Alibaba: Beijing Steps In

Summary

• China’s crackdown against its tech firms is not over yet.
• As Beijing becomes a direct competitor to Alibaba, it will become extremely hard for the tech giant to successfully compete with the state.
• As more key risks materialize, it becomes harder to justify a long-term long position in Alibaba.

Lintao Zhang/Getty Images Entertainment

The biggest mistake of Alibaba (NYSE:BABA) bulls is to think that Beijing's crackdown against the company is over and the stock is significantly undervalued at the current levels. The problem with this thinking is that it ignores the shift in policymaking by the CPC that has taken place in the recent year, which makes the use of traditional valuation metrics to justify a long-term long position in the company relatively useless at this point. As Beijing strengthens its grip over entire industries and becomes a direct competitor to the country's tech behemoths, it's hard to see how Alibaba and its peers will be able to successfully compete with the state in the foreseeable future.

With each passing quarter, more key risks start to materialize and negatively affect Alibaba's business, which is reflected in a massive depreciation of its shares in the last year. While in my latest article on the company I highlighted how the CPC will compete with Alibaba's Ant Group directly via the launch of digital yuan, in this article I will highlight how the new regulations by the state will make it even riskier to hold the company's stock for the long-term.

Beijing Is Becoming A Direct Competitor Of Alibaba

In addition to becoming a direct competitor in the digital payment space, China is also becoming a direct competitor of Alibaba in the cloud and data fields as well. The cloud business itself is an important part of Alibaba, as it's one of the few fast-growing parts of the company, which is able to offset the slow growth of other sources of income. Alibaba's latest Q2 earnings report showed that while revenues of its core customer management business increased by only 3% Y/Y to $11.13 billion, revenues of its cloud computing business increased by 33% Y/Y to $3.1 billion and accounted for 10% of the overall revenues. The growth of the cloud computing business is attributed mainly to increased demand for cloud services within the mainland, and as China digitizes its economy, it's safe to say that demand will remain high in the following years.

The problem is that as Alibaba grows its cloud business, China itself slowly becomes a major player in the cloud computing field as well. Just last August, the government has ordered all state firms to migrate their data from private cloud providers to a state-backed cloud service by the end of September 2022 and at the same time prohibited them from signing new cloud contracts with third parties such as Alibaba. Then in September, reports started to surface that the country's state-run China Electronics Corp. is entering the cloud business as well. In addition to the state support, the biggest advantage of China Electronics Corp. is that it has everything going for it to compete with China's tech behemoths. The company uses the chips of its subsidiary Tianjin Phytium Information Technology Co. to power its data centers and operates them through the Kylin OS, which has been developed by the National University of Defense Technology.

Given the fact that Alibaba continues to be the biggest provider of cloud solutions in China, even though its market share has decreased by a couple of percent Y/Y in the latest quarter, the company stands to lose the most from Beijing's intervention in the business. Right before Christmas of 2021, the news came out that China's Ministry of Industry and Information Technology halted its cloud partnership with Alibaba over safety concerns and there's little possibility that it will be resumed given the shift in state policy. As a result, as investors are waiting for Alibaba to report its Q3 earnings results, there's a risk that the growth of the cloud business might disappoint many in the quarters to come since the events of the last year showed that Alibaba can't successfully compete with Beijing. At the same time, the inability to work with governmental agencies is also likely going to negatively affect its financials in the coming years.

More Regulations On The Way

In addition to competing in the same businesses, Beijing is also constantly imposing new rules that make it harder for Alibaba and its tech peers to keep their competitive advantages for long. While most of the bullish investors have been forecasting Alibaba's Q3 results in recent weeks, Beijing adopted a new set of regulations that go beyond Q3 and could have an even greater negative effect on Alibaba's financials in the long run.

