Alibaba Group: More than a gamble on US-China politics?

Brief company history

What started in a small apartment, ultimately became the leading E-commerce player in China. Jack Ma and 17 of his friends founded Alibaba.com in 1999. They shared a belief that the internet would radically change the way businesses operated in China. The same year, it already raised 5 million USD from a consortium of investors. Soon after, it raised 20 million USD from an investor group led by Softbank. It became profitable three years after launch.

What followed were a number of subsidiaries created in niche areas where the internet had not yet reached its full potential: payments, wholesale (B2B) E-commerce and marketing. In 2005, Yahoo! bought 40% of Alibaba for 1 billion USD. Alibaba continued its technology offerings with the shaping of its Cloud business in 2009, a segment that gained in importance during the recent years. In 2014, it finally offered global investors the opportunity to buy shares in the company, with its IPO on the NYSE bringing in 25 billion USD.

Alibaba Senior Management overview

The below table presents an overview of Alibaba’s leadership

Business Model

Focusing on the numbers a bit more, we can see that Alibaba reports revenue across a range of categories. These are listed below, as well as the % of total revenue for each category.

• Core commerce (0.86)
  • China retail business (0.64)
    • Customer Management (0.46)
    • Others (0.18)

• China wholesale business (0.03)
  • International retail business (0.05)
  • International wholesale business (0.02)
  • Cainiao Logistic Services (0.05)
  • Local Consumer Services (0.05)
  • Others (0.02)

• Cloud computing (0.09)
• Digital media & entertainment (0.05)

We can see that the majority of its revenue is coming from its domestic retail business (64%). Alibaba is most known for its role as an E-commerce intermediate, offering retail and wholesale merchants an online platform to sell their goods on.

Its subcategory “customer management” is an interesting one. This contains revenue from merchants who pay a premium to partner with Alibaba’s marketing & analytics component, Alimama. The merchants pay the company for its insights in its customers data, which is gathered from its “Uni ID”. The Uni ID is a unique identifier key who trackers users as they interact with Alibaba’s business and enabling services. Alimama offers the merchant a new way to receive insights in who its customers are, what they recently bought and what they might need next . Although the details of this technology are exceptionally interesting, the working of the Uni ID and the “Brand Databanks” would lead us to far away from the scope of this analysis.

The “Others” category under China retail business includes revenue that is primarily generated by what Alibaba calls “New Retail”, a way of combining offline and online retail through its subsidiaries Tmall Supermarket, Taoxianda and Freshippo.

The above categories also showcase the range of services Alibaba is offering, from E-commerce on a domestic and international level to logistic services, technology (cloud, collaboration platforms, analytics) and financial services. We’ll have a closer look into these offerings in the next segment.

Subsidiaries

The below report from its 2020 SEC filing (Form 20-F) shows an overview of Alibaba’s main subsidiaries and investments.

As discussing all of the different subsidiaries would lead us to far, we instead want to highlight some of them below.

Sun Art Retail

Recently, Alibaba Group acquired a controlling stake in Sun Art Retail for approx. 3.6 bln USD. With the takeover of the largest hypermarket retail chain in China, it hopes to further develop its “New Retail” strategy. Alibaba provided a number of objectives for Sun Art Retail. This includes “increase digitization of offline traffic and activities, synchronizing online and offline channel inventories, broadening the supply chain network and increasing Sun Art’s addressable market through greater online purchases” (MFTranscribing, 2020). Investors could compare the move with Amazon’s increasing focus on offline commerce through Amazon Go, Amazon Fresh and the (failed) Amazon restaurants. We highly recommend the reader to research the “New Retail” strategy, as it offers a glimpse on future commerce, an effortless new way of shopping by combining offline and online retail methods.

