Description

Summary

We believe Alibaba represents an attractive long from current levels.  We believe headline earnings figures understate the profitability of the core Alibaba China ecommerce model and ignore the value of such large assets as Alibaba Cloud (~$50 billion of estimated value) and Ant Financial ($50 billion value, based on last financing). If we apply a 20x to 25x multiple to forward C21 estimated EBIT at the end of C20, we arrive at a relatively large target EV range of $584 billion to $729 billion.  Adding a conservative valuation of $50 billion for all off balance sheet assets and investments yields a target equity market cap of $634 to $779 billion or $242 to $298 per share.  This represents an IRR of 17% to 30% from current levels.    

We see a few potential catalysts that could contribute to a re-rating in the stock:

1. Reacceleration in growth of customer management revenue, driven by monetization of new recommendation feed

2. Easing earnings comparisons as company cycles against operating losses of non-core assets / potential for operating losses to peak over the next 12 months

3. Improved visibility on the value of Alibaba Cloud and Ant Financial  

4. Short-term resolution of the trade dispute and further stabilization of the Chinese economy

After a year of analysts continually lowering estimates ahead of the quarter, Alibaba management elected to not revise guidance for the March quarter during its January conference call, an encouraging development in our view.  As we discuss in more detail below, we believe customer management revenue, which accounts for over 60% of China commerce revenue and 40% of overall revenue, has the potential to surprise in coming quarters, suggesting potential upside to earnings, which could help drive a re-rating in the stock.  This would represent a major change in the investment narrative.

In addition, current financials reflect an exceptionally high level of investment spending that is concealing the underlying profitability of Alibaba’s marketplace platform.  In the F3Q:19 (December) quarter, Alibaba operating income (adjusting for intangible amortization) totaled RMB 29.6 billion (US$4.3 billion). However, online food delivery, Lazada, Cainao, cloud, content, and other/innovation businesses generated RMB16.1 billion (US$2.3 billion) of operating losses during the December quarter alone.  In fact, the company reported a commerce marketplace adjusted EBITA (excluding stock comp, etc.) of RMB 54.3 billion.  While not apples-to-apples (since this figure ignores stock comp), it serves to highlight the drag that this investment spending is having on current reported results.  We estimate that annualized operating losses on these businesses currently amount to roughly $6.5 billion. Capitalizing this figure at any multiple represents a meaningful drag on value.

As we have seen over time with Amazon over the years, during periods of investment spending / margin compression, the market has tended to take a less constructive outlook on valuation.  Of course, the emergence of AWS over the past 5 years, has permanently improved the AMZN story. A similar opportunity exists with Alibaba.

The combination of exploding investment spending along with a weakening Chinese macroeconomic environment and an ongoing China/US trade war have been a losing formula over the past 6-9 months.  Of course, if there are signs that investment spending is peaking and customer management revenue is inflecting, investors could become much more constructive on Alibaba shares. Improved Chinese macro and scaling of the cloud business could be meaningful catalysts as well.

Customer Management Revenue - A Potential Inflection?

After a period of steadily decelerating growth in customer management revenue, driven by tough comps, competitive pressures and weakening macroeconomic environment, we believe growth in customer management revenue (advertising revenue associated with Taobao and Tmall) has likely bottomed and is poised for potential upside in coming quarters.  Given the exceptionally high profitability of Alibaba’s core commerce segment (60%+ EBIT margins), the flow-through impact to earnings should be noticeable.

To be clear, we are not making a call on BABA’s GMV growth accelerating.  Tmall physical goods year-over-year GMV growth was 30% and 29%, respectively, in the September and December.  These numbers are solid. We have no visibility on March quarter GMV growth.

Customer management revenue growth has decelerated significantly since the end of calendar 2017.  This past year, BABA has been up against tough comps as customer management revenue enjoyed 2 years of exceptional growth in F17 and F18 of 48% and 48% respectively.  Said another way, customer management revenue grew by 118% over the two year period F2016 - F2018. During F17 and F18, BABA benefited from increased paid click growth, algorithm optimization and content page personalization.  

After a period of steadily decelerating growth in customer management revenue, driven by a combination of the tough comps, competitive pressures and weakening macroeconomic environment, we believe customer management revenue growth has likely bottomed and is poised for potential upside surprises.  

