Released: 17 October 2020

Alibaba: Despite Big Risks, Cloud Growth Makes Valuation Compelling

Alibaba (BABA), often referred to as “the Amazon (AMZN) of China,” is the country’s Key Takeaways: largest e-commerce, cloud, and digital • Impressive top-line and bottom-line advertising company. Its e-commerce growth primarily through increasing business has been the growth and profit market penetration and rising ARPU. engine for years, but cloud computing is • Industry leading position in large and positioned to increasingly contribute fast-growing addressable markets in meaningfully to high-margin growth in the China. future. The perception of weak corporate • Strong asset-light business model with governance, combined with geopolitical low capital investment needs in the tensions, are major risks, and November core commerce business. could be a big month considering the US • Robust financial position with ample election and the company’s upcoming liquidity to fund strategic and growth investment needs. Singles’ Day. In this article, we analyze • Trading at a significant discount to Alibaba’s business model, its market other global big tech when considering opportunities, fundamentals, valuation, risks, its superior growth profile. and finally conclude with our option on whether the stock offers an attractive balance between risks and rewards.

Overview: in several global companies across various business sectors including 33% equity interest Alibaba is a Chinese company that in Fintech company which is in specializes in e-commerce, retail, the process of going public. entertainment, and technology. Founded in 1999 by while he was working as Alibaba conducts its business through four an English teacher in Hangzhou, Alibaba’s operating segments: primary area of operations remains in China. Core Commerce: This segment consists of However, it is now taking significant the company’s various digital retail and initiatives to expand its global presence. In wholesale online marketplaces including its initial years, Alibaba raised $25 million China focused ecommerce platforms such from several investors and later went public as , , Freshippo, 1688 etc. as in 2014 at a valuation of $25 billion which well as cross border and global e- was then the largest IPO ever. The company commerce platforms such as Aliexpress, now provides B2B, B2C, and C2C Lazada and Alibaba.com. The segment also ecommerce services as well as electronic incorporates Alibaba’s logistics and local payment and cloud computing services. consumer services platforms. Revenue is Besides, Alibaba has also made investments generated in the form of commission

Page 1 of 9 Released: 17 October 2020

charged on a percentage of sales basis growing segment. As the company is from sellers for each sales transaction on its investing in expanding its cloud business, the platform, Advertising fees charged to segment is not yet profitable. advertisers for online marketing on its Digital media and Entertainment: In this websites, logistics fees charged for shipping segment, Alibaba operates , the third of goods and other software services fee. largest online long-form video platform in This is Alibaba’s largest segment, and the China, as well as, , one of company generates 86% of revenue from it the largest movie production houses in with an operating margin of 38%. This China. The segment contributes just 5% to segment is currently the only profit the total revenue of the company and is generating part of the company. currently loss making. Cloud Computing: Through this segment, the Innovation initiatives: Through this segment, company provides its public cloud Alibaba aims to innovate and develop new computing services to enterprise customers. products and solutions for consumers. Its offerings include database, storage, Previous innovations include, Amap, the management and application services, big largest provider of mobile digital maps in data analytics and a machine-learning China, network communication app platform. Revenue is generated in the form DingTalk and Tmall Genie smart speakers. of subscription fees based on period and This segment comprises of just1% of the total specific usage of facilities. Although this revenue of the company and is currently segment contributes only 8% to the top-line generating losses. of the company, it is Alibaba’s fastest

Revenue Mix

1%

5% 8%

Core Commerce Cloud Computing Digital media and Entertainment Innovation Initiatives

86%

Source: Holding Limited., 20-F

Page 2 of 9 Released: 17 October 2020

Consistently solidifying its leading market position in fast growing e-commerce markets

