Wednesday, June 12, 2024

Short-Term Gains vs. Long-Term Risks: Evaluating Chinese Stocks in Your Portfolio

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Over the past half-decade, China has implemented unpredictable and business-unfriendly policies, including the world’s longest-lasting COVID-19 lockdown, making it a challenging environment for investment. A poll conducted at a Goldman Sachs conference in Hong Kong in early February indicated that over 40% of attendees considered China ‘uninvestable.’

Major companies like Apple Inc. (AAPL) and Samsung are also shifting their supply chains away from China, and many others are not planning future investments in this previously coveted market.

As the Chinese economy grapples with market weakness, the New York Times reported a shift in the government’s stance towards more business-friendly policies.

Moreover, JPMorgan analysts are optimistic about the continuation of positive China trading trends, predicting this momentum could extend through the summer. While longer-term structural concerns such as deflationary backdrop, excess capacity, real-estate demand-supply imbalances, credit saturation, and global decoupling persist, analysts believe the worst of the housing market weakness is over. And that should keep the rally going.

Last week, Alibaba Group Holding Limited (BABA), JD.com, Inc. (JD), and Baidu, Inc. (BIDU) released their quarterly results, revealing that growth, although modest, continues. Their management teams are effectively delivering on efficiencies and enhancing shareholder value.

BABA shares have gained more than 8% over the past five days, while JD saw marginal gains over the same period. Although down 4% in the past week, BIDU has logged nearly a 7% gain over the past month.

Meanwhile, the iShares MSCI China exchange-traded fund (MCHI) climbed 17% over the past month, outpacing the S&P 500, which rose nearly 7%.

Despite these gains, the question still lingers: is the rally short-lived? Let’s dig deeper.

Alibaba Group Holding Limited (BABA)

The Chinese e-commerce giant Alibaba Group Holding Limited (BABA) faced tough regulatory, macroeconomic, and competitive headwinds in the past. For the fourth quarter that ended March 31, 2024, BABA’s revenue increased by a modest 7% year-over-year to $30.73 billion. However, the company’s income from operations declined 3% from the prior-year quarter to $2.05 billion.

Alibaba has been navigating a period of cautious consumer spending in China, yet there have been signs of a slight recovery in its core e-commerce business. Revenue from the Taobao and Tmall Group rose 4% year-over-year to $12.91 billion.

Also, customer management revenue (including marketing services for merchants on Taobao and Tmall) increased 5% after being flat in the prior quarter, and revenue from the Alibaba International Digital Commerce Group (AIDC) surged 45% year-over-year to $3.80 billion.

CEO Eddie Wu’s commitment to “reignite” growth through further investments showed early results in the March quarter, as he noted the strategies were “working and we are returning to growth.”

However, BABA’s net income plunged by 96% from the prior year’s quarter to $127.18 million, primarily due to a decline in the value of its holdings in other publicly traded companies. The company’s non-GAAP earnings per share fell 5% from the year-ago value to $0.18. Also, its adjusted EBITDA decreased by 5% year-over-year to $3.32 billion.

Analysts expect Alibaba’s revenue for the first quarter (ending June 2024) to increase 5.5% year-over-year to $34.22 billion. However, its EPS for the ongoing quarter is expected to decline by 15.2% year-over-year to $2.04. Further, for the fiscal year 2025, BABA’s revenue is forecasted to reach $140.52 billion (up 8% year-over-year), while the consensus EPS estimate of $8.25 indicates a 4.1% decline from the prior year.

In terms of forward non-GAAP P/E, BABA is trading at 10.74x, 31.9% lower than the industry average of 15.79x. Likewise, its forward EV/EBITDA and Price/Book multiples of 6.93 and 1.47 are 28.9% and 40.5% lower than the industry averages of 9.74 and 2.48, respectively. Attractive, isn’t it? But the question remains: why is this stock so cheap in the first place?

