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Is It Time to Buy the Alibaba Bounce?

By Justin Pope - Oct 14, 2021 at 7:37AM

Key Points

  • Alibaba has declined steeply, and investors are beginning to jump on shares.
  • The stock has been expensive for years and now trades on par with its peer.
  • Investors should remain cautious of the political complications in China.

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Alibaba stock has begun to rebound from its lows, but investors should pump the brakes before getting too excited.

Chinese e-commerce giant Alibaba Group Holding ( BABA 1.57% ) has been one of the major investing storylines of 2021. The stock has lost more than 50% of its value over the past year, nearly unheard of for a company of its size and stature.

Shares have recently rebounded 15% from their 52-week lows, and investors are wondering if the worst is over. Here is why I would be cautious about jumping back onto the Alibaba bandwagon.

Woman in China using her smartphone.

Image source: Getty Images.

Why Alibaba sank in the first place

The fascinating part about Alibaba's troubled year is that it has little to do with the actual business. It is the dominant e-commerce company in the massive Chinese economy, and nearly 1.2 billion people worldwide have used its services over the past year. Alibaba had $31.8 billion in revenue in its most recent quarter, ending June 30, a 34% year-over-year growth from the height of the pandemic in mid-2020. The business is easily profitable and generates a ton of free cash flow: $3.2 billion for the quarter, or 10% of its revenue.

The Chinese government has taken a strong stance over the past year in getting more involved in the operations of large Chinese tech companies. The president of China, Xi Jinping, has emphasized a need for wealth distribution from large corporations to the greater population of China via social programs, infrastructure, and the like.

It's putting pressure on powerful Chinese technology companies since China has the regulatory power to threaten them with antitrust lawsuits. Chinese regulators have already fined Alibaba $2.5 billion as the result of an antitrust investigation. Perhaps from this pressure, Alibaba has agreed to donate 100 billion yuan ($15.5 billion) over the next five years for social causes. Considering the company's $3.2 billion in free cash flow this past quarter, this is a significant figure. That's less cash for the business to invest for growth and less money for the company's shareholders.

In late 2020, Chinese regulators blocked the initial public offering of Chinese fintech Ant Group, which would have valued the company at roughly $300 billion. Like Alibaba, Ant Group is another company led by Jack Ma and it owns China's largest digital payments platform. Regulators have made Ant Group restructure its business around China's regulatory guidelines, splitting its Alipay platform away from its lending business and sharing ownership of its newly formed customer data business with the Chinese state. This effectively turns Ant Group into more of a bank and gives China's state access to Ant Group's consumer data, the "secret sauce" of the business. Alibaba owns a third of Ant Group, and the blocking of its IPO is a value-destructive event that likely has played a role in the tumble of Alibaba stock.

China is creating political challenges for Alibaba and similar tech companies that are hard to predict for investors. What happens if the Chinese government wants more money from tech companies? What if regulations get even tighter? There is almost no way for investors to put a number on these risks.

Yes, the stock is cheap

As a result, Alibaba's stock has sold off as investors try to account for these risks. Analysts are calling for $140 billion in revenue for the full 2022 fiscal year (calendar 2021), putting the stock at a price-to-sales ratio of just over 3. 

Heading into the pandemic, the stock traded at a P/S of 10, so it's obvious just how beaten-down the stock has become while the underlying business continues to grow. If we go back further to three years ago, the stock commanded a P/S of 15. In other words, the stock's valuation has declined 80% over the past several years. What a deal! Right?

But how much upside is there?

Let's compare Alibaba to Amazon ( AMZN 2.80% ), a similar company: an e-commerce giant with complementary segments like cloud services. Amazon's P/S has never exceeded 5 over the past five years, meaning at Alibaba's peak P/S ratio, it was valued at five times Amazon's stock. Amazon's current P/S is 3.4, only about 10% higher than Alibaba's, which could be fair because of how similar they are. Alibaba is smaller and could grow a little more quickly, but then you need to account for the political risks and the company's huge donations to China's social agendas.

I would personally argue that Alibaba should trade at a discount to Amazon, as it currently does. But if you want to give Alibaba some benefit of the doubt, it could still be tough to justify a dramatic premium to what Amazon has historically commanded. It could simply be that Alibaba has been expensive for years and that much of the decline has been due to the stock settling into a more appropriate valuation instead of the drop being this once-in-a-lifetime buying opportunity that some investors seem to think it is. That would mean that Alibaba doesn't have nearly as much upside as it seems to on the surface, and why investors might want to think twice before jumping on Alibaba's recent bounce.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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