China has led the world in terms of 2024. This secular shift towards digitization Ecommerce sales for the last few years, and was further accelerated because of the it continues to grow at a fast pace. As per coronavirus pandemic as ‘stay at home’ Statista, Chinese e-commerce revenue orders were enforced globally including stood at RMB 6.04 trillion in 2019 and is China. The same is also reflected in the charts expected to increase to RMB 10.9 trillion by below which show a sharp increase in 2024, growing at a CAGR of over 12.5% over ecommerce activity in 2020. the next 5 years. The user penetration rate of the retail e-commerce market reached 59.3% in 2019 and is expected to expand to Chinese E-commerce market trend 79.2% by 2024. The strong growth is primarily 9450 attributable to technological 10000 9289 9401 100% 8435 8925 advancements, growth in internet 8000 6573 7063 80% penetration in Chinese population, as well as consistent growth in middle/affluent class 6000 60% incomes in the country. Not only are more (RMB) 4000 40% buyers moving to online retail from brick and 2000 20% mortar stores, existing ecommerce customers 0 0% are spending more on shopping online. The 2018 2019 2020 2021 2022 2023 2024 average revenue per user was RMB 7,063 in Average revenue per user 2019 and is expected to reach RMB 9,401 by Ecommerce user penetration

Source: Statista.com Chinese E-commerce market trend 13000 40% 10892 10346 Alibaba Annual Active Users 9674 30% (in millions) 10000 8813 742 7812 20% 674 576 7000 6041

bllions (RMB) bllions 466 10% 5047

4000 0% 2018 2019 2020 2021 2022 2023 2024 Projected Revenue YoY growth Jun-17 Jun-18 Jun-19 Jun-20

Page 3 of 9 Released: 17 October 2020

Riding this secular growth in e-commerce, represents a YoY growth of 10% while Alibaba has consistently delivered impressive average consumer spending on its platform results since getting listed in 2014. In the last reached RMB 9,000. The company’s 12 months ending Q1 FY21, annual active customers are also sticky as evidenced by a customers on Alibaba’s China retail high retention ratio of more than 96% for marketplace reached 742 million, which consumers who spend more than RMB 2,000.

Revenue generated from China retail Gross merchandise value marketplaces increased to RMB 358 billion during last 12 months ending June 2020 8 7.02 30% 6.59 which represents a robust increase of 33% on 5.73 25% a YoY basis. The primary drivers for this strong 6 4.82 20% growth in revenue were increase in total 3.77 4 15% Gross Merchandise Value (GMV) of products traded on its platform as it attracted more 10%

trillions (RMB) trillions 2 affluent and sticky customers as well as 5% increase in take rate that includes 0 0% commission and marketing fees charged FY 17 FY 18 FY 19 FY 20 LTM Q1 from sellers. While China retail GMV during FY 21 the last 12 months reached RMB 7.02 trillion GMV YoY Growth growing by 23% YoY, take rate has expanded Source: Statista.com to 4% in Q1 FY21 as compared to 3.3% in 2017.

Take rate %

Alibaba enjoys a first mover advantage in 4.0% the fast-growing Chinese e-commerce 3.3% market. This has helped the company gain 2.5% market share and become the largest online commerce company in China. Tmall, which is Alibaba owned online mall, was ranked the leading B2C retailer in China with a market share of 50%, almost double than that of its Jun-14 Jun-17 Jun-20 nearest competitor, JD.com (JD). Given it Source: Alibaba Group Holding Limited robust high-margin asset-light business model and strong financial position, Alibaba is well placed to further create a strong competitive moat around its business.

