Alibaba: How To Trade It Post Earnings

Summary

  • Increased regulation has wreaked havoc on Chinese stock investors this year.
  • While there is still a lot of uncertainty out there around future regulation, the larger, more widely held stocks (like Alibaba) may be worth considering at current levels.
  • Alibaba is coming off of another solid earnings report, which included an increase in its share repurchase program from $10 billion to $15 billion.
  • Alibaba has the potential to produce 12%-plus annualized income with a great margin of safety utilizing the Triple Income Wheel Strategy.

Introduction

It’s been a rough year for Chinese stocks in 2021, with the iShares China Large Cap ETF (FXI) declining over 11% YTD (and down ~25% from its recent peak in February).

Data by YCharts
Increased regulation by the Chinese government has been the main culprit for the weakness as investors have become increasingly weary of holding Chinese shares.

That said, some of the larger, more widely-held stocks may be worth a look at current levels post earnings.

Alibaba Group. (BABA) certainly falls into that category. If any Chinese company deserves a look during this regulatory uncertainty, it’s certainly the “Amazon of China”. Alibaba is the second largest Chinese stock (by market cap) and is starting to look attractive at current levels.

Alibaba reported another decent quarter this morning with earnings beating analyst expectations and revenue climbing 34% from the year-ago period!

The company also made a sizable increase to its share repurchase program, increasing it from $10 billion to $15 billion. This could continue to help put a floor underneath the stock price.

Growth stocks, like Alibaba, have the potential to be income-generating machines that you can use to manufacture your own high-yield “dividends.”

Since cash-secured puts are short-term trades in nature (typically less than 60 days until maturity), our analysis certainly depends more on short-term catalysts and technical support levels, but we also like to be long-term neutral or bullish on the stock as well.

Here’s our typical framework for analysis (which is a good outline for the article):

  • Long-Term Thesis (Dividend, Safety, Value)
  • Short-Term Thesis (Strike Zone, EPS Risk, Technical Support)
  • Cash-Secured Put Analysis (Premium Yield, Margin-of-Safety, Delta)
  • Downside Considerations
  • Conclusion

Sources for all data and tables below: Option Income Advisor and YCharts

In the video below, we break down the whole trade for you (listen to this first as the commentary is a great introduction for the rest of the article).

Alibaba Group Holdings Ltd.

Sector/Industry: Consumer Cyclical / Internet Retail

Alibaba is the world’s largest online and mobile commerce company, measured by GMV (CNY 6.6 trillion/$1 trillion for the fiscal year ended March 2020). It operates China’s most-visited online marketplaces, including Taobao (consumer-to-consumer) and Tmall (business-to-consumer). Alibaba’s China commerce retail division accounted for 69% of revenue in the December 2020 quarter, with Taobao generating revenue through advertising and other merchant data services and Tmall deriving revenue from commission fees. Additional revenue sources include China commerce wholesales (2%), international retail/wholesale marketplaces (5%/2%), cloud computing (7%), digital media and entertainment platforms (4%), Cainiao logistics services (5%), and innovation initiatives/other (2%).

(Source: YCharts)

Long-Term Thesis (Dividend, Safety, Value)

In general, our high-level long-term investment thesis on a stock is more quantitative in nature than qualitative.

Alibaba currently ranks above average for 2 of our 3 key long-term ranking measures: Dividend (N/A), Safety (10), Value (8).

Source: Option Income Advisor: Note that our rankings are from 1 (lowest) to 10 (highest).

Dividend

Alibaba does not currently pay a dividend, but it has the potential to be an income-generating machine that you can use to manufacture your own high-yield “dividends.”

Safety

Alibaba’s historical sales and EPS growth charts have always been a thing of beauty (hence the Safety Rating of 10)! Although some sales were certainly pulled forward during the pandemic, the company is expected to earn $9.69 per share in fiscal 2022 (20% increase over 2021). However, BABA expects earnings to grow even further in 2023 and 2024 to $12.17 per share (26% growth) and $4.96 per share (24% growth), respectively. Note that BABA’s fiscal year end is March.

(Source: Parsimony)

That said, the company’s balance sheet also is extremely strong with $73.5 billion of cash/short-term investments and management is producing a solid return on invested capital of 13.5%.

Valuation

High growth companies are always tough to value, but Alibaba looks extremely attractive from a valuation standpoint and is currently trading at a decent discount to all of its long-term valuation metrics (hence the high Value Ranking of 8).

(Source: Parsimony)

Long-Term View

Based on the data above and our various rankings, we have a bullish long-term perspective on Alibaba. That said, the million dollar question is…can you trust this attractive valuation in the face of increased regulatory concern? All the more reason to consider giving yourself a margin of safety by utilizing a cash-secured put strategy.

