When Chinese regulators attacked Alibaba Group Holding Ltd. (BABA, Financial) in late 2020, the market anticipated a long path toward a full recovery. Almost three years later, its stock has yet to gain any momentum, confirming those initial fears were not unfounded.
Amid a broad tech rally that has pushed the Nasdaq Composite 35% higher so far this year, Alibaba's shares have gained only 3.27%, highlighting the strong negative sentiment toward the company.
Although the investor sentiment toward Alibaba and many of its Chinese peers has not improved meaningfully, there have been notable improvements on the regulatory front. Business conditions in China have also improved after the country abandoned its zero-Covid policy earlier this year, paving the way for tech companies to thrive. Most of this progress has yet to be reflected in its market value, which presents a good opportunity for investors.
The improving regulatory and macroeconomic outlook
After punishing Chinese tech companies for well over two years, policymakers in China have turned their attention to supporting the growth of these companies in a bid to achieve technological independence at a time when the country’s relationships with the U.S. are deteriorating. Since the conclusion of the National People’s Congress in March, several key officials have publicly commented that the government will support the growth of the private sector. This is a clear indication of the changing stance of policymakers.
Several recent developments in the private business space point toward a normalized regulatory environment.
First, on July 13, the Cyberspace Administration of China finalized a regulatory framework to promote the growth of artificial intelligence technology while adhering to social norms and government rules.
Earlier this year, China also allowed the importation of more than 45 new video games and granted new licenses to several games built inside the country, signaling an end to the video game bans that had been in place for a couple of years.
Next, China approved the reorganization plan of Alibaba Group, highlighting regulators’ approval of its new business strategy.
Finally, DiDi Global Inc. (DIDIY, Financial) was allowed to enlist its mobile applications in popular app stores, signaling the end of the government crackdown on its business practices.
While the regulatory environment for Chinese tech companies has improved notably over the past several months, Mr. Market has not rewarded these stocks, creating a disconnect between the market value and the economic reality of these companies. Alibaba, as the largest e-commerce and cloud infrastructure company in China, stands to benefit from this favorable shift in regulatory policy.
China's economic growth and its impact on Alibaba
In the first quarter, the Chinese economy grew by 4.5%, ahead of the 4% growth expected by analysts. Although the economy showed signs of growth challenges in the second quarter, policymakers have acted swiftly by slashing several key policy rates to spur consumer spending and business investments. China is one of the few countries in the world to have embraced an expansionary monetary policy framework this year even as many other developed countries are grappling with high inflation and rising interest rates.
There are promising signs from a macroeconomic perspective as well. For instance, retail sales in China climbed more than 5% in June after registering a strong growth of 8.3% in May. This is an indication that Chinese consumers are spending increasing amounts amid the favorable fiscal and monetary policy environment. As a consumer-facing company, Alibaba will directly benefit from a continued increase in retail spending.
Unlocking hidden value through spinoffs
In March, Alibaba announced a major restructuring, splitting into six independent business. This strategic move will unlock value by freeing up the conglomerate discount. In economics, highly diversified businesses are almost always thought to have a lower value than the sum of each individual business, which is referred to as the conglomerate discount.
By establishing separate companies for key business units, such as cloud computing and retail e-commerce, Alibaba will book a notable increase in its enterprise value. When the announcement was made, Alibaba shares surged more than 15%. However, almost all these gains have been wiped out by the lackluster market performance since then, which suggests the market has not added any value to the expected increase in Alibaba’s enterprise value resulting from the spinoffs. This anomaly presents an opportunity for investors.
The cheap valuation
Alibaba trades with a forward price-earnings ratio of 11.4, which makes it one of the cheapest profitable tech companies in the market. A comparison of Alibaba and American tech giants suggest Alibaba is deeply undervalued curretnly. For context, Amazon.com Inc. (AMZN, Financial) trades with a price-earnings ratio of 81, while Alphabet Inc. (GOOG, Financial) has an earnings multiple of 23. Microsoft Corp. (MSFT, Financial), which competes with Alibaba for market share in the cloud computing segment, trades for 36 times earnings.
One of the major reasons for Alibaba’s cheap valuation is its origins. Investors remain cautious about investing in Chinese tech companies because of the uncertainties associated with the relationship between the U.S. and China. However, in the long run, Alibaba is likely to be valued based on its earnings power – not geopolitical concerns. When this happens, Alibaba is likely to attract much higher valuation multiples.
Takeaway
Chinese tech companies are breathing a sigh of relief with local regulators implementing favorable policies to kickstart private sector growth. Policymakers have taken a back seat in recent months, creating a growth-conducive environment for these companies as China looks to battle with the U.S. for global tech supremacy. Alibaba will be one of the biggest winners of the resurgence. At cheap valuation multiples, the company looks like a bargain currently.