Alibaba Customer Management Revenue

Given the high margin of customer management revenue, upside to ad revenue should flow through to the bottom line.

What is customer management revenue?

Customer management revenue is principally composed of pay for performance (P4P) marketing services (similar to Google ad words), whereby advertisers/ merchants bid for keywords that match service or product listings.  Customer management revenue also includes display marketing services, where merchants bid for display positions at fixed prices or prices established by a market-based bidding system on a cost-per-thousand impression, or CPM, basis.

Alibaba is constantly working on ways to improve the Taobao user interface and recommendation feed.  The company has been working on version 2.0 of its personalized feed and introduced the new Taobao app during the September quarter.  The company’s vision for personalized shopping is to leverage all of the data that Alibaba has about its each user to show a shopper products that they haven’t searched for before, purchased before and even thought of previously.  Alibaba has developed a total of 100,000 targeted themes backed by 300 million products and services for its new Taobao feeds.

Alibaba is focused on segmenting the indivdual shopper experience based on the shopper’s previous behavior and their experience level - new, experienced and advanced users.  

Specific changes to the Taobao UI / feed:

(1) The company has added a row of recommended search phrases; (2) There is a section with customizable favorite verticals; (3) The new app contains a section of segmented/personalized items based on user behavior on the front page; previously, it would take 4 scrolls to get to the recommended products section; and (4) product images are bigger, resulting in a better user discovery experience.

The changes that Taobao have made are reminiscent of the ongoing tweeks that Google has been making to search for 10+ years - i.e.  Expanded text ads or Product Listing Ads.

Timing of impact on revenue

Alibaba has been careful to not turn on proper monetization of the feed until it is confident that the feed is providing the appropriate user experience and an enhanced ROI for merchants.  We are optimistic that the new recommendation feed could provide a meaningful boost to revenue in coming quarters. For illustrative purposes, if customer management revenue were to see a 500 basis point lift in revenue, we could see $1 billion lift to operating income.

Cloud business

Alibaba Cloud has grown to RMB 25 billion in F19E (march) and is expected to reach RMB 65 billion ($9.7 billion) of revenue by F2021 (Calendar 2020). We expect material profitability in calendar 2020. Alibaba has roughly 50% of the cloud market in China and dominates the cloud market for high tech companies, where it belives it has 80% market shares.  At 5x revenue, Alibaba Cloud could be worth $49 billion at the end of the year.

Other assets.

Alibaba has a large number of private and public holdings including: Ant Financial, Weibo, PayTM in India, among many others.  For simplicity and conservatism, we value all of these assets cumulatively at the last valuation round of Ant Financial, which valued Alibaba’s stake in that asset at $50 billion.

Thoughts on valuation

Alibaba’s operating income for F2019 (March) is estimated at RMB 60.6 billion.  To this figure, we add intangible amortization of RMB 9.065 billion. This year, we estimate that Alibaba stock comp totaled RMB 38 billion, compared with RMB 16 billion and RMB 20 billion in F2017 and F2018, respectively.  We have added back RMB 10 billion to operating income, assuming the company returns to a somewhat more judicious path with respect to stock option grants going forward. This implies F2019 base year operating income of RMB 80 billion or $11.7 billion (based on 6.75 exchange rate).  We believe operating income can grow at 30% a year over the next three years, suggesting that operating income can reach $26 billion in C2021. If we further assume, that operating losses on online food delivery, Lazada, Cainao, cloud, content, and other/innovation halve over this time period to $US3.25 billion, operating income could total $29 billion in C21 (F22).  As an aside, we believe that cloud alone, could be doing over $2 billion of EBITDA in 2021.

If we apply a 20x to 25x multiple to EBIT at the end of C20, we arrive at a target EV $584 billion to $729 billion.  Adding a conservative valuation of $50 billion for all off balance sheet assets and investments yields a target equity market cap of $634 to $779 billion or $242 to $298 per share.  This represents an IRR of 17% to 30% from current levels.

Catalyst

1. Reacceleration in growth of customer management revenue, driven by monetization of new recommendation feed

2. Easing earnings comparisons as company cycles against operating losses of non-core assets / potential for operating losses to peak over the next 12 months

3. Improved visibility on the value of Alicloud and Ant Financial  

4. Short-term resolution of the trade dispute and further stabilization of the Chinese economy