AliExpress

The well-known international E-commerce platform where foreign buyers have access to goods from (mostly) Chinese merchants. Currently, AliExpress continues its business recovery in the aftermath of the pandemic. Although some might know Alibaba mostly through the AliExpress platform, international retail commerce only accounts for 5% of the group’s revenue. This shows that even with continued pressures on the US vs China front, Alibaba’s business model is quite robust because of its large domestic market.

In their latest earnings call, management stated that they will “continue to drive our business with our three strategies: domestic consumption, cloud computing and data intelligence and globalization.”.

Ele.me

The food delivery market is expected to increase significantly in the coming years, and Alibaba is well positioned to participate in this growth through its delivery platform “Ele.me”. According to management, the business is further expanding from an food delivery platform to a destination on-demand delivery service and in-store consumption services, along with is “New Retail” Strategy.

Cloud

Currently 5% of revenue – but to this date a loss making segment – Cloud is expected to be an important growth driver in the future.  Over the course of March to September 2020, Alibaba’s cloud business grew by 60%. In September, Alibaba CFO Maggie Wu indicated the “cloud computing business is likely to become profitable for the first time in the current fiscal year”. Alibaba’s reporting period runs from the April 1^st to March 31.  She further added that “we do not see any reason that for the long‑term, Alibaba cloud computing cannot reach to the margin level that we see in other peer companies” (MFTranscribing, 2020).

Ant Group

Previously Alipay, the affiliate company got rebranded to Ant Group Services on 23 October 2014. The company is mainly active in financial services. The bulk of its revenue is obtained through a) payments and b) its intermediary role as a Fintech player. Ant Group is able to provide a (quasi) tailor made approach to traditional lending; evaluating customer and SME credit risk and matching this with a credit from its partner banks. It does so without keeping any of the capital on its balance sheet. Other areas where it is active include money market funds (short-term liquidity and settlement funds), mutual protection services and wealth management. Alibaba currently has a 33% stake in Ant Group. The company was expected to make an initial US listing, but this was abruptly halted by Chinese regulators. More on the IPO suspension and its potential causes in the risk segment [4].

Regulatory pressures: Anti-trust laws

It’s worth illustrating the current pressures internet companies are facing from Chinese regulators. In the past, regulators didn’t intervene as much, as China still had a long way to go in terms of building an ecosystem of internet companies that would one day match companies in the United States.

The regime’s stance slowly changed over time, as the internet platforms became larger in size and their influence spread across multiple industries. Recently, the party made their views explicit, raising concerns on the power and dominance of big tech players such as Alibaba and Tencent.

On November 10th 2020, China’s State Administration for Market Regulation (“SAMR”) issued the Guidelines for Anti-monopoly in the Platform Economy “in order to prevent and stop monopolistic behavior in the platform economy, guide operators to operate in compliance with laws and regulations, and promote the sustainable and healthy development of the online economy”.

It rulings includes, for example, for internet platforms not to:

• sell goods below their cost price
• enter exclusive contracts with other parties
• discriminate users on price based on customer data analytics (profiling)

Violations against these guidelines can result in fines of up to 10% of revenue, signaling a significant risk for the company and its investors. Other government bodies have also rolled out new rules aimed at regulating the internet companies in specific sectors, such as finance and media. Around mid-December, regulators even went so far as to fire a “warning shot” at Alibaba of $75.000 for failing to report a recent acquisition.

It’s worth investigating why the regime decided to change course on this matter. Numerous writers and news reports already gave potential rationales, and we go over some of them below:

RATIONALE 1 – The Chinese Party actually wants to prevent monopolistic powers in some sectors

To our belief, this explanation to why the regime is implementing anti-monopoly laws doesn’t reflect the actual strategy. Currently, the State-Owned Enterprises (SOE’s) have much more influence than the technology players. Last April, president XI made clear that the SOEs are “important material and political foundations” and the he would make them “stronger, better and bigger”. If one would want to reduce monopolistic powers in China, one would start by decreasing the reach of these SOE’s instead.

