ALIBABA GROUP HLDG BABA
October 04, 2017 - 12:02am EST by
macklowe
2017 2018
Price: 178.00 EPS 4.87 6.54
Shares Out. (in M): 2,599 P/E 0 0
Market Cap (in $M): 462,622 P/FCF 0 0
Net Debt (in $M): -10,933 EBIT 11,383 15,791
TEV ($): 0 TEV/EBIT 0 0

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  • China
  • Ecommerce
  • Mobile Payments
  • Online Advertising
  • Cloud Computing
 

Description

Overview

I was a bit surprised that no one on VIC had done a write-up on Alibaba yet.  Perhaps this is understandable with the business trading at 16.5x trailing revenues and >40x EBITDA.  Even so, as I will discuss below, I think that BABA is one of the most compelling long-term opportunities and still has room for significant capital appreciation despite the major run-up in its stock over the past year.   At the very least, submitting this write-up may provide a discussion forum for this well-known yet misunderstood name.  Even if you are not swayed to invest, it is still helpful to better understand Alibaba given its major impact on a huge swathe of the modern Chinese economy.

At a high level, the investment thesis here is pretty straightforward:

  • Alibaba is a tollbooth on middle class Chinese consumption which has a long tailwind of growth ahead after only being “unshackled” recently through major policy reforms and the achievement of smartphone ubiquity in China since 2013.

  • Alibaba’s business/financial model exhibits tremendous operating leverage; one of the most attractive I’ve come across.  The majority of each incremental dollar of revenue it captures can either fall to the bottom line or be invested in initiatives that widen its moat or capture new business opportunities.  This is primarily a function of how far ahead Alibaba is compared to the competition in China.

  • Alibaba generates a tremendous amount of proprietary transactional data that is valuable both as a key component in its economic moat and in allowing Alibaba to invest in new business areas on an advantaged basis.

  • Alibaba is in pole position to apply its core business models (commerce, fintech and possibly cloud) to the majority of the developing world and we are already starting to see this play out in the battle for Southeast Asia.

Even as Jack Ma re-iterates that Alibaba is different from Amazon (most recently two weeks ago in an interview on Bloomberg), the comparison is nonetheless still valid and enlightening.  The two companies may look very different from a financial perspective and in the way they do business but there are some interesting insights that investors can draw by seeing where they are similar and where they differ.  The key conclusions I drew from the comparison are that (i) the economics of Alibaba’s business model are superior to Amazon’s, (ii) Alibaba’s e-commerce business is already larger than Amazon’s and still growing significantly faster and (iii) Alibaba’s e-commerce business should arguably be valued significantly higher than Amazon’s.

To gain comfort with the long thesis, one must also be familiar with some key elements of the short thesis:

  • Fake/fraudulent numbers.

  • Accounting “irregularities”

  • Alibaba’s business model is inferior to JD and will lose in the long run.

But first let’s go through the long thesis.

We are still in the early innings of the Chinese middle class moving to a consumption-centric society.

There were two major enabling factors here that have both taken place over the last five years.

The first factor was a series of major reforms that were largely initiated during the Third Plenary Session in November 2013, particularly those impacting banking and consumer finance.  Prior to this, Chinese fiscal and economic policy can best be summarized as “financial repression” where the household sector effectively subsidized capital-intensive economic activity.  This resulted in remarkably high proportion of GDP and economic activity focused on investment at the expense of consumption.  The key enabling policy tool was the suppression of interest rates on bank deposits (often below the rate of inflation, so negative in real terms), strict capital and investment controls (so savers had no other alternatives) and subsidized loan rates for state-owned enterprises.  These policies were systematically dismantled following the Third Plenary session, which featured deep reforms in the banking and consumer finance sectors.  In simple terms I think of it as a major tax on consumption that has finally been lifted.  It is also still quite early in seeing the full effects of this play out.

