I once considered Alibaba (NYSE: BABA) an undervalued growth stock. It is still trading at just 21 times the future profit, and analysts expect its revenue and profit to increase 50% and 37%, respectively, this year. And its market leadership positions in China’s e-commerce and cloud markets also guarantee the scale to easily crush its smaller rivals.
But after carefully reviewing Alibaba again, I believe I will never buy this seemingly attractive Chinese technology stock for three simple reasons.
1. Your growing dependence on lower margin businesses
Alibaba resembles an inverted version of Amazon (NASDAQ: AMZN). While Amazon subsidizes the growth of its low-margin retail segment with its high-margin cloud businesses, Alibaba subsidizes the growth of its non-profit businesses (including its cloud division) with its “core trade” revenue higher.
Image source: Getty Images.
Therefore, Alibaba’s future earnings growth depends heavily on its core trade segment, which includes its online markets, international markets, physical stores and Cainiao logistics unit.
Alibaba’s main trading business is still growing at a healthy pace. Its primary trade revenue increased 35% in fiscal 2020, which ended last March, and accounted for 86% of its revenue. Segment revenue increased another 32% year-over-year in the first fiscal half of 2021.
However, it is also relying more heavily on its “New Retail” business (including its physical stores), its international wholesale segment and Cainiao to drive its growth. All of these companies generate lower margin revenue than their main markets Taobao and Tmall, which charge merchants fees and commissions.
That is why the adjusted EBITA margin of its main trade segment fell from 38% to 35% between the second quarters of 2020 and 2021. Its total adjusted EBITA margin remained stable at 27%, thanks to smaller losses in its non-business profitable, but that balancing act can easily collapse in the near future.
2. Endless regulatory challenges
Meanwhile, a seemingly endless barrier of regulatory challenges in the US and China could make it even more difficult for Alibaba to continue to grow.
Image source: Getty Images.
Last December, the United States passed a law that would remove the list of any foreign companies that did not meet the new audit requirements for three consecutive years. Alibaba’s secondary listing in Hong Kong at the end of 2019 indicates that its NYSE days may be numbered.
Taobao also remains on the US Trade Representative’s “Notorious markets for counterfeiting and piracy” due to the prevalence of counterfeit products on its platform. This reputation can lead to sanctions against its international markets.
In China, government regulators clearly want to control Alibaba. In 2019, the government sent employees to work at dozens of companies, including Alibaba, to oversee its operations. Last year, the Central Committee of the Communist Party tightened this control by requiring all companies to hire a certain number of registered members of the CCP.
That tension finally spilled over last year, when China hit Alibaba hard. This derailed the long-awaited IPO of its fintech affiliate, Ant Group, fined Alibaba for an unapproved acquisition and launched a full antitrust investigation into its e-commerce operations.
Regulators want Alibaba to end its exclusive deals with traders and restrict its promotional pricing strategies, which could make it difficult to maintain its primary profit engine. It would also leave Alibaba more exposed to competition from JD.com (NASDAQ: JD) and Pinduoduo (NASDAQ: PDD) – that both previously accused Alibaba of anti-competitive strategies.
3. Ethical considerations
In 2017, the Chinese government declared that the country would depend on Alibaba for the development of smart cities, Tencent (OTC: TCEHY) for digital health and Baidu (NASDAQ: BIDU) for driverless cars.
The term “smart cities” may seem vague, but it refers collectively to Alibaba’s cloud services and facial recognition technologies. The Chinese government relies heavily on these technologies to monitor its citizens, and these technologies are heavily tied to a government database.
This is already worrying, but Alibaba recently demonstrated how its technologies can be used to identify the faces of Uighurs and other ethnic minorities in China. Alibaba says the feature can be incorporated into websites to monitor users for terrorism, pornography and other “red flags”.
China’s human rights record is already bleak, and it is currently accused of imprisoning and sterilizing Uighurs in re-education camps, so Alibaba’s disturbing statements raise many ethical concerns. They can also make Alibaba an easy target for sanctions if the Biden government maintains the Trump administration’s toughest stance against Chinese technology companies. As a result, I am avoiding Alibaba for the same ethical reasons that I recently sold to Tencent: I am simply not interested in owning a part of China’s mass surveillance system.
The main lesson
I understand why Alibaba still looks like an attractive stock buy to many investors, and it could certainly rise further in the future. However, there are simply too many regulatory, growth-related and ethical challenges ahead to consider them a worthy long-term investment.