Alibaba Is Still Not A Buy, Here’s Why

Summary

• BABA gained close to 7% in pre-market trading on August 4th after reporting stronger-than-expected F1Q23 results.
• Revenues were flat from the prior year, its slowest growth on record, but still better than earlier expectations for declines given the challenging operating environment during the June quarter.
• However, the risks that were associated with Alibaba stock’s selloff over the past ~2 years remain in a fluid state, with no signs of respite in sight.
• Paired with added challenges from a faltering economy at home and overseas, the stock is in for further volatility over coming months.

Alibaba Group Holding Limited stock rose close to 7% in post-earnings pre-market trading Thursday morning (August 4) after reporting better-than-expected results for its challenging fiscal first quarter. It beat consensus estimates on both revenues and EPS. Revenue came in at RMB 205.6 billion ($30.7 billion) for the June quarter, flat from the same period last year. Although it represented the slowest pace of growth on record, it was still welcomed by investors, as consensus had previously expected a decline for the first time in Alibaba’s history due to sprawling city-wide lockdowns during April and May to stem the spread of COVID. Earnings for the June quarter also beat consensus estimates by $0.19 at $1.75, underscoring prudent cost controls amid inflationary pressure and increased costs of navigating through COVID disruptions.

Yet, sentiment on the Alibaba stock remains fragile. All of its gains from the May to July rally have been wiped out in recent weeks, with the stock now down close to 20% since the beginning of the year. Volatility remains the broad-based theme for Alibaba stock, as positive uptrends supported by signs of easing regulatory crackdowns, an improving COVID situation in China, and government stimulus to shore up the Chinese economy get torn down once again on news of heightened worries over a faltering domestic economy and renewed regulatory concerns in recent weeks. The moderate uptrend in pre-market trading following a positive earnings surprise this morning also underscores market’s cautions about the Alibaba stock.

While Alibaba’s valuation appears attractive at current levels considering its robust balance sheet and still-dominant market share in e-commerce and cloud services in China, the investment continues to be overshadowed by risks that remain in a fluid situation. The fragility of Alibaba’s rebounds observed over the past year underscores that the underlying risks to the investment continue to “outweigh any favorable valuation.”

Considering Alibaba’s long-term fundamental growth and valuation multiple expansion outlook remains a big question mark, with all of its biggest underlying risks still in a highly fluid situation that exhibits no structural signs of improvement, the stock holds almost nothing to stand on its own against the added challenge from brewing broad-based macro headwinds. Alibaba could potentially trend lower in the near-term, as its core Chinese market and adjacent international markets grapple with a faltering macroeconomic backdrop, making it a high-risk investment pick despite what look like attractive valuations compared to peers in a similar business.

The Risks Are Still There

Alibaba stock’s downturn began in late 2020, when heightening regulatory concerns drove a “valuation reset” in U.S.-listed Chinese equities. The situation has continued to take a turn for the worse since, as the regulatory headwinds started to take an effect on Alibaba’s fundamental performance. The added impact from recent macroeconomic headwinds, spanning COVID disruptions in China, and a faltering domestic and global economy have only exacerbated the unfavorable results.

1. China Regulatory Crackdowns

Recent signs of easing scrutiny by Chinese authorities have done little in salvaging the losses sustained by the broader cohort of U.S.-listed Chinese stocks, including Alibaba.

Despite repeated vows by the Chinese State Council in mid-March to support market stability and calls that the extended regulatory crackdowns on the private sector – especially internet companies – are nearing an end, the ensuing rally was short-lived as investors’ confidence buckled at the lack of concrete measures taken to date to salvage the carnage across Chinese equities.

And, despite recent optimism stemming from the end to high-profile probes, such as the cybersecurity investigation on DiDi Global (OTCPK:DIDIY), and release of new gaming license approvals, the regulatory risks remain prominent, with investors’ confidence also giving in. Markets continued to punish the stock at the first sign of regulatory weakness, as observed in recent declines following reports that Alibaba was levied a RMB 2.5 million ($375,000) fine in early July for violating state rules on previous acquisition disclosures. Its cloud unit was recently investigated for association with one of the country’s largest data breaches in history.

In addition to fines, the regulatory scrutiny surrounding Alibaba’s business has also resulted in other adverse impacts to its fundamental performance. The company’s cloud-computing unit, Alicloud, is slowly losing market share to its state-backed peers due to increasing national security concerns within the public sector. The unit’s market share in China fell from 46% in 2019 to 37% in 2021, while state-backed peer Huawei’s cloud market share doubled over the same period. Despite still being the largest public cloud service provider in China, Alicloud is no longer the preferred choice as the Chinese Communist Party heightens calls for data safeguarding within government agencies. This has accordingly led to the elimination of “foreign PCs” within the Chinese government and hastened the migration away from private clouds like Alicloud to state-backed cloud platforms, threatening Alibaba’s consolidated bottom-line performance. This is further corroborated by the deceleration in Alibaba’s highly profitable cloud business observed in the fiscal first quarter – the segment’s revenues only grew 10% y/y, the slowest pace on record.

