- BABA is making huge investments in itself at the same time the rest of the market is selling out of fear.
- The company clashes with China’s central government, but they align on BABA’s fastest-growing segment, international retail.
- Fears of recessions, delisting, and energy shortages look like short-term headwinds that are already priced in.
- There’s technical support for BABA at these levels, and with events like Single’s Day not far off, the stock could be in for a rebound back towards $200/share.
A little over a month ago I had a neutral rating on Alibaba as shares traded around $160, and were near the middle of my expected trading range of $130 to $200, but below $140 I see enough support to become bullish once again. In my last article, I focused on the external factors that have driven down BABA’s stock price as the company’s strong fundamentals show the company is undervalued relative to U.S. peers, interest rates, its own history, and just about every other comparable metric. In this article, I’ll examine changes in BABA’s operating environment since my last post and dig into why the company represents a more compelling buying opportunity than it did in August.
Alibaba Is Investing In Everything, Especially Itself
From $320/share to under $140 at the time of this writing, Alibaba is sending a clear message that it thinks the market is wrong by making huge investments in itself. This investment takes the form of:
- An increased share repurchase program to $15 billion through 2022
- A $15.5 billion “common prosperity” contribution / tax / extortion fee to garner support, or at least quell the ire of the Chinese Communist Party (CCP).
- Capital expenditure in nearly all of its underlying business units at levels not seen for a few years.
The share buyback is self-explanatory, but the latter two points warrant some additional detail.
In my last article I expected BABA to follow Tencent and to contribute $8 billion towards “common prosperity”, and while that following did occur, Tencent upped its contribution to $15.5 billion and BABA did the same. BABA pledged this amount by 2025, which is roughly equivalent to its $2.8 billion anti-monopoly fine each year. Even for a company as large as Alibaba, this is a hefty expense, but BABA should get a few benefits:
- Reduced regulatory scrutiny, continued domestic protection from Western tech, and support for international expansion plans as the CCP becomes a direct beneficiary of BABA’s future success.
- Goodwill from the Chinese people, aka BABA’s customers, as it strategically deploys those funds. Compare this with billions in fines that Alphabet and other U.S. big tech have racked up over the years only to be hated more than ever.
- An improved customer base as BABA’s contribution focuses on bringing digital services to underdeveloped geographies and industries, which could become customers for life.
To be clear, this “investment” was forced on the company, but not only are BABA’s balance sheet and cash flow able to support the cost, there may be a small benefit to the company as well.
Investment In Underlying Businesses
With 912 million annual active customers in China as of June 30, 2021, up 21 million from the previous quarter, BABA has captured just about every potential customer in China’s 1.4 billion population. Rather than focus on the 150+ million under ten years old, that are hopefully not customers, BABA’s latest investments focus on increasing sales from existing customers by creating differentiated value propositions, higher consumer engagement, and increased purchase frequency.
These investments are yielding promising results so far whether its expansion offline into physical stores, Taobao Deals adding users in less developed areas or Idle Fish with 100 million monthly active users (MAUs) in the consumer-to-consumer based marketplace. Retail adjacent businesses are seeing investment too, like Ele.me, essentially GrubHub, but with more than just food, saw 50% order growth year-over-year (YoY). Investments in AMap make it much more competitive with Baidu Maps, which coupled with investments in travel services subsidiary, Fliggy, making the overall company more vertically integrated. That vertical integration could put a bigger anti-monopoly target on BABA’s back, but it’s preferable over past, and possibly current, alleged practices like forced exclusivity of merchants on its platform.
Alibaba International and Non-Retail Investment
Alibaba’s domestic retail businesses still represent 66% of total sales, and with 30%+ YoY growth that’s not a bad thing. The investment story gets better given that international retail, logistics, and cloud computing sales are expanding just as fast.
International retail and wholesale businesses grew at 54% and 37% YoY respectively, with Lazada as a 90% YoY standout in southeast Asia. AliExpress, BABA’s B2B variant, made inroads in some European countries and Russia on the back of logistics subsidiary Cainiao. Cainiao itself delivered 50% YoY sales growth and the company sees an opportunity to leverage the world’s current supply chain woes both within China and major markets in Europe. Finally, cloud computing achieved only a 29% YoY sales increase, and it provides a great diversifying component in a rapidly developed Chinese market.
