Regulatory Impact To Alibaba’s E-Commerce Sales

It was announced on Christmas Eve that Chinese regulators will look into Alibaba’s (BABA) practice of pressuring online merchants into entering forced exclusivity agreements, essentially giving them the option of either listing their products solely on Alibaba’s platform or not at all – making them ‘pick one from two’ (with the other usually being Pinduoduo, Alibaba’s main competitor in terms of number of active users).

Alibaba shares were down 13% intraday as at the time of writing this article, and are now down about 30% from the recent peak in late October.

Data by YCharts

This investigation comes on the heels of earlier regulatory announcements relating to new draft rules for online micro-lending and anti-monopoly rules for Chinese internet companies, as reported here.

Alibaba is the largest e-commerce platform in China by annual active users, though rival Pinduoduo (PDD) has been catching up quickly. Pinduoduo has a focus on the group buying channel, a system that lowers prices due to economies of scale in purchasing, which tends to attract the lower-to-middle income consumers, particularly in the lower-tier cities in China. The lower tier cities are seen as the next big battleground for e-commerce platforms in China, given their relative degree of e-commerce under-penetration and potential income growth. Hence, at first glance, the news on regulators’ fresh look into Alibaba’s forced exclusivity practices seems like an early Christmas present for Pinduoduo, as it would ratchet up the competition against Alibaba, lowering growth expectations and valuations. However, as would be seen below, the numbers tell a different story, and the worry about Alibaba losing sales to Pinduoduo is probably overdone.

Source: Alibaba, Pinduoduo, JD.com

Estimating the impact – it is immaterial

Alibaba has disclosed in its filings that it has “tens of millions” of merchants on its China retail e-commerce platforms, of which Tmall (the premium online platform, hosting big names like Nike and Shiseido) has 250,000 brands and merchants. Taobao, the platform which hosts many individual and SME sellers, and accounts for over 80% of Alibaba’s China Retail commerce revenues, would account for the lion’s share of the remainder.

The question is – to what extent do these ‘forced exclusivity’ agreements permeate Alibaba’s e-commerce ecosystem? How many merchants have been forced to list on just Alibaba’s platforms alone?

Thankfully, Pinduoduo had dropped a big hint in their 3Q19 analyst call last November. I quote:

“… prolonged pressure exerted by dominant platforms on merchants to take sides. For the last 12 months, the pressure on brands and businesses have intensified, and over 1000 well-known brands’ flagship stores have been affected on our platform with a total number exceeding 10000.”

Being conservative and assuming the number of merchants affected are 1500 and 15000 respectively, and that Taobao has 15m merchants on it, we can estimate that:

1) 0.6% of Tmall’s merchants (1500/250000) have been forced into exclusivity agreements; and

2) 0.1% of Taobao’s merchants (15000/15m) have been forced into exclusivity agreements

If we further assume that Tmall/Taobao account for 20%/80% of Alibaba’s China Retail revenues, and that half of the revenue from merchants currently in forced exclusivity agreements will shift to other platforms (e.g. Pinduoduo, JD.com), I estimate that the impact to Alibaba’s China retail segment’s revenues is a mere 0.1% in total. That number is likely to be a slightly higher on a profit level (given operating leverage, or de-leverage), but still, we are potentially talking about maybe 0.2-0.4% hit to China retail segment profits.

Source: Author’s estimates

Alibaba’s China retail segment accounts for 65% of the group’s total sales. So the total revenue and profit impact on a group level would be even smaller.

Source: Alibaba’s 20-F filing

Great opportunity to buy BABA at near trough valuations

Given the analysis above, perhaps the selloff we are seeing in BABA has been way overdone, and this provides a great opportunity to buy into the shares at forward P/E valuations that are trading near the bottom of their historical range, and approaching their trough level of about 16x.

Also, given that consensus is expecting Alibaba’s EPS growth to average around 29% in the next three years between FY20 and FY23 (ending March 2023), that puts the current PEG ratio at just over 0.6x, which suggests that Alibaba is substantially undervalued.

Another way to think about it is that the current price of US$222 is very close (albeit still slightly higher) to the price levels that we saw during 2018, while Alibaba’s EBITDA in FY20 has already expanded to over 40% higher than FY18. So we are buying at near 2018 levels for a much higher realised profit level. That’s a steal in my books.

Data by YCharts

Summary

Alibaba shares are down sharply following news that China’s regulators would investigate its practice of coercing merchants into forced exclusivity agreements.

But analysis shows that the impact to Alibaba’s revenues is likely less than 0.1% on a group level.

With Alibaba trading near the bottom range of its forward P/E valuation range and at 0.6x PEG, this is a great opportunity to buy into China’s largest e-commerce platform.