Page 4 of 9 Released: 17 October 2020

Share of Chinese E-commerce sales

Suning 3.0%

Pinduoduo 12.8%

JD.com 26.5%

Tmall 50.1%

Source: Statista.com all set to become the future growth driver of the company

Following the footsteps of Amazon, Alibaba billion in 2019 and is expected to reach RMB also launched its cloud computing business 231 billion by 2023, growing at a CAGR of in 2009, however unlike AWS which has a 35%. Currently, 4 local vendors account for global presence, Alibaba primarily focuses almost 80% of the Chinese cloud market, with on providing cloud computing services in Alibaba leading the pack with a market Asia Pacific region. While globally, Alibaba share of over 40%, more than double its Cloud ranks 4th behind AWS, Azure (MSFT) closest competitor, Huawei and Tencent and Google Cloud (GOOGL) with a market (TCEHY) that hold 15% share each. share of just 5%, the company has been very successful in becoming the largest cloud B2C retailers share in Chinese E- computing service provider in its target commerce sales market. China is the second largest public Others 21.3% cloud computing market in the world after Baidu AI Cloud the US, however it is still 1/10th of the US public 8.0% cloud market and therefore offers immense Tencent Cloud 15.1% potential to expand in the near to medium Huawei Cloud 15.5% term. As per Statista, the public cloud Alibaba Cloud 40.1% computing market in China stood at RMB 69

Page 5 of 9 Released: 17 October 2020

Public cloud computing market size in China (in billion RMB) 230.74 176.68 significantly outperforming other segments. 134.04 This impressive growth was achieved by 99.06 68.93 increased customer usage of its public as 43.74 well as hybrid cloud facilities fueled by the move towards business digitization. The 2018 2019 2020 2021 2022 2023 company recently announced its plans to invest RMB 200 billion in the next 3 years to Source: Statista.com further expand its cloud infrastructure to Although, Alibaba Cloud contributes just 8% capitalize on the growing market opportunity of the total revenue, it is the fastest growing and the industry leading position it currently segment of the company. In Q1 FY21, cloud holds in the Asia Pacific region. We believe computing revenue stood at RMB 12.3 billion the cloud computing segment has the which reflects a YoY growth of 59%, potential to become a major revenue driver for Alibaba in the next few years.

Cloud Computing 60 10% 44.5 40 40 24.7 5% 20 13.4

6.7 billions (RMB) billions

0 0% FY 17 FY 18 FY 19 FY 20 LTM Q1 FY 21 Cloud computing revenue % share of total revenue

Source: Alibaba Group Holding Limited

Robust fundamentals with enough liquidity to fund growth investment needs

In Q1 FY 21, the company reported total all others as discussed earlier by delivering a revenue of RMB 154 billion which represents growth of 59% because of a sharp rise in a YoY growth of 34%. Strong growth was demand. In the last 5 years, the company achieved across all segments. While the core has consistently delivered an impressive top commerce segment expanded by 34% on a line increase by posting a CAGR of 50%. yearly basis, cloud computing outperformed

Page 6 of 9 Released: 17 October 2020

Revenue Trend

600 509.7 80%

376.8 60% 400 250.3 40% 200 158.3 153.8

20% billions (RMB) billions

0 0% FY 17 FY 18 FY 19 FY 20 Q1 FY 21 Revenue YoY growth Source: Alibaba Group Holding Limited On the profitability front, core commerce is being recorded on a gross basis and hence the only profitable segment of the company lower margins as compared to commission as others are still in investment mode as based revenue from its online marketplaces. Alibaba has been consistently re-investing all Besides this, all other major segments profits to expand its customer footprint and reported an improvement in profitability. The fuel further long-term growth. In Q1 FY21, Cloud Computing segment’s operating loss Alibaba’s adjusted EBITDA increased by 30% margin has now reduced to just -3% and the on a YoY basis to RMB 51 billion. EBITDA company expects to achieve operating margins declined from 34% in Q1 FY20 to 33% profitability by the end of this fiscal year. in Q1 FY21. This was because of a higher cost Alibaba’s operating profits will continue to of revenue in the core commerce segment, expand as it further solidifies its customer primarily due to increased revenue footprint in China in a fast-growing contribution from its self-operated New Retail addressable market and achieves and direct sales business (Freshippo), which economies of scale along with higher involves purchase of inventory and revenue operating leverage.

