Why Alibaba’s Quarterly Results Will Disappoint, And Why It Will Have A Positive Impact On Capitalization
- Alibaba’s revenue is likely to be below forecasts, due to the same factors that prevented Amazon from beating expectations.
- In conditions when the government is actively changing the rules of the game, many of Alibaba’s investments may turn out to be unprofitable or require additional investments.
- Alibaba is not a matter of fundamental undervaluation, but a matter of risks.
- Risk itself is dynamic in nature and tends to decrease over time if not realized.
- By and large, it is not very important how bad the Alibaba’s quarterly results turn out to be.
Why Alibaba’s Quarterly Results Will Disappoint
According to the consensus of analysts’ expectations, Alibaba’s revenue in the last quarter in dollar terms will amount to $ 32.7 billion. This means that revenue TTM will be $ 126.42 billion showing an annual growth of 50.6%. This will be one of the highest growth rates in the past three years. Nevertheless, the result will be below the trend that the company’s revenue has been demonstrating for the last two and a half years:
Source: Author (the forecast is highlighted in red)
What could have prevented the achievement of this goal?
First of all, the impact of the yuan exchange rate should be noted. So, if in the first quarter the yuan strengthened against the dollar, in the last quarter it remained practically unchanged:
Source: TradingView, Author
Further. Here is Alibaba’s current revenue structure:
As you can see, despite the diversity of the company’s activities, more than 75% of the revenue comes from e-commerce. So, we can find parallels with Amazon.
According to the results of the second calendar quarter, revenues of both Alibaba and Amazon were below expectations. It is interesting to note that Alibaba’s results in China were a reflection of Amazon’s results in the US, as the easing of restrictions related to the pandemic led to an increase in offline shopping.
Last quarter, Amazon’s revenue was again below expectations:
Source: Seeking Alpha Pro
And this time the phrase about supply chain disruptions appeared in the comments of the management:
… In addition, disruption to the global supply chains and inflation in the cost of materials such as steel and services such as trucking have also raised our cost of operations…
… We are dealing with labor risks and supply chain interruptions like many other companies, which increases our range of potential outcomes in Q4….
Source: Amazon Q3 2021 Results – Earnings Call Transcript
In my opinion, the same factor had the same negative impact on Alibaba in the last quarter. After all, China is the center of this problem.
Now let’s talk about margin. The above factors will also take place here. But there is more.
Alibaba’s operating margin has been steadily declining since 2014:
In the last report, income from operations was $4.778 bn (-11% YoY) and adjusted EBITDA (non-GAAP) decreased by 5% YoY. The company’s management commented on it like this:
…The year-over-year decreases were primarily due to our investments in strategic areas to capture incremental opportunities, such as Community Marketplaces, Taobao Deals, Local Consumer Services and Lazada, as well as our increased spending on growth initiatives within China retail marketplaces, such as Idle Fish and Taobao Live, and our support to merchants…
Source: Alibaba Group
For a long time, Alibaba has been actively investing in directions not related to its core business. And it was the right strategy for a developing, non-over-regulated market.
But, the antitrust investigation against Alibaba last November was the beginning of a period of increased control and pressure from the government. This was followed by new rules regarding the education industry, media, online games, etc. In conditions when the government is actively changing the rules of the game, many of the company’s investments may turn out to be unprofitable or require additional investments to adapt to the new rules.
In general, at this point, it is most likely that the company’s operating margin will continue to decline. It is difficult for me to judge how this will affect the EPS, but it is unlikely that it will be able to exceed expectations in such circumstances.
Why It Will Have A Positive Impact On Capitalization
In this block, it is worth at the very beginning to distinguish between the concepts of price and fundamental value.
Price is the result of a balance between supply and demand. The price depends on investor sentiment, news, market dynamics, etc.
Fundamental value is the present value of the company’s free cash flow in the future. This indicator depends on the dynamics of (1) revenue, (2) margin and (3) risk.
It is assumed that the price can swing like a pendulum but still strive to come to a balanced state with the fundamental value:
Let’s estimate what the fundamental price of Alibaba is now based on the clearly pessimistic forecast. And for this we will build a DCF model.
As a forecast for the company’s revenue, I took the low expectations of analysts for the next decade and reduced them by 10%:
Source: Seeking Alpha Pro, Author
Earlier, I explained in detail why I expect the company’s operating margin to decline. Therefore, I base the model on the assumption that in the current fiscal year, the company’s operating margin will decline to 10% and it will continue to decline to 7% in the terminal year.
To further worsen the result, the model assumes a relative size of CAPEX at 10% of revenue, which is double the average for the last two years.
Here is the calculation of the Weighted Average Cost of Capital for Alibaba:
- In order to calculate the market rate of return, I used values of equity risk premium (5.4%) and the current yield of China 10-Year Bond as a risk-free rate for the Chinese market (2.95%)
- Alibaba’s current beta is around 0.5. In my opinion, this is due to the specifics of the current behavior of shares of Chinese companies traded in the United States. Therefore, I used beta equal to 1. This increases the systematic risk, and hence reduces the model’s outcome.
- To calculate the Cost of Debt, I used the interest expense for 2021FY divided by the average debt in 2020FY and 2019FY.
And here is the Discounted Cash Flow Model itself:
As you can see, even a very pessimistic scenario assumes 100% underestimation of the company. But I don’t think the fundamental value of the company is so high right now. Simply because the risk that investors now associate with Alibaba is very high.
But risk itself is dynamic in nature and tends to decrease over time if not realized. Therefore, the very fact that Alibaba continues to grow (possibly slower than expected), does not conflict with the Chinese government and does not have problems with supervisory authorities in the United States, will reduce the risk over time.
This brings us to an obvious conclusion – now Alibaba is not a matter of fundamental undervaluation, but a matter of risks. And in such conditions, by and large, it is not very important, how bad the company’s quarterly results turn out to be.
Moreover, the following scenario is very likely. Alibaba’s weak quarterly results will force short-term investors to sell shares. Long-term investors will take advantage of this to increase their position. As a result, the share price will not collapse and against the background of weak quarterly results this will be a sign of strong support. And this, in turn, attracted new buyers and, as a result, the price will begin to rise.
Let’s see what results Alibaba will show in two days, but you shouldn’t focus too much on this. And if the market considers these results as weak and declines, it will be a good moment to build up a long position.
Author: Oleh Kombaiev, Seeking Alpha