Alibaba Group (BABA)

Analysts: Weifeng Liang, Bowen Wu

Sector: Technology Current Price: $92.99 EPS: $4.33 Market cap: 232.48B Target Price: $267 Beta: 1.19 Investment Thesis 1: New Retail Model In 2015, e-commerce retail sales accounted for 12.7% of the total retail sales in China, according to China e-Business Research Center. In the coming 10 years, we believe there is still large room for the growth of China’s e-commerce retail sales.

1. Low penetration by organized retailers or consumer brands in small cities and rural areas 2. Cost of commercial property 3. Working overtime has been a new normality in cities 4. Better purchasing experience provided by e-commerce than traditional retailers

With the intrinsic growing potential, Alibaba has an ambition to upgrade enormous traditional offline merchants with Internet technologies so that Alibaba can activate China’s whole retail market. Therefore, Alibaba is building a new retail model. The new retail model is built on three pillars — Big-data-based personalized shopping experience, Entertainmerce and Virtual reality shopping. Specifically, Alibaba’s cloud computing unit-mined e-commerce related data to provide personalized shopping experience to customers and insights about customer’s behavior to vendors. Meanwhile, Alibaba marketed brands, products and promotional events over its media platforms such as TUDOU, YOUKU and UCWeb. The new marketing form Tmall/Taobao broadcasting by famous Internet anchors could stimulate fans’ strong demand of recommended products. Finally, the application of Virtual Reality technology to its e-commerce business could recur satisfying shopping experience and higher monetization rate. With these pillars, Alibaba could continue to expand its presence in both urban and rural area despite fierce competition. The orders for tangible goods placed over Alibaba’s platform would be fulfilled by Cainiao network. Besides, the e-commerce platform would direct customers buying services online to offline stores to check them out.

Because of Alibaba’s new retail model and objective factors, we predicted the online market percentage would increase to 30% by the end of 2026. According to China e-Business Research Center, total GMV of China retail market was CNY30.15 trillions and it will increase to CNY34.58 trillions in 2016. We predicted the GMV of China retail market would grow at a 7.5% for the next five years, and 6% afterwards. For the given GMV of China retail market and the percentage of online market, we calculated the online market GMV.

Alibaba’s current market share of online market is 74%. Getting benefits from the new retail model, we believe Alibaba can at least maintain its market share in the coming 10 years. We got Alibaba’s retail GMV by multiplying online market GMV and Alibaba’s market share.

The proportion of Alibaba’s retail GMV and the revenue generated from China retail market is 2.5%. Finally, we computed the the revenue generated from China retail market. Investment Thesis 2: Rural Taobao China has a population of 0.7 billion living in rural areas in 2015. The rural e-commerce scale in 2014 and 2015 amounted to CNY 181.7 and CNY353 billion respectively, an increase of 94%. Despite the high growth rate, the online consumption per rural consumer is only CNY 504 or $75, which accounted for 4% of their annual disposable income. To tap the great potential of rural e-commerce retail market, Alibaba launched Rural Taobao in 2016 and planned to establish service centers in 100,000 rural villages from 1000 counties in the nest 3-5 years. Service centers serve as the purchasing and delivery center in order to connect more farmers to a broad selection of goods. Besides, Rural Taobao also offers resources to help rural small merchants to open store on its e-commerce platform, and thus solving the channel problems of agricultural products. Investment Thesis 3: Cloud Computing

We believe Cloud Computing is going to be an extremely strong catalyst because it has the most enormous data resources and a bright market with strong demands. As large portion of Chinese people’s daily life behaviors shift to online, those behaviors produce enormous data resources. Alibaba’s platforms and services have highly penetrated to people’s daily life, including digital medias, entertainment platforms, online marketplaces, financial services, online and offline services and logistics. By taking advantage of its high penetration, Alibaba has the most enormous data resources, which is crucial to increase the value of data information. Furthermore, for a country with 1.4 billions population, companies have a strong demand to big data service to capture opportunities. Also, government organizations need this service to manage the society. For examples, Alibaba helps merchants in its marketplaces to increase product sales by providing consumers behaviors information. In addition, Alibaba has cooperated with city authorities to use its artificial intelligence to smooth Hangzhou city’s traffic flow.

In order to predict the Cloud Computing’s growth rate, I took Amazon’s Cloud Computing Services as reference. After calculation, AWS’s geometric average growth rate is 45.9%.

