Summary
- Despite encouraging developments regarding share repurchases and auditing rules, BABA's primary challenges remain unaddressed.
- Growth headwinds are likely to persist in the short and medium terms, contradicting the growth-oriented shareholder base.
- Investors should expect high volatility this year.
The fundamental reason for owning these is exposure to the Chinese economy and the consumer. The growth rates inherent in these names are 20, 30, 40, 50, 55 percent annual growth; you can't get that anywhere else
Alibaba Group Holding Limited$Alibaba(09988)$ shares bounced on headlines of a possible US/China deal allowing US auditors more access to the company's data, assuaging delisting fears.
BABA management also expanded its share buyback program, a move often perceived as a vote of confidence on behalf of management.However, these developments don't address the primary challenge facing BABA.
I uncovered signs of growth headwinds buried under Alibaba's Sun Art acquisition, contrary to what topline growth implies. Sun Art's revenue is so huge that adjusting for the 19 additional days of revenue-consolidation in FQ3 2022 (December 2021 Quarter) above FQ3 2021 signals that BABA's revenue shrank organically.The temporary nature of the net income decline (74% drop) in FQ3 (more about this below) encouraged many investors to buy in the dip.
This would have been an ideal contrarian strategy, except that while the earnings decline is temporary, revenue challenges are not. BABA's core operations are transitioning from growth into a mature stage, making it harder to achieve growth, especially given the inability of its growth engines (such as Cloud) to compensate, given their small revenue base. The government crackdown on BABA's monopolistic practices permanently changed the IT competitive landscape, making it harder for BABA to maintain its artificially-inflated market share, historically protected by unfair abuse of its size.
Statements such as the one at this piece's opening signify a widening discrepancy between BABA's growth-oriented investor base and its new status as a maturing business.
Growth Strategy
BABA has historically attracted a growth-focused shareholder base. When this proposition goes away, so will its investors. Don't get me wrong: I am not saying that BABA has a faulty business model. On the contrary, e-commerce tech has scalable, lucrative, and cash-flow-positive operations. However, growth can't last forever, and BABA's core business is entering a mature stage of the business cycle.
Value-oriented shareholders will eventually replace current growth-focused investors, but the process will create volatility. Investor presentations still market BABA as a growth company. This makes it harder for the market to find an equilibrium that matches the mature fundamentals of BABA's business with the new investor base.The company is speculating on the three strategic initiatives outlined below:
- International growth
- Cloud
- Expansion into rural China
Last quarter, BABA reported an 18% growth in its international segment. This is not bad, except it comes from an extremely low revenue base in a big market. International operations constitute a mere 7% of total income, and no less than 50% - 100% is needed for the business line to make a meaningful difference. At the current growth pace, it will take a few years for Cloud business to contribute materially to topline revenue. At that time, BABA's growth-oriented investors would most likely lose patience, selling shares and further pushing the price downwards.
When BABA posted 10% growth last quarter, shares dropped, mirroring the high expectations of its growth-oriented shareholder base. BABA's 3-year average revenue growth is 42%. For BABA to even hit a 20% growth mark through the international segment, the division must grow by 100%, compared to 18% actual growth.
(Revenue - Nine months ended December is RMB 452,375 million * 0.2 = RMB 90475 million, compared to international segment revenue of RMB 46,743 million).
The company's low revenue base signal an unfavorable market position in the international market. China's consumer tastes prevented Amazon from penetrating the market. Similarly, global consumers seem to favor AMZN outside the Asian nation. Whether I'm right or wrong remains to be seen, but what is true today is that BABA's international commerce revenue is too small to have a meaningful impact, at least in the short and medium terms.
The same dynamics also apply to the Cloud business, which constitutes 8% of revenue. BABA's cloud computing business will likely be confined within China, given lax privacy regulation and culture within BABA itself. How many of us are comfortable saving family pictures on Chinese social media? I expect growth and adoption to be slower than that in the US and Western democracies, where privacy regulation encourages adoption. Still, Alibaba's cloud segment's strengths come from two elements:
- Cloud services are closed to foreign providers
- Alibaba has a natural advantage due to its experience managing its own cloud-based operations.