RATIONALE 2 – Recent regulatory changes is the Chinese party striking back at Jack Ma for his unreserved comments on the way State banks operate.  

Although relevant, the recent anti-monopoly laws are bigger than an attempt to muzzle Jack Ma. As his recent comments on China’s banking system might have helped to induce the IPO suspension, we expect him to follow suit on the party’s will. It’s worth mentioning that he is a party member since 2013, and he publicly supported the government’s action against Hong Kong Protestors in 2016.

RATIONALE 3 – Increase CCP power in areas where they allowed private players to expand significantly

This argument, to us, most likely reflects the regime’s thinking.  Economic power creates political power. By strengthening the CPC’s grip on the economy, it will bolster its political security in the long term. As the SOE’s (State Owned Enterprises) have close to no exposure to this market, it makes sense for the regime wanting to be more involved in strategic decision making of economic (tech) giants in China. It can do so through direct regulatory actions or through SEO’s taking ownership stakes in these companies. In the long term, this might hamper Chinese growths as foreign partners will be less reluctant to do business with these companies.

Key Performance Indicators – GMV / Take rate

Gross Merchandize Volume, an important metric for E-commerce platforms, increased 21% YoY in Q2 of FY2021[1]. GMV is the sum of the value of the goods being sold on the platform for a given period. The fast growing category is FMCG (Fast Moving Consuming Goods), indicating Chinese households are increasingly using online channels for their day-to-day purchases.

Alibaba added a comparison that if economist would consider GMV at par with GDP as a metric for economic scale, Alibaba would be in the group of the 20 (!) largest countries worldwide.

Another important metric is the take rate, which is the company revenue divided by the platform GMV. In other words, the take rate indicates what part of a transaction they facilitate the companies get to keep as revenue. The stronger a brand ecosystem, technologic advantage and customer reach,  the more merchants will be willing pay (commissions, paid clicks…) in return of listing their products on a platform. Alibaba’s take rate has been increasing along with the companies’ platform expansion. As of June 2020, it was calculated at 4.5% (compared to 3.3 % in 2017).

Financial Reporting KPI’s

The below tables provide a detailed view on the financial performance indicators. Some comments are provided where relevant.

Stock performance

Chinese tech stock (listed in the U.S.) made quite the run in 2020, although Q4 was more challenging with Alibaba Group receiving negative press related to Ant Group, its founder Jack Ma and stricter US listing requirement on Chinese (Telecom) companies. The below graph displays the 6 months stock performance of Alibaba together with JD.com and Amazon, Alibaba’s main competitor in respectively China and the U.S. Due to the stock-specific (negative) news concerning Alibaba, JD was able to significantly outperform BABA (orange).

(TradingView, sd)

We compare these companies and their respective valuation in the next segment.

Valuation Metrics

If we look at Alibaba’s stock valuation metrics and compare them with the other tech giants (both Chinese and American), we can identify Alibaba as the leading company in terms of operating profit margin, price to earnings metrics and price to book values. Of course, this is all relative – it’s clear that these companies are currently trading at very high valuations. Investors are seeking a return on their capital and the low-interest environment has pushed stock valuations of technology large caps to all-time-highs. Despite this, we should highlight that Alibaba still has a lot of room to grow in some of its revenue segments, with Cloud being the most important one.

Peter Lynch’s 6 categories of stocks: Alibaba

According to Peter Lynch, one of the world’s greatest fund managers, stocks can be categorized into 6 groups[3]:

Alibaba can be classified as a Stalwart, with a considerable market capitalization while there is still considerable growth in its earnings per share. One advantage of investing in a stock like Alibaba is that you can hold it for as long as it is able to attract value from industries that contain segments that are not (yet) in the maturity stage, like E-commerce (although debatable), food delivery, and financial (technology) services.

[1] Unpaid orders are left out of GMV calculations.

[2] Operating Profit Margin is defined as operating income divided by total revenue (latest available data). Indicating the way in which a company is able to derive operating income from revenue.