The other big factor was the introduction of the smartphone in China and mobile broadband.  Both the iPhone and 3G arrived in China in late 2009.  By 2014, smartphone penetration reached over 60% with near-universal adoption in urban areas.  Having largely skipped the PC  / web browser phase, China was able to swiftly introduce a number of leapfrogging innovations that were designed for a digital and mobile-centric world.  An example of this was skipping credit cards and moving straight to digital/mobile-centric payments – a story where Alibaba played a starring role of course.  Moving to a digital and mobile-centric economy has massively reduced the friction costs of doing business and enabled new business models, many of which help Chinese consumers find creative new ways to consume products and services.

Now I stress “middle class” to differentiate from the “first” boom in Chinese consumption, one that was primarily driven by the top 1% and largely focused on luxury consumption goods.  Emerging in the mid-2000s, this boom was driven by China’s old economic model where corruption and luxury consumption often went hand in hand.  The current middle class-driven consumption boom is built on a stronger foundation and thus more sustainable, and its scale will be many times larger than what we saw in the previous boom.

Alibaba is a tollbooth on broad Chinese consumption.

With its scale and broad reach into transactions of all types, Alibaba is well-positioned to collect a small piece of most types of consumption in China.

For physical products, its two major platforms have dominant market share in both of their respective “segments” (Taobao for smaller merchants and P2P transactions, Tmall for bigger brands).  It has the largest wholesale commerce platforms both domestically focused (1688.com) and internationally focused (the original Alibaba.com).  It holds a 51% stake in a logistics company it co-founded that directs the majority of e-commerce-related fulfillment and logistics in China.

For services-type consumption, Alibaba owns or holds major stakes in many of the leading O2O companies including media and entertainment (Youku, Alibaba Pictures), transportation (Didi Chuxing), and restaurants/delivery (Koubei/Ele.me).

And last but certainly not least, Alibaba’s economic stake in and close relationship with Ant Financial / Alipay means that it gets a small piece of almost any type of transaction imaginable – from taxi rides to fruit vendors to mobile phone top-ups.

Essentially, Alibaba captures a small piece of most types of “modern consumption” (smartphone or otherwise digitally enabled) in China.  And because it is digital and relatively low-friction, the type of modern consumption it specializes in will only continue to take market share from more traditional forms of consumption, even as the overall consumption pie grows in China.

Alibaba’s business model is extremely cash-generative and exhibits tremendous financial and operating leverage.

Let’s take a look at how each incremental dollar of revenue translates into operating income in its Core Commerce division:

Cost of Revenue for Alibaba Core Commerce has typically hovered around 30% (representing mainly the cost of traffic acquisition).  This means that the amount of fixed overhead to maintain rapid growth at Alibaba is quite low, likely amounting to <10% of revenue today (the exact split between gross margin and operating expenses at the segment level is not clear based on the financials).  As this has not impeded its ability to grow, it is clear that Alibaba does not require significant increase in fixed operating expenses to grow the top-line.

Almost all of Alibaba’s EBITA converts into cashflow.  Alibaba itself does not have significant working capital or capex requirements (some of this has been pushed onto certain equity affiliates – more on this later).  And as long as you add back stock-based compensation to EBITA, it is actually quite a good approximation for economic profit on a pre-tax basis.  This cashflow/profit can then be re-invested back into the company and as I will discuss below, there are still plenty of opportunities for Alibaba to deploy capital on an advantaged basis.

Alibaba’s relative dominance in its home market significantly exceeds Amazon’s.

Alibaba’s main competitor in the online world (where it holds greater than 70% market share) is JD.com.  To be fair, JD is a very well-run company that has the tacit backing of major players such as Tencent – but it still does not have the same scale and associated platform position that Alibaba has.  Meanwhile, traditional retail in China is generally quite unsophisticated, with the largest players having matured in a very different era that they are really unable to compete effectively with online in any meaningful way.  Taking market share from traditional retail channels has been (and continues to be) like “shooting fish in the barrel” for Alibaba.  Alibaba is now pushing hard into traditional bricks and mortar retail and I do not see any major reason why they will not be very successful in this endeavor.

By contrast, Amazon has smaller market share in the online world (approximately 45%).  Further, remember that traditional retail players like Wal-mart and Costco are not slouches either – the economic bar is a lot higher for Amazon.  While some explain Amazon’s low operating margins as a sign that they are re-investing in growth, lack of the same degree of pricing power is probably just as large an explanation.

