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Why 1 Analyst Likes Alibaba and YY

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking a few high-profile Wall Street picks and putting them under the microscope...

It's another miserable day for the stock market, with the Dow and S&P 500 both down more than 3% in afternoon trading -- and the Nasdaq off nearly 4%! And yet, when others are fearful, some investors get greedy.

Investors like Jefferies & Co., for example.

This morning, the investment banker announced the initiation of coverage on a whole range of Chinese tech stocks. Jefferies began in the As with Alibaba (NYSE: BABA), ranging all the way down to streaming entertainment provider YY (NASDAQ: YY), and hitting popular names such as Momo and Pinduoduo along the way.

We don't have nearly enough time to cover all the ratings today, but we can at least hit the highlights for you, and we'll start at the top with Alibaba.

Map of China merged with Chinese flag

Image source: Getty Images.

Alibaba and the 45 P/E

Valued at $418 billion in market capitalization, Alibaba stock sells for a whopping 45 times trailing earnings today, and as such, probably isn't a stock you'll find on many value investors' shopping lists. That fact doesn't frighten Jefferies, however, which argues that the company's "[s]trong cash cow marketplace model" gives Alibaba "huge potential."  

Over the past five years, Alibaba has grown its revenue at a compounded annual rate of 48%, and grown its profits at a nearly as impressive 30%, according to data from S&P Global Market Intelligence. Jefferies doesn't believe such rates will continue forever, but the analyst does predict that Alibaba's marketplace revenue will grow at least 26% in 2020. And, supplemented by other revenue from the company's "highly synergistic ecosystem," Alibaba could post total revenue growth of 35%.  

(Even 35% could be conservative, by the way. Last quarter, Alibaba's revenue growth was 51%, and its profits grew...238%!)  

As regards where that extra, nonmarketplace growth is coming from, Jefferies argues that "data insights and high return on investment marketing tools" will translate into "an increasing number of paying merchants" on Alibaba's platform, yielding an increase in "paid clicks." Alibaba's cloud computing unit is another area seeing strong growth, with sales up 72% last year, according to S&P Global data.

Growth and value

One thing to keep in mind -- albeit Jefferies doesn't emphasize this as much -- is the fact that while Alibaba's cloud computing business is growing faster than average, it's still losing money, and detracting from the profitability of the company's core e-commerce business. (This helps to explain why as a general rule, Alibaba's sales growth has been significantly stronger than its earnings growth over the past five years.)

This also poses a risk for investors in the stock. Granted, the 35% sales growth Jefferies is projecting is pretty great, while the 48% growth Alibaba has been posting is even better. To justify a 45 P/E ratio, though, you'd really want to see Alibaba's profits growing at least as fast as sales -- but with the company's nonmarketplace businesses dragging on profit growth, that isn't happening right now. Meanwhile, free cash flow at the company exceeds reported net income ($17.2 billion to $13.1 billion). But free cash flow is growing even slower than earnings -- up a bare 2% last year!

Long story short, while free cash flow remains robust enough for me to think Alibaba stock is fairly valued right now, I'm not 100% convinced that Jefferies is right about it being a buy.

Other options

If not Alibaba, though, are there perhaps other Chinese stocks on Jefferies' list that might be worth a look?

As previously mentioned, Momo, Pinduoduo, and YY also made it onto Jefferies' buy list today, with the analyst initiating coverage of each. Of the three, YY has been hardest-hit lately, and with its stock down 31% over the past 52 weeks, is starting to look pretty attractive.

Valued at just $4.8 billion in market capitalization, and with nearly $2 billion in net cash on its balance sheet, YY trades for a debt-adjusted P/E ratio of just 4.6 -- yet analysts see YY growing its earnings at nearly 11% annually over the next five years. The company sports strong and growing free cash flow as well.

Momo and Pinduoduo are a bit trickier. Momo has run into some significant regulatory headwinds in China, so while I'm tempted by its stock price (down 22% over the past year) and low apparent valuation, I'm leery of investing until the regulatory picture gets clearer. Pinduoduo has the opposite problem: Its $25.5 billion market cap is 14% higher than one year ago. The company is also unprofitable as reported under generally accepted accounting principles, and free cash flow -- although positive-- declined last year.

On balance, although Momo, Pinduoduo, and Alibaba especially all have greater name recognition, I'm of the opinion that the lesser-known YY may actually offer the best bargain of all the stocks Jefferies recommended today.

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Rich Smith owns shares of Alibaba Group Holding Ltd. The Motley Fool recommends MOMO. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com