BABA’s Businesses Are Booming, Yet Its Share Price Is Collapsing
Obviously, the stock market doesn’t hate BABA’s sales growth, its strong balance sheet, its profitability, or the investments the company is making in its future. The market hates the same thing it always has, uncertainty.
Alibaba International and The CCP Are Aligned
I provided evidence in my last article explaining why regulatory actions in the Chinese tech sector were not attempts to cripple the industry, drive away foreign investment or decouple China from the rest of the world. Still, I can see why it looks that way, but if we take a longer-term perspective and think back further, President Xi showed his hand almost eight years ago when he proposed the Belt and Road Initiative (BRI) which had the clear goal of weaving China into all aspects of the global economy. Largely thought of as an investment project in physical infrastructure like roads and shipping ports, the other half of the BRI was digital infrastructure historically developed and led by Baidu, Alibaba, and Tencent (BAT). BABA continues to be strategically important to the CCP when it comes to bringing other countries into China’s sphere of influence. Lazada’s 100% YoY order growth in southeast Asian countries like Indonesia and Vietnam creates an economic interdependence between them and China, and that expansion is establishing footholds in Europe too. As CEO Zhang stated in his prepared remarks “AliExpress continued strong momentum in its major markets, such as Spain, France, and Russia, leveraging the improved cross-border logistic solutions in partnership with Cainiao.”
We’ve watched the BRI play out over the last eight years and while its largely been a case study in just how bad large, bureaucratic, entities are at making investment decisions, there are cases where it has expanded China’s sphere of influence and opened new markets for BABA which now has over 265 million international annual active users. I could be reading too far between the lines of China’s Data Security Law that went into effect last month, but the emphasis on “cross-border data sharing” could be an attempt to insert the Chinese government into the data gathering loop practiced by the countries tech companies. Regardless of the full intent of that law, BAT is clearly in a position to gather economic information for the CCP making it even less likely that the party would want to destroy BABA or its rivals.
Domestic Operating Environment & Regulatory Updates
At this point, we’ve established that BABA’s businesses are performing well, and that the company remains incredibly valuable in meeting the Chinese government’s goals, but investors can’t seem to get past almost daily headlines that would have us believe China is on the brink of total collapse. I went into detail on the regulatory environment in my last article, but I wanted to write more about the anti-monopoly regulation before focusing on three events that appear to pose a threat to China and BABA’s future prospects:
- Evergrande and Chinese debt
- Potential delistings in two years
- Energy shortage
Monopoly Status and Break-up Possibility
I don’t have the legal authority to declare BABA a monopoly, but when a company exerts pricing pressure like a monopoly, limits consumer choice like a monopoly, and generally stifles competition like a monopoly, the company just might be one. At times like that, I personally feel that a painful enough fine is warranted to have a company question whether it wants to continue with business as usual or make some changes. I think CEO Zhang is going in the right direction by focusing on vertically integrated businesses while diversifying sales away from one super-app into a series of businesses addressing different markets, like Idle Fish and Ele.me discussed early. If the government ever got serious about breaking up BABA, this strategy also allows for a cleaner divestitures that could add to the company’s value rather than subtract.
Even if the company is equally valuable in a forced break-up, the old battle between Yahoo and Alipay highlights a cause of concern for investors. Over a decade ago, Alibaba spun off AliPay into a separate company to comply with Chinese regulations that related to foreign ownership of financial institutions. Yahoo claimed that the move was never approved, and it looked like AliPay was just taken away from Alibaba investors. After a three-year battle, the interested parties reached an agreement on AliPay, but it’s another warning of the potential dangers of investing in China compared to the U.S. In a BABA break-up scenario, investors will need to be diligent to ensure valuable parts of the company aren’t simply transferred out of their ownership
Evergrande and the Chinese Debt Profile
The fact that a ton of property development in China was built on bad debt isn’t new. For close to a decade, the question hasn’t been if a company like Evergrande would collapse, simply a question of when. Back in 2012, Andrew Left put out a report on Evergrande’s financial health in part of a saga that led to a ban from his trading in Hong Kong. There is already an SA article that clearly explains why Evergrande’s potential bankruptcy would minimally impact Alibaba, but the question is still whether there is enough bad debt scattered throughout China to lead to a recession. I believe the answer is yes although I’ll add that that’s been the case for many years, and the U.S. debt situation isn’t much better.
Source: Author Created With Data From World Population Review
Where this gets complicated is that in China somewhere between 50%-80% of that debt is local government debt (LGD). For reference, state and local government debt makes up less than 10% of total debt in the U.S. This difference in China appears to be the result of the central government setting goals for the localities to implement without sufficient funding to achieve them.
