$Alibaba (BABA.US)$
Justification and margin of safety
If my above analyses are inaccurate, I believe the inaccuracies are on the conservative side for a range of reasons as detailed below.
Firstly, as mentioned, we're ignoring the rest of the business. Many of the other business segments are high-growth and high-margin segments like the cloud computing business. Many readers are concerned about the regulatory risks. If the regulations do end up hurting BABA’s business, its main impact will be on the China retail business, and these regulations should not impact BABA's other business segments (such as their enterprise cloud services, international commerce, digital media, and many of its strategic investments).
Secondly, the analysis assumes the $15.5B contributions to the common prosperity fund are completely a cost. But in reality, from the language of the announcements (you can see it here), such contribution may actually generate some return for BABA. The language reads like it's a venture capital fund.
Thirdly, and finally, even for the core business, at 5x price to sales ratios, we're valuing it at a substantial discount – probably a discount of more than 50%. As shown in the next chart, both BABA and Amazon are valued at about 4x price to sales ratio. It seems reasonable on the surface – similar business and similar valuation. But as we look deeper next, we will see such a valuation for BABA is too low and the mispricing will be corrected at least for two factors, as shown in the next two charts.
This first chart compares the profit margin between BABA and Amazon. As can be seen, BABA’s profit margin is almost twice that of Amazon. As a result, the sales of BABA should be at least 2x as valuable as that of Amazon – i.e., it should be around 8x instead of 4x. And the next chart compares the growth rate between these two businesses. As can be seen from the second chart, BABA’s enjoys a growth rate that is 1.4x higher than Amazon (54% vs 38% CAGR). As a result, if we also adjust for the growth rate, BABA’s sales should be valued at about 11.3x.
And my above valuation assumes a 5x price to sales ratio, a discount of more than 50% than that it should be worth.
What are the risks?
First, there's always the risk that the Chinese government could confiscate foreign investments in BABA if they decide foreign investments made in BABA under the VEI structure are illegal. This is very unlikely to me for so many reasons. Readers who want a detailed discussion of the unlikelihood of this scenario should read the Asian Investor's excellent analysis of the VIE structure here.
Second, the ongoing crackdown could hurt BABA’s China retail business. Note this is a risk/uncertainty, not a fact yet. These new regulations are being released and interpreted as we speak, and I do not think anyone knows how they will impact BABA's business (or China's tech business in general). These regulations are meant to encourage competition as a key component of the regulation urges tech giants like BABA to unblock web links from competitors in their services. It's not clear to me if such regulation would necessarily hurt BABA. As a simple example, consider Alibaba and $TENCENT (00700.HK)$. BABA and Tencent used to block users from sharing product links from each other due to their long-term rivalry. Under the new regulation, they must stop such blocks. And the key here is that they BOTH have to stop such blocking - BABA will lose some business due to the encroachment of Tencent's links, but at the same time will also gain some business because BABA gets to encroach Tencent with its links too. And therefore, it's not clear to me whether this will hurt BABA (or Tencent) and by how much if it does. And finally, these new regulations are not expected to impact BABA’s other business segments such as its cloud computing and international businesses.
Conclusion and final thought
Alibaba Group, under its current valuation, almost represents a Graham-type net-net deal. This article uses a sum-of-the-parts analysis to show:
a) The current valuation is such that we essentially pay for BABA’s core business only - its retail business in China, and get all other segments for free. And many of the other business segments are high-growth and high-margin segments (like the cloud computing business) and could be even better than its current business. Furthermore, the current crackdown should not impact these other business segments.
b) And even for the core business, we are paying for it at a substantial discount – probably a discount of more than 50% when benchmarked against Amazon.

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