The stock market in China did not fall because of an economic slump, the COVID-19 pandemic, or anything else. They're also not down due to weak earnings—at least not in the most recent quarter. Instead, they're down due to the Chinese Communist Party's (CCP) crackdown on digital companies, which has many investors worried.
As you may be aware, the CCP is currently led by Xi Jinping, its most powerful leader in decades. He has been dubbed China's most powerful man since Mao and is famed for getting his way. Following his ascension to power, Jinping shook up the Chinese government to expand his control. He established working groups in which he served as the leader, and he made essential government bureaucracies directly accountable to him. The end consequence was a leader with an unrivaled capacity to achieve his goals.
Now fast forward to the present day. Xi Jinping is a man on a mission to resurrect and rebuild China. Moreover, he promotes the Belt and Road Initiative, a massive infrastructure project connecting Asia and the European Union. He is bolstering China's military. He's advocating the concept of the "Chinese Dream," a daring new vision for the next century in China. Overall, he is a forward-thinking leader with enormous intentions for his country.
China's tech billionaires appear to be excluded from Xi's goal. A speech by Alibaba's Jack Ma is said to have enraged Xi Jinping in 2020, prompting a full-scale attack on not just BABA but China's whole digital sector. Shortly after the speech, the government began implementing the policies that have sparked so much debate today, including penalties, app de-listings, and attempts to halt U.S. IPOs.
These measures are at the heart of much of the current debate around BABA. Everyone knows the company has a winning combination of growth and value, but the negative thesis is that China's regulatory crackdown will limit growth in the future.
It may. Chinese tech companies may grow more slowly in the future than they would have if Jack Ma hadn't spoken up. BABA's $2.8 billion penalties have already taken a toll on profits, and the CCP isn't finished enacting restrictions.
Nonetheless, the selloff that we've seen is unreasonable. BABA isn't suddenly valued 30 percent less because it will be subjected to regulatory scrutiny in the future. Its stock price is a typical illustration of Ben Graham's "Mr. Market" delivering a terrific business at a low price. As a result, in this essay, I'll present a bullish case for BABA, suggesting that its combination of growth and value is worth the political risk.
Competitive Landscape
Before I get into the meat of my argument, it's essential to understand the competitive environment of BABA. It's a Chinese eCommerce startup that mainly competes with JD.com (J.D.) and Pinduoduo (PDD). In specific ways, it competes with Amazon (AMZN) and eBay (EBAY) in the United States (EBAY). AliExpress, for example, provides lower-cost alternatives to things purchased on Amazon.com in the United States.
However, Alibaba's relationship with the U.S. eCommerce behemoths is more cooperative than competitive. It is a wholesaler of low-cost bulk goods to Western dropshippers that resell BABA-sourced items on eBay or Shopify (SHOP) stores. As a result, BABA enjoys a mainly amicable relationship with U.S. eCommerce enterprises as of today.
BABA is up against the stiff competition in the Chinese market. Alibaba and JD.com, for example, sell identical goods to similar clients in China. They are in direct competition in this regard. There's also Pinduoduo, an agricultural supply company giving BABA a run for its money in agricultural items.
Before I get into the meat of my argument, it's essential to understand the competitive environment of BABA. It's a Chinese eCommerce startup that mainly competes with JD.com (J.D.) and Pinduoduo (PDD). In specific ways, it competes with Amazon (AMZN) and eBay (EBAY) in the United States (EBAY). AliExpress, for example, provides lower-cost alternatives to things purchased on Amazon.com in the United States.
However, Alibaba's relationship with the U.S. eCommerce behemoths is more cooperative than competitive. It is a wholesaler of low-cost bulk goods to Western dropshippers that resell BABA-sourced items on eBay or Shopify (SHOP) stores. As a result, BABA enjoys a mainly amicable relationship with U.S. eCommerce enterprises as of today.
BABA is up against the stiff competition in the Chinese market. Alibaba and JD.com, for example, sell identical goods to similar clients in China. They are in direct competition in this regard. There's also Pinduoduo, an agricultural supply company giving BABA a run for its money in agricultural items.
Whether you're looking at revenue or profit, Alibaba's standing concerning its competitors varies. BABA has a higher profit margin than JD.com, although J.D. has a higher revenue margin. Both companies outperform Pinduoduo in terms of market share but lag in terms of revenue growth.
The CCP Crackdown
Alibaba is a leading eCommerce company in China, which is one of the world's fastest-growing major marketplaces, as we've seen. That appears to be a winning combination. So, why is the stock price falling?
Everything boils down to the CCP. This year, the CCP, led by Xi, initiated various actions against BABA and other similar enterprises. Some have already eaten into BABA's profits, while others are expected to do so in the future. Among the measures taken were:
- BABA was fined a whopping $2.8 billion.
- BABA and other comparable companies were hit with a smaller round of $75,000 fines.
- DiDi's (DIDI) apps have been delisted because they went public in the United States without the CCP's approval.
- Taking away Tencent's (OTCPK:TCEHY) exclusive music rights.
- VIEs, the legal mechanism used by BABA and others to sell stock in the West, are prohibited from being used by private tuition companies.
