Alibaba and the Forty Dips

If the first rule of Fight Club is that you do not talk about Fight Club, the first rule of doing business in China is that you do not talk about China’s shortcomings, lest you risk poking the bear that is the Chinese Communist Party (‘CCP’).

Jack Ma has spent the past 8 months learning this lesson, as Alibaba has been pulled from pillar to post by Chinese regulators, and the eCommerce giant’s share price along with it.

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The Context

On Oct 24th 2020, in an effort to hype up the Nov 5th IPO of his fintech company Ant Group, Ma told a group of investors:

“Banks today still hold a ‘pawnshop mentality’. It is impossible for the pawnshop mentality to support the financial demand of global development over the next 30 years. We must leverage our technological capabilities today and build a credit system based on big data to get rid of the pawnshop mentality. We can’t use yesterday’s methods to regulate the future.”

In China, where the CCP runs the banking system, the “pawnshop mentality” comment was viewed as a step too far from a government that had largely been lenient towards its tech industry.

On Nov 3rd, President Xi Jinping halted Ant Group’s $37bn listing on the Hong Kong and Shanghai exchanges. Regulators took issue with the fact that Ant Group, China’s biggest payments provider, was no longer just a marketplace that connected lenders and borrowers, but a financial services company whose foray into lending meant that it needed to be regulated as a bank.

Ant Group lent to customers through two products: Huabei, like a traditional credit card, and Jiebei, which are small unsecured loans made through its Alipay app. Customers would be directed towards these two products and sometimes Alipay would use Huabei to pay by default, even if the customer didn’t intend to buy on credit.

The lending products, which charge fees from partners including commercial banks, mutual fund managers, insurers and trust firms, contributed 63% to Ant’s revenues in the first half of 2020.

In a span of a year, Ant Group had originated loans worth hundreds of billions of dollars to more than 500 million people and held minimal risk in the process. In its prospectus, it revealed that it only held 2% of its outstanding consumer loan balance. 88% was lent directly by banking partners and 10% was securitised.

It’s clear why the CCP raised concerns. If Ant Group bore minimal risk of default, then it would aim to issue as many loans as possible, with little regard to the effect they might have on the lending institutions that underwrite them, and no regulations to adhere to.

The Fallout

Since regulators stepped in, Ant Group has applied to become a regulated financial holding company and has committed to return to focus more on its platform origins. Additionally, Alibaba was fined $2.8bn after an anti-trust probe found that it abused its market dominance by restricting merchants from doing business or running promotions on rival platforms.

The new rules that Ant Group will have to follow include:

  • Funding 30% of the loans they offer in partnership with banks, and
  • Capping the amount of capital that their bank partners can lend

The suspended IPO and the new demands are estimated to have dropped Ant Group’s valuation from a peak of $315bn pre-listing to just $144bn, according to a recent assessment by Fidelity.

Alibaba, which owns 33% of Ant Group and was set to benefit immensely from its record-breaking IPO, has seen its share price decline 32% to $213 from an Oct 27th high of $317, losing $278bn of its market cap in the process. Even a strong set of Q1 results, in which revenue rose 64% year-on-year and EBITDA grew 18%, couldn’t halt the decline.

So, with an uncertain IPO blowing in the wind and a regulatory environment that seems to be tightening, what does the future look like for Alibaba and its investors?

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The Outlook

It’s important to note that Alibaba is still an incredibly robust business with a future that doesn’t rely on whether Ant Group follows through on its IPO.

Alibaba is the world’s largest eCommerce business by Gross Merchandise Value (‘GMV’), facilitating $1.2 trillion in transactions in the year ended March 2021, and collecting $109bn in revenue. For comparison, Amazon *only* processed $500bn in GMV in 2020. Additionally, Alibaba’s annual active customers recently reached a milestone of over 1 billion, with 240 million of those customers outside of China.

Its vertically integrated operations are its biggest strength, with the Alibaba Group divisions ranging from retail marketplaces to logistics to digital media and entertainment.

Ecommerce comprises 71% of its revenue, and the remaining 29% of revenue coming from cloud computing (8%), wholesale (4%), logistics (5%), local consumer services (5%), digital media and entertainment (4%) and innovation initiatives and others (3%).

Like Amazon, Alibaba’s biggest opportunity currently rests in its cloud computing division. Alibaba has recently been content to operate Alibaba Cloud at a loss to gain market share, but it reported a positive EBITDA margin (2%) for the first time, along with growing its revenue in Q1 by 37% y-o-y which is faster than Amazon Web Services (AWS) with 32% Q1 growth, albeit from a position of market leadership.

AWS currently runs at an operating margin of 30%. If Alibaba can manage to grow the profitability of its cloud computing division similarly and continue to improve its eCommerce EBITDA margins (19% in Q1), then its current price/earnings ratio of 26x could be an attractive buy, especially when compared to Amazon’s 61x.

Ultimately, much of its recent share price decline can be attributed to the political and regulatory environment in China. While the Chinese economy is growing rapidly, and consumer spending along with it, the CCP’s renewed focus on monopoly practices will be a cloud over Alibaba’s growth for quite a while.

Competition is also heating up, which, while it won’t assist with Alibaba’s bottom line, it will help it on the monopoly front.

Pinduoduo has emerged as an interesting, but still much smaller competitor:

  • It grew revenue 239% in Q1, to $3.4bn (vs. $109bn at Alibaba)
  • It grew monthly active users by 49%, reaching 724.6 million customers

Pinduoduo remains unprofitable, reporting a loss of $444 million, but that’s mostly due to its sales and marketing expenses comprising 75% of revenue.

For investors, they’ll have to decide how many battles they’re willing to weather. The anti-monopoly fine and restructuring of Ant Group may mark the end of Alibaba’s problems (and a future listing for IPO) but the possibility of disruption from new competitors is always a risk.

One thing is certain though: investors will be hoping Jack Ma keeps his speeches concise from now onwards.

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