Over the past several months, Chinese tech stocks have been left for dead. The consensus belief among market participants is that China’s economy is slowing down while the risks of its trade conflict with the U.S. are rising. That combination has many economists, investors, and analysts worried about economic growth in China hitting a major speed bump in the near-term or the medium term. Consequently, the market has fallen out of love with China’s high flyers. But the near-term weakness in China tech stocks is a long-term buying opportunity. That is especially true for the biggest China tech name of them all, Alibaba (NYSE:BABA) stock.
China’s economy is slowing. Its GDP growth is steadily decelerating and is likely to decelerate further as its urbanization boom slows and tariffs weigh on its near-term economic output. But there are two important things to note here. China’s economy is still growing at an annualized rate of nearly 7%. That is a rapid expansion. And even as China’s economic growth has decelerated over the past several years, Alibaba’s revenue growth has accelerated, mostly thanks to the company’s robust expansion into new growth markets.
Thus, Alibaba seems positioned to remain a big-growth company over the next several years, both because the company is expanding and because China’s economy will continue to grow at a healthy, albeit slower, rate.
BABA stock isn’t priced for this reality. Trading at less than 30 times the company’s forward earnings when its revenue is supposed to jump 60% this year, the price of BABA stock implies that the company’s growth will collapse over the next several years. That won’t happen. It may take time for the market to realize that, and Alibaba needs to prove that it can stabilize its margins before the market gets bullish on Alibaba stock again. But once investors’ sentiment turns positive, BABA stock could explode higher.
The Near-Term Outlook of BABA Stock Is Uncertain
There are many headwinds facing BABA stock right now. Most importantly, China’s economic growth has decelerated meaningfully from 10% and up earlier this decade to less than 7% now. Moreover, the nation’s economic growth is expected to continue to drop towards 6%, 5%, and lower over the next decade. That is without considering the impact of U.S. tariffs. If you factor that in and assume the worst, China’s economic growth could collapse soon.
Additionally, the U.S. dollar is strengthening dramatically against the Chinese yuan. That strengthening naturally hurts BABA stock and weighs on its valuation. On top of all that, Alibaba is aggressively expanding its business at the expense of its margins. Adjusted operating margins excluding stock-based compensation fell from 40% in fiscal 2017 to 36% in fiscal 2018. So far in fiscal 2019, operating margins excluding stock-based comp have fallen to 30%.
Thus, it is no wonder that BABA stock has struggled to command a premium valuation recently. There are both macro risks (China’s economic slowdown) and micro risks (persistent margin declines) which are weighing on investors’ sentiment. As long as these risks linger, sentiment towards Alibaba stock will remain dour, and BABA stock won’t move meaningfully higher.
The Long-Term Outlook of Alibaba Stock Is Promising
It is only a matter of time before the aforementioned risks disappear and sentiment towards BABA stock dramatically improves.
On the macro front, China’s economy is slowing and tariffs could worsen the slowdown. But China’s economy is still growing at a rate of nearly 7%, and it’s projected to grow at a 6% rate over the next five years. Plus, the Chinese government is committed to boosting economic growth in the near-term through investments to offset any trade-related weakness.
Overall, then, the outlook for continued robust economic growth is promising. It may take the market a while to realize that, but as China continues to pump out 6%-plus GDP growth numbers amid this trade war, investors will start to figure out that China will do just fine despite America’s tariffs.
On the micro front, Alibaba’s margins are declining due to investments that should boost its growth. These investments have helped BABA generate 60% revenue growth. Eventually, the investments will phase out. Once they do, BABA’s revenue growth will decline dramatically from its present 60% rate. But its margins will also rise dramatically from their present 30% rate. Thus, as revenue growth slows over the next several years, Alibaba’s margins will come roaring back, causing its profit growth to rapidly accelerate.
Overall, BABA stock faces two major headwinds. Both of those headwinds will keep Alibaba stock depressed in the near-term. Eventually, though, both of the headwinds will disappear, and when they do, BABA stock will rally tremendously.
Bottom Line on BABA Stock
This is a classic case of near-term pain, long-term gain.
You should buy BABA because it is materially undervalued relative to its fundamentals. Alibaba stock won’t deliver a big rally any time soon because its optics aren’t great. But you should hold the shares because no one knows exactly when those optics will improve. When they do, however, this stock will take off like a rocket ship.
As of this writing, Luke Lango was long BABA.