The end of 2020 was not kind to Alibaba, with its stock dropping roughly thirty percent from its highs. Every day seemed to bring further uncertainty around possible changes to its business practices and the potential ramifications these changes could have on its future growth. With an outspoken co-founder and finding themselves facing Antitrust/Data Privacy Crackdowns is it time to bench Alibaba from your portfolio?
Earlier this month, we explored the “Holding Foreign Companies Accountable Act” and assessed the risk it presents to companies such as Alibaba and their shareholders. For Alibaba, that was only the beginning…
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Some Rare Clarity for Alibaba- the US to Not Block Investment
Update 1-13-2021. Before we get into the current issues facing Alibaba, the US provided some clarity this week. President Trump had named Alibaba as a holding which the US might bar from US investments. The primary reason behind this directive was because of a concern that they directly benefited the CCP. While this was never likely to come to pass, the US officially revoked this concern this past week. This reprieve brought some comfort to investors causing the stock to rally over five percent.
Jack Ma and the Communist Party of China
While many of the issues facing Alibaba stem from reform which has been working its way to China for years, the timing and focus of investigations into its business have raised eyebrows.
We first look at the ANT group, one of China’s most dominant and fastest-growing Fintech companies. Alibaba holds a thirty percent ownership stake in ANT, which was set to go public late last year. Initial guidance placed the valuation of their Initial Public Offering(IPO) at just over three hundred billion dollars. This would have made ANT the largest IPO on record and presented an expected(priced in) windfall for Alibaba investors. Shortly before the offering, Shanghai Stock Exchange announced a delay, causing the first of many headaches Alibaba would soon face.
The decision to delay The Ant Group’s IPO came shortly after Jack Ma, co-founder of Alibaba and China’s wealthiest entrepreneur, rocked the status quo by publicly decrying several aspects of the government’s philosophy on the Fintech industry. In his speech, Ma accused many of the government’s beliefs of being outdated. Ma continued by stating their actions were holding back innovation within the areas of finance and technology.
Shortly after, the Ant Group’s planned IPO was placed on hold. On Christmas Eve, a formal investigation into anti-competitive measures employed by Alibaba’s core business was announced.
What is Being Asked of Ant Group?
The Central Bank audited the business practices of the ANT group. In their findings, they publicly recommended that ANT “go back to their roots” as a payment processor. They were advised to consider reducing their focus on, or cease their movement into, the areas of credit, insurance, and investments. This guidance would shift the focus of the Ant group away from their fastest-growing areas. These same areas are those that investors had looked to as the direct avenues to spur future growth.
ANT was given further guidance to increase the amount of cash they carry to support the loans they give out. As the Financial Times reports
the regulations call for companies such as the Ant Group to provide 30% of the funding…currently ANT funds only 2% themselves.
This would shift much of the risk of their outstanding loan profile from the banks directly to ANT themselves. The tie-up of additional funds would also slow the rapid growth this area of business has brought in recent years.
The Ant group may very well still go public, but suddenly that three hundred billion dollar valuation no longer appears justified.
Consumer Protection and Data Privacy
Being such a ubiquitous presence in its customers’ daily lives, Alibaba collects and stores a wealth of information. They can then leverage this data at the aggregate and personal levels to tailor their platform to their audience. This knowledge of their consumer furthers their other business units. It provides them easier inroads into new areas and solidifies their existing businesses. This well of knowledge is perhaps their most vital competitive advantage.
Proposed Limits on What Can be Tracked…
Governments across the world are struggling to catch up to a time where so much of our lives is digital. Alibaba finds itself in a similar situation as Facebook. They know their customers so well through activities their platforms support they can tailor their offerings and the user experience to maintain their position, but their audience is starting to become weary of the data the companies keep. The ANT group recently faced a public outcry as they opted their users into a system that leveraged the information they had on an individual’s online purchases into a credit system without consent.
Consumer protection laws may very well eat into the moat that this accumulated knowledge has built up to Alibaba’s advantage. If these laws erode their established moat, it would partially level the playing ground for their competitors.
but Maybe You Should Share What You Track?
Alibaba also fends off government requests for data obtained from their platform in areas such as financial transactions. The sharing of this data would strip Alibaba of a key advantage that spurs the success of several business units. Any restriction in the data they will collect in the future and/or the nationalization of the information they already have would threaten their future growth and increase the competition set to face them.
What are the Antitrust Issues Facing Alibaba?
Rivals have accused Alibaba of operating under an “us or them” mentality. They may offer certain partners the opportunity to either list their products on one of their platforms or with their competitors, but not both. As the largest digital marketplaces in China, this stance allows them to leverage their standing to keep valuable partners exclusively tied to their platforms and away from their competition.
China continues to refine its stance on antitrust issues. They currently mandate that companies do not abuse their position as market leaders to harm other businesses. Late last year, the CCP announced a formal inquiry into the business practices of Alibaba. The possible ramifications of this inquiry range from a host of fines, to the restructuring of business elements found to be in breach, to the forced separation of business units.
