Once the shining star of China’s tech industry, Alibaba (NYSE:BABA) is falling back to earth. The e-commerce titan is down over 30% from peak levels, having been walloped by regulatory investigations in the U.S. and China.
Investing legend Charlie Munger sees this as an opportunity. In April, Munger revealed he had bought a $37 million stake in Alibaba via the Daily Journal Corporation (NASDAQ: DJCO), where Munger sits as chairman. Some investors were left scratching their heads over this decision. Others wonder if they should do the same thing.
There’s no doubt that Alibaba is now cheaper than it was a year ago — but that’s purely from a valuation standpoint. Investors shouldn’t rush to buy the dip before knowing two of the company’s biggest risks.
1. Alibaba’s cash cow is swimming with sharks
Founded in 1999 as a platform for small businesses to sell their products via the internet, Alibaba has since expanded far beyond e-commerce. It’s ventured into many other industries, such as cloud computing and entertainment.
But make no mistake. E-commerce is by far the largest Alibaba segment, generating 87% of the group’s annual revenue. This business is also highly profitable, delivering $29.7 billion in adjusted earnings before interest, tax, depreciation, and amortization (EBITDA) in fiscal 2021.
For years, many players have tried to loosen Alibaba’s grip on China’s e-commerce industry. The likes of JD.com (NASDAQ:JD), Vipshop Holdings (NYSE:VIPS), and NetEase (NASDAQ:NTES) have been formidable rivals, but never posed a serious threat. That all changed when Pinduoduo (NASDAQ:PDD) arrived on the scene in 2015.
A few smart moves set the company up for success. From the get-go, Pinduoduo targeted users from rural areas. This meant it would avoid directly competing with industry incumbents. Pinduoduo also focused on being a mobile-only, social e-commerce platform. This allowed it to ride the explosion of mobile devices — and social media — to turbocharge its own growth. On top of that, an early partnership with Tencent (OTC:TCEHY), which owns a 15.6% stake in Pinduoduo, helped the company leverage WeChat to acquire users rapidly and cheaply.
Today, Pinduoduo has 824 million active buyers on its platform. It hit a milestone in the fourth quarter of 2020 when it overtook Alibaba in terms of active buyers — making it China’s biggest e-commerce platform by this measure. It is also outpacing Alibaba in terms of growth. Pinduoduo’s revenue surged 239% in its latest fiscal quarter, while Alibaba’s commerce revenue grew 72% over the same period.
For now, Alibaba is still holding on to its crown. Its e-commerce business generates over seven times as much revenue as Pinduoduo’s. And Alibaba is taking on Pinduoduo by launching its own version of group-buying services and expanding its e-commerce business in rural areas.
From a revenue perspective, Alibaba is still — by far — the elephant in the room. But Pinduoduo is a threat Alibaba can no longer ignore. If Pinduoduo continues expanding at the same rate, it will soon start eating into Alibaba’s market share and growth.
2. Alibaba’s newer ventures are mostly unprofitable
So far, we’ve addressed the bear case for Alibaba: an increasingly competitive e-commerce industry, and intensifying regulatory scrutiny in the U.S. and China. But bulls argue that Alibaba’s fast-growing new businesses could transform it into China’s version of Amazon — a company with more than one success story.
Alibaba’s business empire includes logistics division Cainiao, cloud computing service Alibaba Cloud, and streaming platform Youku. These ventures have shown great potential and, in the long run, could help diversify Alibaba’s revenue. Some of these businesses are also growing rapidly. For example, Alicloud — the biggest cloud infrastructure company in China — grew revenue by 50% in fiscal 2021. Cainiao grew up even faster with revenue up 68% over the same period.
The problem with Alibaba’s side bets is that most of them are unprofitable. Some of these businesses are years away from profitability and require heavy investments before they can hit a profitable scale.
In the past, Alibaba has funded these ventures with money generated by its e-commerce business. But as this segment comes under increasing pressure, Alibaba may soon need to start investing in it. This will reduce the amount of money Alibaba can splurge on its rising stars. The risk here is that if Alibaba is forced to slash its investments in these businesses, they may never grow big enough to become mature and profitable companies.
For now, Alibaba can draw on its strong balance sheet if it needs to. The company had $72 billion in cash, cash equivalents, and short-term investments as of March 31, giving it plenty of firepower to fuel its side bets. But even then, there’s no guarantee Alibaba’s unprofitable businesses will ever turn a profit. And if they don’t, Alibaba will ultimately need to write off these investments — destroying shareholder value.
What all this means for investors
Alibaba is currently trading at 5.4 times trailing 12-month sales. That makes it relatively cheap, especially when you consider that Tencent — Alibaba’s archrival — trades at almost double that multiple.
But as Warren Buffett once pointed out, “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Just because a stock looks cheap doesn’t mean it’s a good investment.
While I’m not suggesting that Alibaba is not a good business — on the contrary, its e-commerce business is still incredibly profitable — investors will need to consider the aforementioned risks before investing in Alibaba.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
View more information: https://www.fool.com/investing/2021/06/16/2-risks-investors-should-know-before-buying-alibab/