Alibaba Stock: Top Choice To Get Chinese AI Exposure (NYSE:BABA)

Investment thesis

My previous bullish thesis about Alibaba (NYSE:BABA) aged well, as the stock gained 7.3% since March, outperforming the broader U.S. market. A lot happened over the last three months, and today I want to share my insights about recent developments, which make me even more optimistic.

Recent developments suggest that the company is betting big on generative AI, as the company invested in several promising Chinese AI startups, each leveraging a large language model [LLM]. With Alibaba’s current dominance in the Chinese cloud infrastructure industry, all these acquisitions might be quite synergetic over the long term. As one manager at an Alibaba-backed AI start-up said, “If you want to invest in China AI, just buy Alibaba stock. It’s a China AI ETF”.

Alibaba has been massively undervalued for years, and the stock price started moving towards its fair value. Nevertheless, my discounted cash flow [DCF] model suggests that there is still vast upside potential ahead. All in all, I reiterate a “Strong Buy” rating for Alibaba’s stock.

Recent developments

The company released its latest quarterly earnings on May 14, beating revenue consensus estimates and missing bottom line projections. Revenue grew by 3.7% YoY, the adjusted EPS shrunk from $1.52 to $1.40. In RMB, revenue was up 7% YoY.

The EPS shrinkage is explained by extraordinary items attributable to losses from BABA’s investments in publicly traded companies compared to net gains in the same quarter last year. The operating margin expanded on a YoY basis from 9.2% to 13.4%. BABA’s net cash position deteriorated slightly in fiscal Q4 2024 due to accelerated share buybacks. Still, Alibaba’s balance sheet is a fortress, with a $50 billion net cash position. Liquidity ratios are in excellent shape and leverage is low.

Apart from buybacks, Alibaba aggressively invests in acquisitions as the company aims to become the leading Chinese AI company. Alibaba is a leading cloud infrastructure company in China, and it is a solid basis to develop AI capabilities.

During FY 2024, Alibaba invested about $800 million to acquire a 36% stake in the AI startup called Moonshot. This startup developed a Kimi AI chatbot that can handle up to 2 million Chinese characters in a single prompt. Even ChatGPT cannot boast such capacity per prompt.

In early March, Alibaba also was the leading investor for a $600 million funding round for another Chinese AI startup, MiniMax. In 2023, Alibaba invested in two other prominent Beijing-based young AI companies, including Zhipu and Baichuan. All of them are generative AI startups, which underscores Alibaba’s strong focus on leveraging its own comprehensive LLM model, which will bring synergies for its cloud business. Alibaba’s balance sheet with a massive cash pile means that the company’s pockets are deep enough to continue aggressively acquiring the most promising AI startups.

Alibaba’s focus on AI and cloud is sound because the Chinese AI industry is expected to compound with a 28.6% CAGR by 2030, a massive tailwind Alibaba cannot miss. Machine learning is by far the largest sub-industry in Chinese AI and expected to keep its number one spot over the long term. Alibaba already enjoys massive industry tailwinds. During the latest earnings call, the management announced that the company’s AI related revenue increased triple-digit YoY in fiscal Q4.

Apart from strong momentum and bright prospects in AI, the company’s core business, e-commerce, is still shining. In fiscal Q4, online gross merchandise value [GMV] achieved a double-digit growth, driven by order growth, supported by increase of purchases and purchase frequency. International commerce grew by 45% YoY, another solid positive catalyst.

BABA’s Seeking Alpha Quant momentum grade is consistently improving, with shorter timeframes having higher grade. This might indicate that the stock is gaining momentum, and it is another positive catalyst for the stock.

Valuation update

BABA declined by 7.7% over the last twelve months and is almost flat YTD. The stock lags behind the iShares MSCI China ETF (MCHI) in 2024, as the ETF’s price increased by around 8% 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.

To calculate the upside potential, I must simulate the DCF model. Gurufocus suggests that BABA’s WACC is 7.2%. 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 11.1% FCF ex-SBC margin.

According to the DCF, the business’s fair value is $312 billion. This is 65% higher than the current market cap, meaning there is a vast upside potential from current share price levels.

Risks update

China’s tense geopolitical relationships with the developed world and Taiwan certainly does not add optimism to investors. Recent hawkish public speech of the Chinese defense minister regarding the U.S. and Taiwan definitely does not help in improving the situation. On the other side, the U.S. recently escalated the trade war against China to another level by introducing 100% tariffs on Chinese EVs. As we see, the geopolitical situation between the world’s two largest economies is not improving, and this is a downside risk for BABA investors.

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.

Bottom line

To conclude, BABA is still a “Strong Buy”. The stock trades with a deep discount to the fair value, despite fundamentals improving continuously. Investing in Chinese stocks is inherently risky, but the upside potential outweighs all the political and geopolitical risks, in my opinion.

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.