of trading at such multiple.
Furthermore, the IPO of Ant Group is still an important catalyst that should be accretive to BABA. Because of recent delays in the IPO, my sense is there is a lot of fear the IPO won’t happen. My belief is those fears are misplaced, and when the road clears for Ant Group to go public, BABA will recover the recent losses and reach new all-time highs.
My price target for BABA is $415, which reflects a 30x EV/EBITDA multiple on my estimate of USD $37B of EBITDA for the next twelve months (equivalent to RMB 240 billion of EBITDA at the latest exchange rate).