Short-Term Thesis (Strike Zone, EPS Risk, Technical Support)

From a short-term perspective (especially as it’s related to selling cash-secured puts), estimating a good “strike zone” is key to our analysis. Our strike zone takes into account (1) the stock’s volatility, (2) recent performance (i.e., how much has it already pulled back from its recent highs), (3) near-term EPS risk, and (4) the overall volatility of the market (i.e., VIX level).

As shown in the table below, our strike zone for Alibaba currently is $172.00-$186.00, representing a required minimum margin of safety of 7.2%.

(Source: Parsimony)

Alibaba has historically been a volatile stock (41% Implied Volatility), as highlighted by its high Volatility/Risk rating of 7. However, the stock is currently down 38% from its recent high (so its Pullback Indicator of 10 has a positive effect on minimum required margin of safety, which is currently at 7.2%).

Alibaba also reported earnings before the bell on Tuesday, so that will need to be on our radar for the option analysis.

As shown in the chart below, the stock is in a downtrend with its 50-day moving average (blue line) trading below its 200-day moving average (red line). That said, the stock is down almost 40% from its recent high and it is approaching some potential strong levels of support in the $160.00 – $180.00 range.

Short-Term View

There appears to be some decent technical support in our strike zone of $172.00-$186.00, which obviously makes us feel relatively good about selling a cash-secured put in the strike zone if we can.

Cash-Secured Put Analysis (Premium Yield, Margin-of-Safety, Delta)

We primarily trade an income strategy that we call the Triple Income Wheel, which starts with writing cash-secured puts on high-quality stocks that you would like to own at a lower price. We won’t go into full detail here, but the diagram below is a good summary of the strategy.

Ideally, when we sell a cash-secured put and start the Triple Income Wheel process, our put is in our “Strike Zone” for that stock. In our opinion, that puts the odds of long-term success in our favor.

The three main data points we look at when analyzing a cash-secured put trade are:

  • Premium Yield% (or Average Monthly Yield%): Measure of expected return on capital assuming that the option expires worthless (out-of-the-money). Assumes that the option is fully cash secured.
  • Margin-of-Safety %: Measure of downside protection or the percentage that the underlying stock could decline and would still allow you to break even on the option trade.
  • Delta: A good proxy for the probability that the put option will finish in-the-money.

Note that there is always a negative correlation between Premium Yield and Margin of Safety: The higher the Premium Yield for a given strike month, the lower the Margin of Safety.

An investor should always be honest with themselves about their risk tolerance. The Triple Income Wheel can be adapted to suit your needs.

Now let’s look at the cash-secured put analysis for Alibaba. We’re focused on the September monthly contract that expires on 9/17/21.

(Source: Parsimony)

We have highlighted three levels of trades based on various risk profiles: Aggressive (-A-), Base (-B-) and Conservative (-C-). Please listen to the video above for further details.

Ideally, we like to stick with our target levels for our Base portfolio:

  • Average Monthly Yield % (AMY%): 1.0%-1.5%
  • Strike price that is in the strike zone (i.e., margin of safety above the required minimum)
  • Delta < 30

The BABA Sept 17th $170.00 put option @ ~$2.46 meets all of our criteria with an AMY% of 1.0%, a Margin-of-Safety of 15.0%, and a Delta of 14.

Again, based on your risk tolerance, you could choose a strike price that is more aggressive ($185.00 strike) or more conservative ($155.00 strike) than the base trade.

Downside Considerations

Assuming we sold the BABA Sept 17th $170.00 strike put option @ $2.46, we would collect $246.00 of premium for each option contract sold. In return for this premium, we agree (and are obligated) to buy 100 shares of BABA stock for each contract sold at the strike price of $170.00.

If the stock stays above $170.00 between now and expiration (9/17/21), the option expires worthless and we keep the premium of $2.46.

However, the downside of this trade comes into play if the stock closes below $170.00 on expiration (9/17/21). Since we’re obligated to buy the stock at $170.00, we would have a potential unrealized capital loss on our hands (depending on how low the stock closed on expiration). We do get to keep the premium either way though, so our breakeven cost basis would be $167.54 ($170.00 – $2.46).

All that said, when managing the Triple Income Wheel, you should expect to take assignment (buy the stock) on 5%-10% of your cash-secured put trades.

But when this happens, we get to move to step 3 in the diagram above and sell some covered calls on our stock position to start the income flowing again and start mitigating our risk right away.

Conclusion

Based on our long-term and short-term views on Alibaba, we believe that a cash-secured put strategy makes a lot of sense right now for investors interested in the stock (especially given the recent regulatory concerns with the Chinese Government). The BABA Sept 17th $170.00 put option would generate an average monthly yield of 1.0% (or 1.5% over the next 46 days) with a margin-of-safety of 15.0%.

Assuming you could continue to roll this position every 45-60 days with similar risk/reward parameters, you could manufacture 12%-plus annualized income from Alibaba over the next 12 months (on a great growth stock that currently does not pay a dividend). Turning growth into income!

Author: Parsimony Investment Research, Seeking Alpha

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