Alibaba’s e-commerce business is already larger than Amazon’s.

Because the way they generate and recognize revenue is so different, it doesn’t make sense to compare Alibaba and Amazon on that basis (where Amazon is >6x larger).  Meanwhile, issues such as “brushing” (merchants self-ordering as a form of marketing spend) also make comparing Alibaba and Amazon on the basis of GMV (where Alibaba is >2x larger) misleading.  And as there is such a large element of re-investment in growth embedded in both Alibaba and Amazon’s operating expense figures – particularly the technology/content/product development line item – it may also not be very reasonable to judge the two strictly on their ability to generate GAAP operating income (where Alibaba is significantly higher).

But one quick-and-dirty way to “normalize” the numbers is to net out Amazon’s cost of revenue (primarily the cost of 1P products sold) and fulfillment expenses, which gets you down to a figure that is a lot more apples-to-apples comparable to the way Alibaba recognizes revenue:

This comparison is not perfect of course.  One can argue that you should not net out fulfillment expenses as Amazon is actually adding significant value here by systematically re-organizing the way logistics are done around the world in the name of operational efficiency.  But as you will see from the P&L of logistics/warehouse businesses, the vast majority of the fulfillment expense line is captured by warehouse owners, industrial equipment vendors and workers etc. while the direct value capture by Amazon shareholders of fulfillment is likely quite low or even negative.  In other words, it may be a necessary and important part of Amazon’s moat, but it may not actually add significant economic value on its own.  To illustrate this point, if you were to carve out the “Fulfillment” division at Amazon and run it as a separate business, its profit margins would be low or even possibly negative (somewhat understandable, as it is still in rapid growth mode).

As you can see above, measured this way Alibaba’s Core Commerce division was slightly smaller than Amazon as late as 2015 but began to pull ahead in 2016. Today, it is significantly larger and significantly more profitable – all while growing at a faster clip.

Alibaba’s core business growth rate in China is accelerating.

Following its IPO, revenue growth actually slowed down moderately for Alibaba’s core e-commerce business in China, leading some to question whether the rapid growth phase for Alibaba was already coming to an end.  But over the past year, growth of Alibaba’s retail business in China has been accelerating – on a much larger base – strong indication that there is still quite a long tailwind of growth ahead.  To put some perspective on it, just over the past year, Alibaba’s China retail business has grown by RMB40 billion (approx. $6 billion), which was the same size of the entire business in 2013 (a few months before it went public).  Today’s run-rate business is almost triple the size of the business when it listed.

The acceleration in Alibaba’s organic growth rate runs contrary to the narrative that Alibaba’s e-commerce business in China is reaching maturity or losing market share to competitors like JD.  Instead, it is evidence that there is both significant long-term consumption growth left in China and also lots of room to take market share from traditional modes of consumption.

To me, the acceleration in Alibaba’s organic growth rate is a clear indication that Alibaba’s commerce business in China could eventually be several times larger than Amazon’s e-commerce business.  While this may not seem that intuitive for many, that is because folks often tend to frame Alibaba in the context of Amazon.  But Amazon should by no means represent the upper bound for Alibaba.  Indeed, the combination of Alibaba already being bigger than Amazon and growing significantly faster makes a compelling case that case that Alibaba should be significantly more valuable than Amazon over the long run.

Alibaba’s got the best data.

Transaction data is probably the most valuable and monetizable type of data in the world because out of all the various categories of data, verified transactions signal the highest level of intent.  Transactional data is significantly more valuable than keyword search data, browsing history data and chat data.  After all, figuring out your next transaction is the Holy Grail of marketing.

Through its core commerce operation and the transactional data it collects from Alipay, Alibaba has just about the best and broadest set of transactional data in the world.  Higher quality than Google and Facebook.  Broader than than Amazon.  In China, almost all digital transactions can be tied to a verified person – as everyone who signs up for these services needs to register his or her National ID.  Now I love privacy rights as much as the next person, but that doesn’t stop me from recognizing that they make it that much harder to attribute data and transactions to specific users and build out the profiles that are used by computer algorithms to mine actionable knowledge.