The company has also reduced the size of its in-house investments unit after “Beijing’s regulatory crackdown sharply slowed down the deal-making pace.” This is consistent with our earlier observations that it will only be a matter of time until Alibaba follows suit on its peers’ pre-emptive moves in unloading investments and shutting down internal deal departments as the Chinese government intensifies calls against the consolidation of power and wealth within the fast-growing tech sector. Investments have played a substantial role in the development of Alibaba’s comprehensive Internet ecosystem and related success in past years. The recent downsizing of Alibaba’s deals, team operations, and subsequent reduction on external investments are expected to drive significant adverse implications to its fundamental performance, in addition to slowed growth observed in recent quarters, adding further pressure to its valuation prospects down the road.

On a positive note, recent speculations over Alibaba founder Jack Ma’s potential relinquishment of his control in Ant Group could be a “step in the right direction” to appease Chinese regulators’ wishes to prevent the consolidation of power and wealth. As discussed in our previous coverage, the ongoing regulatory probe in Ant Group is symbolic of Beijing’s years-long crackdowns on the private sector. And any positive developments in the ongoing Ant probe could potentially mark a structural alleviation of regulatory pressures on both the fundamental and valuation performance of Alibaba, drawing a full circle from the crackdown that started it all. Yet, given the regulatory overhaul that has taken place over the past year, with the Chinese government’s steadfast commitment to “common prosperity,” Alibaba’s growth profile is unlikely to return to its explosive past, meaning any structural valuation upsides – which remains an area of high uncertainty – will be in moderation.

2. Holding Foreign Companies Accountable Act (“HFCAA”)

Chinese equities also remain hostages to the HFCAA still, as the U.S. SEC steps up efforts to ensure all issuers in the U.S. stock exchange are subject to the same rules and regulatory treatment, including compliance with PCAOB audit inspection requirements. Mainland China and Hong Kong remain the only regions that have not yet complied with PCAOB audit inspection requests.

Alibaba was recently added to the rolling list of delinquent issuers whose auditors have failed to comply with PCAOB inspection requests, renewing investors’ fears of delisting risks for the stock. This has effectively started the clock on a three-year countdown for Alibaba, subjecting it to potential delisting from the NYSE if Chinese regulators cannot reach an agreement with the SEC and PCAOB on opening up the books of its domestic enterprises for inspection.

In the latest development, the China Securities Regulatory Commission (“CSRC”) is “considering allowing U.S. officials to inspect documents on firms that do not possess sensitive data,” but the agency would still like the ability to “withhold sensitive data from inspection” where applicable on the grounds of national security concerns. However, the offer still does not address the key reason for PCAOB audit inspections, which is the need to assess “unredacted” audit papers to ensure information reported in publicly disclosed financial statements are reasonable and free from material misstatements. Negotiations are ongoing, but the two countries “have yet to reach a conclusive agreement on moving forward with the checks.”

As mentioned in our initial coverages on Chinese equities, increasing institutional exits due to burgeoning regulatory and economic risks in China will continue to drive downward valuation adjustments to the cohort until a concrete resolution is reached. This is further corroborated by the recent pullback in foreign funding allocation towards Chinese equities as discussed in earlier sections, given “increased skepticism among U.S. pension funds and endowments about the growing political and market risks of Asia’s largest economy.” Many foreign investors have abstained from committing new allocations to Chinese funds over the past 12 months, while “Florida’s pension system has halted new investments in China [altogether] as it assesses the risks.” Investments in China stemming from U.S. dollar-denominated funds have fallen for the third consecutive quarter to $1.4 billion as of March 31, marking the lowest sum since 2018. As a result, the valuation multiples on Chinese equities are continuing to lose their luster as institutional investors remain on the side-lines.

While Alibaba’s recent plans to pursue a primary listing in Hong Kong would open the door to incremental capital from mainland investors, related trading volumes remain a far cry from those in the U.S. – the average daily trading volume for Alibaba stocks in Hong Kong last month was “about $700 million, compared to about $3.2 billion in the U.S.” Although plans for a primary Hong Kong listing were viewed as a positive development by market participants, uncertainties over the Alibaba stock’s future on the U.S. exchange remain a deterring factor to investors, considering declines observed last week following the announcement of the company’s addition to the SEC’s HFCAA shortlist as discussed in the earlier section.

3. Global Economic Uncertainties

Easing mobility restrictions across major cities like Shanghai and Beijing following months-long COVID lockdowns during the June-quarter, and China Premier Li Keqiang’s subsequent vow to shore up the country’s economy with fiscal and monetary stimulus, have also failed to orchestrate a structural rebound in the cohort of U.S.-listed Chinese stocks. Even internal improvements at Alibaba, including stronger-than-expected March quarter results, improved retail trends observed during the “618” bargain shopping event, and plans for a primary listing in Hong Kong by year-end, have been unsuccessful in staging a sustained rally for the stock.

