Robert Way
U.S.-listed Chinese stocks are no longer stranger to sudden steep declines. Gains from earlier in the month had already fizzled as previously expected, resembling all other previously short-lived relief rallies as cautious optimism on easing COVID policies and supportive economic measures take a sharp U-turn. As we head into the new week, sentiment has only soured further as China grapples with more expansive COVID curbs in hopes of curtailing surging new case counts that have now exceeded 30,000 – the worst on record. Protests and unrest are also stirring up debate on whether Beijing might succumb to the will of its people and push harder for a reopening, or lead to more tightening of restrictions over coming months.
The following discussion seeks to analyze both the bear and bull cases on China’s COVID situation – namely, the biggest overhang on Chinese equities today – and gauge their implications on the Alibaba stock (NYSE:BABA) in the months ahead. We believe it has become increasingly difficult for China to orchestrate any meaningful restriction easing anytime soon as COVID cases continue to surpass all-time highs, putting its insufficient healthcare system at risk. While bullish arguments citing the protests coming out of three years of oppression from on-and-off lockdowns may convince the Chinese government to mellow down its COVID restrictions, the bearish near-term outlook likely continues to take precedent and harbingers greater volatility ahead for the Alibaba stock.
The Bear Case – One Step Forward, Two Steps Back
What we had expected two weeks ago has only worsened – both for the markets and for the people dealing with sporadic lockdowns firsthand across China:
While the latest injection of policy support for the property sector, as well as adjustments to the country’s COVID restrictions are a welcome relief, it remains too soon to tell if the expected improvements to China’s stalling economy will materialize. Recall the relief rally in March when the central government vowed to stabilize public markets and alleviate its heavy hand on regulatory overhauls over the private sector, which was short-lived as investors failed to see any structural evidence of said promises being materialized nor any related economic relief delivered. We expect similar risks of fizzling gains this time around, especially with authorities reiterating strict adherence to the country’s COVID Zero policy, while cases also remain on a rapid rise. As such, we would not bank of said sentiment relief, and instead remain cautious on a likely soft December-quarter guidance ahead for Alibaba, which will likely inject further volatility in the near-term.
Source: “Alibaba: Don’t Be Fooled Again”
Since Beijing laid out its “20-point playbook” on reining in COVID infections in China, calling on local authorities to implement a “more targeted approach” to ensure social and economic stability, mobility restrictions in the country have only gotten tighter with consistently backtracking progress on reopening efforts. And social unrest has only amplified, with videos of a widespread “white paper protest” going viral on the internet and sparking global awareness of the dire situation within China that President Xi has sought to mask with repeated narratives on “stability” and “common prosperity”.
Looking ahead, the likelihood of any immediate near- to medium-term resolve to China’s COVID Zero situation is becoming increasingly remote, meaning more challenges to Alibaba’s fundamental and valuation outlook. With daily new cases now sitting comfortably in the five-figure territory with no immediate signs of slowing, any sudden pivot would put significant pressure on its healthcare system. This has continued to fuel the Chinese government’s interest in “saving lives [through] strict lockdowns, mass testing and travel curbs…in defiance of a world that has allowed the virus to run rampant and kill millions”. Recent research expects COVID Zero to “stretch beyond 2023” in the bear case given China’s lack of appropriate intensive care capacity:
A full reopening may lead to 5.8 million people being admitted to intensive care, overwhelming a health system that currently has less than four ICU beds per 100,000 people, far less than developed countries…Daily ICU admissions would hit 32,000 [upon immediate reopening], more than twice the 14,500 high-care beds China is estimated to currently have.
Source: Bloomberg
Any sudden pivot in China’s yearslong adherence to COVID Zero would also risk tarnishing the Communist Party’s credibility, though little remains given today’s social unrest spreading across the country in defiance of failed promises time and again from Beijing. To some extent, China’s policy stance is similar to the fear- and respect-based parent-child relationship in the Chinese culture – there is likely fear within the Chinese government that any let up of stringent pandemic preventative measures in the immediate-term would be viewed as authority giving in to people’s cries, which would be considered a power imbalance and sign of weakness, and risk more disobedience to authority in the future (i.e. moral hazard).