Alibaba monetizes this data in several ways.  First is by continuing to optimize its ability to help market products and services for its merchants and thus taking an increasingly higher share of marketing budgets of its merchants.  You can see this in the rapid evolution of its core Taobao app from a PC-centric marketplace to a mobile-centric lifestyle app that incorporates social media, key opinion leaders, live streaming, personalized recommendations etc.  With its proprietary transactional data, Alibaba can generate the most accurate customer profiles and use these profiles to improve its various algorithms whose ultimate goal it so make the process of connecting buyers with sellers even more efficient.  This data-centric approach is in no way unique to Alibaba but what is unique is its treasure trove of data.

Alibaba can also leverage its data to create value by launching new businesses, making strategic acquisitions and even while making minority investments.  Joseph Tsai (Vice-Chairman) talked about this at the most recent Investor Day presentation when he discussed Alibaba’s capital allocation strategy using the game of Go as an analogy to how the company evaluates its next moves.  Data allows Alibaba to see more clear through the “fog of war”.

Alibaba’s data on customers and trends puts it in a prime position to identify emerging business models.  Access to Alibaba’s data and customers is also a unique asset that can provide decisive advantage in China’s cut-throat world of capitalism.  Alibaba’s data and scale literally give it the power to create winners and its shareholders have benefitted significantly from this over the years.  Alibaba’s track record in both launching new businesses (Alibaba Cloud) or making minority investments has been very strong, as shown in one of the recent Investor Day slides:

And just in the last two months since this slide was presented, two other Alibaba /Ant Financial affiliates have gone public at multi-billion dollar valuations: Best Logistics (now Best Inc.) and ZhongAn Insurance.

I expect that Alibaba’s treasure trove of proprietary data will continue to pay dividends in the future, possibly for businesses that we cannot even imagine today.  Take A.I. as an example.  What is the most important ingredient to feed and train A.I. algorithms?   Yep ... data, the higher quality the better.

Alibaba will win the battle for emerging markets.

I believe that Alibaba is better positioned than others to win the battle for the emerging markets.  First, Alibaba has had more relevant experience building a business in an actual developing market environment.  The consumer profile and business environment that it has grown up with in China are more similar to countries like India, Indonesia and the Philippines than the experience Amazon had building up its business in developed North America.  We have already seen how U.S. giants like Amazon and Wal-Mart failed to build businesses in emerging markets and we are seeing in real-time Uber losing in Southeast Asia.

Second, Alibaba and Ant Financial have already established themselves in these markets through investments in companies that appear to be emerging as the winners (Lazada in Southeast Asia and Paytm/Paytm Mall in India).  It brings not only capital, but a large captive customer base (outbound Chinese tourism) and most importantly, the battle scars and experience of having successfully built businesses in emerging markets.  Eighteen months after making its first major foray through its initial minority investment in Lazada in April 2016, Alibaba looks increasingly likely to replicate its success in China in other emerging markets around the world.

Valuation

Alibaba’s stock has been on a nice run since the beginning of the year.  But even at the current price of $178/share, I believe that there is still compelling long-term value and a good case can be made for the share price to double over the next three years.

I value Alibaba by breaking down it down into three main elements:

  • Core Commerce Business – China and International; B2C, C2C, B2B

  • Emerging Businesses – Alibaba Cloud, Youku and others

  • Investment Portfolio and Cash – Alipay, Weibo, Suning, Cainiao Network, Didi Chuxing, Koubei, Alibaba Pictures, Alibaba Health, Paytm, Paytm Mall, other minority investments

Core Commerce Business

Core Commerce represents greater than 100% of Alibaba’s profitability/cashflow and by my calculation over two-thirds of its market capitalization.  Growth actually accelerated this past fiscal year even when calculated on an organic basis.  I forecast robust growth to continue over the next three years, gradually moderating in percentage terms; but I still expect growth in 2020 (>20%) to exceed the Amazon’s current e-commerce growth rates today.  At a minimum, the company should be able to maintain its operating margins which would mean the business at that point in time could easily be generating run-rate EBITA well north of $35 billion per annum.  With its scale, market dominance and continued growth prospects, I do not think an 15-20x multiple is unreasonable for this type of business.

