Why Is Alibaba Stock so Cheap?
A closer look at Alibaba's cheapness
Alibaba is a $300 stock. Amazon + PayPal of China and cheap. China risk overblown. Government doesn’t want to destroy their national champions. Also Munger bought it.
- John, first time BABA shareholder
From the end of 2020, Alibaba’s stock has seen a dramatic rise in interest among investors and the general public following the halting of the Ant Group IPO, headlines surrounding Alibaba co-founder Jack Ma, and Charlie Munger’s purchase of BABA. Many like to point out the massive scale of Alibaba, with commonly cited anecdotes including:
Alibaba’s GMV compared to Amazon
Alibaba Single’s Day numbers compared to Black Friday
Alipay’s transactions compared to PayPal
However, instead of focusing on the scale of Alibaba and the potential upside for its stock, we’ll go over 3 reasons that have led the stock to becoming so cheap in the eyes of many investors, which include:
Regulation
Fund flows
Competition
1. Regulation
In 2020 and 2021, Alibaba faced government regulation regarding its credit lending and e-commerce businesses. This regulation appeared to spark fear in a large number of investors, placing significant downwards pressure on Alibaba’s stock price.
However, other regulatory events outside of Alibaba have also seemed to have a negative effect on Alibaba’s stock, which include the cybersecurity regulation of ride-sharing giant Didi, platform exclusivity regulation of Tencent, and regulation of edtech companies. These events have led to increased discussion and uncertainty regarding Alibaba’s stock and its investability.
Narrative vs Price
This is where it’s important to distinguish between narrative and price. Most investors follow the idea that price follows narrative, when in reality narrative can also follow price. For example, with Alibaba’s two major regulatory events regarding its payments and e-commerce business, the narrative was that these events led to a sell-off in the stock once the information was publicly released. However, since Alibaba’s stock has continued to fall, along with multiple waves of regulatory headlines, a narrative has been rising regarding Alibaba’s variable interest entity (VIE) structure, and the investability of companies like Alibaba. In this instance, it appears that price is driving narrative, with Alibaba’s downwards stock price performance leading to the resurgence of the VIE risk narrative.
What is the VIE Structure?
The VIE structure is a complex legal structure that allows foreign investors to invest in certain international companies like Alibaba. Rather than owning the underlying assets, for example, the Alibaba company itself, investors instead own a contract that represents ownership of the assets. Without actually owning the underlying asset, shareholders can be potentially taken advantage of.
This was seen in the situation with Alipay and Yahoo back in 2011, where Yahoo lost control of one of Alibaba’s most valuable assets, Alipay, despite Yahoo being a significant shareholder of Alibaba.
However, the VIE structure risk is nothing new, with investors expressing their concerns with this structure since its use in early 2000. Every so often, this risk resurfaces in discussion, usually along with the following phrases:
China is uninvestable.
You don’t actually own anything when you buy BABA.
While the VIE structure increases the probability of significant downside, this risk is somewhat reflected in Alibaba’s share price, contributing to the stock’s cheapness.
2. Fund Flows
The VIE structure along with other risks have always deterred a portion of investors from ever investing in companies like Alibaba. This leads us to the second reason for the cheapness of Alibaba’s stock: fund flows and liquidity. Certain funds, despite noting positive fundamentals from Alibaba, purposefully restrain themselves from investing in the company. With flows artificially limited from a number of funds, this likely contributes to a discount in the share price.
The sharp selloff following the regulation of the edtech industry also had an effect on fund flows. After regulatory constraints were placed on edtech companies’ operations and their relationships with the capital markets, their stocks plummeted, with some dropping 70% in a single day. This selloff likely led to forced liquidation and degrossing among levered investors who had high exposure to the industry, along with the broader China tech sector.
Meanwhile, long-only investors, including mutual funds and pension funds, also reduced their exposure to the sector for risk management purposes. As a result, the dramatic selloff in edtech dragged down other stocks such as Alibaba as a consequence of fund outflows from the overall sector.
Career Risk
Another major factor to consider regarding the outflows of Alibaba is the career risk of institutional managers and analysts. Allocating money to companies like Alibaba would potentially bring significant career risk, given the heightened concerns about the sector. If that analyst or portfolio manager were wrong about Alibaba and the sector, and their stocks were to decline further, they could be potentially fired from their job.
Investment professionals are less likely to be criticized for hugging their benchmark indexes and overweighting “safe” US tech stocks like FAAMG compared to actively allocating money to “risky” China tech stocks like Alibaba. As a result, to avoid this career risk, a number of funds have significantly reduced their exposure or completely liquidated their holdings in Alibaba.
