- Alibaba stock has underperformed major U.S. stock market indexes this year.
- Many investors are already aware of the reasons behind this underperformance, but we believe there are two additional risks investors need to keep an eye on.
- Alibaba is cheap from a valuation perspective, but to invest in its stock, investors need to find the answer to one key question.
Alibaba Group Holding Limited has been having a rough ride over the past year. The series of blows the company has been dealt with is widely believed to be a result of the speech given by Jack Ma in October 2020, rebuking the state financial institutions in China for being outdated. Alibaba was fined a record $2.8 billion in April by antitrust authorities, and Ant Financial, the Fintech arm of Alibaba, was ordered to restructure its business as well. The Chinese government’s crackdown is not only limited to Alibaba. For instance, DiDi Global Inc., the Chinese ridesharing giant that pulled off the second-largest U.S. initial public offering for a Chinese firm by raising $4.4 billion in June, was ordered to stop onboarding new customers and its applications were taken out of the Google Play Store and Apple Store citing privacy concerns regarding user data. Tencent Holdings Limited was also fined $1.5 billion in April for inaccurately reporting investments and acquisitions for antitrust reviews.
Alibaba stock has declined by 11% this year, which is a noteworthy underperformance compared to the S&P 500 Index and NASDAQ Composite Index that have gained by almost 15% and 16%, respectively. The tech giant is undoubtedly in a high growth phase and trading at an inexpensive valuation but the risks attached to Alibaba need to be taken seriously. Investors believed the announcement of the $2.8 billion fine by the State Administration for Market Supervision in China signaled the worst had come to an end, which resulted in the sentiment toward Alibaba turning bullish. However, Alibaba was once again fined RMB 3 million in July for its acquisition of a 50% stake in China’s Evergrande Football Club in 2014 and the purchase of a 40% stake in Landmilk, a Shanghai-based milk producer.
Amid the intensifying competition, trade wars, as well as regulatory scrutiny, Alibaba’s financial performance has been exceptional. Taking into account the risks faced by the company and assuming Alibaba will follow the stringent requirements put upon the tech industry, we believe investing in Alibaba is suitable only for investors with an extensive investment time horizon. A lot can still go wrong for Alibaba, and we would not be surprised if the stock sheds more value before staging a recovery. In the absence of a crystal ball to predict the future, however, we believe long-term-oriented investors should slowly build a position in Alibaba at the current price level.
Alibaba earnings recap
For the fourth quarter of fiscal 2021, Alibaba reported a 64% year-over-year increase of revenue to RMB 187.4 billion, beating consensus estimates by over RMB 6 billion. The company reports revenue under 4 main segments:
- Core Commerce.
- Cloud Computing.
- Digital Media and Entertainment.
- Innovation Initiatives.
Core Commerce has always been the leading contributor to company revenue, which was no different in the most recent quarter as well as this segment accounted for more than 80% of total revenue.
Exhibit 1: Revenue contribution by segments
Source: Investor presentation
Below are some of the key highlights from the most recent quarter.
- Annual active consumers surpassed 1 billion, which includes 891 million in China and 240 million outside the country.
- Mobile monthly active users and annual active consumers of China retail marketplaces came to 925 million and 811 million, respectively.
- The Gross Merchandise Value for China retail market grew 14% to RMB 7.5 trillion with the average revenue per user coming to RMB 9,200.
- The core e-commerce segment which includes Alibaba, Taobao, and Tmall portrayed solid growth in the quarter reporting a 72% YoY growth in revenue to RMB 161.4 billion.
Launched in 2009, accounting for 8% of total revenue, the cloud business segment also reported YoY revenue growth of 37% to RMB 16.8 billion in the quarter. Although there’s a long way ahead for this segment to meaningfully contribute to the earnings of the company, we believe cloud computing will be a bright spot for Alibaba in the coming years in helping the company sustain its stellar revenue growth rates.
While the top line has been performing extremely well, the bottom line has been negatively impacted by the ongoing government pressure which has resulted in a substantial increase in litigation costs and other non-recurring costs such as the payment of fines and legal fees. We are encouraged by Alibaba’s ability to maintain double-digit revenue growth, which is something we expect to see in the next few years as well. However, we are wary of the pressure on operating margins, and we believe it would be wise to project flat margins for the next couple of years because of regulatory risks.
Risks that need to be monitored
There is no doubt that you are already keeping an eye on the regulatory risks facing Alibaba and other Chinese tech companies, but there are a couple of additional risks that need to be monitored to identify inflection points in Alibaba’s story.