Emerging Businesses

As you can see, Alibaba’s other consolidated businesses are collectively losing about $1.5 billion a year, primarily driven by losses at its Media/Digital Entertainment and its “Innovation and Other” group where new and sub-scale businesses reside until they gain some semblance of scale.  Its cloud business is turning the corner on profitability and is expected to start being profitable on a run rate basis as early as this year.

The majority of the value here is in Alibaba’s Cloud business.  It is still relatively small compared to Amazon Web Services but it is nonetheless the dominant cloud provider in China, and growing 100% per annum.  While I believe China’s cloud market is still quite nascent and also likely to evolve in a different manner from the North American market, I do have fairly strong conviction that Alibaba’s cloud business will be one of the big winners in the long run.  In my valuation, I have valued Alibaba’s cloud business at $30 billion (vs. $175 billion for Amazon Web Services).

Alibaba’s Digital Entertainment business, largely built around its acquisition of Youku in 2016, is still in rapid growth mode and losing lots of money.  I do not think Alibaba’s positioning is quite as strong here (relative to Tencent) so I have valued this business at $10 billion which roughly approximates the amount of capital that has gone into the business.

Alibaba also has several other smaller businesses in its “Innovation and Others” group.  For the sake of valuation purposes, I have assigned just nominal value here.

Investment Portfolio and Cash

Alibaba has a large portfolio of strategic and financial investments that provide a fairly significant amount of value.  As I mentioned earlier, I believe that Alibaba’s dominant position in the economy, huge customer base and proprietary data give it a major advantage when investing in new businesses.  Essentially, Alibaba is one of the best venture capital investors in the world and as a shareholder you can gain access to this without paying 2 and 20.  Alibaba owns major stakes in many of the most exciting businesses in the world.  I will highlight some of the key assets below.

Ant Financial is by far the most important asset here.  Alibaba “owns” about one-third of Ant Financial.  “Owns” in quotes because it is not a direct ownership stake here.  I do not want to cover it in this report but I think there is a separate discussion to be had – perhaps in the comments section – about how the whole process by which Alipay was divested from Alibaba and whether that should be a concern for shareholders. As an investor, clearly you will need to gain comfort with this.

In its last funding round (April 2016), Ant Financial was valued at $60 billion.  I believe that Alipay is now worth significantly more than that on its own.  Digital payments have exploded in China with over $5 trillion in digital payments in 2016 and likely at least $8 trillion this year.  Given the growth trajectory, it is likely that digital payments volume in China will exceed credit card transaction volume from Visa/Mastercard in the near future.  Keep in mind Visa/Mastercard/American Express/Discover have a combined market cap of close to $500 billion.  I have pegged Alipay’s current valuation at $75 billion but there is major upside here.

Besides Alipay, Ant Financial has also built the largest online consumer finance business in China.  It has established China’s largest money market fund (Yu’E Bao) with over 300 million users, one of China’s largest consumer/SME loan businesses, one of China’s largest insurance businesses and is establishing a next-generation credit scoring system (Zhima Credit) by utilizing all of the rich data that it generates from transactions.  I have valued these “other” businesses at $25 billion in my valuation but you can easily make an argument for how they can be worth much more in the future.

Finally, Ant Financial itself (like Alibaba) is a preferred and strategic investor in a number of prominent businesses, most notably Paytm, Didi Chuxing and Koubei/Ele.me (alongside Alibaba).  I have valued these minority investments collectively at around $13 billion (including about $3 billion in cash).

Altogether, Ant Financial could very well top Alibaba’s IPO if and when it becomes a public company.

Cainiao Networks is the logistics business that Alibaba established to organize the highly fragmented logistics and inefficient industry, using the massive scale of physical goods that it pushes to drive change.  This business was also the key source for charges of inappropriate accounting, as Alibaba does not consolidate the financials for this money-losing business.  This issue should soon be put to rest as it was just announced that Alibaba is investing RMB5.3 billion to increase its ownership to a majority 51% stake.  For valuation purposes, I have valued its stake at the most recent financing round last year which was led by GIC and Temasek (note: the recent round at which Alibaba invested suggests a valuation 3x the 2016 financing but because it was an internally-led round with minority/majority control implications, I have kept Cainiao’s valuation unchanged).

