Alibaba Stock: Tough Times Ahead (NYSE: BABA)
The fundamental reason for holding them is exposure to the Chinese economy and consumer. The growth rates inherent in these names are 20, 30, 40, 50, 55% annual growth; you can’t get this anywhere else – Kevin O’Leary, March 16, 2022
Alibaba Group Holding Limited (NYSE: BABA) shares bounced on headlines of a potential U.S.-China deal allowing U.S. auditors more access to the company’s data, allaying delisting fears. BABA’s management has also expanded its share buyback program, a move often seen as a vote of confidence on behalf of management.
However, these developments do not address the main challenge that Baba faces. In my last article, I discovered signs of growth headwinds buried under Alibaba’s acquisition of Sun Art, contrary to what revenue growth implies. Sun Art’s revenue is so huge that adjusting for the additional 19 days of revenue consolidation in Q3 2022 (December Quarter 2021) above Q3 2021 indicates that BABA’s revenue has declined organically .
The temporary nature of the drop in net income (down 74%) in the third quarter (more on that below) encouraged many investors to buy during the decline. This would have been an ideal contrarian strategy, except that while the decline in earnings is temporary, the revenue issues are not. BABA’s core businesses are moving from a growth phase to a maturity phase, making it more difficult to grow, especially given the inability of its growth drivers (such as Cloud) to compensate, given of their low income base. Government crackdowns on BABA’s monopolistic practices have permanently altered the competitive IT landscape, making it harder for BABA to maintain its artificially inflated market share, historically protected by unfair abuse of its size.
Statements such as the one at the opening of this piece signify a growing gap between BABA’s growth-oriented investor base and its new status as a fully mature company.
BABA has always attracted a growth-oriented shareholder base. When this proposal disappears, its investors will also disappear. Don’t get me wrong: I’m not saying BABA has a flawed business model. On the contrary, e-commerce technology has scalable, lucrative and cash-positive operations. However, growth cannot last forever and BABA’s core business is entering a mature phase of the economic cycle. Value-oriented shareholders will eventually replace current growth-oriented investors, but the process will create volatility. Investor presentations always market BABA as a growing company. This makes it harder for the market to strike a balance that matches the mature fundamentals of BABA’s business with the new investor base.
The company speculates on the three strategic initiatives described below:
- International growth
- Expansion into rural China
In the last quarter, BABA recorded 18% growth in its international segment. That’s not bad, except it’s coming from an extremely low revenue base in a large market. International operations make up only 7% of total revenue, and no less than 50% to 100% is needed for the line of business to make a meaningful difference. At the current rate of growth, it will take a few years for the Cloud business to contribute significantly to revenue. At that time, BABA’s growth-oriented investors would most likely lose patience, sell stocks and push the price further down.
When BABA posted 10% growth last quarter, shares fell, reflecting the high expectations of its growth-oriented shareholder base. BABA’s average revenue growth over 3 years is 42%. For BABA to achieve even 20% growth in the international segment, the division must grow 100%, compared to actual growth of 18%. (Revenue – Nine months ended December is RMB 452,375 million * 0.2 = RMB 90,475 million, compared to international segment revenue of RMB 46,743 million).
The company’s weak revenue base signals an unfavorable position in the international market. Chinese consumer tastes have prevented Amazon (AMZN) from entering the market. Likewise, global consumers seem to favor AMZN outside of the Asian nation. Whether I am right or wrong remains to be seen, but what is true today is that BABA’s international trade earnings are too low to have a significant impact, at least in the short to medium term.
The same dynamic also applies to the Cloud activity which constitutes 8% of turnover. BABA’s cloud computing business will likely be confined to China, given the lax privacy regulations and culture within BABA itself. How many of us are comfortable posting family photos to Chinese social media? I expect growth and adoption to be slower than in the United States and western democracies, where privacy regulations encourage adoption. Still, the strengths of Alibaba’s cloud segment come from two things:
- Cloud services are closed to foreign providers
- Alibaba has a natural advantage due to its experience running its own cloud-based operations.