Adj. EBITA Trend

160 137 50% Cloud computing profits 107 40% 120 97 Q1 FY 30% FY 17 FY 18 FY 19 FY 20 21 80 69 0.0 0% 45 20% 40 -2% billions (RMB) billions 10% -0.5 -0.3 -0.5 0 0% -4% -1.0 -0.8 FY 17 FY 18 FY 19 FY 20 Q1 FY -6%

21 (RMB) billions Adjused EBITA Adj. EBITA margin -1.5 -1.2 -8% -1.4 Source: Alibaba Group Holding Limited Cloud computing EBITA EBITA margin

Page 7 of 9 Released: 17 October 2020

Alibaba’s primarily asset-light focused The company is using its FCF to fund several business model has helped the company other growth initiatives apart from generate strong free cash flow margins and commerce and cloud. In the Digital media internal capital to consistently invest in and entertainment segment, Alibaba expanding its business without much outside operates its video streaming platform Youku funding. In Q1 FY 21, FCF increased by 39% to which it acquired in 2016. In the quarter RMB 37 billion, from RMB 26 billion in the same ended June 2020, Youku’s daily active quarter mainly because of rising sales and subscriber base increased by more than 60% improving profits. It ended the recent quarter on a YoY basis following the release of local with liquidity of RMB 382 billion in the form of popular TV shows, whereas the number of cash and short-term investments. With no paying subscribers increased by 52%. The major financial liabilities on the balance company’s small but growing young sheet, the current liquidity position provides businesses will benefit from its robust financial enough firepower to meet growth and position and market reach. strategic investment needs in the near to medium term. Appealing valuation despite inherent risks involved

Alibaba’s stock price has risen by almost 40% potential Joe Biden win in next month’s in 2020 and currently trades at a forward elections could be a catalyst for Alibaba’s price to earnings multiple of 31.6x which is stock as well as other Chinese companies below its global peers including given his perceived less-hostile stand on Amazon.com despite superior growth rates. globalization and China. Apart from corporate governance risks that Finally, the upcoming IPO of Ant Group could are inherent in China based companies, act as a catalyst spurring the company’s another reason for this discounted valuation valuation multiples. Ant group operates is intensified scrutiny of US listed Chinese ‘’ which is China’s biggest digital companies by the Trump administration. payment app and is controlled by Jack Ma. Adding to that is the ongoing trade war Investors valuing Alibaba’s stake of 33% in between China and the US. Given that Ant Financial post IPO would further magnify geopolitics has suppressed multiples of the current valuation discount. Chinese names over the last few years, a Forward TTM Revenue Price/Earnings EV/EBITDA Particulars Revenue Growth % Ratio Fwd TTM Growth % Alibaba 33.5% 31.8% 31.6 25.9 Amazon.com 27.7% 23.0% 105.3 31.8 JD.com 27.8% 23.8% 54.2 36.5 Google 12.0% 14.9% 35.3 16.3 Microsoft 13.7% 11.5% 34.2 24.8

Page 8 of 9 Released: 17 October 2020

Source: Seeking Alpha

Risks Geopolitical tensions: China has been in the midst of consistent geopolitical tensions for Weak corporate governance: Several the last 3 years. The trade war between the Chinese companies suffer from weak US and China followed by increased global corporate governance structures primarily scrutiny because of the coronavirus because of subpar regulatory oversight as pandemic as well as the passing of Hong well as allegedly significant interference of Kong national security law. These Government authorities in business activities. geopolitical conflicts may invite sanctions We believe the risk of a large-scale against China or China based companies. corporate governance failure in big tech in Given Alibaba’s revenue is concentrated in China is relatively low as compared to China and parts of Asia Pacific, we believe Chinese small and mid-caps. the company is, relatively speaking, well placed. Conclusion

Alibaba is one of the largest e-commerce platforms in the world and controls almost 50% of the Chinese online commerce market. It has consistently delivered strong top-line and bottom-line growth since its listing in 2014, benefiting both from growth in the Chinese internet as well as company specific growth initiatives. The company has multiple sources of growth as it rides the cloud trend as well as secular growth in global e-commerce in the foreseeable future. Despite the risks, we believe the current valuation and business model present an attractive opportunity for long- term investors. We are currently long-shares of Alibaba.

Page 9 of 9