Alibaba is being sold for one reason right now, fear that the Chinese Communist Party's (CCP) policies will do "something". That "something" ranges from nationalizing large companies in China to banning profits and foreign investment to the more standard communist practices of wealth redistribution and an inefficient government bureaucracy amongst widespread corruption. Very few have sold BABA based on the company's operations or fundamental business metrics. In fact, one of the few bearish articles on BABA, and in hindsight one of the few correct ratings at the time, proposed that the stock had further to fall despite great fundamentals. I'll explain why there's upside in BABA's stock in an environment of fast-changing policy that sparked a panic-induced selloff in Chinese stocks.
With so much regulation and policy announcements made in rapid succession, it's easy to miss the implications of each individual action. Breaking the headlines down, and we'll see some good, some bad, and many cases in which the Chinese Communist Party is behaving just like the U.S. Government.
Chinese President Xi Jinping stated a need for "common prosperity" for China to become a "fully developed" country by 2049. This helped fan the speculative flames towards fears of corporate nationalization, but more likely, this statement suggests two things:
I draw the first conclusion because China already has a progressive tax system similar to the U.S., yet outside observers like the Council on Foreign Relations have suggested that China's tax system was extremely regressive at the bottom, with social insurance programs that lagged nearly all developed nations. In general, China lacks a property tax, inheritance tax or a capital gains tax, which feels like low-hanging fruit for the CCP. Likely uses of this tax revenue are welfare programs for the elderly and healthcare in rural areas.
I draw conclusion two from Tencent's immediate response that it would set aside $7.7 billion for a "common prosperity program", and the CCP's acknowledgement that it needed to leave room for people to get rich.
The suggestion that this is a precursor to widespread corporate nationalization runs contrary to recent history around state-owned enterprises (SOEs) "There were in total 110,000 industrial SOEs nationwide in 1996, and by the end of 2008, only 9,700 remained, which included large SOEs that had been partially privatized." The CCP only did this to prevent its banking system from collapsing and is well within Xi's living memory.
The $2+ trillion CARES Act authorized stimulus checks for people under a certain income threshold, yet no one declared then President Trump, or the U.S., as communist. On the tax front, the U.S. taxes capital gains, inheritance, income, and in most states, property. These taxes are used in part to fund Medicare, a welfare program for the elderly, and the fact that the CCP is suggesting China implement similar policies isn't so outrageous.
As for pointing the nationalization finger at China, we can't forget the history of nationalization in the U.S. From telephone operators in WWI to railroads in WWII, to financial institutions during the S&L crisis in the late 80s, Fannie and Freddie from the 2007 financial crisis, and a controlling interest in General Motors, the U.S. is no stranger to nationalization. To be clear, the risk is significantly greater in China, but the risk in the U.S. is far from zero.
The biggest headwind will be the expectation for Alibaba to make donations towards "common prosperity". Using Tencent's donation as a baseline ~$8 billion is significant for BABA with ~$23 billion of net income, although a large one-time payment is likely succeeded by much smaller annual contributions going forward. Such donations should also earn the company some goodwill, hopefully avoiding huge fines like the $2.8 billion it was hit with earlier this year.
When it comes to taxes, China already has a 25% corporate tax rate, between the U.S. current rate of 21% and the previous 35%. It may fluctuate as it does in the U.S., but higher rates incentivize avoidance loopholes. It may increase a bit going forward, but there are easier tax targets. The company will face a headwind from property taxes as they are likely implemented over the next decade, but the impact should be negligible for an eCommerce/tech focused company.
China placed strict regulations on China's private tutoring which banned profit in core education. I was caught by surprise, and while I didn't hold any Chinese education stocks I can sympathize for investors that were blind-sided by the ban. This action by the CCP appears to have three primary motivators:
The first is an unfortunate side-effect of an authoritarian one-party system and is one of China's biggest economic weaknesses and a long-term investment risk.
The second point isn't surprising given China's wealth gap, which is significantly wider than in the U.S. The third has an analogous counterpart in the U.S. in which teacher's unions lobby against private and charter schools to maintain their education monopoly.
