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.
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.
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.
First, the Chinese government may decide in the future that the arrangement is illegal. Second, even though BABA’s PRC counsel thinks the current arrangement is legal, uncertainty remains. As Alibaba notes in the 20-F:
“Fangda Partners has also advised us that there are substantial uncertainties regarding the interpretation and application of current PRC laws, rules and regulations. Accordingly, the PRC regulatory authorities and PRC courts may in the future take a view that is contrary to the opinion of our PRC legal counsel.”
There may be little warning if things do change:
“In addition, the PRC legal system is based in part on government policies and internal rules, some of which are not published on a timely basis or at all, and which may have a retroactive effect. As a result, we may not be aware of our violation of these policies and rules until after the occurrence of the violation.”
The Communist Party still rules China, and judges may have limited independence. That could affect the enforcement of contracts.
Disputes could arise in the future. As I noted in my article on ANT Financial, Alibaba once owned Alipay entirely, but then Jack Ma decided to spin it out into an entity controlled by himself. Alibaba ended up with a mere 37.5% interest in Alipay, to the chagrin of its shareholders.
And if there are disputes between foreign investors and Alibaba’s management in the PRC, can foreign investors expect the Chinese government to take their side?
BABA Stock’s Accounting Risks
Also, questions remain over Alibaba’s accounting. Jim Chanos, the hedge fund manager who profited from shorting Enron, revealed in 2015 that he is shorting BABA stock. Chanos cited concerns over Alibaba’s margin being overstated, since its Cainiao Logistics division does not appear on BABA’s financial statements.
Herb Greenberg agreed, raising concerns over Cainiao Logistics as well as ANT Financial not being on the books. If they are right, Alibaba stock’s impressive margins could be lower, meaning its business model is not as profitable as it seems.
Indeed, the SEC launched an investigation into BABA in May 2016. The New York Post reported in November that a high-profile Alibaba insider was cooperating with the SEC.
With these risks, should BABA stock really be trading at similar multiples to Facebook? Many of these thorny regulatory issues do not apply to Facebook, which is blocked in China.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.