Alibaba Group Holding Ltd. (NYSE:BABA) has had a rough year. BABA stock is down from $232.73 at the end of 2020 to $170.30 as of Sep. 3, a drop of $62.43 or 26.8%. Moreover, from its peak on Feb. 17 at $270.83, the stock has tumbled $100.53, or 37.1%.
Now the stock is so cheap that management has decided to step up its share repurchase program. In Alibaba’s recent second-quarter earnings release on Aug. 3, CFO Maggie Wu said the company was raising its buyback program from $10 billion to $15 billion.
She did not say over what period the repurchases would occur. But this is quite significant since, if Alibaba were to complete the buybacks within one year, it could use up most of its free cash flow.
In fact, Alibaba has already bought back $3.7 billion worth of shares since April 1, or about 4 months. That works out to an annualized rate of $11.1 billion in buyback activity.
FCF Will Cover Alibaba’s Buybacks
Alibaba can afford to do these buybacks since it produces a large amount of free cash flow (FCF). In fact, the company is one of the few Chinese American Depositary Receipts (ADRs) that specifically delineates its actual FCF production each quarter.
For example, page 31 of the company’s Q2 earnings release provides a specific calculation of the FCF generated during Q2, $3.2 billion. That puts it on a run rate of $12.8 billion annually. Moreover, that $3.2 billion FCF represents 10% of its $31.87 billion in quarterly revenue.
So, if we use analysts’ estimates of $142.98 billion in revenue for this year, its full-year 2021 FCF could be $14.3 billion. That essentially covers most of the $15 billion share buyback program, if that is going to be completed over the next year.
The reason I say that is because analysts also expect sales to rise more than 20% by the end of 2022. So even if half of that comes through in the next year, then FCF will rise to $15.73 billion.
How Buybacks Will Help Shareholders
The buybacks will also help shareholders because the lower number of shares outstanding will increase its earnings per share (EPS). For example, $15 billion represents 3.25% of its 461.61 billion market cap as of Sep. 3.
So this means that Alibaba’s EPS will be 3.25% if all of the shares are bought back at today’s price. In fact, theoretically, over the next five years, earnings per share could rise 17.3%, assuming $15 billion in share repurchases occur at today’s price. This is because a 3.25% share reduction each year compounds out to 17.3%.
But, of course, the share repurchases will tend to force BABA stock higher, so this 17% compound growth rate in EPS over the next five years will be lower. The actual EPS growth rate due to repurchases will depend on how fast the stock rises.
So, in effect, the repurchases will have a double catalyst effect. They will both raise the EPS and eventually the stock price (assuming the price-to-earnings ratio stays level or rises), while also pushing up the stock price from the market buying action.
What to do With BABA Stock
The Wall Street Journal says that Alibaba is “one of the first major Chinese tech companies to come under scrutiny by Chinese regulators in a wide-ranging crackdown that started last year.” Alibaba was forced to admit it was using its dominant position to pressure merchants with a practice known as “er xuan yi,” or “choose one of two.” It ended up paying a $2.8 billion fine.
That did not help the stock price at all. Since then, fears of further regulatory scrutiny plus increasing competition from other online sellers have pushed BABA stock down further.
But investors should probably begin thinking about taking advantage of these fears. That is what it means to be a contrarian investor. So, even if BABA stock drops further, it will allow value investors to lower their costs. But they can also take comfort in the fact that the company now thinks its stock is too cheap.
Assuming that this buyback program acts as a catalyst, BABA stock could move significantly higher over the next year as a result.
On the date of publication, Mark R. Hake did not hold, directly or indirectly, any position in any of the securities mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.