Alibaba (BABA +2.61%), one of the bellwethers of China's tech sector, lost roughly 50% of its market value over the past year as Chinese antitrust regulators probed and fined its e-commerce business. The regulators also imposed new restrictions on Alibaba's exclusive partnerships with merchants, promotional pricing strategies, data collection methods, and investments.
The decelerating growth of Alibaba's e-commerce business in the first half of fiscal 2022, which is expected to worsen throughout the rest of the year, indicated those restrictions were taking their toll. Moreover, the ongoing threat to delist U.S.-listed Chinese companies that don't comply with new U.S. auditing standards prevented value-seeking investors from buying the dip.
Image source: Alibaba.
Alibaba will likely remain a battleground stock in 2022 as investors weigh the strength of its e-commerce and cloud businesses against the regulatory and competitive threats. Two recent developments support both camps, so let's examine the latest green and red flags for Alibaba's future.
The green flag: Less pressure for VIE stocks
Alibaba, like most other Chinese tech companies, went public in the U.S. by listing shares of a variable interest entity (VIE) located in the Cayman Islands instead of its actual company in China.
A VIE holds shares of a Chinese company but is owned and controlled by Chinese citizens. This structure enables companies to bypass China's ban on foreign direct investments in sensitive sectors like technology and education.
China and the U.S. both turned a blind eye to this loophole for many years. But trade tensions have prompted both countries to reevaluate VIEs over the past year, and the potential termination of the controversial structure has cast a dark cloud over Alibaba and its U.S.-listed industry peers.
That's why Alibaba's investors breathed a sigh of relief when China's Securities Regulatory Commission (CSRC) drafted new rules for VIEs on Dec. 24. Instead of banning VIEs outright, as many investors had feared, the CSRC will require VIEs to register their plans with Chinese regulators before being allowed to pursue overseas IPOs. It will also allow some Chinese companies to directly list their shares on overseas exchanges without VIEs.
That's a green flag for Alibaba's investors, but the coast isn't clear yet. In the U.S., the Securities and Exchange Commission (SEC) issued a public warning regarding VIEs earlier this year, and these companies could still be delisted if they don't open their books to third-party auditors.
The red flag: Alibaba's cloud blunder
Alibaba's cloud revenue rose 33% year over year last quarter, which outpaced the growth of its e-commerce business, and accounted for 10% of its top line. Alibaba Cloud also controlled 38.3% of China's cloud infrastructure market in the third quarter of calendar 2021, according to Canalys, putting it far ahead of Huawei Cloud (17%), Tencent (TCEHY +0.19%) Cloud (16.6%), and Baidu's (BIDU +5.46%) AI Cloud (8.2%).
Alibaba Cloud isn't profitable on a generally accepted accounting principles (GAAP) basis yet, but it turned profitable on an adjusted earnings before interest, taxes, and amortization (EBITA) basis over the past four quarters.
Simply put, Alibaba's cloud business had been steadily improving and gradually reducing the company's dependence on its slowing e-commerce business.
Unfortunately, that cloud business recently suffered a big setback after a security flaw prompted China's Ministry of Industry and Information Technology (MIIT) to suspend its cybersecurity information-sharing partnership with Alibaba Cloud for six months. The MIIT said it would review "rectification measures" before deciding on whether or not to resume the project.
The immediate financial impact of the MIIT's suspension is unclear, but it could cause other government agencies and large enterprise customers to reevaluate their cloud partnerships with Alibaba. It could also create an opportunity for underdogs like Huawei, Tencent, and Baidu to gain more ground. In short, a bright red flag has just appeared for Alibaba's second-largest business.
Expect more green and red flags in 2022
Alibaba's stock might look cheap at 13 times forward earnings, but its valuations will likely remain depressed until the regulatory headwinds wane and its e-commerce growth stabilizes. Until then, investors should expect more green and red flags to appear next year as the Chinese tech giant works through its near-term challenges.
