Eric Francis Background and Thesis The events surrounding Alibaba (NYSE:BABA) reminded me of American Express during the salad oil scandal in the 1960s. There are a few essential similarities in view between these two cases. First, both businesses face horrendous uncertainties. For readers who are not familiar with American Express’ salad oil crisis, this Wiki page provides a good summary. In a nutshell, the business suffered a huge loss because of fraud. The salad oil inventories (about $180M) a client used as collateral did not actually exist. The loss, or the anticipated loss, is so large that many investors feared that it could bankrupt the business. For the BABA case, the sudden cancellation of its long-anticipated Ant Group IPO at the end of 2020 signaled the risks it faced. The cancellation marked the beginning (i.e., from hindsight) of the Chinese government’s tightening on its tech firms. And BABA (together with other major Chinese tech firms) suffered fines (about $2.8 billion in an antitrust case), committed large sums to the China common prosperity fund (about $15.5 billion), and also witnessed their profit compressed (as to be detailed later). Second, in both cases, despite the horrible uncertainties ahead, the core businesses of both companies remained intact. Or you could say popular or even essential. And in both cases, the market overreacted, pricing the stock based on the worst scenarios – something the market is very good at when fear creeps in. In American Express’ case, its stock price dropped by more than 50% before investors fully understand the impact of the fraud. Many investors acted based on the assumption that American Express was going to be responsible for 100% of the fraud, although the eventual outcome was that American Express was responsible for about $30 million of the fraud. In BABA’s case, the stock price reactions are even more violent as you can see from the following chart. Again, in my view, the eventual outcome of its ongoing uncertainties is still unclear, and yet its stock prices have suffered an 80% loss from the IPO cancellation (about $310) to its recent bottom (around $63). And lastly, even the main characters are similar in both cases. Warren Buffett’s role in the American Express episode has become not only a defining point in his career but also a legendary case in the history of value investing. And in the BABA episode, his good friend, Charlie Munger, attracted most of the attention. And this leads me to my main thesis, which is twofold. First, I will argue that Munger’s BABA investment is another textbook illustration of buying good stocks while they are on the operation table. And second and more importantly, I will explain why I think BABA’s salad oil moment seems to be over. As you can see from the following chart, there is a strong technical signal in its prices: the stock staged a ~100% price rally in the past 3~4 months (from a bottom of $63 to the current price of $113 as of this writing). And fundamentally, I will explain signs of its profitability stability and also the implication of Jack Ma’s recent decision to cede control of Ant Group. Author based on Yahoo! data Munger bought BABA on the operation table Just like Buffett bought American Express on the operation table, Munger took action in the BABA case when its stock price became disjointed with business fundamentals. According to disclosures provided by Dataroma.com, Munger doubled the position of BABA in his DJCO portfolio twice during 2021 (note that DJCO then reduced the BABA position by about half after Munger retired from the chairman position). To wit, despite the trimmed position, BABA remains one of DJCO’s largest positions and also the only non-bank position as you can see from the following disclosure provided by Dataroma.com as of Jan 5, 2023. DJCO’s BABA position stands at more than $26M and represents more than 15% of DJCO’s concentrated equity portfolio. Source: Dataroma.com Signs of profitability stability The market fear is not completely baseless, and BABA’s profitability indeed has suffered severe compression since 2020 as seen in the chart below. The chart displays its return on capital employed (“ROCE”) since 2014 with data from 2020 highlighted. The calculation of ROCE and why it is the most important profitability metric in my mind are elaborated on in my blog article here in case you are interested. As you can see from the chart, BABA maintained an astronomical level of ROCE before 2020: with an average above 150% – it is the kind of ROCE that invites attention and scrutiny. Even in 2020 when China began to tighten its regulatory control, BABA’s ROCE still hovered around 105%. Then as the regulation tightened, its ROCE compressed substantially to 80% to 90% in 2021 and at the beginning of 2022. And the ROCE then bottomed at 62.4% in Q3 2022. There are signs of profitability stability the way I see things. If I aggregate the TTM 2022 data, the ROCE turned out to be about 65.7%, quite close to the Q3 bottom of 62.4%. And also note the BABA’s ROCE sharp decline in the past 1~2 years is also caused by the COVID lockdowns. Now with China’s zero COVID policy lifted, the headwinds caused by the lockdowns should gradually disappear now. Moreover, BABA’s current ROCE in the 65% range is more aligned with other peers. As you can see from the second chart below, a ROCE in the ~65% is in line with the average of the FAAMG group. And in particular, the ROCE of JD.com (JD) is about 75%, substantially higher than BABA now. And hence, BABA’s ROCE is more sustainable and should invite less scrutiny going forward. As a side note, an additional reason that I favor BABA over JD is that JD’s valuation multiple is too high. I do not see JD’s higher ROCE as being able to justify the valuation premium as detailed next. Source: author and Seeking Alpha.Source: author and Seeking Alpha. Valuation Onto valuation. BABA’s PE multiple is simply too compressed as seen in the table below. Even after the ~100% rally in the past few months, BABA’s current TTM PE sits at 14.5x only and FY1 PE sits at only 13.9x. The contrast is too dramatic when compared to a few other peers such as JD, AMZN, and TCEHY. The TTM PE is 29.2x for JD and 27.1x for TCEHY, both about 2x higher than BABA. The valuation premium from AMZN is even higher. Finally bear in mind that BABA has a sizable net cash position on its ledger too. Well, all four stocks in the table below carry a net cash position on their books. But the cash position for BABA and JD are much larger (with about $11 and $7.4 behind each of their share, respectively) and the cash position for the other two are much smaller. Their cash positions represent about 10% of their current share prices. And therefore, if the cash position is adjusted, BABA’s FY1 PE would be about 13x only and JD’s would be 23.5x. And BABA’s valuation discount relative to the JD would shrink a bit, but its discount relative to other peers would be even larger. Source: Seeking Alpha Ant Group, other risks, and final thoughts and risks Besides the signs of its profitability stability and its valuation discount, another immediate catalyst I see involves Jack Ma’s recent decision to cede control of Ant Group. A large reason for Ant Group’s 2020 IPO cancelation is stipulated to be Jack Ma’s criticism of Chinese regulators at that time. Earlier this month, Ma agreed to an arrangement that essentially removed his majority control of Ant Group. In this new arrangement, he will only own about 6% of Ant in essence. As detailed in my other article, Ma’s decision could be a key catalyst for the revival of the Ant Group IPO. And furthermore, in the case of a revived IPO, BABA would be a good investment purely from an asset purchase point of view even with all of BABA’s future earnings ignored. Admittedly, there are still considerable risks surrounding BABA, and not all the negatives have been resolved. These risks include more generic risks such as the risk of the VIE legal structure, the risk of delisting from the U.S., and also the all-encompassing “China” risk that kept many potential investors away. And also, the COVID pandemic is still an evolving situation in China. However, to me, these risks only accentuate the market overaction and also Munger’s unfazed role in BABA’s salad oil episode. Consider this: JD and TCEHY should be subjected to all the above-mentioned risks. I simply do not see any reason why they should be immune from any of these risks. However, as just analyzed above, both are valued at about 200% premium relative to BABA. With this, I will conclude by reiterating my main thesis here. To me, Munger’s BABA investment is another textbook example of buying a good business on the operation table. Furthermore, BABA’s salad oil moment seems to be ending based both on technical signs (~100% price rebound in the past 3~4 months), fundamentals (ROCE stabilizing in a sustainable range), and also political development on the Ant Group front. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
