Alibaba's Q1 Performance: Navigating Challenges and Opportunities in a Changing Economic Landscape

Alibaba Q1: Bulls Underestimated The Headwinds Ahead (BABA)

My last article on Alibaba Group Holding Limited (NYSE:BABA) argued for a hold rating on the stock. That article was entitled "Alibaba: I Keep Disagreeing with The Crowd" and was published on the Seeking Alpha platform on July 22, 2024. In the article: I discussed the recent bullish sentiment surrounding BABA stock and the factors contributing to it, such as its low P/E ratio and regulatory easing in China. However, I argued that the P/E ratio is not as low as it appears when compared to peers like JD or PDD. Additionally, even if regulatory easing persists, BABA's profitability and competitive position have already weakened compared to its pre-crackdown days in my view. Since that writing, the company has released its fiscal Q1 earnings report (ER, for the quarter ended in June). The ER provided key updates for its business in the past quarter and the results are very mixed results in my view. As such, I thought it would be helpful to reassess my previous thesis with a focus on the new developments described in its Q1 ER. As you will see in the remainder of this article, my reassessment concludes with a reiteration of my hold thesis. I think the BABA bulls are still severely underestimating the headwinds, in particular, the margin pressures and growth uncertainties ahead. Before I dive into these issues, let me start with a brief recap of its FYQ1 financials to better prime the more in-depth analysis. As just mentioned, the results are overall very mixed in my view, with the top line missing consensus estimates and the bottom line topping it. More details of the FY Q1 ER are provided in the chart below. To wit, revenue for the quarter came in at $33.47 billion, falling short of the consensus estimate of $34.62 billion. Despite this revenue miss, adjusted earnings per ADS beat expectations, coming in at $2.26 compared to the consensus estimate of $2.09. Notably, its free cash flow shrank a whopping 56% YOY. On the positive side, several of its business segments reported healthy growth. The Cloud Intelligence Group saw revenue increase by 6% year-over-year, while the Alibaba International Digital Commerce Group's revenue surged by 32%. Cainiao, BABA's logistics arm, also saw robust growth with revenue increasing by 16% YOY. Next, I will explain why I do not expect a speedy growth recovery in its earnings and cash flow. The top reason on my list is that I expect the margin pressure to persist in the years to come. BABA has been experiencing higher costs of goods and selling, general, and administrative expenses in recent quarters. As illustrated by the chart below (taken from its Q1 ER), product development expenses, sales & marketing expenses, and general & administrative expenses have all climbed substantially in the past quarter. This is both in absolute terms and also as a percentage of revenue compared to the last year. To broaden the context a bit more, the next chart illustrates the historical trend of BABA's operating margin over the 5-year period from 2016 to 2024. As you can see from the chart, despite some fluctuations throughout the period, the overall trend is downward. It started at a high level of almost 40% in 2016, then declined steadily and reached a low point around 2022. The margin has improved a bit since then to the current level of 12.1%. But it is still among the lowest levels historically and is far below the average level of 20.68%. Looking ahead, I see several headwinds to keep pressuring its margins. Besides the macroeconomic uncertainty (the focus of my last article), I expect the company's recent reorganization efforts (including a fresh strategy for its largest segment, Taobao, and Tmall) to keep the operating expenses at an elevated level even though these operational initiatives may drive growth in the longer term. The above pressure, when combined with the current choppy macroeconomic climate and uncertain consumer spending in China, is very likely to hinder BABA growth. As an example, the next chart provides a forecast of its EPS growth over the coming years based on consensus estimates. As seen, BABA's EPS is expected to show essentially no growth in the next 5~6 years. Its EPS is projected to grow from $8.78 in FY 2025 to $8.98 in FY 2030, an increase of only ~2%. In terms of the forward P/E ratio, BABA's multiples are certainly attractive in absolute terms, a key point most BABA bulls highlight. Indeed, as seen in the chart below, the stock is only trading at an FY1 P/E ratio of 9.39x. However, such a single-digit P/E becomes far less attractive when adjusted for its growth. As mentioned above, consensus expects essentially no EPS growth in the next 5~6 years. Even for the period where the highest growth is expected (i.e., from FY 2025 to 2027), the compound annual growth rate (CAGR) is only about 7.4%. With this growth rate and a 9.4x P/E, the PEG (P/E growth) ratio is about 1.3x, substantially higher than the threshold most GARP (growth at a reasonable price) investors would like to see. In terms of upside risks, its initiatives in artificial intelligence products and services have the largest potential for nonlinear growth, in my view. As part of the Cloud Intelligence Group, its AI-related products/services have been reporting triple-digit YOY growth rates in recent quarters. For example, as illustrated by the chart below, its FY Q1 quarter reported 155% growth in its adjusted EBITA earnings. I certainly expect demand for AI to accelerate both in its domestic China market and also globally in the years ahead. Judging by my observations, it's very likely that the technology will be utilized across various enterprises and industries. However, despite the rapid growth rate, the Cloud Intelligence division currently only comprises a relatively small piece of the revenue pie for BABA. As an example, the EBITA earnings for this segment in the FY Q1 quarter were reported to be RMB2,337 million, less than 5% of the RMB48,810 million generated by its Tmall and Taobao segments. All told, I certainly do not see anything obviously wrong with holding shares of a sector leader at its current low P/E ratio. It is, of course, a very compelling value proposition. However, I urge investors to consider the company's sluggish growth outlook and margin pressures too. I think the BABA bulls are severely underestimating these risks, judging by the financials it recently reported in FY Q1.