Investors have reason to be concerned. However, consider this:
- BABA was not subject to all of these actions (music rights, app de-listings, etc.).
- Only private tuition companies were subjected to the most severe penalties. It was a comprehensive set of reforms when seen as a whole.
The CCP's tech crackdown has a variety of effects on different types of businesses. Some of the actions adopted, such as the fines, had a negative influence on BABA. However, those are primarily in the past, and the CCP is currently not considering fining BABA again. Furthermore, this is a company with annual earnings of $22 billion; even a $2.8 billion punishment every year would not put the company out of business.
Recent Earnings
Let's take a look at BABA's most recent financial statements.
BABA reported the following in its most recent quarter:
- Revenue increased by 34% to $32 billion.
- Operating income was $4.8 billion, down 11%.
- Net income increased by 10% to $6.7 billion.
- $2.57 diluted EPS, up 12 percent.
- Operating income was $4.8 billion, down 11%.
- Net income increased by 10% to $6.7 billion.
- $2.57 diluted EPS, up 12 percent.
That's not awful at all. Because of extensive expenditures in subsidiaries, earnings did not expand as fast as revenue. Nonetheless, the quarter was one of solid growth, with EPS exceeding expectations.
Let's take a look at the entire year:
- Revenue increased by 41% to $109 billion.
- Operating income was $13.7 billion, down 2% from the previous year.
- Net income increased by 30% to $26.25 billion.
- Free cash flow increased by 32% to $26.35 billion.
These are impressive findings. Despite the anti-monopoly fine, BABA was nevertheless able to generate positive revenue, net income, and free cash flow growth.
What does this mean in today's world?
To be honest, these growth rates imply that BABA would be a dirt-cheap buy at today's pricing if the trend continues. Even in the event of a major deceleration, the same would be true.
- Operating income was $13.7 billion, down 2% from the previous year.
- Net income increased by 30% to $26.25 billion.
- Free cash flow increased by 32% to $26.35 billion.
These are impressive findings. Despite the anti-monopoly fine, BABA was nevertheless able to generate positive revenue, net income, and free cash flow growth.
What does this mean in today's world?
To be honest, these growth rates imply that BABA would be a dirt-cheap buy at today's pricing if the trend continues. Even in the event of a major deceleration, the same would be true.
BABA increased sales by 41% and adjusted profitability by 30% in the most recent fiscal year. This yields a fairly cautious growth projection of 20% annualized sales growth and 15% annualized profitability growth. Let's merely halve those values when estimating the future for the sake of caution and to allow for any deceleration. Assume the following:
- In just under four years, revenue doubles.
- In around five years, your earnings will have doubled.
BABA is presently trading at 3.84 times revenue and 16.42 times profits, according to Seeking Alpha Quant. If the stock price remained unchanged and the growth as mentioned earlier rates materialized, then:
- In five years, the P/E ratio would drop to 8.2.
- In four years, the price/sales ratio would drop to 1.92.
For high-growth tech equities, these are practically unheard-of, rock-bottom values. Even if BABA's growth were to slow significantly from here on out, the stock would quickly become an outstanding bargain at its current price. That's before you consider that BABA is planning a $15 billion stock repurchase program!
Risk & Challenges
As I've demonstrated in this post, Alibaba is a high-growth tech business with a bargain valuation. If political risk were not a factor, its stock would be a no-brainer purchase. However, political risk is present, implying that my theory faces substantial dangers and problems. These are some of them:
- Fines will be imposed indefinitely or will be increased. Alibaba could afford to pay a $2.8 billion fine every several years and be OK. But annual fines in the billions of dollars? Instead of $2.8 billion, how about a fine of $10 billion? In these cases, BABA is no longer such a fantastic deal. And the CCP appears to be hell-bent on bringing Chinese tech businesses to heel.
- Regulations that are cumbersome. So far, the CCP's I.T. crackdown has primarily come in the form of fines for BABA. There may be restrictions to consider in the future. Tencent's exclusive music rights have already been taken away, and tutoring companies are no longer allowed to use VIEs, according to the authorities. Will BABA's ability to operate be hampered by such regulations? Only time will tell, but it's a plausible scenario.
- VIEs are being phased out. The CCP is now investigating the mechanism that BABA utilizes to offer foreigners equity. Tutoring companies, in particular, were prohibited from employing it. And all businesses must directly obtain authorization from the CCP before proceeding. The CCP doesn't appear to enjoy VIEs—after all, they're illegal in China—and it may take even more challenging steps in the future than it has previously.
The Bottom Line
It's a rare occasion that Mr. Market presents us with a high-growth, high-margin firm at a bargain price. Investors have dumped BABA in droves, fearful of the CCP tech crackdown, bringing it down to multiples that would be unheard of for similar-sized U.S. I.T. businesses. Is the political risk that BABA is currently facing real? Yes. However, if this all blows over, the potential profit is enormous.
I'm also still holding my Alibaba stock position in my portfolio. As a matter of fact, I might want to increase my holdings when I receive my rental income and dividends. Hopefully, I can buy this great company at a further discount.
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