Hu Chengwei/Getty Images News

Hu Chengwei/Getty Images News

It's been a rough few years for Alibaba (NYSE:BABA ). Between Trump Tariffs in 2019, a virus outbreak in 2020, a regulatory crackdown in 2021, and this year's Zero-COVID policy, the ticker, once considered the face of the Chinese stock market, lost its momentum, with shares down by 50% in the past twelve months.

Contrarian investors, tempted to capture potential mispricing, e.g., market overreaction, bought the dip, encouraged by the temporary nature of many (but not all) of these challenges. Shares were up 35% from 52-week lows before shedding half of the gains after a $375,000 fine, and a data leak probe renewed concerns over the tech giant's relationship with regulators.

Q1 (3 months ended June 2022) revenue will likely be the worst in the company's history, primarily due to COVID's impact on China Commerce during the past three months, but also due to the suspension of the merchant subsidy program that held up revenue against the anti-trust crackdown.

I don't believe that shareholders had a chance to objectively assess these challenges due to frictions in obtaining data and policy direction from China and the rapid progression of these events. Prominent billionaires continue touting the stock on mainstream media while shares continue shattering Wall Street's price guidance, mainly due to a failure to assess the impact of the new anti-trust laws, subsequently distorting retail investors' investment decisions and comprehension of BABA's new market position.

Shares will continue to demonstrate volatility throughout the year as shareholders adjust revenue expectations with the company's new economic realities created by anti-trust laws, notwithstanding the uncertainty stemming from the data breach and data security policy revamp. For this reason, I expect shares to go down before ending the year flat.

Q4 Revenue (three months ended March 2022) (BABA)

Q4 Revenue (three months ended March 2022) (BABA)

BABA's Q4 results confirmed our concerns (laid out in the previous articles) that the unit-trust crackdown constitutes a permanent and detrimental change in BABA's market position rather than what is widely perceived as a politically-motivated, fleeting reprimand with limited economic consequences, a proposition adopted by leading investment banks, including JPMorgan, and numerous prominent investors such as Kevin O'Leary and Charlie Munger, who went on touting the growth potential and market position of BABA on CNBC, not long before it reported 9% topline growth in Q4 (ended March 2022), the lowest in its history, highlighting a mismatch between the company's growth-oriented shareholder base and its new economic realities. This mismatch underpins our hold rating, despite BABA's moderate valuation, which in great measure remains a marginalized driver for share price movement.

Seeking Alpha Quant Score Rating

Seeking Alpha Quant Score Rating

It is doubtful that BABA will deliver on growth expectations, putting pressure on price, this year. The next quarter will likely be worse than Q4, and I won't be surprised if revenue shrank for the first time in the company's history, breaking another record in its spiraling slump.

BABA's core business segment, China Commerce, which represents 69% of revenue, faces multiple revenue headwinds, contributing to its modest 8% growth last quarter. As of March 2022, BABA served 903 million customers in China, out of a total population of 1400 million, 260 million of which are below the age of 15, signaling a maturing core market. I don't see the China Commerce segment growing much above GDP in the future.

One common mistake among shareholders is grouping "regulatory crackdown" into one category, but the fact is that different regulatory changes have a different impact on different segments. Anti-trust regulation had an immediate and permanent impact on BABA's core market competitive position. Data Security probes (both the Data Breach and the industry-wide Data Security policy revamp) have a smaller effect on short-term revenue trends, mainly shaping the nascent China Cloud market, where BABA is still building its market position, as mirrored in AliCloud's small contribution to total revenue.

Anti-trust crackdown loosened BABA's grip on China's e-commerce traffic. The new laws banned BABA from using its scale to push merchants to sign contracts that prohibited them from listing their products on other websites, nicking the product exclusivity that created a scale that allowed it to strike these deals in the first place. These dynamics are exacerbating an already competitive landscape composed of about 15 e-commerce companies with +$1 billion in revenue, all now having access to the same merchants that BABA has, including the new rising star Douyin (TikTok), which, unlike its US version, has an e-commerce feature allowing businesses to sell merchandise, directly competing with BABA.

Having lost product exclusivity, BABA resorted to price differentiation, subsidizing merchants via the Taobao Deals, explaining the 19% Adjusted EBITDA drop in Q4, which touches on our dim expectations for Q1 revenue as management winds down the program. Although these subsidies slowed traffic migration to peers, maintaining revenue, the program merely delayed the inevitable.