The risk of delisting Alibaba from the NYSE – the U.S. Securities and Exchange Commission adopted the Holding Foreign Companies Accountable Act in March. According to the law, companies listed will go through audits carried out by a U.S. watchdog, and those who fail to provide the required documentation could be forced to cease trading on American stock exchanges. While this could be a risk to Alibaba as well as other Chinese tech giants, a decision to delist could only be reached after 3 years of non-compliance. We believe this long time frame gives Chinese tech companies enough time to make some progress from this front and reach a middle ground with American regulators. However, we believe it’s prudent to account for this risk when determining the intrinsic value of Alibaba shares.
Another risk is the increasing competitive pressure in domestic and international markets. Alibaba serves about 80% of the Chinese e-commerce market, but the pressure from peers such as JD.com, Inc. and Tencent has been increasing over the last few years. JD is China’s largest retailer in terms of revenue with a simpler business model compared to Alibaba. Second to Alibaba in terms of the market share, JD’s share price has remained flat amid government pressure, unlike Alibaba that has shed its market value. The 2 business models are different in that Alibaba makes most of its revenue by onboarding third-party sellers whereas JD is a retail store that fulfills orders with its warehouses and logistics network. As Alibaba continues to expand its low-margin businesses, investors might penalize the company for failing to convert higher revenue into higher profits. We believe companies such as JD have implemented tighter cost control mechanisms that would help them expand operating margins in the future. In return, cost advantages will help these companies compete head-on with Alibaba for market share.
Alibaba’s international expansions will also come under pressure from the likes of Amazon and other e-commerce players that are already established in fast-growing markets. The trade war between the United States and China is not an encouraging sign as we believe geopolitical uncertainties will cap Alibaba’s international growth, at least in the short run.
Favorable industry conditions make us believe in Alibaba’s potential
With the pandemic continuing to make waves in every part of the world, it would be reasonable to assume that global online shopping activity will remain elevated in the next few years, although 2020 could prove to be a near-term high from a revenue growth perspective. According to GlobalData, e-commerce sales in China are expected to register a robust growth of 17.2% in 2021. The expected increase in smartphone penetration, together with the increasing number of e-commerce platforms and payment methods, has created a favorable demographic environment that supports the growth of the leading players in this industry.
Exhibit 2: China e-commerce value
Exhibit 3: Countries with the highest e-commerce share of total retail sales
While China leads the world in terms of e-commerce share of total retail sales, the pressure from the government seems to be a threat to the continued growth of this industry. Chinese tech entrepreneurs who were considered to be the idols of the Chinese economy are now expected to lay low, as they face regulatory scrutiny. While this crackdown started after Jack Ma’s comment on state organizations, this could prove to be a much larger movement in which China might attempt to limit the power of these tech companies.
The future outlook for Alibaba
Management guided for revenue of RMB 930 billion for fiscal 2022, which implies YoY growth of 30%. The company expects to add 100 million annual active customers in China as well, bringing the total to 1 billion. Amid the regulatory pressure, we believe Alibaba will invest the bulk of its earnings to support merchants and in businesses that will support the company’s goal of diversifying into new business verticals.
Enhancing the value proposition to merchants and customers is without a doubt going to support this tech giant to maintain its leadership as supporting merchants would translate to a higher GMV growth and impact the monetization of the platform positively as well. We also believe that Alibaba’s investments in consumer businesses could help the company drive up the transaction frequency of customers on its platform.
Considering our long-term view of Alibaba, we believe the company is very cheaply valued in the market today. Alibaba is trading at a forward P/E of close to 20 although the company is growing in double digits annually, which we believe is the result of the negative sentiment toward Chinese companies in the market. There is every reason for an investor to be cautious when investing in Chinese stocks, but we believe earnings will eventually dictate terms over the performance of Alibaba stock in the long run, and we are fairly confident that regulatory scrutiny will not have a material impact on company earnings in the long run.
Alibaba continues to be a leader in China’s e-commerce industry. Capturing over 50% of the market share, Alibaba can be considered a proxy for the Chinese economy ignoring the current geopolitical tensions and regulatory scrutiny. Alibaba’s established ecosystem as well as its strong position in the e-commerce industry continues to be a threat to its competitors, and we expect these competitive advantages to last a long period of time. The fiscal year 2022 should be a transitory year for Alibaba, where they will focus on reinvesting incremental profits into strategic areas to reaccelerate long-term growth especially in its cloud segment where Alibaba dominates in China.
With all that’s going on around the company, we urge investors to focus only on the outlook for long-term earnings although it is easier said than done. Doing so will help investors conclude that Alibaba stock presents a very attractive investment opportunity today. We also believe that investors with an investment time horizon of less than 5 years should not invest in Alibaba in the hopes of a recovery as things could continue to go south in the foreseeable future. The most important question, therefore, is what’s the length of your investment time horizon? The longer it is, the more attractive Alibaba looks.
Author: Nirasha Senanayake, Dilantha De Silva, Seeking Alpha