Andrew Burton
In the last couple of weeks, Alibaba’s (NYSE:BABA) shares have slightly appreciated on the news that Beijing would ease its zero-Covid policy, which recently caused Chinese citizens to protest against the government. While this is certainly a positive development for the company, its effect is likely to be short-lived as some of the fundamental risks that are associated with Alibaba remain and could materialize at any moment, creating additional downward pressure on its stock.
To this day, Alibaba’s shares are down ~35% since I began covering the company here on Seeking Alpha in October of 2021, and the latest geopolitical developments suggest that it’s highly unlikely that we’ll witness a major appreciation of the stock anytime soon. In addition to the relatively weak earnings report for Q2, Alibaba’s cloud computing business continues to be under pressure due to several domestic and foreign issues, which indicate that Beijing’s policy would continue to heavily affect the business’s performance. As a result, I continue to believe that Alibaba is uninvestable for long-term investors as the political risks outweigh the growth opportunities at this stage.
Cloud Business Is Under Pressure
Last month I’ve already covered Alibaba’s recent mixed earnings results for Q2. My first article published after the latest results highlighted the decline of the company’s core commerce business in recent months, while the second one covered the existential threat that Alibaba’s Ant Group is facing due to the rise of the digital yuan. The current third and final article for a while is aimed at highlighting the recent results of Alibaba’s cloud computing business, which accounts for 10% of total revenues, and discussing how Beijing’s domestic policy along with Washington’s international pressure could hamper the company’s ability to successfully scale its cloud offerings anytime soon.
If we once again go through Alibaba’s recent Q2 earnings report, we’ll see that the company’s cloud computing business has grown by only 4% Y/Y in the latest quarter to RMB20.76 billion. For comparison, a year ago, Alibaba’s cloud business has grown by 33% Y/Y in Q2’21. This nearly flat Y/Y growth rate of Alibaba’s cloud business in recent months indicates that Beijing’s domestic policy continues to play a decisive role in defining the level of success that Chinese companies could achieve.
Let’s not forget that after passing a series of data security laws last year, Beijing began to actively regulate the collection and transfer of data within the mainland due to it being a matter of national security. In April, Bloomberg even reported that some municipally controlled companies were asked to migrate to state-backed cloud providers, while I also mentioned earlier this year how Beijing itself has been entering the cloud-computing industry through its controlled companies and became Alibaba’s direct competitor in the business.
In addition to that, due to Beijing’s decision to devalue the yuan in order to prop up its export-oriented economy, Alibaba’s cloud business has shown a decline in Q2 in dollar terms. The same report for Q2’22 shows that during the quarter Alibaba’s cloud revenues were $2.9 billion, down from the $3.1 billion that it recorded in Q2’21.
For comparison, Amazon’s (AMZN) AWS, Microsoft’s (MSFT) Azure, and Google’s (GOOG)(GOOGL) Cloud have grown by 27%, 20%, and 38%, respectively, in dollar terms for the same period. Considering that those businesses are able to show such aggressive growth rates by competing mostly in the U.S. with each other, while Alibaba is unable to show double-digit growth by having almost a monopoly in the second-biggest cloud market in the world indicates that there are not much growth opportunities in the cloud business for the company at this stage.
In addition by having to compete with state-owned cloud providers, Alibaba also continues to suffer from the weak state of the Chinese economy, while at the same time Beijing’s aggressive foreign policy that limits the company’s international footprint along with constant interference in the education sector leave the business little room for a maneuver. The company’s management indirectly admitted all of this when discussing the results of its cloud business in the latest earnings report by stating the following:
Revenue from customers in the Internet industry declined by 18% year-over-year that was mainly driven by declining revenue from the top Internet customer that has gradually stopped using our overseas cloud services for its international business due to non-product related requirements and online education customers, as well as by softening demand from other customers in China’s Internet industry.
More Downside To Come
In addition to domestic issues, Alibaba’s cloud business also faces several external risks, which could limit the growth of its cloud offerings even more. Just a few weeks after announcing its latest cloud computing system powered by chips made by American firms such as Intel (INTC) and Nvidia (NVDA), the U.S. implemented the harshest export control rules that prohibit the exports of highly advanced chips into China, which put some of Alibaba’s AI and cloud computing projects at risk.
After that incident, news came out recently that Beijing has set up a consortium of companies and institutions, which are working on mitigating the potential further export controls on Arm-based chips by creating new IP for chips based on the open-source RISC-V instruction set architecture. That consortium includes Alibaba and Tencent (OTCPK:TCEHY). While at first, it might seem that by cooperating with Beijing, all of Alibaba’s domestic issues described above could be considered solved, the reality is a little bit different.
The likely main reason why Alibaba cooperates with Beijing is simply that it has no other choice. Due to China’s military-civil fusion doctrine that forces tech companies to share their advanced technologies with the Chinese military, Alibaba is required to help the state with its expertise. This creates a love-hate relationship between Alibaba and the state. We’ve already seen how the Chinese regulators first announce the biggest fine in history against Alibaba, which gives hope to investors that the worst for the company is over, but then later Beijing ‘encourages’ the company to invest in the state-sponsored common prosperity fund while at the same time increases the amount of taxes that it now needs to pay.
In the case of the news about the development of a new chip, it’s safe to assume that the state itself, and not the western shareholders of Alibaba’s VIE, is going to be the biggest beneficiary. At the same time, as Alibaba shares its technological expertise, Beijing is highly unlikely to revert its stance and allow the state companies to use the private cloud offerings anytime soon if ever, limiting the growth opportunities for the business.
This brings us to another problem. Due to the closer cooperation of Alibaba with the Chinese military, there’s a possibility that the U.S. would finally pull the trigger and enforces the delisting of the company from the American exchanges, which is something that it decided not to do more than a year ago. In such a scenario, even a potential positive audit by the PCAOB inspectors wouldn’t save the stock. We’ve already seen examples of when companies that are closely linked to the People’s Liberation Army or the Chinese state were added to the list of Communist Chinese Military Companies, which prevented the U.S. passport holders from owning or trading any stocks of businesses from that list.
Considering that China has been recently called the top threat to the United States in the recent National Defense Strategy report by the DoD, while new legislations are being proposed to crack down on CCP-backed businesses, Alibaba’s cooperation with Beijing on various matters could be considered a major red flag.
However, even if the U.S. doesn’t enforce the delisting of its shares anytime soon, there’s always a risk that it could prohibit exports of Arm-based chips to China in the foreseeable future, especially since Arm itself is planning an IPO on the American exchanges next year. As a result of this, it’s safe to say that Alibaba’s ability to scale its cloud offering remains fairly limited since the domestic issues along with the external risks are creating new sets of problems that hamper any potential to show similar growth rates in comparison to its western peers.
The Bottom Line
To my article on Alibaba’s Q2 earnings results that described the weak state of its commerce business, I’ve added a DCF model, which showed the company’s fair value to be $115.71 per share. The problem with that model is that it’s based solely on the fundamentals. While it shows that Alibaba is undervalued, we shouldn’t forget that its stock has been trading at distressed levels for more than a year while being undervalued solely due to the constant direct and indirect interferences of Beijing in its affairs.
Even though there’s a high chance that the stock would pick up momentum on the news of the easing of the zero-Covid policy, it’s highly unlikely that it would be able to greatly appreciate and create additional shareholder value in the long-term, as Beijing is unlikely to loosen its grip on the company anytime soon. Add to this the fact that the company could also become one of the biggest casualties of the worsening Sino-American relations and it becomes even harder to justify a long-term long position in its stock in the current environment.
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