The obvious fear is that if the CCP decides private tutoring companies can't earn a profit, which companies are next. The reality is that the CCP wants to reel in the tech sector, but China needs tech to meet the country's global goals. The tech regulation should focus squarely on the companies that can handle it, which means that Alibaba, along with Tencent, and to a lesser extent BIDU, JD, and PDD, are in the crosshairs. It is strange that investors sold off China's mid-cap companies like VIPS and MOMO, where the CCP is not worried about monopolistic power, but markets aren't always rational. The threat for a company like BABA is real, but don't expect the CCP to hit the company with anything that would jeopardize its ability to compete in the long term against its U.S. mega-cap tech counterparts.
Outside nationalization and banned profits, the biggest fear from foreign investors is China's financial decoupling from the rest of the world, which could make any currently held Chinese stocks worthless or significantly devalued. While there has been a flurry of regulation recently, the relationship between the U.S. and China was already tense during the Trump administration and hasn't changed much under Biden. There are three fears around financial decoupling that are weighing heavily on investors' minds:
I described what happens to a delisted company in a previous article, and for a company like Alibaba that's widely known to the investment community, the practical impact would be minimal with other methods available to trade the stock. Forced delisting fears stem from the U.S. which wants to be able to inspect the reports of the accounting companies that audit Chinese stocks. The Holding Foreign Companies Accountable Act (HFCAA) gives companies until 2024 to comply and Chinese regulators have supposedly already sent a proposal to the Biden administration to sort out the issue.
When it comes to the VIE structure, many of the companies caught in the regulatory crosshairs are listed in the U.S., and it feels like China might be making moves to restrict foreign investment. Andy Rothman of Matthews Asia paraphrased a Vice Chairman of the China Securities Regulatory Commission (CSRC) on a call with Chinese brokerages and stated that recent regulations were not an attempt to restrict foreign capital and that the variable interest entity (VIE) structure remains necessary and important to Chinese markets. It was Mr. Rothman's conclusion that the vice chairman was acknowledging that they didn't get the communication around this regulation right. The vice chairman's words may comfort some, but I need to see some action backing up those words. Fortunately, we got some action as the CSRC granted JPMorgan approval to take 100% control of its Chinese JV on the mainland up from 49%. This historic approval makes JPM the first foreign bank to receive this opportunity, but it is unlikely to be the last as Goldman Sachs, Morgan Stanley, and UBS appear close behind. With these actions, China has made it clear that it welcomes foreign investment and the VIE structure is an important part of that strategy.
Foreign ownership bans on Chinese stocks are primarily a risk for U.S. investors imposed by the U.S. government. This possibility worries me more than delisting or the VIE situation because we've actually seen bans imposed when the U.S. government makes the determination that a Chinese company is tied to China's military complex. Because the U.S. government makes the determination, it won't always be obvious which companies will be targeted next. Furthermore, the prohibitions take effect fairly quickly, meaning forced selling from a large portion of the market will lead to investor losses.
The issues created by the HFCAA are not difficult to resolve, and a delisting wouldn't prevent BABA from being traded, so the possibility of a forced delisting feels like more of an interesting headline than an actual concern. Recent commentary and actions by the CSRC help solidify the VIE structure that Alibaba utilizes as an important tool to maintain foreign investment. As an eCommerce company, there's distance between BABA and China's military, but we've seen an increasing trend of U.S. tech giants bidding on U.S. military contracts. BABA following suit would blur the line and make the company a target for a U.S. imposed ban. Furthermore, BABA's importance to the Chinese economy could be enough to make the company a target. For these reasons, I would be inclined to invest in a smaller Chinese company with a clearly non-military focus if it had fundamentals as good as Alibaba Group Holding Limited.
Down ~50% from all-time highs at the time of this writing, BABA's share price is certainly reflecting much of the regulation discussed above. Revenue grew 34% in the quarter, year-over-year (yoy) with its core commerce business growing 35% and cloud computing at 29%. Free cash flow in the quarter declined 43% yoy, from $5.7 billion to $3.2 billion. The partial settlement of a $2.8 billion fine cost $1.4 billion of cash in the quarter while capital expenditures and land acquisition consumed almost another $2 billion. The fine is unfortunate, but the heavy capital investment suggests BABA sees plenty of room for growth while still returning $1.1 billion to shareholders through share repurchases. While painful in the short term, Alibaba's depressed stock price means its share repurchase authorization delivers more bang for the buck, which should be a blessing for long-term shareholders.