Currently, BABA China Commerce’s active customers are 882 million. It seems that BABA’s core business is saturated. The total population of China is 1.4 billion, of which 260 million are under the age of 15. This could explain why the expansion of rural China is now one of its official pillars of strategic growth. However, the purchasing power of this market segment is low, and I doubt that this is the answer to the company’s main operational and economic problems. Earnings from Pinduoduo (PDD), the e-commerce platform targeting rural China, give a clue to the purchasing power of this market. Despite around 800 million users, PDD’s annual sales are only RMB 94 million, a fraction of BABA’s 836 million TTM sales.
Last week, BABA extended its $10 billion to $25 billion share buyback program in a bid to reassure investors of its outlook after shares tumbled to a multi-year low of $86 per share. Historically, the company has not been consistent in implementing its share buybacks, and the total number of shares outstanding has increased, as shown in the chart below.
This is the first time the company has expanded its share buyback program as far as I know, signaling its determination to execute a significant portion of the program’s budget.
The program is huge, but it does not guarantee stock performance. Consider Oracle (ORCL), Intel (INTC) and International Business Machines Corporation (IBM), all of which have mammoth stock buyback programs, but their stocks have underperformed the market.
US sanctions embarrassing for BABA
China opposes US sanctions against Russia, placing Baba between rock and stone. If BABA withdraws its operations from Russia, it contradicts one of the pillars of growth – the international market – especially as revenues from Russia grew by 46% in 2021. This also contradicts CCP’s guidance, reflected in the statements of the Chinese ambassador to Russia, encouraging Chinese companies to “fill the void” created by the Western withdrawal. On the other hand, serving the Russian market increases the risk that the Chinese tech giant will be sanctioned by the United States and its allies. These risks are real, especially since all of BABA’s partners in its Russian joint venture are on the US sanctions list and include three of the Russian oligarchs and the Russian Investment Fund.
I don’t think many investors appreciate the harshness of the regulatory changes against BABA’s monopolistic practices. BABA has been brutal against the competition, abusing the scale of its platform to coerce companies into signing exclusivity agreements that prohibit them from selling their products on other platforms, such as JD.com (JD). Now that merchants have more autonomy, they could negotiate better fees and be free to sell their wares on other platforms.
Recently, JD and PDD have added live streaming functionality to their platforms, and this marketing method is no longer a unique advantage of Alibaba. BABA is also not immune to the growing popularity of short-form video platforms, including TikTok and Kuaishou, which have negatively impacted BABA’s advertising revenue and generally loosened its grip on social media channels. Chinese e-commerce.
In the last quarter, BABA spent heavily on subsidizing its merchants to combat renewed competition, allowing it to maintain sales at the expense of margins. However, this strategy is not sustainable. Sooner or later, investors, and the company, have to face a new reality.
Some notable investors are buying the decline in BABA shares. Charlie Munger doubled down on his position and long cited the tech giant’s competitive advantage. In March, Kevin O’Leary went on CNBC touting BABA’s growth prospects after buying the dip. These examples reflect the fundamental flaw of what BABA can offer and what its shareholders expect.
New anti-monopoly rules mean the competitive advantage touted by Mr Munger is no longer valid. Last quarter’s gigantic spending on trader subsidies shows how terrified BABA is of losing its artificially inflated market share, blown away by years of market abuse. Mr. O’Leary’s growth premise is also invalid, given growing competition and BABA’s maturing core segment. As mentioned in a previous article, excluding the acquisition of Sun Art, BABA’s main revenue declined for the first time in its history, as far as I know. Its pillars of growth are still too new to bring any significant change in Baba’s fortunes.
So, while I understand the potential of BABA’s long-term promise, I think the best course of action is to proceed cautiously, unleveraged, and prepare for short- to medium-term volatility.