Alibaba Group Holding Ltd.'s (BABA, Financial) stock has been under pressure for over two years. The company’s struggles began with Ant Group’s failed initial public offering attempt in late 2020 amid increased regulatory scrutiny. The company’s struggles continued as Chinese regulators showed no intentions to go easy on Alibaba and other local tech giants amid a broad crackdown on the tech sector. The company suffered from the deteriorating relationship between the U.S. and China as well, with investors seeing Alibaba as a company that could be penalized by American regulators at a time when the two nations are battling for tech supremacy.
The stock started 2023 on strong footing, aided by the improving sentiment toward risky assets, but investors' focus yet again shifted to the challenges faced by Alibaba in the months that followed. Many global tech giants, such as Microsoft Corp. (MSFT, Financial), Meta Platforms Inc. (META, Financial) and Apple Inc. (AAPL, Financial), have seen their market value increase by double digits this year, but Alibaba's shares have fallen more than 8% over the same period, which highlights how the stock has failed to breakthrough even on the back of a notable improvement toward the information technology sector. This lackluster market performance has pushed Alibaba into deeply undervalued territory.
The improving regulatory outlook
The Chinese economy faced growth barriers last year stemming from the zero-Covid policy enacted by the government. With the country now focused on boosting economic growth, policymakers are adopting a more lenient stance on the tech sector, which forms the backbone of its economy. Without letting the tech sector innovate and grow, China is highly unlikely to pose a meaningful threat to the Western world as an economic superpower. For this reason, it is reasonable to expect Chinese regulators will promote the growth of the tech sector this year.
There are some improvements already. For instance, the government allowed DiDi Global Inc. (DIDIY, Financial) to relist its mobile applications on popular app stores in January, lifting one of the major barriers to DiDi’s growth. In addition, regulators started approving new video games in April after banning new releases for several months. Policymakers also invited several big tech CEOs, including Tim Cook, last March to discuss the outlook for foreign companies doing business in the country. These recent developments suggest China is once again focused on creating a platform for tech companies to thrive, which paints a promising outlook for Alibaba.
The restructuring will unlock value
According to widely used valuation principles, diversified conglomerates attract lower valuation multiples compared to companies with a focus on one business segment. This discount is often referred to as a conglomerate discount, where the market and analysts agree that individual businesses have a higher value than the sum of the parts value of a diversified company. Alibaba may have also suffered as a business that touches different parts of the economy through its segments.
In March, Alibaba announced its business will be separated into six units in the coming months in a bid to improve its efficiency. During this restructuring process, the company will also divest some non-core businesses, paving the way for a higher returns on invested capital in the future. These divestments are likely to lead to some distribution of capital among shareholders as well.
The six independent business units will be able to raise capital individually, giving them the option to seek IPOs in the coming years. Alibaba shareholders stand to benefit from such a development as it creates a platform for these business units to be valued independently, thereby creating an opportunity to attract higher multiples than if they were valued as a diversified business entity.
The valuation is unreasonable
Alibaba is a profitable tech company with a long runway for growth in several fast-growing industries such as e-commerce and cloud computing. At a forward price-earnings ratio of 10.8, the company is valued like a mature company with no growth prospects. To put things into perspective, Microsoft, Amazon.com Inc. (AMZN, Financial) and Apple are valued at forward earnings multiples of 31.86, 71.37 and 28.43, respectively. The massive disparity between Alibaba and American tech giants seems unreasonable currently amid the improving regulatory outlook for the Chinese tech sector.
Regardless, the valuation gap between Alibaba and its American counterparts is likely to disappear in the coming quarters – at least partially – aided by strong earnings, continued policy support and a notable improvement in investor sentiment once the business restructuring is completed.
Takeaway
Alibaba is cheaply valued despite a notable improvement in the regulatory environment. This presents investors with a good opportunity to consider investing in the stock with a long-term perspective in the hopes that Mr. Market will reward the company once earnings start trending in the right direction, aided by the recovery of the Chinese economy.
