alibaba equity research report

AlibabaGroupHoldingLimitedACC645GroupProject

PREPARED BY: ADIL HASAN JANHAVI KHANDELWAL KATIE CHASE YUE SU VINAY VEKARIYA

May 5, 2016 NASDAQ: BABA

Alibaba Group Holding Limited

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I. Investment Summary Alibaba Group Holding Limited is a tech-giant that provides fundamental technology infrastructure and

marketing reach to help businesses establish an online presence and conduct commerce with consumers and businesses. Their revenue is generated through online marketing services, commissions on transactions and fees for online services. Their major business also includes the Alimama marketing technology platform, which provides marketing services to sellers and Alibaba Cloud Computing, which supports their business and also provides computing services to third parties. Recent Developments:

§ Ant Financial, the e-commerce group’s payments arm, has just raised funds worth $4.5 billion at a $60 billion valuation and is preparing for an initial public offering. The e-commerce group currently has a profit-sharing agreement with its financial affiliate, which Ma controls. In the 12 months to March last year, Alibaba received 37.5 percent of Ant’s pre-tax income – roughly $269 million. The online retailer has three choices ahead of an IPO: continue this agreement, receive a one-time payment, or take a 33 percent equity stake. If Alibaba opts for a smaller shareholding, Ant can make up the difference with cash or a revised profit-sharing agreement.1

§ Alibaba Group Holding Ltd (BABA.N) said it's considering whether to launch an appeal against a Hong Kong regulator's finding that it breached takeover rules. Alibaba said that the Hong Kong Takeovers and Mergers Panel, part of city's Securities and Futures Commission (SFC) watchdog, found it broke rules by arranging a deal with certain investors in CITIC 21CN, now known as Alibaba Health Information Technology Ltd (0241.HK), at beneficial terms not extended to other shareholders. But the e-commerce firm said the regulator issued a new waiver in view of the sharp rise in Alibaba Health stock since 2014, meaning Alibaba is not currently required to launch a full buyout.2

Investment Recommendation We recommend to acquire short positions in Alibaba at current stock price and cover the positions in the range of $65 to $70. As per our financial analysis, Alibaba is growing at higher rate and has unique competitive over competitors in high volume industry. However, as per our valuation analysis, the stock is trading at premium compared to its intrinsic value. After reviewing Alibaba’s financials and other valuation criteria, the estimate of share price of Alibaba falls in the range of $60 to $70. As of April 22, 2016, Alibaba is trading at $79.89. Therefore, Alibaba proves to be trading at an average to premium compared to the investment alternatives available within the industry. II. Company Overview:

Alibaba Group Holding Limited, which is a Cayman Islands holding company established on June 28, 1999, conducts its business in China through its subsidiaries and variable interest entities. Alibaba runs in the world’s largest internet market, China. Alibaba Group is an e-commerce company. Alibaba Group was founded in 1999 by 18 people led by Jack Ma, a former English teacher from Hangzhou, China. “Our founders started our company to champion small businesses, in the belief that the Internet would level the playing field by enabling small enterprises to leverage innovation and technology to grow and compete more effectively in the domestic and global economies.”3 They offer a sales service through web portals which allows for consumer to consumer, business to consumer, and business to business to be connected. Other services are electronic payments, cloud computing, and a shopping search engine.4 In simpler terms, it is a combination of Amazon.com, eBay, and PayPal.

Alibaba consists of 34,985 employees, which is more than Yahoo and Facebook together. The main office is in Hangzhou, but is spread throughout the world with other offices in the US, UK, India, Japan, and Korea. Alibaba’s revenue for the year ended March 2015 was $12.3 billion and a market capitalization of around $190 billion as of April 7th, 2016.



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For the third quarter of their fiscal year ending December 31, 2015, Alibaba reported revenues from the China commerce business were RMB29.9 billion. The retail business recorded RMB28.7 billion (US$4.4 billion) as revenues, up 35% total years from their growth in online marketing services and commissions revenue. The wholesale business revenues reported in at RMB1.16 million (US$179 million).

