4 Big Reasons Alibaba Group Holding Ltd (BABA) Stock Is a No-Go

With these risks, Alibaba stock should be trading at a discount to Facebook

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As mega-cap tech stocks, Alibaba Group Holding Ltd (NYSE:BABA) and Facebook Inc (NASDAQ:FB) share some things in common.  They both dominate their respective fields. Facebook is the unquestioned leader among social networks, while Alibaba stock dominates e-commerce within China.

4 Big Reasons Alibaba Group Holding Ltd (BABA) Stock Is a No-Go
Source: Photo by via Alibaba

Facebook derives 97% of its revenue from ads and needs to diversify its revenue sources. BABA derives 83% of its revenue from e-commerce within China, and is looking at global expansion to reduce its dependence on the Chinese economy.

Some talk of JD.com Inc(ADR) (NASDAQ:JD) displacing Alibaba stock or Snapchat disrupting Facebook among Millennials, but so far, they haven’t affected the market leaders.

The amount of counterfeit goods sold on Alibaba’s Taobao marketplace caused the U.S. government to place it again on a blacklist in December 2016. Battling counterfeit goods may come at the expense of revenues and earnings, at least in the short-run. Likewise, Facebook is currently battling the fake news problem; righting that may cost it valuable ad revenue.

However, this is where the similarities end because BABA stock faces greater exposure to regulatory and macro risks such as a falling renminbi. When these are taken into account, does it make sense for Alibaba stock and Facebook to be trading at similar multiples?

Alibaba Stock’s Valuation Versus Facebook

Facebook and BABA stock trade at very similar multiples.

Alibaba stock changes hands at 6.14 times book value, almost exactly the same as Facebook (6.6).

Facebook stock trades at 13.64 times sales, compared to a multiple of 12.26 for Alibaba. I don’t think the market is wrong in granting Facebook a slightly higher sales multiple. Facebook’s 30.4% margin beats BABA’s 26.4% margin, while Facebook also beats Alibaba on sales growth.

You can buy BABA stock for 47.4 times earnings and 21.6 times forward earnings. Facebook stock trades at 55.9 times earnings and 22.4 times forward earnings.  

Admittedly, Alibaba stock trades at a discount to FB relative to free cash flow; 22.6 for BABA vs. 34.7 for FB. But Alibaba trades at a much higher price-and-earnings-to-growth multiple than Facebook: 12.06 vs. 0.81, respectively. Analysts expect BABA to grow earnings at a 3.82% CAGR, compared to 34.84% for FB.

Given currency and regulatory risks unique to Alibaba, though, I can’t help but wonder why BABA stock isn’t trading at a discount to Facebook on all measures of valuation. FB also enjoys greater liquidity and no debt.

BABA Stock’s Currency/Macro Risks

I discussed the risk that a falling RMB poses to Alibaba stock before. Nearly all of Alibaba’s revenues and assets are denominated in RMB. Also, as Alibaba notes in a Form 20-F filed with the U.S. Securities and Exchange Commission in May, “a significant portion of our debt is denominated in U.S. dollars.” A falling yuan could create problems for Alibaba’s balance sheet and cash flows.

Markets expect the RMB to fall in 2017, since the Federal Reserve will probably raise rates. This will increase the demand for dollars and trigger capital outflows from China. The dollar will appreciate relative to the RMB. Deutsche Bank thinks the yuan will fall 17% over the next two years.

The Chinese Global Times noted that Trump’s tax cuts could pull more money into the U.S. from China, pushing up the dollar against the RMB.

But if they let the RMB fall too much, they may risk angering President Trump, who accuses China of currency devaluation and wants to label it a currency manipulator. Admittedly, predicting the future value of the RMB is very tricky.

BABA stock may hedge against the risk of a falling RMB. On the Form 20-F, Alibaba states that “from time to time we enter into hedging activities with regard to exchange rate risk”. This might not succeed.

But the cost of hedging could go up, pressuring margins. More Chinese firms want to insure against a falling RMB, and when the demand for something goes up, so does the price. Articles written in 2016 noted that hedging exchange rate risk became more expensive for Chinese firms. Another article from 2016 suggested that covering a $2.5 billion exposure would cost 500 million RMB, so some Chinese developers decided not to even bother with hedging.

Even if Alibaba successfully hedges, RMB depreciation could hurt consumer confidence in China and lead Chinese consumers to save more and spend less, meaning less business for BABA.

BABA Stock’s Regulatory Risks

I’ll leave aside the problem of counterfeit goods on the Taobao marketplace and focus on other risks.

First comes the risk involved with Alibaba’s structure as a variable interest entity, which I have written about before. Even if Alibaba’s underlying business model is sound, you still do not necessarily own a stake in the productive assets of the firm.

Instead, you own shares of a Cayman Islands-based company that contracts with Alibaba to receive a share of the profits. This comes from a Chinese law that forbids foreign investment in Chinese tech firms. Baidu Inc (ADR) (NASDAQ:BIDU) and Tencent (OTCMKTS:TCEHY) have similar arrangements.

This brings problems.

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Article printed from InvestorPlace Media, http://investorplace.com/2017/01/4-reasons-alibaba-group-holding-ltd-baba-stock-no-go/.

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