Alibaba Group (BABA 2.96%) and Tencent (TCEHY 3.44%) are two of China's top tech companies. Alibaba is China's largest e-commerce and cloud services company, while Tencent is a market leader in the social networking, advertising, gaming, streaming media, cloud, and fintech markets.
I compared these two stocks last August, and claimed Tencent's better diversified business, higher operating margins, and stronger earnings growth made it a better buy than Alibaba. But back when I made that call, I hadn't expected China to launch a sweeping crackdown on its top tech companies.
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Over the past 12 months, Alibaba's stock has declined 22% as Tencent's stock has slipped 7%. Alibaba was hit by an antitrust probe, a record $2.75 billion fine, new restrictions on its e-commerce business, and the suspension of the long-awaited IPO for its fintech affiliate Ant Group.
China's regulators also blocked Tencent's planned merger of Huya and DouYu, which would have created the country's top esports streaming platform; temporarily suspended new user registrations for WeChat; and forced Tencent Music to give up all of its exclusive music licensing rights.
Those headwinds, along with the ongoing threats to delist shares of U.S.-listed Chinese companies, likely caused many investors to sell all their Chinese stocks. That might be a prudent move, but some contrarian investors might be willing to take a chance on these two tech giants while the market is looking the other way. Let's see which stock has a better shot at recovering.
Alibaba is losing its momentum
Alibaba generates most of its revenue and all of its profits from its core commerce business, which includes its online marketplaces, brick-and-mortar stores, and Cainiao logistics subsidiary.
Alibaba's core commerce business supports the growth of its cloud, digital media and entertainment, and innovation initiatives businesses. All three of those smaller businesses are unprofitable by GAAP measures, but Alibaba Cloud's adjusted EBITA turned positive over the past three quarters.
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Alibaba's revenue rose 41% to 717.3 billion yuan ($109.5 billion) in fiscal 2021, which ended in March. Its commerce revenue rose 42%, buoyed by the expansion of its lower-margin brick-and-mortar and direct sales segments, while its cloud revenue increased 50%.
However, Alibaba's higher dependence on its lower-margin commerce businesses -- along with its antitrust fine in the fourth quarter -- caused its operating income to dip 2%. But its adjusted earnings, which exclude that fine and its stock-based compensation, still increased 23%.
In the first quarter of fiscal 2022, Alibaba's revenue rose 34% year over year to 205.7 billion yuan ($31.9 million). Its commerce revenue grew 35% year over year, but its cloud revenue rose just 29% against a tough comparison to elevated usage rates during the pandemic.
Alibaba's growing dependence on lower-margin businesses to boost its commerce revenue, the ongoing losses at its three smaller businesses, and other investments reduced its operating income by 11%. However, its adjusted earnings still increased 12% as it repurchased more shares.
Tencent also faces unpredictable challenges
Tencent's revenue rose 28% to 482.1 billion yuan ($73.9 billion) in 2020. Its three core businesses -- VAS (valued-added services, including in-game and in-app payments), online advertising, and fintech & business services (including Tencent Cloud and WeChat Pay) -- grew at double-digit rates.
Tencent's adjusted operating profit rose 30% as its adjusted earnings -- which exclude its investment-related gains and losses -- also rose 30%.
In the first quarter of 2021, Tencent's revenue increased 25% year over year to 135.3 billion yuan ($20.6 billion), with double-digit growth across all three of its core segments again, as its adjusted operating profit rose 20% and its adjusted earnings increased 22%.
Those growth rates look solid, but Tencent's gaming business experienced a slowdown during the quarter as it faced tougher post-pandemic comparisons. Tencent still generated nearly a third of its revenue from its video games, which include Honor of Kings and Peacekeeper Elite.
That's why the recent buzz about another potential crackdown on video games in China -- which originated from a retracted Xinhua article that originally called games "digital opium" -- weighed down the stock. Its other unresolved challenges regarding Tencent Music, WeChat, and WeChat Pay -- which the government wants to tightly regulate alongside Ant's Alipay -- have also largely overshadowed the robust growth of its core businesses.
The valuations and verdict
Analysts expect Alibaba's revenue to rise 30% this year, but for its earnings to dip 4% as it relies more heavily on lower-margin retail businesses and ramps up its investments. They expect Tencent's revenue to rise 22% and 21%, respectively, this year, as its three core businesses keep expanding.
Alibaba's stock trades at just 20 times forward earnings, while Tencent has a forward P/E ratio of 26. Those valuations look historically cheap for both companies -- but they're pegged to wobbly estimates that might not fully account for the fierce regulatory headwinds in China and the U.S.
I wouldn't touch either stock until those headwinds wane. But if I had to pick one over the other, I'd once again argue that Tencent's better diversification, higher operating margins, and stronger earnings growth make it the better overall investment.