Alibaba: Riding The Wave Of A Strengthening Macroeconomic Environment (NYSE:BABA)

My DCF simulation, using an aggressive WACC and conservative revenue growth assumptions, underscores substantial undervaluation. My previous bullish thesis about Alibaba (NYSE:BABA) aged well as the stock outperformed the broader U.S. market since June 5 with its 6.7% total return. I think that there are no reasons to become less bullish about Alibaba's long-term prospects. The company continues delivering solid revenue growth. Despite a temporary pullback in the EPS, its profitability is still strong and will help to accumulate value for shareholders. The financial position is a fortress, which is also a vital bullish indicator for a company that relies on growth and innovation. A new positive catalyst is the robust macroeconomic environment in China as I believe that the monetary policy is supportive, and the country's economy is in early stages of a recovery phase of the business cycle. The valuation is still extremely attractive. All in all, I reiterate my "Strong Buy" rating for Alibaba. Alibaba released its latest quarterly earnings on August 15, missing consensus revenue and GAAP EPS expectations. On the other hand, there was a positive adjusted EPS surprise. I do not consider revenue miss to be a big problem since it was insignificant from the relative perspective. Revenue grew by 4.6% YoY, but the adjusted EPS decreased from $2.41 to $2.29. The EPS shrinkage is mostly explained by the increased SG&A and R&D spending. Nevertheless, I think that the EPS YoY decline is not dramatic as Alibaba's profitability metrics are still stellar. Moreover, Alibaba is well-known for its aggressive reinvesting in growth and innovation. Therefore, I do not think that a temporary pullback in profitability is a sustainable trend. Alibaba also boasts a fortress financial position with a massive $62 billion cash pile as of the latest reporting date. The total debt is substantially lower compared to the outstanding cash balance, and liquidity metrics are in great shape. Therefore, I believe that Alibaba is able to exercise strong financial flexibility, which is crucial to be able to drive growth and innovation. In my previous thesis I have explained in detail that Alibaba is investing hard to be the undisputed Chinese AI powerhouse. It is also crucial that Wall Street analysts are quite bullish about Alibaba after its latest quarterly earnings release. Several prominent analysts reiterated their buy ratings for BABA in August, which is another positive sign for investors. According to Nasdaq, Alibaba's consensus target price for the next twelve months is $109.53. The upcoming quarter's earnings release is scheduled for November 15. Wall Street analysts expect fiscal Q2 revenue to be $33.8 billion, which means a solid 8.9% YoY growth. The adjusted EPS is expected to decline slightly once again, but I am comfortable with this pullback as the company invests in fueling future growth. According to Financial Times, investment bankers are doubtful about the ability of China to achieve a target 5% GDP growth in 2024. The pessimism is explained by the Q2 4.7% GDP growth lagged notably behind expectations. On the other hand, the Q1 GDP growth was confidently above 5%. Therefore, investment bankers' recent pessimism might be misleading. According to the Q3 2024 business cycle update from Fidelity, China is in early stages of the recovery phase. According to the below chart, from this point it is more likely to see further growth acceleration than cooling down. Moreover, the country's Central Bank's policy is quite supportive as there was an interest rate cut in July. To sum up, I remain bullish about Alibaba's prospects. The company's revenue growth momentum is expected to accelerate in Q3, and profitability metrics are still stellar. The temporary dip in EPS is explained by accelerated investments in growth and innovation, which is good for investors from the long-term perspective. Moreover, the macroeconomic environment appears to be favorable in China at the moment. BABA declined by 12.9% over the last twelve months and gained 6.4% YTD. The stock outperforms the iShares MSCI China ETF (MCHI) in 2024, as the ETF's price increased by a mere 1% YTD. Most of Alibaba's valuation ratios are significantly lower than the sector median, and all of the current multiples are substantially below BABA's historical averages. That said, valuation ratios point to substantial undervaluation. I am simulating the DCF model to figure out the upside potential. Gurufocus recommends to implement a 6.6% WACC for BABA. On the other hand, we all know that there are massive political and geopolitical risks surrounding all Chinese stocks and Alibaba particularly. Therefore, I use the same high 15% WACC as I did in my previous analysis. Using such a high discount rate is also useful to emphasize the extent of BABA's undervaluation. Consensus estimates forecast BABA's revenue CAGR to be 5.3% for the next decade, which I consider conservative enough for my DCF model. I use a flat TTM 13.1% FCF ex-SBC margin. My DCF simulation suggests that the business's fair value is almost $340 billion. This is 77% higher compared to the current $192 billion market cap. The upside potential is vast, and I want to remind you that I have used extremely conservative assumptions. The below seasonality bar chart suggests that September and December are historically the weakest months for BABA. Therefore, there might be a temporary pullback before the stock returns to growth in mid-Autumn. On the other hand, BABA demonstrates solid momentum and this might offset historical seasonality patterns. Significant political and geopolitical risks are still in place for BABA's investors. Relationships between China and the U.S. are still complicated, and it is very unlikely that the situation will get better if Donald Trump wins the U.S. presidential election. Readers should be aware that a substantial geopolitical factor is one of the primary reasons why Alibaba's valuation is that cheap. While Alibaba dominates in the Chinese e-commerce and cloud infrastructure businesses, the competition is not very far behind and is willing to overtake BABA's crown. For example, PDD Holdings (PDD) is an e-commerce player who has been driving revenue growth aggressively in recent years. From the business scale and diversification, PDD is not even close to BABA, but PDD's market cap is already higher. Tencent (OTCPK:TCEHY) is a prominent Chinese name in cloud and AI, with a 2% market share in global cloud infrastructure business. To conclude, I believe that BABA is still a "Strong Buy". External factors are mostly favorable, and the company efficiently absorbs macroeconomic tailwinds. Moreover, the valuation is still extremely attractive.