In response to its low valuation, Alibaba’s management repurchased $4.8 billion worth of shares in the fourth quarter. Although buybacks can theoretically boost the value of remaining shares by reducing the number outstanding, they fail to tackle the fundamental reasons for Alibaba’s low stock price.

Alibaba’s diverse investments dilute its focus on core e-commerce and cloud businesses, impacting its efficiency and valuation in the long run. For instance, although the management reported triple-digit growth in AI-related revenue in the fourth quarter, the cloud computing division only expanded by 3% year-over-year to $3.55 billion.

The stock has gained over 28% over the past month and nearly 14% year-to-date. Despite these gains, many investors are wary of the unpredictable and hostile Chinese market, and Alibaba’s sprawling conglomeration of disjointed businesses further diminishes its appeal. Plus, the company’s AI prospects seem weak compared to U.S. competitors.

Given BABA’s mixed financial performance and uncertain near-term outlook, waiting for a better entry point in this stock seems prudent.

JD.com, Inc. (JD)

Headquartered in Beijing, JD.com, Inc. (JD) offers a wide range of products, including computers, communication devices, consumer electronics, home appliances, and general merchandise. It also provides online marketplace services for third-party merchants, marketing services, omnichannel retail solutions, and online healthcare services.

In the latest quarter, the Chinese online retailer saw accelerated growth in its topline and market share, complemented by a robust bottom line that exhibited healthy gains. As consumers have been gravitating toward low-cost, discount-focused platforms, the company’s strategic price cuts and discount coupons have boosted sales that have been hit by cautious consumer behavior.

JD’s CEO, Sandy Xu, highlighted strong performance in categories like general merchandise, electronics, home goods (especially mobile phones), and apparel. He added that improved price competitiveness resonated with users, accelerating growth in lower-tier cities faster than in higher-tier cities.

During the first quarter that ended March 31, 2024, JD’s net revenues increased 7% year-over-year to $36 billion, beating analysts’ estimate of $35.68 billion. Its income from operations grew 19.8% from the prior year’s quarter to $1.10 billion. Furthermore, non-GAAP net income attributable to the company’s ordinary shareholders came in at $1.20 billion and $0.78 per ADS, up 17.2% and 18.7% year-over-year, respectively.

Earlier this month, analysts expressed concerns about the impact of JD.com’s low-cost strategy on margins and profitability. However, CFO Ian Shan dismissed these worries, stating that increasing users and profitability simultaneously is not contradictory.

“We believe by constantly dedicating resources to product, price, and service, this improves user experience, which drives up GMV (gross merchandising volume) and market share,” forming a virtuous cycle of business enhancement and profit growth, Shan explained.

Looking at the balance sheet, JD.com holds more cash than debt, which indicates financial stability and potential for investment in growth opportunities. As of March 31, 2024, its cash and cash equivalents stood at $11.31 billion, and its total current assets were $39.34 billion. Also, JD’s free cash flow increased by 166.3% over the past 12 months, reaching $7.01 billion.

This strong cash position allowed the company to pay an annual dividend (yielding 2.19% at the current price level) for the year ended December 31, 2023, of $0.38 per ordinary share, or $0.76 per ADS, to its shareholders on April 23, 2024. JD’s four-year average dividend yield is 1.24%, with a payout ratio of 23.45%.

Despite robust short-term performance, JD.com has been cautious with international expansion compared to its peers. For instance, it opted not to acquire the warehouse and store network of British electrical retailer Currys in March. However, with expectations of slowing domestic growth, the company might need to explore new overseas revenue streams to sustain its momentum.

In terms of forward non-GAAP P/E, JD is trading at 10.66x, 32.5% lower than the industry average of 15.79x. Similarly, its forward EV/Sales multiple of 0.30 is 75% lower than the industry average of 1.22. Also, the stock’s 0.33x forward Price/Sales compares to the 0.89x industry average.