Alibaba’s investment in Weibo is an interesting story that can help illustrate how Alibaba can be an advanced investor.  Weibo is similar to Twitter and was sort of an afterthought following its IPO in 2014 with the share price languishing close to its IPO price two years later. Alibaba owned about 18% on a Pre-IPO basis but then upped its stake to over 30% in 2016.  Alibaba drives significant revenue to Weibo (>20%) in exchange for traffic flows – another example of how Alibaba’s position in the economy gives it a major edge.  Since upping its stake in 2016, Weibo’s business has flourished and its stock price has increased over 5x.

As an investor you should do more of your own work into these underlying investments but as I alluded to earlier, a major theme here is how Alibaba is such an advantaged investor given its commanding position in the economy.  Alibaba’s investment track record has been excellent and Alibaba shareholders have been able to participate in this success.  It is likely that this trend will continue.

Implied Value Today vs. Amazon

Based on the latest stock price, the sum-of-the-parts valuation of Alibaba and Amazon imply that Alibaba’s core commerce business is valued slightly higher than Amazon’s.  As discussed above, you can make a good case for Alibaba’s business to be worth significantly more (basically its around the same size, far more profitable and growing significantly faster).

Value in 2020

In 2020, I am forecasting Core Commerce to contribute over $35 billion per year in pre-tax operating income (EBITA) and have valued that business at approximately $600 to $800 billion.  The emerging businesses I have grown at a CAGR of about 25% while compounding the investment portfolio at 15%.  Given the growth trajectory as well as the company’s past track record, I think these rates are reasonable.  Add another $60 billion in accumulated free cash flow and I arrive at my valuation three years from now of $864 billion (upside: $1,114 billion), or approximately $333 (upside: $429) per share.

 

The Case Against Alibaba

All of this doesn’t matter if we don’t consider the downside, especially since some Alibaba bears call into question the legitimacy of Alibaba’s entire business model itself.  The downside case has been well-articulated by prominent investors over the past two years with three key points of the downside case revolving around:

  • “Fake” numbers

  • Accounting “irregularities”

  • Alibaba losing to JD over the long run

 

“Fake” numbers

The biggest “fake” number revolved around GMV.  There was a sense that the massive GMV number could not possibly be real, whether compared to overall Chinese consumption (as a percentage of GDP).

I actually agree that GMV is significantly inflated, especially Taobao GMV.  But there is quite a good explanation for this that revolves around the phenomenon of “brushing” which I see as merely another form of marketing spend.  If you cut down on “brushing”, those marketing dollars will merely go to another bucket that Alibaba can capture, so over-stated GMV does not actually affect Alibaba’s underlying economics.

In recent investor reports, Alibaba has shifted emphasis away from GMV to other metrics, I think in large part due to its decreasing relevance.

Accounting “irregularities”

The main point about accounting irregularities had to do with Cainiao Network, which was until recently owned 47% and accounted for using the equity method of accounting.  Skeptics pointed out that Alibaba was using equity method accounting to shift certain fulfillment expenses off the books.

In response, Alibaba has provided more disclosure about Cainiao Network, enough where you can do a pro forma consolidation of Cainiao’s figures to see how consolidation may change the overall financial picture.  Instead of generating revenue of RMB144 billion in 2016, consolidating Cainiao (RMB9.3 billion) might only increase revenue 1.% to around RMB146 billion as the majority of volume (I estimated 75%) that goes across Cainiao’s network comes from Alibaba and would be eliminated upon consolidation.  Factoring in the RMB2.2 billion loss generated at Cainiao, Alibaba’s pro forma consolidated net income would decrease 3% from RMB36.7 billion to RMB35.5 billion (adjusting for the recognized equity method losses).  Net income after minority interests should be the same.  As you can see, the financial picture is not substantially different – this does not support one bear view that Alibaba chose equity method accounting to hide massive off-balance sheet losses.

