Why Alibaba’s stock seems chronically undervalued

If I had to choose just one business, whose stock I had to keep for decades to come and which with I would almost certainly be 100 % at ease, then it would be e-commerce and cloud computing giant Amazon.

From its very beginning, Amazon has shown incredible growth and literally shaped and disrupted the competitive landscape in several technology sectors.

Amazon started in 1994 as a book store and in a matter of a few years, it became the everything store.

Amazon’s ability to put customers at the core of all its operations, processes, and innovations is unique and thanks due to its founder Jeff Bezos.

The flipside of an obviously high-quality growth stock like Amazon is the fact that the stock rarely gets cheap. I am not talking about the traditionally often used metric Price-to-Earnings ratio (P/E-ratio). When you look at the Amazon stock, you have to take a different approach. As Amazon continuously reinvests all its cash flows into the business, it has become one of the greatest compounding machines on earth. Its revenue pattern is almost exponential, which also is reflected in its parabolic stock price chart.

So, while investors that don’t have already a position in Amazon and want to wait to get an attractive entry point, it certainly makes sense to have a look at its immediate competitors.

There are three that come intuitively into my mind competing with Amazon, such as

  • Microsoft in the cloud sector (Microsoft Azure is a fierce competitor of Amazon Web Service),
  • Shopify in the e-commerce space (it delivers tech infrastructure to small businesses to establish a e-commerce presence and to be able to compete with companies like Amazon) and
  • Alibaba Group Holding Limited

Alibaba is often dubbed “the Amazon of China“.

Alibaba is the obvious Amazon rival, but with another approach, a different philosophy behind its business model.

As said, Alibaba is a Chinese company, it’s providing online and mobile commerce businesses in China and other international markets. 

Alibaba operates in the four segments:

  • e-commerce,
  • cloud computing,
  • digital media and
  • innovation initiatives.

While the company expects meaningful growth from all four segments over the medium and long term, its core commerce business is currently by far the most important one, generating almost all the earnings of the company. Its cloud computing business has crossed break-even and it’s to be expected that this segment will be an important contributor to the company’s top and bottom lines.

Alibaba’s stock tends to be rather undervalued given the quality of its businesses, financial strength, market position. The growth prospects are very attractive, Alibaba can monetize tons of services and in my view, it’s one great way to take some exposure to the giant Chinese market.

Just think of that: Alibaba accounts for over 50 % of all online retail sales in China. We are talking about an incredibly huge and massively dynamic market.

2020 and 2021 have been particularly tough for Alibaba investors, with threats from the US to delist its stocks from the American market. In addition, the company faced severe headwinds due to a canceled spin-off of its payment services company Ant Group and a difficult relationship between its founder and the Chinese government led to some uncertainty among investors.

But regardless of these rather temporary challenges and uncertainties, we can see that Alibaba’s stock development seems to have been subdued for some years now.

In my view, this is due to its business model. More specifically due to headwinds to its profit margins which show a downward trend for some time.

Let’s dig here a bit deeper.

Alibaba is different from Amazon’s in various aspects and having a closer look at its business model shows equally its strengths but also the weaknesses of the company.

In the e-commerce sphere, through its main brand names Alibaba, Taobao, Tmall, the company acts as a middleman, connecting various types of buyers and sellers. Alibaba is not handling merchandise.

Amazon, in contrast, has its own stores, warehouses around the world, owns trucks, has a fleet of airplanes, etc.. Amazon’s e-commerce business is much more capital intense than Alibaba.

So, Alibaba has traditionally higher profit margins than Amazon which on the other side has one of the world’s deepest and broadest economic moats when it comes to e-commerce.

Just imagine, if a company really wanted to compete with Amazon, this would require tens of billions alone to build the infrastructure Amazon has. Amazon can act more flexibly, specifically, more dominantly than every other company on earth. It’s like one huge machine consisting of different businesses and operations that are almost perfectly aligned and highly scalable.

In contrast, Alibaba does not take any inventory risks which per se could be seen as a positive. The company controls the channels from production to final sale. Whereas at Amazon, the third parties are mostly wholesalers. With Alibaba in contrast these are mostly producers. This leads to higher profit margins.

So, good and well. Alibaba is one of the most profitable businesses that exist. But its profit margins have been on a decline for each of the last years from over 65 % to 45 % due to the need for massive investments into the business.

Falling margin trends are not something an investor wants to see! Alibaba’s revenue growth has been robust in the past years, but never comparable to Amazon’s.

With Amazon, investors are accustomed to the company’s policy to reinvest a huge part of the cash flows into the business. For years, you could not see any profit. Fair enough, but revenues have been just massive, growth has been huge. And it is set to continue.

Amazon seems to have figured out its way, its “way of growth”. There is a clear path ahead.

In fact, Amazon is already showing increasing Free Cash Flows. Its high margin business in the cloud sector (AWS) contributes nicely and revenue growth is phenomenal. It doesn’t require a lot of imagination to see that Amazon will become one of the most profitable businesses on earth. Just some years down the road. Amazon literally has built an empire. And the trajectory is clear.

With Alibaba, there are more uncertainties. Its e-commerce business is huge and the basis for huge profits for many years to come. Its cloud business just turned profitable. But it is to see, whether it can play a complementary role, comparable to AWS in the Amazon empire.

So, there clearly are reasons for a suppressed Alibaba stock. But this gives also the potential for an attractive long-term investment in one of the most dynamic and strongest businesses in the world.

Disclaimer
You are responsible for your own investment and financial decisions. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.

About Savy Fox

SavyFox is an investment blog that writes about various interesting investment topics and shares research and opinions with respect to Stocks, Peer 2 Peer Lending, or Crypto Currency investment opportunities.

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