Update: The Chinese Government hit Alibaba with a record 2.8 billion dollar fine. While a substantial amount, and a sign that China is willing to crack down on companies such as Alibaba, this one time expense should have minimal impact in and of itself to a company the size of Alibaba.
Often, when we look at large conglomerate companies such as Google or Facebook, we meet regulatory inquiries with a shrug. The likelihood of a government forcing the breakup of a company known on a global scale always seems remote. These companies create millions of jobs and have caused the saying “too big to fail” has become a common refrain. Further reducing the concern of such action is the thought that often the individual business units that make up these companies may be worth more than the valuation given to the company as a whole. With the CCP and an untested investment investing structure known as VTE, we cannot brush aside the risks these investigations pose to Alibaba so easily.
What is The VTE Structure and How Does it Differ from Equity-Based Investments?
An Untested Investing Structure Exasperates the Unknown
The dream of investing in the stock market is to own a piece of a company you love. When you invest, you receive equity in the underlying company and often a voice to help guide future actions. Your ownership grants this power in the form of a vote which comes with your ownership.
The CCP makes it illegal for any foreign entity to own, in full or in part, or control “key assets”. When you invest in these companies, you are working with a company that exists outside of China. This middleman has a contract with the Chinese security to receive a distribution of their profits. The company then has a second contract with you as an investor to share in these profits.
If Alibaba were forced to break up its assets, such as Alibaba Cloud, this structure muddies the water as to what earnings investors would be entitled to. Would the contract extend to those divested assets? Most likely yes but, it is untested and just another layer of uncertainty around your investment.
This investment structure is not new, and it applies to every Chinese holding from Alibaba to Nio to JD.com. Investment in foreign assets is always a game of trust. Everyone operates under the faith that, all things being equal, everyone will comply with an arrangement that allows global investments to function. If there is a fallout of the VTE contracts, it will be because of much larger issues between world governments.
Is the Chinese Government Acting Punitively against Alibaba?
Perhaps in part, though the timing of their actions, censorship of media coverage, and the forced seclusion of Jack Ma suggest Alibaba is being singled out, many of the charges Alibaba face result from changes the world has been scrambling to face since the dawn of the information age, many a long time in coming and universal.
Any government, any group in power, ultimately will have concerns when an external party becomes so ubiquitous in the lives of their citizens they have power and influence that threatens to approach, or supersede, their own. The CCP might be higher on this spectrum than some, but the inherent desire to protect one’s power is universal. We see it in the US with probes into the impact platforms such as Twitter and Facebook have on the discussion (and formation) of public opinion around politics, medicine, and science. We see it as Apple and Amazon leverage their market position to fend off, integrate, or even kill competitors.
In the past few days, media outlets in China have censored coverage relating to the ongoing investigations into Alibaba’s business. As Barron’s economist Rory Green stated :
“Authorities are working to ensure public opinion remains on the right side of the debate,”
further demonstrating the risk of a business finding itself in the CCP’s crosshairs.
What Could all of This Mean for Alibaba?
While the investigations into Alibaba are supported by evolving business reforms, we can look to past instances where their business practices have come under scrutiny. Just last year, the State Administration for Market Regulations (SAMR) closed an investigation several years in the making, finding Alibaba to have failed to disclose several past acquisitions or even obtain proper approval. The result was a fine of roughly seventy-five thousand dollars. This amount means nothing to a company the size of Alibaba. Similar results from current investigations would have little impact on the company moving forward.
Alibaba is almost certainly looking at another fine. If found to have leveraged their market position unfairly, they could be subject to a fine of up to ten percent of last year’s turnover. Additionally, and here translations of the possible penalties read a little nebulously, they could be forced to part with “illegal income”. Without a definitive statement on what falls under illegal income, this verbiage may open the door to a more substantial fine and complicates efforts to project the possible impact on Alibaba’s business.
Additionally, Alibaba may very well face some level of business practice reform, such as having to release partners from exclusivity contracts opening the door for them to work with competitors. While this may cause increased competition, partners are not likely to leave the Alibaba platform. Mild concessions such as these would most likely result in slightly reduced growth going forward and a smaller valuation attached to their stock.
Regulators could also decide to make an example of Alibaba and force large-scale changes to their business or even force them to divest select business units. While less likely, this outcome would have severe short-term and long-term effects on the company and its shareholders.
Is it Time to Bench Alibaba?
Depending on your risk tolerance, Alibaba may or may not make sense as a current investment. On a purely technical level, the recent sell-off presents an intriguing entry point. With so many companies doing well, it may be best to place Alibaba on the sidelines and wait for some uncertainty to pass.
Disclaimer
Alibaba currently represents about one percent of my overall portfolio. I am at an age and place in my life where I am willing to assume the risks for what may end up being a time of opportunity. I am still weighing this risk as the situation develops. For now, I will cap my exposure to BABA around 3% of my overall portfolio. This level is lower than I would have been comfortable at two months ago until additional clarity comes to light.