The domestic Chinese economy continues to show cracks on the back of a worsening property slump that has been exacerbated by COVID disruptions. The country’s official PMI data for June indicated a “contraction in activity…led by production and new orders, signaling disruptions to supply and unstable domestic demand recovery.” The outlook is further dampened by the deterioration in retail sales and profits in July. Specifically, China retail sales growth is estimated to have fallen for a fourth consecutive month in July based on preliminary observations; official data is set for release in mid-August.

This has added pressure to Alibaba’s recent intentions to pivot its core Chinese commerce strategy from user acquisition to retention. Gross merchandise value – which measures the total value of transactions completed on Alibaba’s core commerce platforms – in its core China commerce retail segment “declined mid-single-digit y/y” during the June quarter, with a meaningful drop in demand for discretionary goods accounting for the bulk of the setback. However, Alibaba’s “88VIP” members – similar to Amazon Prime (AMZN) members – demonstrated strong purchasing behavior during the annual 618 shopping event, providing slight relief to the period’s GMV decline thanks to budget-conscious bargain hunting as consumer wallets shrink.

The slowing global economy is also threatening to derail Alibaba’s recent shift in focus to growing its international e-commerce platforms. Alibaba’s international commerce retail segment revenues declined by 3% y/y, while order volumes declined by 4% y/y during the June quarter. Rising inflation and tightening central bank policies across Alibaba’s major overseas markets, including the U.S. and Europe, have resulted in weakening consumer discretionary spending, disrupting Alibaba’s plans to compensate for deceleration in its domestic commerce business with international growth. The challenges have been further exacerbated by the EU’s removal of VAT exemptions on Chinese imports, which has directly impacted order volumes on AliExpress in recent quarters. Increasing competition in Southeast Asia is also thwarting Alibaba’s ambitions in international e-commerce, as observed by consecutive quarters of deceleration in order volumes at Lazada.

Alibaba Stock – Fundamental and Valuation Update

Adjusting our previous forecast for Alibaba’s actual June quarter financial results and recent developments in its operating environment as discussed in the foregoing analysis, the company is expected to generate consolidated revenues of RMB 901.5 billion ($135.2 billion) for fiscal 2023, which represents moderate y/y growth of 6%. The adjustments take into consideration the downward shift in performance at segments – namely, Alicloud and international retail commerce – that were supposed to uplift Alibaba’s growth trajectory and offset the near-term uncertainties within its core Chinese retail commerce business. Specifically, the modest growth rate applied on fiscal 2023 revenue projections intend to reflect the near-term headwinds pertaining to fundamental impacts from ongoing regulatory challenges, as well as global macro uncertainties.

And over the longer-term, we expect the consolidated business to grow at a modest five-year CAGR of 4.6%, with Alicloud being the core driver. As mentioned in the foregoing analysis, the regulatory overhaul implemented by Beijing on the private sector over the past two years have materially transformed the explosive growth that Chinese big tech had once benefited from over the past few years. As the government continues to pursue “common prosperity,” we expect any recovery to Alibaba’s business over the longer-term to remain in moderation.

On the valuation front, we are maintaining a neutral stance on the stock with an expectation that the shares will remain in flux within the $100-range in the near-term. The valuation analysis assumes a perpetual growth rate in line with China’s long-term GDP outlook considering Alibaba’s growth profile as one of the largest big tech businesses in the world, adjusted by its current trading discount to U.S. counterparts like Amazon to account for the Chinese sector’s risks.

However, considering the near-term macro uncertainties across both its domestic Chinese market and international markets, the Alibaba stock could potentially trend lower and contest the $80-range again – this bear case figure implies a perpetual growth rate in line with China’s long-term GDP outlook, further discounted by a downward valuation adjustment in the extent of those experienced by peers in the tech industry during the heights of their regulatory turmoil.

Any structural momentum above the $100-range would require concrete evidence from both Alibaba and the Chinese government in maintaining resilience in the face of a faltering economy, and providing support for the private sector, respectively, in order to restore investors’ confidence in the performance of U.S.-listed Chinese equities.

Final Thoughts

In the ongoing tug-of-war between attractive valuations and a growing profile of underlying risks, the latter continues to take a stronger hold on the Alibaba stock. Reiterating our stance from previous discussions, volatility remains the broad-based theme for the Alibaba stock, with no concrete near-term catalysts to offer respite.

For one, ongoing regulatory and delisting headwinds are not only warranting a downward valuation reset compared to its U.S. counterparts, but also risking erosion into Alibaba’s fundamental performance – a double-whammy to its market value. Meanwhile, China’s property slump is also on the brink of a structural collapse, with default risks amongst developers now showing signs of spillover into other sectors and the broader retail population.

Investors continue to yearn for concrete resolutions to the challenging external environment for Chinese equities. However, this is likely still a while away, and even then, any upside recovery will be in moderation given that the old days of sprawling growth are likely no more.

Author: Livy Investment Research, Seeking Alpha