What’s interesting about LGD is that a lot of that money went into the property market. Since land sales are responsible for most local government income, the debt situation was exacerbated starting in 2017 when the central government focused on deflating housing bubbles. The problem with Chinese LGD data is that it is difficult to find and questionably accurate. Evergrande on the other hand gives very visible insight into the state of the Chinese property market which means there’s a good chance local governments across China are having trouble paying their debts.
This all sounds grim, but remember that localized debt isn’t a problem in all regions, and with a relatively low total debt to GDP ratio, the central government shouldn’t have a problem either containing or supporting localities as needed.
Even if LGD and the property market spiral down in what results in a recession for China, it still could make sense to own BABA at its current valuation if you have a long time horizon. Microsoft cratered over 50% in the U.S. financial crisis and had about as much to do with the property markets as BABA does. I think that comparison is reasonable as BABA is also a large tech player, posting solid sales growth, with a conservative balance sheet. Because BABA is already down more than 50% from its 52-week high, the possibility of a recession in China looks priced in.
Two Years Until Delisting?
The Holding Foreign Companies Accountable Act created the possibility of delisting foreign companies, specifically Chinese, that don’t comply with all the standards and rules of the Public Company Accounting Oversight Board (PCAOB). This year a Senate passed bill could shorten the time to delisting from the original three years down to two. As a result, many Chinese firms have dual-listed in Hong Kong with some investment firms making the switch as well. The primary difference is that Americans can easily purchase ADSs, which represent eight ordinary shares, on the NYSE, while it can be an inconvenience to purchase ordinary shares on the Hong Kong exchange. Both share variants represent ownership in Alibaba Group Holding Limited, incorporated in the Cayman Islands, not a company incorporated in China.
Of the possible outcomes, BABA could comply with the PCAOB, the Chinese and U.S. regulators might work out a compromise, or BABA’s shares could be removed from the NYSE. If shares are removed, there are two likely outcomes, either the shares are re-registered in Hong Kong or they trade over-the-counter just like the shares of many other companies. This effort by Congress to look “tough on China” feels more like a coin flip where China either wins or the NYSE and other U.S. exchanges lose. If the regulators work out an agreement or BABA complies, China gives up nothing while gaining credibility for its public companies and economy. If the shares leave the U.S. exchanges, the Hong Kong exchange becomes even more important to global finance. Either way, the impact to shareholders should be limited to short-term volatility and the possible inconvenience of dealing with a foreign exchange. I suspect many brokerages and banks would seize the opportunity to make owning the HK shares less burdensome as they already do with ADSs.
China is experiencing its worst power shortage in decades in yet another centralized government blunder. Chinese citizens don’t have the same expectations for near-100% electrical uptime as people in the U.S. and Europe. Just last year, China had to cut power during a shortfall of supply and rebounding demand, but it is worse this year and extends beyond China. For months, miners were ordered to remain under capacity limits, but it seems all former plans are on hold for the winter. Miners are now being asked to produce as much coal as possible, deliveries are coming in from Australia despite the import ban, price controls are being relaxed in certain areas, and more renewable energy is being brought online. Because so much of China’s current power crisis was self-inflicted by its government policies which are now on hold or reversed, I think the winter will be brutal but not catastrophic to the country as a whole. As it relates to BABA, the power shortage should have a negative impact for a quarter or two, but with a resolution already underway, I don’t think it impacts the company’s long-term prospects.
Is BABA Stock A Buy, Sell, Or Hold Now?
In my last article, I estimated a fair value of BABA at $191/share after discounting for “China risk”, but expected shares to be trapped in a trading range of $130 to $200 for the remainder of the year. Under $140, I’m willing to add to my position as I haven’t seen any news or results that lead me to adjust my fair value or trading range estimates. The company has incredible fundamentals that could lead to a rebound to $200, although I might consider closing out my position in favor of other beaten-up Chinese stocks at that point. Investing in any market, but especially China comes with unique risks that make downside protection important. I choose to own BABA in the form of long-dated, bullish put spreads, which I see as offering a favorable premium at the moment due to heightened volatility in the stock. I’m not specifically recommending this strategy, but it is personally the only way I feel comfortable getting exposure to BABA’s upside potential while limiting my risk on the downside.
Author: The Stock Dudar, Seeking Alpha