Before highlighting those regulations, it's important to understand why they matter in the first place by looking at how Alibaba is structured. While the company positions itself as an eCommerce company, a significant amount of its revenues is generated by providing digital advertising services. In fact, with a 29% market share in 2021, Alibaba is the biggest player in China's digital advertising market. The problem is that Alibaba's advertising revenues are consolidated within the commerce business, which accounts for 85% of all revenues, so it's impossible to know how much exactly is the company making from providing advertising and marketing services to its merchants.

However, we do know that the major revenue source within Alibaba's advertising business is Alimama. Thanks to its proprietary algorithms, Alimama collects and analyzes thousands of entry points of users such as behavioral data, engagement, and others within the Alibaba ecosystem to help merchants efficiently spend their advertising budgets and increase conversions. In its 2014 S-1 filing, Alibaba described Alimama as follows:

Alimama operates a cluster of servers that is capable of analyzing terabytes of data points for the modeling of tens of billions online advertising impressions. With rich consumer data generated from our China retail marketplaces, we utilize our proprietary algorithms to evaluate the quality of advertising inventory from thousands of publishers and make predictions of click through rates and conversion rates of online marketing messages. This capability enables sellers to improve consumer targeting efficiency and enhance the return on investments for online marketers.

The problem is that Alibaba is not frequently mentioning Alimama to foreign investors and its website itself is available in Chinese only. As a result, it makes it hard to analyze Alibaba's overall advertising business. However, a few years ago Alibaba's CFO Maggie Wu publicly said that over 60% of the company's overall revenues are generated by Alimama. Considering this, it's safe to say that any disruption to Alimama's business could negatively affect Alibaba's overall performance. What's worse is that given the recent developments, it seems that's exactly what's about to happen.

Just last month Beijing announced that it is about to regulate the use of algorithms, similar to the ones that Alimama uses, to strengthen its grip over the digital economy. Those new regulations could be catastrophic for Alibaba's business. First of all, companies will now be required to give users the ability to opt-out from being targeted by the algorithms, and at the same time give the option to delete all the tags that those algorithms attributed to those users, which could make the use of Alibaba's advertising services less effective for merchants. In addition, new rules, which will come into effect on March 1, also state that companies should change their algorithms so that users don't engage in excessive spending or develop an addiction to the platforms.

In addition, given the fact that China's cybersecurity administration has the ability to oversee the implementation of new data laws that were implemented last year, it's safe to assume that with the passage of new rules it will have the option to inspect the algorithms that Alibaba and its peers use as well. The problem with this is that due to the inefficient law system, regulators in China have the option to interpret laws at their discretion, which could lead to more crackdowns in the future.

While some investors could think that new rules are not a big deal, we should look at how Meta Platforms (FB) suffered from Apple's (AAPL) decision to give people the choice to opt-out from being targeted via the app tracking transparency program. As the majority of iPhone users decided not to be tracked by advertisers, Meta's advertising tools became less effective for advertisers, and the company now expects to receive $10 billion less in revenues due to those changes.

Given the fact that Alimama's algorithms help merchants drive sales and encourage them to spend more on its advertising and marketing solutions, a change of algorithms could disrupt Alibaba's whole business, making its stock even less attractive for investors. While we'll likely see a minimal impact of new rules in Q4, as they'll be implemented only in March, it's safe to assume that Alibaba could be financially hit by them in FY23 and beyond.

The Bottom Line

Beijing has greatly weakened Alibaba in the last year and there's no reason to believe that the crackdown is over. With each passing quarter, new key risks materialize, which make it significantly harder to justify a long-term long position in the business. The company has already suffered from the new tax policy, which worsened its bottom-line performance in Q2, and is currently being disrupted in the digital payment space via the introduction of the digital yuan. In addition, new cloud and algorithm rules make Beijing a direct competitor of Alibaba, while at the same time giving the state more oversight over China's tech behemoths.

Due to this, big investors continue to flee from Alibaba, and in the last six quarters, the institutional capital outflow has exceeded the capital inflow, which signals that one of China's biggest tech conglomerates is not as attractive to investors as before. For that reason, I continue to believe that Alibaba's stock is not a solid long-term investment as long as Beijing continues to pull the strings and call all the shots.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.