As a result of China’s relentless grip on COVID Zero, among other regulatory risks, the volume of foreign capital outflows from Chinese equities has only gained momentum this year, reaching RMB 6.3 billion ($874 million) during Asia trading on Monday (November 28) alone following the growing drumbeat of social instability across China over the weekend. And this persistent trend of high-volume foreign outflows has only added further pressure on Alibaba’s valuation, which is likely to continue given uncertainties over China’s COVID policy agenda. The downward shift in sentiment over the prospect of Chinese equities this year has also encouraged many existing holders looking to recover their losses to sell at any and all rallies, putting any sustained recovery on Alibaba’s valuation further out of reach. This is further corroborated by the Alibaba stock’s inability to shore up momentum last week even after reports that the high-profile Ant Group probe is likely coming to an end with a $1 billion fine.
Worsening outbreaks, ensuing lockdowns, and now, loudening protests have also brought major cities counting Beijing, Guangzhou, and Zhengzhou to a standstill, with vendors and truckers unable to move goods around due to stringent quarantine orders. This continues to underscore the logistics headache that Alibaba’s core Chinese commerce business has been reeling from this year, which has already contributed directly to the company’s first consolidated sales decline over the summer since becoming a public company. The dramatic slowdown in Alibaba’s domestic core commerce sales this year is likely to continue through the December-quarter as China’s economic-driving cities remain in some form of lockdown.
Related risks have already led the company to a pivot in its business strategy from expanding its Chinese user base to retention instead, while turning to overseas opportunities to shore up its top-line growth. But said approaches will be costly to implement, as e-commerce competition ramps up worldwide, while profit margins remain relatively slim in comparison to Alibaba’s low-cost operations on home soil. In addition to global industry leader Amazon, local online marketplace operators spanning Sea’s Shopee (SE) and Zalando (OTCPK: ZLDSF / OTCPK: ZLNDY) are also gradually amplifying risks of overseas market share erosion for Alibaba. Paired with the looming global economic downturn that is requiring deep discounts to win over share of consumers’ dwindling budgets, Alibaba’s near-term growth and profit outlook is likely to remain muted, which risks shattering investors’ confidence further.
Bull Case – China Reopens in the Near-Term
On the flip side, bulls are saying growing unrest within China might just be what it takes to snap the government out of its yearslong adherence to COVID Zero. While any optimistic sentiment has been met with a dash of caution so far, institutional firms including Goldman Sachs are expecting a good chance that China will emerge from COVID Zero “before the second quarter of 2023”. With new cases breaking all-time highs and sprawling lockdowns failing to make any meaningful progress on curbing the virus’ spread rate across the country, bulls see that “China has arrived at the beginning of the end of Zero COVID”.
While chances of reopening in the immediate- to near-term remain slim, given additional considerations like whether China’s healthcare system would handle and the Communist Party’s repugnance towards any action indicative of weakness, it is not entirely out of the question. If the bull case does materialize, Chinese equities would be well-positioned for at least a mild recovery – it would essentially be the best-case scenario in almost two years with the regulatory and COVID overhang stepping out of the front seat.
Although regulatory crackdowns on the private sector remain a key investment risk over Chinese big tech like Alibaba, the intensity and frequency of said impacts have largely mellowed in recent months, while U.S.-mandated PCAOB audit inspections have also yet to uncover any immediate red flags that would amplify delisting risks for the cohort. On the fundamental front, although China’s ongoing property slump will likely continue to weigh on the country’s economic growth prospects, a potential COVID Zero exit could at least bring some welcomed relief to Alibaba’s fundamental performance by clearing up logistics constraints driven by lockdowns and improving both investors’ and consumers’ sentiment:
China’s economic reopening is set to boost equities as households have excess savings, strategists led by [Bank of America’s Michael Hartnett] wrote in a note dated Nov. 22, adding that the ending of Covid restrictions boosted stocks in the US and other countries.