Currently, BABA's China Commerce active customers are 882 million. It seems that BABA's core segment is saturated. The total population in China is 1.4 billion, 260 million of whom are below 15. This might explain why rural-China expansion is now among its official strategic growth pillars. However, the purchasing power of this market segment is low, and I doubt it is the answer to the company's core operational and economic troubles. The revenue of Pinduoduo $Pinduoduo Inc.(PDD)$ , the e-commerce platform targeting rural China, gives a clue about the purchasing power of this market. Despite having about 800 million users, PDD's annual sales are a mere RMB 94 million, a fraction of BABA's 836 million TTM sales.
Share Buybacks
Last week, BABA expanded its share buyback program from $10 billion to $25 billion in an attempt to reassure investors of its prospects after shares slumped to a multi-year low of $86 per share. Historically, the company hasn't been consistent in implementing its share buybacks, and overall shares outstanding have increased, as shown in the graph below.This is the first time that the company has expanded its share buyback program, as far as I know, signaling a determination to execute a significant portion of the program's budget.The program is huge, but it does not guarantee share performance. Think Oracle, Intel, and International Business Machines Corporation , all of which have behemoth share buyback programs, but their shares have underperformed the market.
US Sanctions Embarrassing BABA
China opposes the US sanctions over Russia, putting BABA between a rock and a hard stone. If BABA withdraws its operations from Russia, it contradicts one of the pillars of growth - international market - especially given that revenue from Russia increased 46% in 2021. It also contradicts China's guidance, mirrored in the Chinese Ambassador's statements in Russia, encouraging Chinese companies to "fill the void" created by Western withdrawal. On the other hand, serving the Russian market increases the risk that the Chinese tech giant gets sanctioned by the US and its allies. These risks are real, especially given that all of BABA's partners in its Russian joint venture are on the US sanctions list and include three of Russia's oligarchs and the Russian Investment Fund.
Rising Competition
I don't believe that many investors appreciate the severity of the regulatory changes against BABA's monopolistic practices.
BABA was brutal against the competition, abusing the scale of its platform to coerce businesses into signing exclusivity agreements that prohibit them from selling their products on other platforms, such as JD.com $JD.com(JD)$ . Now that merchants have more autonomy, they'd be able to negotiate more favorable fees and be free to sell their goods on other platforms.Recently, JD and PDD added live streaming features on their platforms, and this marketing method is no longer a unique advantage of Alibaba.
BABA also isn't immune from the rising popularity of short-video platforms, including TikTok and Kuaishou, which have had a detrimental impact on BABA's ad revenue, and generally loosened its grip on China's e-commerce channels.Last quarter, BABA spent heavily to subsidize its merchants in an attempt to fight back against the renewed competition, allowing it to maintain sales at the expense of margins.
However, this strategy is not sustainable. Sooner or later, investors, and the company, must face a new reality.
Summary
Some notable investors are buying the dip in BABA's shares. Charlie Munger doubled his position and has long cited the tech giant's competitive advantage. In March, Kevin O'Leary went on CNBC touting BABA's growth prospects after buying the dip.
These examples mirror the fundamental flaw in what BABA can deliver and its shareholders expect.New anti-monopoly rules mean the competitive advantage touted by Mr. Munger is no longer valid. Last quarter, the behemoth spending on merchant subsidies shows how terrified BABA is from losing its artificially-inflated market share, blown by years of market abuse.
Mr. O'Leary's growth premise is also invalid, given the rising competition and BABA's maturing core segment. As mentioned in a previous article, excluding Sun Art's acquisition, BABA's top revenue declined for the first time in its history, as far as I know.
Its growth pillars are still too new to deliver meaningful change in BABA's fortunes.Thus, while I understand the potential of the long-term promise of BABA, I believe the best course is to proceed with caution, no leverage, and prepare for short and medium-term volatility.
Comments