I once considered it Alibaba (NYSE: BABA) an undervalued growth share. It is still trading at only 21 times the prepaid earnings, and analysts expect earnings and earnings to rise by 50% and 37% respectively this year. And its leading positions in China’s e-commerce and cloud markets also give it the scale to easily crush its smaller competitors.
But after thoroughly reviewing Alibaba again, I believe I will never buy this seemingly attractive Chinese tech share for three simple reasons.
1. Its growing dependence on lower-margin businesses
Alibaba looks like a reverse version of Amazon (NASDAQ: AMZN). While Amazon subsidizes the growth of its lower-end retail segment with its higher-end cloud business, Alibaba subsidizes the growth of its unprofitable businesses (including its cloud division) with its higher-income ‘core retail’.
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Therefore, Alibaba’s future earnings growth relies heavily on its core trading segment, which includes its online markets, cross-border markets, brick-and-mortar stores and the Cainiao logistics unit.
Alibaba’s core industry continues to grow in a healthy way. Its core trading revenue rose 35% in fiscal 2020, which ended last March, and was 86% off the top line. The segment’s revenue increased by another 32% year-on-year in the first half of fiscal 2021.
However, it also relies heavily on its “New Retail” business (including its brick-and-mortar stores), its cross-border wholesale segment and Cainiao to drive its growth. These businesses all generate lower margin revenues than the core markets Taobao and Tmall, which charge traders listing fees and commissions.
Therefore, the adjusted EBITA margin of its core operating segment decreased from 38% to 35% between the second quarters of 2020 and 2021. The total adjusted EBITA margin remained stable at 27% due to smaller losses at its unprofitable businesses, but the balancing act can easily fall apart in the near future.
2. Endless regulatory challenges
Meanwhile, a seemingly endless deluge of regulatory challenges in the US and China could make it even harder for Alibaba to keep growing.
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Last year in December, the US passed a law that would remove all foreign companies that do not meet new audit requirements for three consecutive years. Alibaba’s secondary listing in Hong Kong at the end of 2019 indicates that the days can be counted on the NYSE.
Taobao also remains on the black trade list of the US trade representative ‘Notorious Markets for Counterfeiting and Piracy’ due to the appearance of counterfeit products on its platform. This reputation could lead to sanctions against its cross-border marketplaces.
In China, government regulators clearly want to curb Alibaba. In 2019, the government sent officials to work with dozens of companies, including Alibaba, to oversee their operations. Last year, the Central Committee of the Communist Party tightened that grip by requiring all companies to appoint a certain number of registered members of the CCP.
Tensions finally boiled up last year when China dropped its hammer on Alibaba. It derailed the long-awaited IPO of its fintech subsidiary Ant Group, fined Alibaba for an unapproved acquisition, and launched a full antitrust investigation into its e-commerce operations.
The regulators want to believe that Alibaba will end its exclusive deals with traders and accelerate its price-limiting strategies, which could make it more difficult for its core profit engine to continue operating. This would also make Alibaba more exposed to competition from JD.com (NASDAQ: JD) and Pinduoduo (NASDAQ: PDD) – which has previously accused Alibaba of competition strategies.
3. Ethical considerations
In 2017, the Chinese government declared that the country would rely on Alibaba for the development of smart cities, Tencent (OTC: TCEHY) for digital healthcare, and Baidu (NASDAQ: BIDU) for driverless cars.
The term ‘smart cities’ may seem vague, but it collectively refers to Alibaba’s cloud services and face recognition technologies. The Chinese government relies heavily on these technologies to monitor its citizens, and these technologies are strictly tied to a government database.
This is already worrying, but Alibaba recently showed how its technologies can be used to identify the face of Uighur’s and other ethnic minorities across China. Alibaba claims that the feature can be embedded in websites to monitor users for terrorism, pornography and other ‘red flags’.
China’s human rights record is already sad, and he is currently accused of capturing and sterilizing Uighur’s in prison camps. Alibaba’s disturbing allegations are causing far too many ethical issues. They could also make Alibaba an easy target for sanctions if the Biden government maintains the Trump administration’s tougher stance against Chinese technology companies. As a result, I avoid Alibaba for the same ethical reasons I recently sold Tencent: I simply do not want to own part of China’s mass surveillance system.
The most important takeaway
I understand why Alibaba is still buying an attractive stock for many investors and that it could definitely climb higher in the future. However, there are simply too many regulatory, growth-related and ethical challenges for me to consider it a worthy long-term investment.