Management cited COVID for the company's modest performance during the Q4 (three months ended March) earnings call. Chinese authorities put the nation's major trade hubs under lockdown in March. A partial reopening since June and talks of an infrastructure spending bill offered a positive catalyst that pushed shares up 35% from their lows (albeit temporarily due to last week's fine and data breach probe). However, the bulk of the lockdowns' impact fell in the second calendar quarter, which wasn't captured in the latest earnings report, instead affecting BABA's Q1 fiscal period (three months ended June).

Yesterday's (Friday, July 15) GDP results for the three months ended June show 0.4% YoY change, the slowest rate in decades (excluding Q1 2020), tipping-off investors to roll up their sleeves before the company reports its Q1 results in August.

In response to these challenges, management created a growth strategy consisting of the following pillars:

As mentioned above, BABA already serves 80% of China's population above the age of 15, leaving little room to grow regardless of the demographics. China Commerce's performance will become increasingly aligned with general income levels, measured in GDP, which I believe has moderated to mid-single digits.

The company is seeking to enhance logistics efficiencies in remote areas, which might create a premium over GDP growth rates, but purchasing power remains an issue. For example, Pinduoduo (PDD), which targets rural China, records annual average revenue per customer "ARPC" of $21, a fraction of BABA's current ARPC.

AliCloud currently lacks the scale to compensate for BABA's core market challenges, limiting its role as a growth driver in the short and medium run, posing a small risk to our investment hypothesis, hold rating, and share price guidance. For example, its 15% growth contributed a mere 1.1% to topline growth in Q4.

The data breach adds product quality to the mix of concerns facing AliCloud. It coincides with an industry-wide data security crackdown, alienating cloud customers fearing that these challenges will brim over their operations, either through service disruption or worse, corruption or negligence charges, or whatever the communist party throws at them, a scary prospect in a country where state prosecution success rate is 99%. Last year, DiDi (OTCPK:DIDIY) offered to surrender its data processing operations to state-owned enterprises to appease regulators, mirroring the tension within the cloud industry. Fines and probes are not helping instill confidence in the sector, explaining why last week's $375 thousand fine created a $25 billion market cap loss.

The sector's rocky relationship with Chinese authorities pushed away the state-owned enterprises into building their private cloud, narrowing the market size. For these reasons, I believe that until tech companies and China regulators resolve data security issues, I don't expect a considerable contribution from AliCloud.

BABA hasn't been able to fully capitalize on its competitive advantage from its proximity to Chinese manufacturers. The international segment constitutes a mere 7% of total sales. Like AliCloud, the international segment lacks the scale to provide a meaningful growth driver in the short and medium run.

Wholesale represents two-thirds of BABA's international revenue, an interesting composition for a peer-to-peer e-commerce platform. The majority of retail activity centers in South East Asia, where BABA expanded through M&A, namely the Lazada acquisition in 2016. Retail investors remain alienated outside the South East Asia region for two reasons. First, the lack of distribution centers around the world prolongs delivery times. Second, privacy concerns drive away retail investors, especially in Western Countries influenced by political rhetoric. This mistrust is captured in Byte Dance's decision to reallocate its data processing operations from AliCloud to Oracle (ORCL) to ensure service continuity in North America. I can imagine a scenario where BABA does the same for its Aliexpress.com segment, reassuring international retail customers that their important data is safe on US servers. Still, for now, I don't see the international retail segment as a meaningful growth driver, at least with momentum to compensate for the China Commerce segment.

During Q4, BABA reported slower growth in its international segment compared to past periods for two reasons. First is the Russia/Ukraine war. Second, the new VAT regulations in Europe, which now charge VAT directly on Chinese imports, in an attempt to close Tax evasion from the rising online economy and retail trade. These dynamics mirror some of the challenges that are less foundational in nature, in my view, offering the basis of the majority of the contrarian bet on the ticker.

Many of BABA's challenges are temporary, driving a contrarian trade seeking to capitalize on potential market mispricing of its many challenges. However, I believe the market failed to properly assess challenges that matter, specifically those permanently impacting the market position of its core segment; China Commerce.

The newly-announced growth strategy suffers from multiple drawbacks, making it unlikely that the initiatives will succeed in offsetting softness in its core market. AliCloud and International segments are too small to provide a meaningful growth driver in the short and medium run (3 years horizon). Privacy issues alienate international retail customers from AliExpress, while the same concerns impact international business customers from AliCloud. In local markets, Chinese businesses remain concerned that BABA's rocky relationship with authorities might brim over their companies, alienating them from the AliCloud service.

The company already serves 80% of China's population above 15 years old, pointing to a mature market, and casting doubt over the effectiveness of the Rural China Expansion program.

This article was written by

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.