Instead, a very reasonable explanation is that Alibaba believed that forming a consortium of equity holders including partners in the logistics eco-system was increased the chances of the consortium’s success.  The fact that a well-regarded investor (GIC/Temasek) invested at a substantially higher valuation later is strong validation that the consortium has been a success to date and that any alleged accounting irregularities are at worst, immaterial.

Alibaba will ultimately lose to JD

Some predict that JD will eventually prevail against Alibaba and the argument here is centered upon JD’s superior approach to logistics allowing them to provide better service.  Supporters of JD also point to how JD’s management team is more competent and more trustworthy than Alibaba’s.

The key difference between the approach JD and Alibaba have taken on logistics is that JD has a vertically integrated operation (similar to Amazon) while Alibaba has taken a lighter-touch approach by pushing the logistics to third-party logistics service providers but creating Cainiao to apply a software-centric approach to organizing them.

It is not clear to me that JD’s vertically integrated approach to logistics and fulfillment is the right approach.  What is clear to me is that Alibaba’s scale is unquestionably greater and conveys certain economic and strategic advantages that JD does not have.  For example, the huge volume that Alibaba drives, primarily through its Taobao and TMall platforms, means that the Cainiao eco-system immediately became the largest player in the industry.  Logistics can be a capital-intensive business and despite having access to significantly more capital than JD, Alibaba’s approach is further strengthened as it has enlisted other industry players to take on much of the financing burden.  And in China, where the logistics industry is incredibly fragmented, I expect that the economics will be mediocre at best until major consolidation takes place.

And even if JD’s fully integrated approach is superior, Alibaba has the wherewithal to increase its level of vertical integration.  Indeed, just this week, Alibaba announced that it was investing RMB5.3 billion in Cainiao to increase its ownership back to majority ownership and pledged “RMB100 billion over the next five years” to expand its global logistics network.  Meanwhile, JD has recently announced that it is spinning off its logistics unit into a separate entity.  Both of these moves suggest that their approaches are converging and less of a unique differentiator.

Regarding counterfeit goods and overall reputation, this is an area of relative weakness for Alibaba compared to JD but I do not see this as a source of long-term competitive differentiation.  Almost all of the counterfeit issue originate with small sellers on Taobao and outside of a few exceptions (notably Coach), I do not see reputational issues bleeding over to Tmall, JD’s direct competitor.  Alibaba is taking steps to combat counterfeiting on Taobao but ultimately it will take a change in mindset in the overall Chinese consumer to really change things.

Regarding management team, I think Qiangdong Liu is a wonderful entrepreneur and building JD to where it is has been an incredible achievement.  But I also think Jack Ma, Joe Tsai and the Alibaba senior executive management team are also incredible entrepreneurs in their own right.  They have built multiple multi-billion dollar businesses that are leaders in their respective industries.

 

Believing that Alibaba will most likely win in the long run does not equate to thinking that JD will lose.  I predict that the two will co-exist just fine.  JD will not only survive, but it will thrive as the clear number two player in the marketplace.  Powerful forces will ensure that Alibaba faces some degree of competition, from Tencent to the Chinese government – but I believe that Alibaba will retain its position as the dominant leader and continue to enjoy the superior economics that come with that standing.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Long-term value as a catalyst.

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    Description

    Overview

    I was a bit surprised that no one on VIC had done a write-up on Alibaba yet.  Perhaps this is understandable with the business trading at 16.5x trailing revenues and >40x EBITDA.  Even so, as I will discuss below, I think that BABA is one of the most compelling long-term opportunities and still has room for significant capital appreciation despite the major run-up in its stock over the past year.   At the very least, submitting this write-up may provide a discussion forum for this well-known yet misunderstood name.  Even if you are not swayed to invest, it is still helpful to better understand Alibaba given its major impact on a huge swathe of the modern Chinese economy.

