During the recent market volatility, I decided to build a position in Alibaba Group Holding (NYSE: BABA). This might be surprising to those who are familiar with my long-standing bearishness on the Chinese economy. Aside from buying one Chinese stock 5 years ago (which turned out to be a fraud), I have always traded China from the short side.
That being said I am always searching for companies having market leading positions in large industries with secular tailwinds and being run by highly successful operators. These companies tend to be easily identified by investors, and consequently trade at rich valuations. However, during market corrections and economic slowdowns, the baby is often thrown out with the bathwater. I believe the recent stock market correction along with an economic slowdown in China has presented a compelling investment opportunity in Alibaba.
Alibaba is synonymous with e-commerce in China. The company’s platform provides the fundamental technology infrastructure and marketing reach to help businesses leverage the power of the Internet to establish an online presence and conduct commerce with consumers and businesses. Given the scale it has been able to achieve, an ecosystem has developed around its platform that consists of buyers, sellers, third-party service providers, strategic alliance partners, and investee companies. Much of Alibaba’s effort is spent on initiatives that are for the greater good of the ecosystem and the various participants in it.
The popularity of Alibaba’s platform has resulted in rapid revenue growth and high profitability as shown in the table below.
Although China’s economy is facing a significant slowdown, the weakness is likely to be confined to fixed asset investment as investing slows after outpacing the overall economy for the past several decades and being artificially stimulated during the recent global financial crisis in order to revive growth. As shown in the following chart, the growth in retail sales has been fairly stable and now exceeds investment spending.
Within China’s retail sector, e-commerce will continue to take a greater share of total retail sales, which is to the benefit of Alibaba.
With 386 million annual active buyers and 346 million monthly active users on mobile, it is inevitable that Alibaba’s China e-commerce growth will slow. However, investors are overlooking some of Alibaba’s other businesses which are experiencing hyper-growth and have the potential to significantly add to the bottom line down the road, while strengthening the company’s platform.
Aliyun is Alibaba’s cloud computing unit which was started in 2009. Restrictions on foreigners investing in the online services industry gives Chinese companies a significant advantage when competing against Amazon and Microsoft. Aliyun has become a world-class cloud computing service platform and is the market leader in China. While holding a 23 percent market share in its home market, Alibaba has set its sights on the cloud computing space beyond China, eager to tap into a market that according to researcher IDC could grow into a $100 billion industry by 2017. With only about 10 percent of IT budgets spent on cloud computing in Asia, there is plenty of room for growth outside of China. Cloud Computing can be a highly profitable business as disclosed by Amazon’s AWS unit which had 21% operating margins last quarter. The chart below shows that Aliyun is registering exponential revenue growth.
Alibaba is also disrupting the financial services industry in China through its 37.5% ownership of Ant Financial which raised money last year at a $45 billion valuation. Ant Financial’s Alipay platform is China’s largest Internet payments platform.
When it comes to mobile payments, China is years ahead of the rest of the world. Traditional noncash payment methods such as credit cards, debit cards, and personal checks never really caught on in China meaning that until recently cash was king. This has allowed China to leapfrog traditional payment systems. In the US, mobile-payment providers rely on the traditional infrastructure of bank-card numbers. However, in China Alipay only require user accounts to be linked to a traditional bank account. Alipay charges small merchants just 0.6%, which amounts to very little profit. One way Ant Financial can increase profitability is to cross-sell other financial products, including loans and investments. But new regulations in China make this difficult.
To get around these restrictions, Ant Financial created an online bank, called MYBank, which has a license to provide loans and other financial services, though regulations still limit its scope. It is only a matter of time before restrictions are eased because China desperately needs to reform its banking sector by providing more competition to China’s state-owned banks. The state-owned banks tend to favor state-run firms, while underserving individuals and small businesses. MYBank and other online lenders can fill this void by doing away with brick-and-mortar branches to keep costs low and reach more users. Ant Financial has an advantage over other online banks because it can use its huge trove of user-behavior data from Alipay to assess creditworthiness.
In addition to cloud computing and financial services, Alibaba is establishing an Internet-based entertainment ecosystem for domestic households by delivering of a variety of video content over the Internet using set-top boxes and online video website Youku Tudou; operating online music platforms that offer music streaming services through websites and mobile apps; and producing films and television programs via Alibaba Pictures.
Alibaba has spent over $6.3 billion on logistics-related deals in the past three years because there are signs that getting packages to consumers quickly and reliably is an increasingly important battleground. JD.com offers same-day and next-day services for over 80 percent of orders it delivers while Alibaba aims to have next-day delivery available in 50 cities by the end of the year.
Another notable investment that Alibaba has made is a minority stake in Didi Dache-Kuaidi Dache, the leading and most widely used mobile taxi booking app provider in China.
In the coming years, I believe Alibaba founder and chairman, Jack Ma, will integrate all these businesses to strengthen Alibaba’s ecosystem resulting in double-digit annual revenue growth over the next decade. At 29x this year’s EPS and 22x next year’s EPS, I believe BABA is trading at an attractive valuation given its growth prospects. I am adding BABA to my Trades page with an initial price equal to Monday’s closing price of $76.69.
Due to the significant relative underperformance of YHOO as compared to BABA, I am replacing my holding of BABA with YHOO. Yahoo has become so cheap that if you strip out its holding of BABA (assuming a modest tax hit for selling), Yahoo Japan and cash, the core business is selling for nothing. The core business is on track to generate nearly $1 billion in adjusted EBITDA in 2016 and has 600 million monthly mobile users. The board’s statement that it is willing to sell the core, should unlock several billions of dollars. Therefore, YHOO is a cheaper vehicle for owning BABA. I will adjust up my cost basis on YHOO on the Trades page to reflect that I am currently down around 13% on my BABA long.