3. Competition
While many investors have been focused on regulation and flows, the third reason for Alibaba’s negative stock performance appears to be less discussed, which is increasing competition. Alibaba competes in a variety of industries, which includes e-commerce, cloud computing, and digital media. Alibaba faces intense competition in all of these, which include not just major e-commerce competitors such as JD.com and Pinduoduo, but many more including Tencent’s WeChat Mini Programs, ByteDance, and Meituan.
In order to drive future growth and face competition, Alibaba has started, invested, and acquired a large number of new businesses, which have helped the company expand into new markets. To fund these new businesses, Alibaba uses the positive cash flow from its flagship marketplaces Taobao and Tmall. Many of these new businesses are not only not as profitable as its main marketplace business, but are unprofitable and require significant recurring investment due to fierce competition.
Reinvestment and Capital Allocation
In early 2021, Alibaba’s management announced that they planned to reinvest all additional profits back into their business in the 2022 fiscal year. This means that Alibaba will likely report flat or low earnings growth, which has weighed down on the company’s stock price. A large portion of this reinvestment is being allocated towards Alibaba’s discount e-commerce platform, Taobao Deals, as well as community group buying. Alibaba is also ramping up investments into its other businesses beyond commerce, such as food delivery.
Some investors are concerned that these investments are destroying shareholder value, with Alibaba’s investments having low or negative return on invested capital (ROIC).
Looking at Alibaba’s capital allocation track record, there are a number of investments that have struggled, including Youku Tudou, Ele.me, Suning, Lazada, and more. What these investments have in common is that all of them face high competition, lack profitability, and are losing market share to the leaders in their industries.
Taobao Deals and Group Buying
When it comes to Alibaba’s main commerce business, there are reasons why investors may be concerned about its ROIC as well. For example, Alibaba’s investment into Taobao Deals and community group buying is part of a larger effort to compete against e-commerce giant Pinduoduo, which actually surpassed Alibaba in annual active buyers in early 2021.
That said, Pinduoduo has remained unprofitable ever since its public listing, and has experienced significant negative cash flow in order to subsidize prices on their platform. To compete against Pinduoduo, competing on price is key, and Alibaba will need to subsidize prices on their platform as well. As a result, as with many platform business models, the situation appears to be a winner take most scenario. Until then, both platforms could see significant losses until one rises as the clear winner in this business segment.
With businesses such as Youku Tudou, Ele.me, Taobao Deals and community group buying expected to produce negative cash flow for the foreseeable future due to competition, some shareholders have taken a negative view on Alibaba’s capital allocation efforts.
SOTP Valuation
When it comes to valuing conglomerates like Alibaba, many in the investment community (especially the sell-side) like to use a sum-of-the-parts (SOTP) valuation. For Alibaba’s profitable businesses like Taobao, investors usually apply a forward earnings or cash flow multiple to the business.
Meanwhile, for Alibaba’s unprofitable businesses like food delivery or digital media, since no earnings or cash flow exist yet, investors like to apply a forward sales multiple to these businesses. Let’s take a look at a rough SOTP valuation for Alibaba’s stock.
Starting with Alibaba’s core marketplace business, a 20x earnings multiple was applied to reflect the segment’s margin profile, durability, and growth. For the rest of the segments, a range of sales multiples based on comps were applied due to low or nonexistent earnings. For Alibaba’s investments, a 40% holding discount was applied to the book value of the investments to take into account illiquidity and tax considerations. Finally, net cash was added. In total, this results in an estimated SOTP valuation of $818B, or $300 per share (ADR).
However, if Alibaba’s new businesses and investments are expected to generate low or even negative ROIC, it could be argued that these businesses should be ascribed not just zero value, but negative value in a SOTP. If this is the case, then many of Alibaba’s unprofitable businesses would drag down Alibaba’s stock. Meanwhile, declining ROIC for Alibaba’s marketplace and headwinds for cloud may warrant lower valuations.
For example, after hypothetically ascribing negative value for Alibaba’s unprofitable businesses, no value to Alibaba’s investments, and lower value for Alibaba’s core marketplace and cloud business, we arrive at the market price of $195 per share.
Final Takeaways
With multiple catalysts ahead, including potential positive earnings revisions and a public listing of Ant Group, Alibaba’s stock has much to look forward to. However, the key factors that will likely contribute to an increase in Alibaba’s stock price over time include 1) decreasing headline risk, 2) fund inflows from institutions, and 3) demonstrated resilience against competition.
Subscribe to stay updated on new posts on business, investing, and Asia.