I once considered Alibaba (NYSE: BABA) an undervalued growth stock. It’s still trading at just 21 times expected earnings, and analysts expect sales and earnings to rise 50% and 37% respectively this year. And its market-leading positions in the Chinese e-commerce and cloud markets also give it the scale to easily crush its smaller rivals.
But after taking another careful look at Alibaba, I don’t think I’ll ever buy these seemingly attractive Chinese tech stocks, for three simple reasons.
1. The growing dependence on lower margin companies
Alibaba is like a reverse version of Amazon (NASDAQ: AMZN). While Amazon subsidizes the growth of its lower margin retail segment with its higher margin cloud business, Alibaba subsidizes the growth of its unprofitable businesses (including its cloud division) with its higher margin core commerce revenues.
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Therefore, Alibaba’s future earnings growth is highly dependent on the core trade segment, which includes the online marketplaces, cross-border marketplaces, brick-and-mortar stores and the Cainiao logistics unit.
Alibaba’s core business is still growing with healthy growth. Core trade revenues increased by 35% in fiscal 2020, which ended last March, and represented 86% of sales. The segment’s revenues were up 32% year over year in the first half of fiscal year 2021.
However, it also relies more heavily on its “new retail” (including its brick-and-mortar stores), its cross-border wholesale segment and Cainiao to drive its growth. These companies all generate lower margin income than the main Taobao and Tmall marketplaces, which charge sellers fees and commissions.
That is why the adjusted EBITA margin of its core trading segment decreased from 38% to 35% between the second quarters of 2020 and 2021. The total adjusted EBITA margin remained stable at 27%, thanks to smaller losses in its non-profitable activities , but that act could easily fall apart in the near future.
Endless regulatory challenges
Meanwhile, a seemingly endless barrage of regulatory challenges in the US and China could make it even more difficult for Alibaba to keep growing.
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Last December, the US passed a law that would scrap foreign companies that failed to meet the new audit requirements for three consecutive years. Alibaba’s secondary listing in Hong Kong in late 2019 indicates that the days on the NYSE can be counted.
Taobao is also still blacklisted by the US Trade Representative “Notorious Markets for Counterfeiting and Piracy” due to the prevalence of counterfeit products on its platform. That reputation could lead to sanctions against its cross-border marketplaces.
In China, government regulators clearly want to keep Alibaba in check. In 2019, the government sent officials to dozens of companies, including Alibaba, to monitor their activities. Last year, the Central Committee of the Communist Party reinforced that grip by requiring all companies to hire a certain number of registered members of the CCP.
That tension finally boiled over last year when China brought down Alibaba. It derailed the highly anticipated IPO of its fintech subsidiary Ant Group, fined Alibaba for an unapproved acquisition, and launched a full antitrust investigation into its e-commerce business.
The regulators reportedly want Alibaba to end its exclusive deals with traders and limit its promotional pricing strategies, which could make it more difficult for its main profit engine to keep running. It would also expose Alibaba to more competition from JD.com (NASDAQ: JD) and Pinduoduo (NASDAQ: PDD) – both of which previously accused Alibaba of anti-competitive strategies.
3. Ethical considerations
In 2017, the Chinese government stated that the country would rely on Alibaba for the development of smart cities, Tencent (OTC: TCEHY) for digital healthcare, and Baidu (NASDAQ: BIDU) for self-driving cars.
The term ‘smart cities’ may seem vague, but collectively refers to Alibaba’s cloud services and facial recognition technologies. The Chinese government relies heavily on those technologies to monitor its citizens, and those technologies are closely linked to a government database.
That’s alarming, but Alibaba has recently shown how its technologies can be used to identify the faces of Uyghurs and other ethnic minorities across China. Alibaba claims the feature can be embedded in websites to monitor users for terrorism, pornography and other “red flags”.
China’s human rights situation is already bleak, and it is currently accused of detaining and sterilizing Uyghurs in re-education camps, so Alibaba’s troubling claims raise far too many ethical concerns. They could also make Alibaba an easy target for sanctions if the Biden administration maintains the Trump administration’s tougher stance against Chinese tech companies. As a result, I’m avoiding Alibaba for the same ethical reasons I recently sold Tencent: I’m just not interested in owning any part of China’s massive surveillance system.
The main takeaway
I understand why Alibaba still looks like an attractive stock buy to many investors, and it could certainly climb higher in the future. However, there are just too many regulatory, growth and ethical challenges for me to consider it a worthwhile long-term investment.