Alibaba finished the quarter with $73 billion in cash, equivalents and short-term investments. Backing out goodwill, intangibles, and illiquid assets, BABA had $186 billion in assets vs. $92 billion in total liabilities. The combination of a strong balance sheet with billions of free cash flow generated each quarter means BABA is more than capable of making a Tencent-sized "common prosperity" donation with plenty left over for investment and growth.
With a market cap of around $479 billion, the company's operations are being valued at roughly $385 billion after subtracting net cash and liquid assets. With roughly $23 billion in net income, Alibaba is being valued at roughly 16.7x income, not at all expensive for a company growing revenue more than 30% while spending heavily on growth initiatives. Its U.S. counterparts are valued at 2-4 times this multiple with similar growth rates, although that's with a much higher penetration of profitable cloud computing, while BABA achieved these results largely through its commerce business. This means BABA still has a very clear and untapped growth runway that has become increasingly crowded and mature for its foreign counterparts. This needs to be offset by China specific risks as discussed above, and the fact that BABA still trades at a premium compared with other Chinese companies, particularly outside the mega-cap space. Given the growth, and solid balance sheet, BABA could easily command a 20x income valuation of $191/share, and still trade at a risk-adjusted discount to U.S. peers.
Cut in half from 52-week highs with no deterioration in underlying fundamentals, investors are clearly in a shoot first, ask questions later mode. That said, the true China stock believers haven't had their faith shaken by government policies and regulations. Ray Dalio penned a piece on LinkedIn warning investors not to "misinterpret these wiggles as changes in trends" suggesting the reactions to both Didi's listing and the education companies are being misdirected towards all Chinese companies. The team at Matthews Asia made the case in a presentation that recent regulations have not changed their view because the Chinese focus has never been stability, but rather quality of life improvements. I take these endorsements with a grain of salt because investment managers always talk their own book, but the insight that comes with experience is valuable.
Source: Yahoo Finance
Alibaba has collapsed through all the major moving averages, but there is support at $150/share, $140/share, and a final bastion at $130/share, before a collapse to major support in the $100-$120/share range. Unfortunately, the moving averages will provide resistance to the upside, and minor regulatory announcements are still sending Chinese companies into freefall. In the absence of a catalyst, I expect BABA's shares to be trapped between $130 and $200 for the remainder of the year. A major catalyst would likely have to take the form of serious containment of the Covid delta variant in China, coupled with an extraordinary show of good faith from the CCP to foreign investors. The first will take time, while the second may never come. At a certain point Chinese investors, who harbor much less fear towards their own government will step in to buy domestic stocks. At that point, momentum is likely to shift from fear of loss to FOMO for BABA and the broader Chinese market. With a little more than four months left in the year, I'm not betting on a significant rebound in 2021.
As stated earlier, Alibaba seems to be worth more than its current valuation, although there are plenty of Chinese companies that look even more undervalued. Companies under the mega-cap threshold like BIDU, JD, MOMO, BILI, etc. should face less regulatory scrutiny and generally trade at a larger discount to fair market value leading to a larger margin of safety for investors. The trend suggests BABA will continue heading lower in the near term before an oversold bounce and sideways consolidation. If you understand the risks associated with options and the strategy fits your risk tolerance, a position like a long-dated, bullish put spread could take advantage of historically high levels of volatility, while limiting downside and providing income during a volatile sideways consolidation. Ultimately, any price movement in the near term is a guess, and while I do believe BABA's stock is headed higher in the long term, there appear to be greater opportunities in China at the moment. If BABA hits $120/share, it becomes a much more compelling investment with an estimated intrinsic value closer to $191/share.
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Disclosure: I/we have a beneficial long position in the shares of BABA, JD, BIDU, MOMO, DIDI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.