Source: Bloomberg
On the valuations front, any potential for a near-term exit from COVID Zero would also come at an opportune time as U.S. equities face further downside risks in the aftermath of continued monetary policy tightening aimed at reining in decades-high inflation. Theoretically, the removal of the COVID Zero overhang on the valuation of viable Chinese big tech companies like Alibaba would make it a reasonable hedge against the looming U.S. downturn.
However, we view risks of investing in U.S.-listed Chinese stocks a bigger problem than just COVID. Aside from the ongoing economic instability in China stemming from its ailing property sector, the opaque regulatory and policy playbook implemented by the Communist Party is one that cannot and will not be overlooked by both retail and institutional investors. As discussed in a previous coverage, China’s commitment to common prosperity under President Xi’s leadership is not something that would bode well for those that are already prosperous – namely, Alibaba and its big tech peers. Common prosperity is essentially a smokescreen for more income redistribution, antitrust crackdown, and a pandora box of other uncertainties for wealthy and influential private operations like Alibaba from a regulatory perspective.
As discussed in our analysis last year, the rhetoric likely means a potential eradication of Alibaba’s leadership in e-commerce and cloud-computing, as any indications of “inequality” would not meet the requirements of common prosperity…Common prosperity essentially aims at “reducing inequality” across wealth and opportunities, amongst other things. While Alibaba hopes to take its core commerce operations overseas to maintain a longer-term growth trajectory, common prosperity could potentially say otherwise as the mandate aims at levelling out “market leadership.” The opaqueness of China’s regulatory agenda means any rule changes could happen swiftly and brutally (cue the edtech sector that went from everything to nothing overnight). Beijing could easily cite national security concerns as a mean to stop Alibaba short from its aggressive overseas expansion efforts, the same way it restricted overseas securities issuances on Chinese companies, levied harsh penalties against findings of antitrust violations, and released an “unspoken order” for big tech to unravel their sprawling influence through divestments.
Source: “Revisiting Why Alibaba is Uninvestable”
This is further corroborated by high-profile divestments taken by Alibaba and its big tech peers like Tencent (OTCPK:TCEHY) over the past year, with the latest being the latter’s exit from its stake in Chinese meal delivery giant Meituan (OTCPK:MPNGF/OTCPK:MPNGY). And related risks have continued to pressure institutional investors such as Nasper-backed (OTCPK:NPSNY/OTCPK:NAPRF) Prosus NV (OTCPK:PROSY/OTCPK:PROSF) and SoftBank Group (OTCPK:SFTBY/OTCPK:SFTBF/OTCPK:SOBKY) into unloading billions of dollars’ worth of their respective stakes in Tencent and Alibaba to derisk their portfolios. This is consistent with our earlier bear case discussion on the imminent weight of derisking-related selloffs on the Alibaba stock’s prospects, which remains a headwind that extends beyond just the current COVID Zero overhang.
Final Thoughts
While COVID Zero is in the spotlight today, with a potential exit being a welcomed near-term relief for battered Chinese equities, it is not the solution to Alibaba’s dire valuation prospects in our view. With common prosperity still deeply embedded in President Xi’s regime, today’s COVID Zero situation and ensuing protests are merely a smokescreen for deeper rooted risks in investing in private Chinese big tech.
The structural problem weighing on the valuation of successful private Chinese companies like Alibaba is not COVID Zero nor regulatory uncertainties, but rather China’s common prosperity campaign. Paired with a Standing Committee today that offers little experience other than loyalty at all costs to President Xi, common prosperity will remain a reappearing dagger over Alibaba’s performance time and again whenever smokescreens – whether it be COVID Zero lockdowns, regulatory changes, macroeconomic uncertainties, or geopolitical bickers – get resolved.
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