Besides, according to the growth rates for previous 3 fiscal years, Alibaba’s Cloud Computing has been showing a high growth momentum. Plus, considering the future wide applications and data resources advantage, we predicted a 60% growth rate in the coming 5 years, and 45% afterwards. DCFAnalysis

In order to calculate the intrinsic value accurately, we predicted the revenue growth rate by performing breakdown analysis to each component of revenue. 1. China Retail Market As discussed in the investment thesis 1, getting benefits from Alibaba’s New Retail Model, we predicted the revenue generated from China Retail Market would grow at a 15.41% geometric average growth rate in the coming 10 years. 2. China Wholesale Market According to the historical growth rates, it has been showing an upward momentum. Therefore, we took the average historical growth rate as the growth rate for the coming 5 years, which is 26%; and we decreased the growth rate to 18% afterwards due to the increase of uncertainty in the future. 3. International Retail Market Based on the historical growth rates, the growth momentum is becoming stable after expansion. Although Alibaba is actively attracting overseas merchants and consumers to join its marketplaces, it takes a long time. So we predicted a 15% growth rate for the coming 5 years and 10% afterwards. 4. International Wholesale Market Since the previous growth rates were unstable, we took the average growth rate for the next 5 years, which is 13%; and we lowered the rate to 8% afterwards because of the increase of uncertainty in the future. 5. Cloud Computing Based on the investment thesis 3, we predicted a 60% growth rate in the coming 5 years, and 45% afterwards because of its wide market prospect and data resources advantage. 6. Entertainment and Innovations In April 2016, Alibaba acquired YouKu Tudou, which is one of the top 3 multi-screen media and entertainment company in China. Due to this significant event, we took the average revenue in the latest two quarterly reports and then timed 4 as the revenue for 2017, whose corresponding growth rate is 158%. Considering that it needs more time to show its merger synergy, we predicted a moderate growth rate in the coming 4 years, which is 20%; and 15%.

Total

By summing up all components, we got the total revenue in CNY in the coming 10 years. We converted the revenue in CNY to USD at the same exchange rate as of the fiscal year 2016, which is 1 USD equals to 6.49 CNY. At last, the total revenue’s geometric average growth rate for the coming 10 years is 20.85% DCF Results For the given 20.85% revenue growth rate, 4% constant growth rate and 11% discount rate, we computed the intrinsic value of Alibaba, which is $267. The margin of safety is 65%. Additionally, we performed MOS sensitivity analysis as below:

Key Ratios Comparison

We can see from the above table that Alibaba outperform its peer Amazon and Industry Average in terms of ROA, ROE, Profit Margin, Financial Leverage and Gross Profit Margin. Furthermore, its P/E and P/B ratios are smaller than the ratios of counterparties. This strongly indicates that Alibaba is underestimated. Relative Approach

We used ROA, BETA and Log Revenue to generate a regression model for P/E and P/B and computed the intrinsic P/E and P/B ratios for Alibaba and Industry Average. The regression analysis tells us P/E of Alibaba should be 58 higher than that of Industry. However, the current P/E ratio of Alibaba is smaller than that of Industry. This is another indicator for Alibaba’s underestimate.

Precedent Transactions

We used the above three median multiples to calculate Alibaba’s intrinsic value and Margin of Safety. The results tell us Alibaba is at least 32.5% underestimated. Risk and Hedging Strategy SEC’s Investigation On Accounting Practices and Sales Figures on Singles' Day SEC has been probing Alibaba’s accounting practices and Sales figures on Single’s Day since this April. Alibaba owns a 47% of Cainiao – a minority stake – therefore it used an equity method instead of a consolidation method when it reported Cainiao’s earnings. Some analysts commented that the equity method used by Alibaba to report its affiliate Cainiao Logistics could inflate its revenue. These reports from bearish analysts raised investors’ concerns over Alibaba’s integrity and caused Alibaba’s stock price to drop immediately. To ease doubt of analysts and investors, Alibaba started to disclose the cost and revenue structure of Cainiao and provide revenue guidance for its business. We don’t think the comments make sense as the change of accounting practice from equity method to consolidation method, and will not make revenue and operating income look much different as Cainiao’s revenue is only about 3% of the total revenue. Alibaba’s GMV on the 2015 Single’s Day was $14 Billion. Many analysts cannot believe this figure as it is more than double the total online sales from Thanksgiving, Black Friday and Cyber Monday combined in the US. However, this number is reasonable. Alibaba has 0.439 Billion active users. Most active users will spend money on Singles’ Day. By doing a simple calculation, we can know that if half of the active users shop on that specially day and if each user spend $64, the total GMV $14 Billion could be easily achieved. $64 per user is warranted as one down jacket costs more than $64 in China. On top of that, Alibaba’s strict and comprehensive internal control would not offer soil for seriously counterfeited sales figure. China’s Potential Downward GDP Growth Even though China’s economy is slowing, China’s GDP growth rate is very high compared with all the big economies. In addition, China is the second largest economy in the world. A small growth rate will generate a large absolute term. Therefore, the slowing economy won’t affect consumers spending level too much especially considering the fact that China’s middle class is blooming and Chinese government is committed to balancing the income level between urban and rural areas. China’s retail market still has large room to increase. Trump’s Potential Policies to Disrupt Trade with China The total international commerce generated 8% of the total revenue. Therefore, if Trump implemented the policies he proposed during campaign trail, Alibaba’s business will not be affected too much in the near future. Besides, Alibaba’s international focus is now put on Southeast Asia. Alibaba made its largest overseas investment with a $1 billion deal for control of Lazada, taking itself to Southeast Asia and closer to a goal of shedding its home-market reliance.