Street expects JD’s revenue and EPS for the second quarter (ending June 2024) to increase 5.6% and 7.2% year-over-year to $41.69 billion and $0.79, respectively. Also, the company has topped the consensus EPS estimates in all four trailing quarters.

For the fiscal year 2024, the Chinese online retailer’s revenue and EPS are anticipated to grow 6.6% and 7.4% year-over-year to $160.66 billion and $3.31, respectively.

Shares of JD have surged more than 43% over the past three months and approximately 20% year-to-date.

Based on the company’s outlook, JD.com is focused on enhancing user experience and solidifying its market position for sustainable growth. This includes developing an ecosystem benefiting both first-party and third-party merchants. Additionally, the company’s shareholder-friendly actions, such as share repurchases and dividends, will likely bolster investor confidence and support the stock’s valuation.

Analyst Saiyi HE maintains a bullish outlook on the stock, with a price target of $51.90.

Considering these factors, along with JD.com’s ongoing initiatives and potential for margin expansion, investors should closely monitor the company’s performance throughout this year.

Baidu, Inc. (BIDU)

Baidu, Inc. (BIDU) operates as a Chinese-language Internet search provider with its headquarters in Beijing. Its Baidu.com platform enables users to discover online information. The company operates through two segments, Baidu Core and iQIYI.

Often called the “Google of China,” Baidu is a prominent AI leader in the world’s second-largest economy. It not only develops AI tools but also supports the technology through its cloud computing infrastructure. Baidu launched the ERNIE bot, China’s first public ChatGPT-like tool, and has a growing business in self-driving taxis.

For the first quarter that ended March 31, 2024, BIDU reported a marginal year-over-year increase in its revenues of $4.37 billion, slightly above Wall Street’s estimate of $4.34 billion. Its non-GAAP operating income rose 4% from the year-ago value to $924 million. Its non-GAAP net income came in at $971 million, up 22% year-over-year.

 Baidu’s focus on AI-driven advertisements and cloud services is expected to drive long-term growth despite potential short-term volatility in ad revenue due to the lower monetization of AI-generated search results. Moreover, AI significantly contributed to Baidu’s performance in the latest quarter. The core business, which includes online marketing and AI efforts, reported revenue ahead of analyst expectations, driven by a 6% annual growth in the AI Cloud segment.

“Baidu Core’s online marketing revenue remained stable, while the end-to-end optimization of our AI technology stack continued to propel the growth of our AI Cloud revenue during the quarter,” said Robin Li, Baidu’s CEO, in a statement.

The company’s non-GAAP earnings per ADS amounted to $2.76, a 23.7% increase from the prior year’s quarter. In addition, its adjusted EBITDA increased marginally year-over-year to $1.14 billion.

As of March 31, 2024, the company’s cash and cash equivalents were $4.21 billion, and its total current assets stood at $30.12 billion.

Rong Luo, Baidu’s Chief Financial Officer, stated, “In the coming quarters, we will execute on what is needed to optimize our operational efficiency in support of our AI enabled businesses and high-quality growth, and maintain a healthy non-GAAP operating margin.”

In terms of forward non-GAAP P/E, BIDU is currently trading at 9.87x, 28.7% lower than the industry average of 13.86x. Also, its forward EV/EBIT multiple of 8.61 is 42% lower than the industry average of 14.85x.

Analysts expect BIDU’s revenue for the second quarter (ending June 2024) to increase 3.1% year-over-year to $4.81 billion. However, its EPS for the current quarter is expected to decrease by 12.2% year-over-year to $2.71. Over the past month, the stock has gained more than 17% to close the last trading session at $108.87.

While the firm’s short-term gains are apparent, demonstrated by robust financial performance and stock price increases, there are looming risks, primarily due to potential fluctuations in ad revenue and the complexities of integrating generative AI capabilities.

Given this backdrop, investors should monitor BIDU’s progress closely, especially its advancements in AI and cloud services, to evaluate the sustainability of its growth.

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