Revenues from total International commerce business were RMB2.1 billion. Its retail business revenues were RMB632 million (US$97 million), rising due to higher GMV transacted on AliExpress. Wholesale business revenues were RMB1.43 billion (US$221 million).Revenues from Cloud computing and Internet infrastructure were RMB819.0 million (US$126 million), increasing an astounding 126% year over year and contributing 3% to total revenue. Revenues from Others were RMB1.79 million (US$277 million), down 7% from the year-ago period and accounting for 5% of total revenue. This weakness was due to the loss of revenues from the SME loan business which was transferred to Ant Financial in Feb 2015. Higher mobile Internet services revenues somewhat offset the decline.5

A company this size and with this many components is going to have a large number of expenses. Alibaba’s expenses are primarily made up of product development, sales, marketing, administrative, and interest expense.

Product development expenses consists mostly of salaries, shared compensation payment, operating systems, software, databases and networks for marketplaces, mobile products and service platforms. Alibaba expenses product development costs as they are incurred.

Administration expenses are made up of salaries, shared compensations, professional fees, office facilities, overhead costs, and donations. In 2014, a donation of RMB1, 269 million was given to a non-profit organization and was recognized in full. Interest and investment income expense (net) entails interest income, investment gain/loss, revaluation of investments. This has been a growing expense for Alibaba and has created a net gain of RMB 6,535 million recognized in 2015 due to revaluation of equity interests. Interest expense is comprised of mostly interest payments and amortization of upfront fees. Alibaba’s interest expenses began growing significantly in 2013 which led to them refinancing their US8.0billion credit facility and obtaining an US3.0billion revolving credit in August 2014, which has yet to be used.

III. Management and governance: Alibaba’s governance structure is unique and unparalleled for a company this large. In their filings, they

wrote that the company tries to run itself like partnership. This type of management style has led to them to in 2010 establish the "Alibaba Partnership," a 30-member steering committee (which is made up of more women than most of its competitors) consisting of managers at Alibaba and other related companies. Alibaba claims that this arrangement allows executives to concentrate on long-term goals, collaborate better and "override bureaucracy and hierarchy."

In filings, the company also stated that they believe this is a better alternative to dual-class share structures, which have been used by other large tech companies. In that style of management, votes by shareholders who own a certain class of stock carry an unequal weight.

However, Alibaba managers do have one very important decision to make. They get to recommend many of the company's governing body, also known as their board of directors. This gives them the ability to choose whom they report to. “You’re basically ceding control to management,” says Charles Elson, the director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. “It’s very unusual. I’ve never seen anything like it for a company of this size.” Management having this much control can be a concern. It may cause investor to wonder how much control over the board insiders have on their decision making. This fear is supported by Ma’s letter written to the shareholders that stated Alibaba “will put customers first, employees second, and shareholders third.”6



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Board Members:

7 Source: http://www.bloomberg.com/research/stocks/private/board.asp?privcapId=42083601

IV. Industry Overview & Competitive Positioning Industry Overview:

The overall industry that Alibaba associates with is the Internet industry. Essentially it operates within the e-commerce industry that serves clients worldwide. The e-commerce industry is highly competitive and price elastic where customers base a great deal of their buying decisions on price points. As information is so readily available, customers switching costs are minimal and their switching incentives are greater due to price differences and therefore companies within industry compete on the basis of price. Major players in the e-commerce industry besides Alibaba are Amazon, Ebay, Tencent and JD.com.8 There is a significant reliance on information and data within this industry. Therefore, having an infrastructure in place to facilitate data collection and evaluation is imperative for the leading competitors within this industry. The top competitors have started investing in analyzing Big Data for e-commerce activities such as online retailing and entertainment to further stimulate the business operations. According to the U.S. Census Bureau, the manufacturing sector is the largest contributor to e-commerce sales (46.4% of their total shipments), followed by merchant wholesalers (24.6% of their total sales)9. These two segments make up the business-to-business category. The key drivers within this industry are price savings, time savings and convenience. Since the invention of smartphones and tablets, e-transactions have increased further and the importance of ease of use and online platform sophistication has increased. This industry is not capital intensive but technology intensive. There are fewer barriers to entry and large number of competitors. Due to the large scope and reach of e-commerce businesses, buyers and suppliers have considerable influence on the businesses too. Competitive position:

Alibaba’s competitive advantages have been attributed to many reasons. The first being its competitive position in China. Alibaba has become the largest e-commerce platform in China and is providing its customers with benefits that were otherwise not accessible to them. Being the first mover in China’s e-commerce market has given Alibaba an advantage over other competitors. Alibaba possesses economies of scope within its functions. By taking advantage of their supply and distribution network the company has been able to serve many businesses and their respective customers with limited modification and resources. Economies of scale is another way Alibaba maintains its competitive position within its industry. By distributing larger volumes of sales and competing on the basis of size, the company is able to weed out competition. The company accounts for more than half of all parcel deliveries in China and, in 2012, the combined transaction volume of the company totaled one trillion yuan ($163 billion) which is more than Amazon and eBay combined.10 And lastly



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by continuing to expand their networks and establishing good relationships with the Chinese government, the company has established themselves as the market leader in China. Analysis using Porter’s Five Forces Model:

Barriers to Entry - High: There is some threat of new entrants that plagues Alibaba but it is not considerable enough to be a cause for alarm. In order to be successful in the online retail business, new entrants need to have a sophisticated network of suppliers, distributors and logistics that are only developed through years of experience. New entrants can come in to the industry but the industry itself is very competitive which become barriers eventually.

Threat of Substitutes - Low: There is threat of substitutes in the form established brick-and-mortar retailers providing online services. These retailers usually lack economies of scope and scale which does not make them as efficient as Alibaba or Amazon. Hence the threat of substitute is minimum at best.

Bargaining power of buyers – Medium: Bargaining power of suppliers (customers that sell through Alibaba’s market places) is strong in Alibaba’s case as suppliers can affect the market dynamics by choosing not to opt to sell through Alibaba. It is not very high in case of buyers since most buyers do not act collectively and fail to impact the business individually. Alibaba’s customer base is in millions with different interest groups and diverse demographics.

Bargaining power of suppliers – Low: In general, suppliers have little bargaining power in this business model.

Industry Rivalry – High: Industry rivalry is strong within the online retail business. Alibaba competes with Amazon, Ebay etc. on the basis of price and customer service. Although this industry is not condensed with a lot of businesses, the existing companies within this industry compete rigorously with each other. References: V. Investment Risk Analysis Market Risks

Market risk refers to what happens when the market turns against or ignores your investment. According to Alibaba 20-F, there are three main market risks inside the corporation.

Interest rate risk: The main interest rate exposure relates to bank borrowings. Once the interest rate fluctuates in an absolute level, the fair market value would be influenced prominently.

Foreign exchange risk: Foreign currency risk arises from future commercial transactions, recognized assets, and liabilities in foreign operations. RMB is the denominated currency when Alibaba operate businesses. During last decade, the exchange rate between dollar and RMB fluctuated astatically, which lead to an unstable market price when trading worldwide.

Market price risk: Their investment securities are reported at fair value. If market prices of the instrument securities, such as trading securities, held by Alibaba had been 1% higher as of March 31, 2015 and March 31, 2014, this securities would have been approximately RMB132 million (US$21 million) higher, vice versa. Financial strength

Investors care about financial strength ratios first since a balance sheet–oriented value investor looks closely to make sure that the company will be around tomorrow. As calculated, the current ratio, quick ratio and debt to equity ratio are 3.58, 3.46 and 0.35, respectively. Compare to other corporations in the same industry, the current ratio and quick ratio of Alibaba are higher than the ratios of EBAY, and twice more than them of Amazon, which shows a good ability of solvency. The debt to equity ratio of Alibaba is much less than it of EBAY and Amazon. This difference indicates that Alibaba has a small percentage of debt, which proved a healthy financial condition.