[3] Source: https://library.jitta.com/en/blogs/peter-lynch-6-types-of-stock

Risk 1: Ant Group

The first risk we want to highlight in investing in Alibaba is the uncertainty around its 33% stake in Ant Group, a fintech firm specialized in payments, analytics and financial services. What should have been the largest IPO ever (raising 34 billion USD), was abruptly shut down by financial regulators, stating the company was ill suited for investors. At the time, Ant Group was valued at over 300 bln. USD, with Alibaba’s stake representing around 15% of the group’s market cap.

Despite some headlines indicating that outlets of Jack Ma on the Chinese banking industry cause the IPO shutdown, a closer look into the issue shows regulators had raised concerns regarding fintech companies for some time. Banking regulators had even submitted policy proposals to the government, according to an unnamed source (Jiang, 2020).

Ant Group, in an attempt to satisfy regulators, would restructure its business and create a separate holding for its banking business. As this entity would fall under banking regulations, it would have to comply with the same standards (of regular banks) on topics like data protection, risk management, capital requirements and fraud prevention. Ant had previously avoided those rules by arguing that it’s not a bank, but a technology company that works with banks to facilitate financial services (PYMNTS, 2020). Increasing regulatory requirements are a significant risk to Ant’s growth, and thereby also to investors in Alibaba Group. 

Risk 2: Anti-monopoly regulation

This point was already discussed in the “qualitative analysis” section, and we will add some comments and share our outlook with regards to regulation of Chinese tech firms. 

What concerns Alibaba’s, we believe that the company will start to feel more pressure from regulators and eventually concede to this pressure by marching in correspondence with the party’s will or even go as far as allowing public ownership of some of its (media) subsidiaries. The newly appointed CEO and chairman, Daniel Zhang, pledged loyalty to authorities on behalf of the company, saying the new guidelines on internet companies are “timely and necessary”.

The company management will have to find a balance in pleasing its own regulators while simultaneously maintaining its status as independent identity towards foreign countries and partners, unless it wants to be regarded as the next Huawei.

Jack Ma’s influence on Alibaba will remain limited, as he is no longer involved in the company’s decisions making.

Conclusion

Despite its size, Alibaba is a stock that receives a lot of attention and is regularly traded on the basis of news instead of underlying fundamentals. As a result of this, trading is often highly volatile. Investors should factor in the geopolitical risk of rising US/China tensions, but also the growing influence of the Chinese Party on the domestic tech players. 

Despites these risks, we believe Alibaba is unique in its vision, range of offerings, leadership and – most notable for investors – stock valuation. Compared to its US peers, it still has a lot of margin for growth in areas like global E-commerce, food delivery and cloud. In our opinion, this growth is not fully reflected in the current stock price.

Over the past 3 – 4 months, Alibaba’s stock has been lagging the broader market and its Chinese peers. We believe this will not continue, unless regulators take drastic measures as a way of reducing Alibaba’s monopolistic powers by forcing it to split up (some of) its subsidiaries. Other downward pressures might involve negative (regulatory) news regarding Ant Group.

Potential catalysts for the stock include the new US administration taking a (somewhat) softer approach to China, Alibaba’s next financial reporting on February 2021, as well as fading regulatory pressures in its domestic market.

Entry point & how to take on a position

Given the recent headwinds, the stock is trading slightly above where it was 1 year ago. We believe the short-term outlook is positive, and would advise investors to take on a first position around the 245 USD region.

Shares of Alibaba are trading on the New York Stock Exchange (in USD) and on the Hong Kong Stock Exchange (in HKD). Other trading options include the options and bond market. We would advise international investors to take a position on American Exchanges, as liquidity is higher in these markets.

Note that on the date of publishing – and apart from the Chinese Telecom companies  – it looks like no further action will be taken by the US government to restrict or fully remove Chinese listings on American exchanges.