Why I will never own Alibaba shares

I once considered Ali Baba (NYSE: BABA) an undervalued growth stock. It is still trading at just 21 times forecast earnings, and analysts expect its revenue and earnings to increase by 50% and 37% respectively this year. And its leading positions in China’s e-commerce and cloud markets also allow it to easily crush its smaller competitors.

But after carefully reviewing Alibaba again, I don’t think I’ll ever buy this seemingly attractive Chinese tech stock, for three simple reasons.

1. Its growing dependence on low-margin companies

Alibaba looks like a reverse version of Amazon (NASDAQ: AMZN). While Amazon is subsidizing the growth of its low-margin retail segment with its higher margin cloud business, Alibaba is subsidizing the growth of its unprofitable business (including its cloud division) with its core commerce revenue at higher margin.

Image source: Getty Images.

Therefore, Alibaba’s future profit growth relies heavily on its core commerce segment, which includes its online marketplaces, cross-border marketplaces, physical stores and Cainiao logistics unit.

Alibaba’s core business activity continues to grow at a steady pace. Its core business revenue grew 35% in fiscal 2020, which ended last March, and represented 86% of its revenue. Segment revenue grew a further 32% year-over-year in the first half of fiscal 2021.

However, it also relies more on its “New Retail” business (including physical stores), its cross-border wholesale segment and Cainiao to drive its growth. These companies all generate lower margin revenues than its main markets Taobao and Tmall, which charge merchants listing fees and commissions.

As a result, the Adjusted EBITA margin of its core business segment increased from 38% to 35% between Q2 2020 and 2021. Its Total Adjusted EBITA margin remained stable at 27%, thanks to lower losses in its unprofitable business, but this balance act could easily collapse in the near future.

2. Endless regulatory challenges

Meanwhile, a seemingly endless barrage of regulatory challenges in the United States and China could make it even more difficult for Alibaba to continue to grow.

Image source: Getty Images.

Last December, the United States passed a law that would strike off all foreign companies that failed to comply with the new audit requirements for three consecutive years. Alibaba’s secondary listing in Hong Kong at the end of 2019 indicates that its days on the NYSE may be numbered.

Taobao also remains on the US Trade Representative’s “Notorious Markets for Counterfeiting and Piracy” blacklist due to the prevalence of counterfeit products on its platform. This reputation could trigger sanctions against its cross-border markets.

In China, government regulators clearly want to put the brakes on Alibaba. In 2019, the government sent officials to work at dozens of companies, including Alibaba, to oversee their operations. Last year, the Communist Party Central Committee tightened this grip by requiring all companies to hire a certain number of registered CCP members.

That tension finally ended last year when China slammed its hammer on Alibaba. It derailed the long-awaited IPO of its fintech subsidiary Ant Group, fined Alibaba for an unapproved acquisition and launched a full antitrust investigation into its e-commerce operations.

Regulators would like Alibaba to end its exclusive deals with traders and slow down its promotional pricing strategies, which could make it harder to pursue its main profit driver. It would also leave Alibaba more exposed to competition from JD.com (NASDAQ: JD) and Pinduoduo (NASDAQ: PDD) – who both accused Alibaba of anti-competitive strategies.

3. Ethical considerations

In 2017, the Chinese government said the country would rely on Alibaba for the development of smart cities, Tencent (OTC: TCEHY) for digital health, and Baidu (NASDAQ: BIDU) for driverless cars.

The term “smart cities” may sound vague, but collectively it refers to Alibaba’s cloud services and facial recognition technologies. The Chinese government relies heavily on these technologies to monitor its citizens, and these technologies are closely linked to a government database.

It’s already troubling, but Alibaba recently demonstrated how its technologies can be used to identify the faces of Uyghurs and other ethnic minorities across China. Alibaba says the feature can be integrated into websites to monitor users for terrorism, pornography and other “red flags.”

China’s human rights record is already dismal, and it is currently accused of imprisoning and sterilizing Uyghurs in re-education camps, so Alibaba’s worrying claims raise far too many ethical concerns. They could also make Alibaba an easy target for sanctions if the Biden administration maintains the Trump administration’s tougher stance against Chinese tech companies. As a result, I am avoiding Alibaba for the same ethical reasons that I recently sold Tencent: I am just not interested in owning any part of China’s mass surveillance system.

The key to take away

I understand why Alibaba still looks like an attractive stock buy for many investors, and it could definitely climb higher in the future. However, there are just too many regulatory, growth and ethical challenges ahead for me to consider it a worthwhile long-term investment.