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Moody’s evaluation

Furthermore, Moody's Investors Service claimed that Alibaba's FY2015 results support its A1 issuer and senior unsecured debt ratings, remaining stable.11 VIII. Financial Analysis Summary of Important Accounting Policies and Events12 Recognition of revenue:

Alibaba’s revenue principally represents online marketing services revenue, commissions on transactions, membership and cloud computing revenue. Revenue comprises the fair value of the consideration received or receivable for the provision of services in our ordinary course of activities and is recorded net of VAT. Consistent with the criteria of ASC 605 ‘‘Revenue Recognition,’’ we recognize revenue when the following four revenue recognition criteria are met:

(i) Persuasive evidence of an arrangement exists (ii) Delivery has occurred or services have been provided (iii) The selling price is fixed or determinable, and (iv) Collectability is reasonably assured.

Depreciation and Amortization:

The costs of property and equipment and intangible assets are charged ratably as depreciation and amortization expenses, respectively, over the estimated useful lives of the respective assets using the straight-line method. Alibaba periodically reviews changes in technology and industry conditions, asset retirement activity and residual values to determine adjustments to estimated remaining useful lives and depreciation and amortization rates. Material Non-Recurring Event: Equity settled Donation Expense

In October 2013, Alibaba granted options to acquire 50,000,000 of their ordinary shares to a non-profit organization designated by Jack Ma and Joe Tsai, subject to irrevocable instructions to designate and transfer these share options to the separate charitable trusts to be established by Jack and Joe. This has raised red flags for analysts and investors everywhere. Alibaba’s generosity with options and stocks dwarfs anything Silicon Valley has ever witnessed.13 Off-Balance Sheet Arrangements:

Alibaba claims that it did not have any material off-balance sheet arrangements in fiscal year 2013, 2014 or 2015, but we could find a contractual commitment of RMB 1,056 million (USD 158.4 million) due in the next 5 years (2016-2020) for leases of office facility & transportation equipment. The nature of this lease and accounting method used could not be ascertained from the information provided in the company’s 20F.



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HistoricalAnalysis: Income statement:

The revenue has increased by approximately 50% over last few years but the net income has not increased at same rate due to rising cost of revenues. The cost of revenues has increased mainly due to increase in SG&A and Product Development Expenses as the company is positioning itself in the market after its IPO. Balance Sheet:

When a large amount of cash is recorded on the balance sheet, it's generally a good sign as it offers protection during business slow-downs and provides options for future growth. Growing cash reserves signal strong company performance for Alibaba. It is a characteristic of this industry that a firm has to be highly liquid; high cash to total asset ratios can be observed in peers also. Moreover, as can be seen from the chart, the total assets are rising at almost double the rate of liabilities which means the company is efficiently using its debt to create value. Since Alibaba is in its early growth phase, the increasing debt can be justified as long as it has a good interest coverage.



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Cash Flow:

Free Cash Flow: Free Cash Flow is considered one of the most important parameters to measure a company’s earnings power by value investors because it is not subject to estimates of Depreciation, Depletion and Amortization (DDA). The rising trend in Free Cash Flows of Alibaba can be partially attributed to the declining Capex.

Share Price: The Company was listed at a price of $68 and quickly rose to $93. Since then Alibaba stock price chart has constantly shown an uptrend reaching a peak of $119.15 on November 10, 2014. The company had modest beginnings but due to the first mover’s advantage it was able to grow at a high rate. The result has been that Alibaba has cornered a majority of China’s ecommerce business. One can imagine the scale of its operations by looking at the sales on Single’s day in China which was on November 11, 2014. The total sales topped $9.3 billion on Single’s day in China whereas the total purchase on Black Friday was $1.2 billion last year in US! As of April 22, 2016, it is trading at $79.89.

VII. Valuation Ratio Analysis:



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Alibaba’s P/E ratio is 19.1, which indicates average to lower price compared to industry average and peers. For additional comparison, while Alibaba has average industry price-to-book ratio, its price-to-sales ratio is significantly high compared to industry. Price-to-cash flow ratio suggests that Alibaba is trading at a valuation on par to its peers. Following table shows key ratio of Alibaba, Amazon, & Ebay.

Key Ratios

Alibaba Amazon Ebay Analysis 2015 TTM 2015 2015

Profitability & Performance Analysis

Gross Margin, % 68.72 67.23 33.04 33.04

Profitable than peers

Operating Margin, % 30.36 28.17 2.09 25.57 Net Margin, % 31.69 73.09 1.47 28.00 EPS 9.70 26.79 1.25 1.42 ROA, % 13.16 21.74 0.99 5.48 ROE, % 27.63 39.19 4.94 13.03 ROIC, % 13.99 10.64 3.39 8.62 ROCE, % 10.72 12.32 7.08 14.15

Growth Ratio

Revenue Growth, % 45.14 31.95 20.25 -52.01 Fast revenue growth

Operating Income, % -7.16 33.03 1154.49 -37.48 Net Income, % 4.06 84.36 - 3650 EPS, % - 113.97 - -50.58

Solvency & Financial Health Analysis

Current Ratio 3.58 2.53 1.08 3.49 Highly liquid & average debt & risky

Quick Ratio 3.46 2.23 0.77 2.98 Debt/Capital 0.21 - 0.13 0.38 Debt/Equity 0.35 0.25 1.06 1.03 Financial Leverage 1.76 1.70 4.89 2.70

Activity Analysis

Total Asset Turnover 0.42 0.3 1.78 0.27

Average performance

Days Sales Outstanding 3.2 0 20.53 30.08

Fixed Assets Turnover 10.35 8.25 5.52 3.86 Receivables Turnover 6.83 - 17.78 12.14

Credit Analysis

Altman Z-Score (As of 04/18/2016)

6.63

5.25 3.73 Safe in peers

Valuation: We have used Discounted Cash Flow model, Residual Operating Income model & Market multiples approach to value the price per share of Alibaba. Our Beta estimate is 1.04, which has been calculated using the deviation of return of Alibaba’s stock to the market (S&P 500) since Alibaba went public. We estimate WACC of Alibaba to be 7.48%. Following tables show sensitivity analysis of price per share of Alibaba for DCF & ROPI model. For market multiples approach, we have used both income statement and balance sheet multiples & considered Bestbuy in addition to Amazon, Ebay as peers to Alibaba. Detailed calculations for Beta, WACC, DCF, ROPIM, and Market multiple models are showed in appendix.



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Discounted Cash Flow valuation Model:

Residual Operating Income Model:

Market Multiple Approach: While selecting comparable companies, we have added Bestbuy in our analysis. The reason for this addition is the significant performance difference between Amazon and Ebay, while still being important comparables to Alibaba. Therefore, for realistic and fair estimate, we added Bestbuy, which also operates in same business environment and market. We estimate stock price of $64.96 from NOPAT Multiple & of $94.63 from BV multiple. We emphasize the Market multiples approach over DCF and ROPI models as it better captures the market conditions and business environment. While DCF and ROPI uses future assumptions, market multiples approach relies on real market data. In addition, for fast-growing companies, like Alibaba, DCF poses the risk of unpredictable growth potential. As shown in above table, 2% fluctuation of terminal growth rate, approximately doubles or halves the stock price estimate. Therefore, DCF and ROPI models are only as good as its assumptions. VIII. Conclusion

We recommend to acquire short positions in Alibaba at current stock price and cover the positions in the range of $65 to $70. Investors need to keep a close eye on Alibaba chart and how the stock moves in the coming weeks. A huge amount of shares will be unlocked in the next year which will increase the liquidity of the stock and might also reduce the bullishness in the stock. There are a couple of voices in the market suggesting a bearish trend for Alibaba. The reason is that when one looks at Alibaba stock chart the overall multiples enjoyed by the stock is higher than Google. This is when the company is restricted in a particular geography and has given limited control to investors in the management decisions.14

Price per Share (Terminal growth rate – 4%)

Growth Rate 22% 23% 24%

WACC

7% 62.54 64.28 66.07 8% 47.82 49.07 50.36 9% 39.00 39.97 40.96

Price per Share (Growth rate – 23%)

Terminal Growth rate 3% 4% 5%

WACC

7% 51.17 64.28 90.50

8% 41.59 49.07 61.53 9% 35.23 39.97 47.08

Price per Share (Terminal growth rate – 4%)

Growth Rate 22% 23% 24%

WACC

7% 64.09 65.83 67.61 8% 49.36 50.62 51.90 9% 40.55 41.52 42.51

Price per Share (Growth rate – 23%)

Terminal Growth Rate 3% 4% 5%

WACC

7% 52.72 65.83 92.05 8% 43.14 50.62 63.08 9% 36.78 41.52 48.63



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Appendix: *Financial figures are pulled from Alibaba 20-F.

Beta Calculation:

WACC Calculation:



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Discounted Cash Flow Model:



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Residual Operating Income Model:



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Market Multiple Method:

Valuation using Income Statement Multiple:

Valuation using Balance Sheet Multiple:



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References:

1 – Mak, Robyn (April 27, 2016). Jack Ma’s jewel is a $20 bln mystery for Alibaba. Source: http://www.reuters.com/article/idUS366028003820160427 2 – Alibaba weighs appeal against HK panel ruling that healthcare deal broke takeover code. (April 26, 2016) Source: http://www.reuters.com/article/us-alibaba-ali-health-sfc-idUSKCN0XN09W 3 - Alibaba Group (2016). Source: http://www.alibabagroup.com/en/about/overview 4 - Alibaba Group (2016). Source: http://en.wikipedia.org/wiki/Alibaba_Group 5 - Alibaba (BABA) Beats Q3 Earnings and Revenue Estimates (January, 29, 2016). Source: http://www.zacks.com/stock/news/205440/alibaba-baba-beats-q3-earnings-and-revenue-estimates 6 - McGregor, Jena (September 18, 2014) Five things to know about Alibaba’s leadership. Source: https://www.washingtonpost.com/news/on-leadership/wp/2014/09/18/five-things-to-know-about-alibabas-leadership/ 7 – Company Overview of Alibaba Group Holding Limited (2016). Source: http://www.bloomberg.com/research/stocks/private/board.asp?privcapId=42083601 8 – Bajpai, Prableen. Alibaba's Top Competitors. Source: http://www.investopedia.com/articles/investing/110714/alibabas-top-competitors.asp 9 - Banerjea, Sejuti (2013). e-Commerce Industry Outlook - Part 1 - Industry Outlook. Source: http://www.nasdaq.com/article/ecommerce-industry-outlook-part-1-industry-outlook-cm225925 10 - Mourdoukoutas, Panos (2014). Alibaba's Five Advantages. Source: http://www.forbes.com/sites/panosmourdoukoutas/2014/04/15/alibabas-five-advantages/#45e0ac301425 11 - Moody's: Alibaba's 2015 financial results support its A1 ratings (2016). Source: https://www.moodys.com/research/Moodys-Alibabas-2015-financial-results-support-its-A1-ratings--PR_324984 12 – https://www.alibabagroup.com/en/ir/secfilings 13 – Tully, Shawn (September 20, 2015). Why Alibaba's investors should still be wary. Source: http://fortune.com/2015/09/20/alibabas-investors-ipo-compensation/ 14 – Alibaba Stock Charts (2014). Source: http://amigobulls.com/stocks/BABA/stockcharts#BABA-revenue-chart 15 – http://quotes.wsj.com/BABA/financials 16 - Easton, Peter D, et al. Financial Statement Analysis & Valuation. Cambridge Business Publishers, 2015

alibaba equity research report

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