    At a high level, the investment thesis here is pretty straightforward:

    Even as Jack Ma re-iterates that Alibaba is different from Amazon (most recently two weeks ago in an interview on Bloomberg), the comparison is nonetheless still valid and enlightening.  The two companies may look very different from a financial perspective and in the way they do business but there are some interesting insights that investors can draw by seeing where they are similar and where they differ.  The key conclusions I drew from the comparison are that (i) the economics of Alibaba’s business model are superior to Amazon’s, (ii) Alibaba’s e-commerce business is already larger than Amazon’s and still growing significantly faster and (iii) Alibaba’s e-commerce business should arguably be valued significantly higher than Amazon’s.

    To gain comfort with the long thesis, one must also be familiar with some key elements of the short thesis:

    But first let’s go through the long thesis.

    We are still in the early innings of the Chinese middle class moving to a consumption-centric society.

    There were two major enabling factors here that have both taken place over the last five years.

    The first factor was a series of major reforms that were largely initiated during the Third Plenary Session in November 2013, particularly those impacting banking and consumer finance.  Prior to this, Chinese fiscal and economic policy can best be summarized as “financial repression” where the household sector effectively subsidized capital-intensive economic activity.  This resulted in remarkably high proportion of GDP and economic activity focused on investment at the expense of consumption.  The key enabling policy tool was the suppression of interest rates on bank deposits (often below the rate of inflation, so negative in real terms), strict capital and investment controls (so savers had no other alternatives) and subsidized loan rates for state-owned enterprises.  These policies were systematically dismantled following the Third Plenary session, which featured deep reforms in the banking and consumer finance sectors.  In simple terms I think of it as a major tax on consumption that has finally been lifted.  It is also still quite early in seeing the full effects of this play out.

    The other big factor was the introduction of the smartphone in China and mobile broadband.  Both the iPhone and 3G arrived in China in late 2009.  By 2014, smartphone penetration reached over 60% with near-universal adoption in urban areas.  Having largely skipped the PC  / web browser phase, China was able to swiftly introduce a number of leapfrogging innovations that were designed for a digital and mobile-centric world.  An example of this was skipping credit cards and moving straight to digital/mobile-centric payments – a story where Alibaba played a starring role of course.  Moving to a digital and mobile-centric economy has massively reduced the friction costs of doing business and enabled new business models, many of which help Chinese consumers find creative new ways to consume products and services.

    Now I stress “middle class” to differentiate from the “first” boom in Chinese consumption, one that was primarily driven by the top 1% and largely focused on luxury consumption goods.  Emerging in the mid-2000s, this boom was driven by China’s old economic model where corruption and luxury consumption often went hand in hand.  The current middle class-driven consumption boom is built on a stronger foundation and thus more sustainable, and its scale will be many times larger than what we saw in the previous boom.

    Alibaba is a tollbooth on broad Chinese consumption.

    With its scale and broad reach into transactions of all types, Alibaba is well-positioned to collect a small piece of most types of consumption in China.

    For physical products, its two major platforms have dominant market share in both of their respective “segments” (Taobao for smaller merchants and P2P transactions, Tmall for bigger brands).  It has the largest wholesale commerce platforms both domestically focused (1688.com) and internationally focused (the original Alibaba.com).  It holds a 51% stake in a logistics company it co-founded that directs the majority of e-commerce-related fulfillment and logistics in China.

    For services-type consumption, Alibaba owns or holds major stakes in many of the leading O2O companies including media and entertainment (Youku, Alibaba Pictures), transportation (Didi Chuxing), and restaurants/delivery (Koubei/Ele.me).

    And last but certainly not least, Alibaba’s economic stake in and close relationship with Ant Financial / Alipay means that it gets a small piece of almost any type of transaction imaginable – from taxi rides to fruit vendors to mobile phone top-ups.

    Essentially, Alibaba captures a small piece of most types of “modern consumption” (smartphone or otherwise digitally enabled) in China.  And because it is digital and relatively low-friction, the type of modern consumption it specializes in will only continue to take market share from more traditional forms of consumption, even as the overall consumption pie grows in China.

    Alibaba’s business model is extremely cash-generative and exhibits tremendous financial and operating leverage.

    Let’s take a look at how each incremental dollar of revenue translates into operating income in its Core Commerce division: