Alibaba Spinoff Likely - How To Play The Restructuring

Alibaba Group Holding Limited (NYSE:BABA) (OTCPK:BABAF) is about to be restructured. Specifically, it will split into six separate businesses, some of which might pursue IPOs of their own. In a Bloomberg report dated March 28, CEO Daniel Zhang said the move would be a welcome opportunity for new business growth. Under the new arrangement, each of Alibaba's business units would get its own CEO, and possibly become independent of Alibaba. BABA stock rallied 11.3% on the news.

The move to split up into several different businesses has the potential to unlock value for Alibaba shareholders. If BABA goes ahead with splitting up into different businesses, shares will likely be spun off to current holders as happened when Brookfield Corporation (BN) spun off Brookfield Asset Management (BAM). It remains to be seen whether Alibaba’s new business units will list in Hong Kong or New York. If the shares are HK-listed only, it could create some issues for U.S. shareholders, as not all brokers support direct trading on the Hong Kong stock exchange by retail investors. Nevertheless, most BABA shareholders should realize benefits from the possible spinoff should it occur.

The last time I covered Alibaba, I said that I was not likely to cover it any more, as I had said pretty much everything I had to say about the stock. I still believe that my opinions about BABA’s basic fundamentals and future trajectory have been established well enough on Seeking Alpha that it would be redundant to write more articles about the basics of the company. However, with such an obvious and unexpected catalyst on our hands, it pays to explore what exactly this new development could do for BABA shareholders. In this article, I will explore some possible outcomes for Alibaba’s breakup and why I think it’s a positive development for shareholders.

A Brief Review of my Bullish Case on BABA

Before exploring Alibaba’s possible spinoff, I need to explain briefly why I’m bullish on the stock as a whole. If you check my author profile you’ll see many of my previous articles on the stock which explain it in detail, but a quick summary is in order:

• The stock is fairly cheap. For example, it trades at 11.5 times adjusted earnings, 1.5 times book value, and 9.5 times operating cash flow. These multiples are very low by the standards of tech stocks.

• Growth should resume in the future. One of the reasons BABA fell last year was because the previously-high growth company lost its growth. That tested shareholders’ patience, but now we have a good reason to think that BABA’s growth will ramp up again: China’s economic re-opening. In the fourth quarter, China reversed almost all of its COVID rules, which had been holding back corporate earnings severely. China’s lockdowns were much more strict than those in the West, people were very limited in what they could buy, so e-commerce companies in China got hurt along with the rest of the economy. It was a tough time to be holding BABA stock, but now, with the economy re-opening, there is potential for growth to re-emerge.

• Alibaba has a fairly strong competitive position. With the emergence of new platforms like Pinduoduo (PDD), Alibaba has more competition than it once had, but it still has only two large Chinese competitors–PDD and JD.com (JD)--so it has ample room to earn large margins.

Taking Alibaba’s growth potential, valuation and competitive position into account, the company looks like it has a lot of value to offer shareholders today. My price target for the stock is about $150. If you take the trailing 12 month free cash flow ("FCF") per share ($5.92) and discount it at 6% (the current treasury yield plus a 2.5% risk premium), you get a $98.6 price target. That’s already above the current stock price, and remember that free cash flow is likely to grow in the quarters ahead, as Alibaba has reduced its costs. If BABA can simply get back to 2021 FCF levels ($10.67), then its fair value under a 0% growth assumption (I mean, 0% growth from the point when it hits $10.67 FCF onward) is above $150 using a 6% or even 7% discount rate. So, there is a case to be made that we don’t even need to assume any revenue growth to get Alibaba with a fair value above its current stock price. The growth in free cash flow in the last two quarters was well into the double digits, even though revenue barely grew at all, because BABA was able to increase its operational efficiencies by cutting costs. So, more increases in free cash flow are likely.

How Will a Spinoff Affect Valuation?

Having looked at my core thesis on Alibaba stock, it’s time to assess the effects of the possible spinoff.

Here’s what we know so far:

• The company is set to be split into six businesses.

• Current CEO Daniel Zhang will be CEO of the Cloud.

• Taobao Tmall will be run by Trudy Dai.

• Local services will be run by Yu Yongfu.

• Cainiao Smart Logistics will be run by Wan Lin.

• Global e-commerce will be run by Jiang Fan.

• Digital Media will be run by Fan Luyuan.

• Taobao Tmall will remain a wholly owned subsidiary.

Essentially, all of Alibaba’s current major businesses will operate more independently after the reorganization. However, not all of them will be spun off. Taobao Tmall, a foreign e-commerce subsidiary, will remain wholly owned. It seems likely that global e-commerce will remain wholly owned as well, as it’s simply the Chinese e-commerce business operating globally. That leaves us with e-commerce, the cloud and digital media as the three Alibaba business units that could end up trading separately.

Were Alibaba e-commerce, cloud and digital media to become three separate stocks, I would keep holding e-commerce and the cloud, and most likely sell the digital media business. Below I’ll explain my thinking in arriving at this conclusion.

First, Alibaba’s core e-commerce business, valued on its own, merits a market cap equal to that of the entire Alibaba business. In the most recent quarter, it delivered:

• $27.42 billion in revenue, which grew at approximately 0% overall (the small international segment grew 18% but China declined 1%).

• $7.4 billion in EBIT.

• $8.6 billion in adjusted EBITA.

Now, this was a December quarter, which features the 11/11 shopping season, so we wouldn’t expect whole year results to be as good. However, past quarters saw as much as $5 billion in EBIT from e-Commerce. If the next three quarters did $5 billion in EBIT each we’d end up with $22.4 billion in 12 month EBIT. Slap a multiple of 10 on that and you get to a $224 billion market cap–that’s Alibaba’s entire market cap right now.

Next up we have the cloud. This segment did:

• $2.98 billion in revenue, which grew at 3%.

• A $-217 million EBIT loss.

• $51 million in adjusted EBITA profit.

As you can see, this segment is not nearly as profitable as e-commerce is. However, it is profitable by at least one of the metrics that BABA uses to measure profitability, and the EBIT losses have been shrinking. So, I would likely continue holding Alibaba Cloud if it were spun off.

I would sell the media business if it were spun off. The fourth quarter earnings release showed a 6% decline in revenue and significant losses. It was the worst performing of all of Alibaba’s business units and there’s little reason to think it could turn around. Media companies have been struggling with revenue for over a decade as companies have shifted to social media ads instead of print ads. That applies to Alibaba’s digital media segment, unfortunately.

One Risk to Watch Out For

As we’ve seen, Alibaba’s business restructuring has a lot of potential to create value for Alibaba shareholders. The e-commerce business alone could easily be worth as much as Alibaba as a whole is worth today, and the Cloud has a lot of potential. Nevertheless, there is a risk to keep an eye on.

Specifically, the risk is where the shares will be listed. Lately, a lot of Chinese companies - including BABA - have been pushing to gain primary listing status in Hong Kong. If BABA’s subsidiaries end up being spun off and listed in Hong Kong, then foreign shareholders might have trouble selling them. Not all brokers support the Hong Kong exchange. Mine, for example, does not. If your broker doesn’t support HK shares, then you may end up having to transfer some shares to a different broker.

All of this assumes, of course, that Alibaba will in fact spin off shares. So far, all that’s set in stone is a restructuring. Daniel Zhang strongly hinted that some of the new companies would go public, but that could be achieved without doing a spinoff. For example, BABA could sell shares directly from its corporate treasury. In that scenario, the stock would likely gain from the influx of cash on the balance sheet, and shareholders would benefit that way. The listing issue notwithstanding, this restructuring news is good news for Alibaba Group Holding Limited shareholders.

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.