Alibaba: Don’t Worry About The ADRs

Summary

  • Alibaba is a stock with great historical results and fundamentals.
  • It is also subject to a massive amount of regulatory risk right now.
  • Some people think that the stock’s ADR structure itself is a risk.
  • In this article, I dispute that claim and re-affirm my bullish take on Alibaba stock.

The markets don’t seem to know what to think about Alibaba (BABA) stock. Shares have spent much of the year sliding, with a particular steep selloff having occurred after a disappointing Q4 earnings release. In the fourth quarter, BABA was fined $2.8 billion, which turned GAAP earnings for the period negative. A few months later, it was hit with a string of $75,000 fines totaling $450,000. The second set of fines didn’t add up to much, but that combined with DiDi’s (DIDI) app de-listing ignited a selloff in Chinese ADRs that, as of Monday, was still ongoing. Alibaba was one of those stocks affected by the selloff, falling 7.15%.

To an extent, the concern over Chinese ADRs is justified. The Chinese Communist Party (CCP) cracked down on DIDI because it dared to list in the United States. BABA is also listed in the U.S. as an ADR. The CCP can’t take any direct action against Citigroup (C) – the bank that sponsors BABA ADRs – but it can punish American shareholders by taking action against BABA itself. If it chose to do so, it could have a devastating effect on shareholders.

China’s tech crackdown is a real risk to Alibaba at the moment. Fines have already taken a big bite out of BABA’s earnings, they’ll take a smaller bite out of earnings when BABA reports for Q1, and the risk of the company’s operations being interfered with is ever-present.

Some think the ADR structure of NYSE-listed BABA shares is part of this picture. Recently, Short Hills Capital’s Steve Weiss came out swinging against Chinese stocks, saying that he will “never own them again.” One issue he zeroed in on was the fact that most U.S. listed Chinese stocks are ADRs. Citing the inability to collect if you get into a dispute, Weiss claimed that owning ADRs is tantamount to owning nothing. Other investors echoed the same sentiment. Basically, the idea is that when you own ADRs you have no direct recourse when you get into some kind of dispute with the company or other shareholders. There is at least some plausibility to this, as ADR holders generally don’t have direct voting rights. Therefore, they can’t influence the board, can’t sway shareholder votes, and ultimately can’t influence the company.

For large institutional investors with significant voting power, this is indeed a concern. However, it is largely immaterial for smaller investors. Small shareholders don’t usually have enough voting power to sway elections or other votes; so for them, Citigroup’s stewardship of BABA shares isn’t practically different from direct ownership. In this article, I’ll develop a bullish thesis on Alibaba, arguing that the stock has significant upside from here and that its ADR structure is not a major issue for individual investors.

BABA’s Significant Regulatory Risk

Before I go any further, I should make one thing clear:

The regulatory risk facing BABA is very real right now. China is currently in the midst of a crackdown on its biggest tech companies that has included measures like:

  • Fining BABA $2.8 billion.
  • Pulling DiDi’s apps from app stores.
  • Giving several major Chinese internet stocks multiple $75,000 fines.
  • Stripping Tencent Holdings (OTCPK:TCEHY) of its exclusive music rights.
  • Cancelling Ant Group’s IPO.
  • And more.

Taken together, these moves show that the CCP means business. The party’s actions have already cost BABA $2.8 billion – which caused Q4 earnings to show a net loss – and the pressure is only mounting. Just recently, the CCP hinted that it would basically ban private tutoring outright. That extreme action led to billions of dollars’ worth of market cap being wiped off Chinese edu-tech stocks overnight. If it can happen to DiDi and edu-tech stocks, it could conceivably happen to BABA as well. However, as I’ll argue in the next section, it probably won’t happen.

Why it Probably Won’t be a Problem for BABA in the Long Run

While the CCP definitely is flirting with policies that could lead to some companies collapsing outright, it probably will not pursue such aggressive action with BABA. There are at least three reasons for this:

  1. Alibaba is vital to China’s economy. Alibaba has 811 million users in China who use it to buy goods, and it also generates a lot of exports for China. Without Alibaba, China’s GDP growth would probably not be as strong as it is. The company is vital to China’s economy and therefore unlikely to be totally crushed by the government.
  2. The CCP isn’t trying to stop M&A activity. Tencent’s acquisition of Sogou (SOGO) was approved and Alibaba’s own Suning.com deal looks poised to go ahead. The CCP may be looking to fine or even restructure its internet giants, but it isn’t stopping them from grabbing up market share.
  3. Alibaba is not without competition. Alibaba has at least one noteworthy Chinese competitor, JD.com (JD), and an upstart competitor Pinduoduo (PDD), which is becoming a massive player in agricultural goods. So, Alibaba is not a monopoly, and the CCP is unlikely to pursue truly devastating measures against it on anti-trust grounds.

