Alibaba Valuation and China Deep Dive
Alibaba is as beaten down as ever. Is this a huge opportunity or is China simply uninvestable? Let's take a look!
An Introduction to Investing in China
China’s Economic State
The Main Problems
The Big Picture
The Debt Trap
Consumer Sentiment, A Slow Economy, and Deflation
The Taiwan Conflict
Summary of the Macroeconomic Risks
Alibaba’s Business Model
Introduction to the Business Segments
Cloud Deep Dive
Global Cloud Market
Chinese Cloud Market
Taobao and TMall Deep Dive
Personal Fit and Risks
My reasons for being invested
Discounted Cash Flow Analysis
Reverse Discounted Cash Flow Analysis
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An Introduction to Investing in China
As a value investor, I’m usually looking for bets that offer unlimited upside and limited downside. That’s the best-case scenario. In reality, while you can find asymmetric bets, few of them will actually have a limited downside and simultaneously offer a huge upside. If you want to find such investments, you need to look in places that are less efficient than internationally well-known large caps. (We’ll do that, by the way, in the next Deep Dive that will focus on an Italian mid-cap).
Alibaba is no such business. The possible upside is huge, but there are many questions regarding its downside potential. As we will see, the financial strength of Alibaba’s business offers a significant margin of safety microeconomic-wise. However, the macroeconomic side of investing in China comes with many risk factors and unknowables. You invest in a country where one person has the power to do whatever he wants and an ideology that companies should not earn huge excess cash. However, that didn’t seem to bother anyone for years, in and outside of China.
After researching China more in-depth, my guess is that China’s leadership wants to see their international companies, especially the technological innovators, succeed rather than cripple them with regulation. Every now and then, they will need to set an example to show they are still the monopoly of power which will result in some headlines and perhaps some little fines. This can, once again, scare investors and compress multiples. The underlying businesses, however, barely change.
But that’s just an introductory hypothesis, let’s start with analyzing the facts.
China’s Economic State
There are three main problems we currently read about in the media.
China’s Debt Trap
Weak Consumer Sentiment, A Slow Economy, and Deflation
The Taiwan Conflict
Before we discuss each, let’s take a broader view.
The Big Picture
With more than 1.4 billion people, China is the most populated country on earth, has the fastest-growing middle class in the world, and remains one of the fastest-growing economies in the world.
According to McKinsey’s China Consumer Report 2023: “There is still no other country that adds as many households to the middle class each year as China does. And increasingly, these households are joining the ranks of the upper-middle and high-income bracket, with annual incomes above RMB160,000 (~$22,000). Over the next three years, China is expected to add another 71 million upper-middle and high-income households.”
Another crucial part of the bull case for China is the global dependency on China’s economy. If China struggles, so does the world. That’s why the economic interests of China are more aligned with economies worldwide than recent news make it seem at first glance (or, better said, the other way around). Take a look at this visualization of China’s trade balance:
China is also directly or indirectly responsible for millions of jobs worldwide. Mineral-exporting countries such as Brazil and Australia would suffer from weaker demand in China, and some of the biggest economies in Europe rely on China for rare earth materials. Ursula Von Der Leyen, the EU Commission President, said: “This is an area where we rely on one single supplier – China – for 98% of our rare earth supply, 93% of our magnesium and 97% of our lithium – just to name a few.”
These materials are essential for the production of phones, electric vehicles, solar panels, or semiconductors. In short, there is no way a modern society and economy will run without them.
Because of this, the EU made plans for a de-risking strategy that focuses on diversifying trade partners, looking for alternative sources for rare earths, and producing its own semiconductors. The goal is to produce 20% of the global market’s need for semiconductors in Europe in 2030. Germany wants to take the lead here, and Intel, as well as TSMC, will build factories in Germany with an investment at the size of about 15 billion Euros.
This is a first step, however, this policy is controversial in many ways, and it’s also unknown how the rare earth problem should be solved, considering that demand will only grow in the future. According to the World Bank, demand is expected to increase by 500% by 2050 due to the acceleration of the green transition.
While diversifying trade partners can resolve some of the dependency, Europe is simply lacking its own rare earth resources, which will sooner or later result in even more trade with China.
China is also becoming a leading exporter of some of the most important goods and services for future economies. The times when China produced cheap and low-quality goods are over. China is now the world’s biggest car exporter and accounts for over 50% of global EV (electric vehicle) sales and 70-90% of every stage in battery and solar production.
There is no sustainable future without China. Not only because of their importance in green technologies but also because of their huge impact on global warming. Without China, the goal to limit the temperature increase to 1.5°C above pre-industrial levels is impossible to achieve.
The good news is that China, and Xi Jinping especially, are aware of the importance of climate change, and while they are still one of the largest emitters of emissions, they are also leaders in the expansion of renewable energies.
Now that we have a perspective on the big picture, let’s discuss the four problems China currently faces and see how big they really are and what they will mean for the Chinese economy and, therefore, Chinese companies like Alibaba.
1. The Debt Trap
Over the last two decades, China’s growth depended heavily on infrastructure and property investments financed by debt. Real estate now accounts for over 30% of the national GDP and over 80% of household wealth. China’s property developers collectively owe more than $390 billion to various suppliers.
How did this bubble build up?
Historically, the Chinese population preferred real estate over investments in pensions or stocks. There’s also a cultural component to this. Owning real estate in the form of an apartment is a common prerequisite for marriage. Thus, real estate investments seemed to be a no-brainer, for developers and Chinese citizens.
The growth was additionally fueled by government stimulus following the financial crisis of 2008. State-owned steel and cement firms were sitting on massive inventory, which led to lower prices and even more incentives for developers to start additional projects.
This went on for a while without becoming an immediate problem. But this changed when a series of bad developments occurred and changed the overarching growth story. China’s demography is on a downtrend, marriage and urbanization rates are falling, and Covid-19 initiated financial troubles for a large part of the population. Demand for real estate dropped, and it became clear that millions of apartments would stay empty or wouldn’t even be finished.
Unsurprisingly, a large part of the debt, with which all of these projects were financed, won’t be paid back. This caused a big credit crunch, and more than half(!) of China’s former top 50 developers have gone into default.
All of these developments are slowing down growth for China in the years ahead. However, we’ve seen similar crises in other countries before. The narrative about this one is that China will experience a “Japan-like” depression and that times of rapid growth and the overall success story are now over.
I think this comparison is lacking on multiple fronts. The circumstances and challenges are different. First, Japan did not only have a property bubble but an asset bubble that included all types of assets equally. Secondly, prices were much higher than in today’s China. Especially if you look at private and public company valuations. China’s equities are everything but overvalued. You pay some of the lowest prices ever.
Another essential point is, who owes to whom? In 1990s Japan, the whole economy was intertwined. Banks owned the shares of companies, and companies the shares of banks. This led to a complete breakdown of Japan’s economy since there was a spiral of defaults and decreasing values. Basically, the balance sheet of the whole country came down as one.
This isn’t the case in today’s China. Corporate China and financial China are a lot less intertwined. Debt in one industry will not affect other industries as much.
In fact, large, publicly listed Chinese companies actively deleveraged their balance sheets for decades. Xi Jinping and his government made clear that they do not want highly leveraged companies, and thus regulators pushed to cut the debt levels of companies.
This doesn’t mean that the debt problem of China will be easy to solve or won’t lead to further problems, it just means that the Japan comparison, and with that, the eternal end of growth seems more than unlikely.