The Question of ADRs

As we’ve seen already, Alibaba faces significant regulatory risk but is unlikely to be among the Chinese stocks that are truly crushed by the CCP’s measures. The company could lose some money, but it won’t be steamrolled into oblivion.

So far so good.

But what about the ADRs themselves? Some people think that the ADR structure is itself a risk, one that only compounds the significant regulatory burdens BABA faces.

Theoretically, the ADR nature of NYSE-listed BABA shares gives investors less rights. You can’t directly vote with most ADRs, therefore you can’t influence management or the board. You may also have a harder time bringing the company to court. So you have less recourse when you don’t like something management is doing.

This is a disadvantage for large shareholders for whom influencing management is a real possibility. It is NOT really a disadvantage for small individual investors with positions under $1 million. When your position is that small, you don’t have significant say in running a $558 billion company. Your votes are unlikely to sway elections and the board is unlikely to pay attention to you.

A multi-billion dollar fund manager might have legitimate interests in owning shares instead of ADRs, because for such an investor, the possibility of swaying management is very real. But for a smaller individual investor, owning an ADR is not practically different from owning a share. You simply pay Citigroup a miniscule $0.02 fee each year for holding shares for you; a smaller cut than you’d pay to the manager of an S&P 500 ETF.

So, for the individual investor, the ADR structure of Alibaba’s equity is not a significant problem. It does not present risks above and beyond those faced by a normal shareholder.

Alibaba’s Recent Financials

Having thoroughly reviewed a number of risks facing Alibaba, we can proceed to the good stuff: the company’s financials. Even with the $2.8 billion fine, BABA’s most recent quarter was pretty solid, boasting the following metrics:

  • Revenue: $28 billion, up 64% year over year.
  • Loss from operations: $-1.2 billion.
  • Net income: $-836 million.
  • Cash from operations: $3.6 billion.
  • Free cash flow: $100 million.
  • Active customers in China: 811 million, up 32 million.

Sure we have net and operating losses here. But note that users and revenue were up year over year, and cash flow was still positive. Assuming Alibaba isn’t going to be getting too many more fines, it can do very well with such a strong revenue base. Additionally, let’s look at the full-year metrics:

  • Revenue: $109 billion, up 41%.
  • Operating income: $13.7 billion, down 2%.
  • Adjusted EBITDA for core commerce: $29 billion, up 17%.
  • Adjusted net income: $26 billion, up 30%.
  • Free cash flow: $26 billion, up 32%.

Even in a fiscal year that saw a $2.8 billion dollar fine in the mix, we still get free cash flow and adjusted earnings growing by double-digits! Which goes to show that Alibaba will be able to handle whatever the CCP throws at it going forward. If the company got fined $2.8 billion every single year, it could still grow its earnings. $26 billion grows to $33.8 billion in one year at a 30% annualized growth rate. The additional income gained from organic growth would more than eat up another $2.8 billion fine. And the fine in question was seen as unprecedented for the time – it’s probably not a punishment the company is going to have to take continuously year after year from here until the end of time.

Valuation

When we look at Alibaba’s growth potential and its ability to absorb whatever the Chinese government throws at it and still come out stronger, its stock begins to look downright cheap. This is a company growing revenue at 41% if you go off the full year, or 67% if you go off the most recent quarter. It’s also growing adjusted earnings at 30% for the full year. That’s pretty impressive growth, and yet the valuation multiples come in as follows:

  • Adjusted P/E: 20.
  • GAAP P/E: 24.
  • Price/sales: 5.
  • Price/book: 3.1.
  • Price/operating cash flow: 15.

These are far lower metrics than you’ll get with any big U.S. tech stock. The FAANG stocks are all trading at earnings multiples over 30, yet few of them are delivering as much growth as BABA is. According to Seeking Alpha Quant, BABA has a PEG ratio of just 0.69. That’s a dirt cheap ratio factoring in both earnings and growth – perfectly illustrating why some people are so excited about this stock despite the CCP’s hostility.

The Bottom Line

The bottom line about Alibaba is this:

It’s a very high growth stock that is currently exposed to some regulatory risk, but not so much that it damages the bullish case. Yes, Alibaba could lose some money to the CCP’s various fines and regulatory measures. No, that will not stop it from growing full-year earnings over the long term. At present growth rates, BABA could fully absorb the largest fine it has ever received every single year and still post bottom line full-year growth. That’s a resilient company. And as an individual investor, it doesn’t really matter whether you hold it as an ADR or a Hong Kong listed share. The practical differences between the two are minimal.

Author: Andrew Button, Seeking Alpha

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