Description

Executive Summary

• Company: Alibaba (NYSE: BABA) is the second largest publicly traded company in China, with a 55% market share in online retail and a 45% market share in cloud computing.  Because of its dominance in those markets, Alibaba is frequently dubbed the “Amazon of China”.  Alibaba’s other assets include $82b of cash, $25b in investments in public Chinese companies and a 33% stake in Ant, a financial services company.
• Situation: Over the last two years, the Chinese government has implemented a series of regulations considered hostile to the tech sector.  Mostly due to these regulations, BABA is down 65% from the highs.  The breakout of Omicron in China has put further downward pressure on Chinese stocks
• Thesis: While the regulations imposed on tech companies over the last 2 years may seem onerous, there is method to the madness.  The Chinese tech sector was underregulated (even by Western standards) for most of the last decade.  The government is now playing catch-up.  By understanding the Party’s regulatory objectives, investors can avoid landmines.  Alibaba is not one of those landmines.  We see substantial earnings growth and multiple expansion in the years ahead.  Our price target is $268/share for the ADRs.

Basic Financials

BABA generates approximately $10b in cash and $16b in earnings with a TEV of $256b.  Online commerce is the cash cow while cloud is growing fast but not yet profitable.  Cloud's lack of earnings power should not raise eyebrows as most SaaS businesses lose money when they are growing 30%+ annually.  (It took AMZN 9 years to get cloud segment to profitability).  "Other" is primarily the company’s digital media segment, which includes Youku, an online video platform like Youtube.

Note that online commerce segment saw a drop in margins this year.  This was due to weakness in the Chinese economy (expenses outgrew revenues) and BABA cutting merchant fees slightly to keep competition at bay.  Earnings are likely to improve this year now that BABA is cutting expenses and continuing to experience rapid topline growth.  The figures below fully expense share-based compensation for both FCF and earnings.  Net of cash, the company is trading at 15.6x LTM earnings. 

Sentiment Cycles in the Chinese Stock Market

The Chinese stock market is prone to cycles of fear and exuberence.  A fair comparison might be the U.S. stock market in the late 19th and early 20th century.  

• Q1 2011 to Q3 2014 – SHCOMP -30%.  Short sellers photograph Chinese “ghost cities”.  A crash is said to be imminent.
• Q3 2014 to Q2 2015 – SHCOMP +140%.  Ghost cities have become bustling metros.  Retail participation in the stock market skyrockets.
• Q2 2015 to Q1 2016 – SHCOMP -46%.  China halts margin buying of stocks. 
• Q1 2016 to Q1 2018 – SHCOMP +13%.  Period of relative stability.
• Q1 2018 to Q4 2018 – SHCOMP -24%.  U.S. Trade War.
• Q4 2018 to Q4 2020 – KWEB +110%.  Rapid growth in tech sector.
• Q4 2020 to Q1 2022 – KWEB -70%.  Regulations trigger meltdown in technology sector.

While sentiment on the Shanghai comp is volatile, the facts on the ground have been relatively stable.  We're frequently told China is a house of cards, but these claims have little to no support.  At every level, China is less levered than the United States.  The current account surplus is massive.  GDP will likely surpass the United States in the next 10 years.  Analysts who believe China will suddenly stop growing at $20k GDP per capita can never justify their reasoning.  More likely, China is headed towards Taiwanese/Korean standards of living. 

Growth is important part of the arithmetic of businesses valuation, especially for the technology sector where returns on capital are high.  Chinese management teams are not as good as U.S. management teams, but they are good by EM standards.  EPS growth for technology companies has been strong.  The Shanghai comp has a dividend yield that is 60% higher than the S&P 500.  Of the five largest tech companies in China, four have repurchased more than $1b in stock over the last year.  Alibaba’s current buyback program is $25b.  

This is a long way of saying, China is a decent place to invest.  Especially when sentiment is bombed out like right now.  

The United States vs. China

Regulatory changes are surprising in China because political discourse happens behind closed doors.  In the United States, investors get lead-times on policy actions.  Grumblings are heard in Washington.  Bills are drafted.  Industry has input.  Eventually, legislation is passed into law.  This is different from a China where companies and investors wake up to a news headline that rules have changed.  While regulations come suddenly in China, they are not random.

In the United States, media governs society.  Although U.S. media cannot pass legislation into law, media wields tremendous power through its ability to dictate cultural norms and control the Overton window.  Because political attitudes are downstream to cultural attitudes, the essence of capitalist democracy is media oligarchy.  Chinese regulators are keenly aware of this dynamic and are wary of corporate influence on culture.  Elites (including CEOs) that criticize the Party run the risk of banishment.  Jack Ma suffered this fate.  If the CCP senses that a business is disrupting Chinese culture, it is at risk of being regulated out of existence.

Chinese regulators understand the concept of a natural monopoly.  Natural monopolies face more intense scrutiny, and the government may set limits on pricing power.  This inherently makes natural monopolies less valuable in China than they are in the United States.  Alibaba and Tencent are not China’s preferred national champion. China would prefer hard tech businesses defended by innovation, rather than light tech defended by network effects.  China would rather have TSMC than an FB. That’s something you should think about when valuing BABA. 

The above notwithstanding, BABA’s core businesses – cloud and retail – are in no way antithetical to the goals of the CCP.  The online retail business has enabled millions of Chinese entrepreneurs to make a living selling online.  Cloud helps Chinese businesses scale quickly online without physical infrastructure.  At a high level, these business objectives are far less fraught with regulatory risk than tech companies emphasizing search, media, social networks, or video games.  The Chinese tech sell-off has essentially treated all tech the same when regulatory risk varies from company to company.  

Although navigating China’s regulatory framework is challenging, growth is meaningful offset.  BABA’s retail and cloud businesses are earning a royalty on the growth of the internet economy in China.  One big lesson we learned in the U.S. over the last decade is that tech companies had far more growth runway and operating leverage than we imagined.  If you are peeved about not making AMZN a core position in 2013, you are being given another shot. 

The regulatory headwinds began in October of 2020.  At that point BABA was trading at 55x earnings heading into the Ant IPO.  In italic we provide a response to each of the major regulatory headwinds.  

• October 2020 – Regulators halt the Ant IPO and say Ant needs additional regulation.  Completely appropriate.  It's amazing Ant got as far as it did without the government stepping in.  Ant was taking rapid share in lending and was completely unregulated.  No capital requirements.  Huge systemic risk.  Ant's lending business would have been shut down in the U.S.    
• April 2021 – Alibaba is fined $3b for anticompetitive behavior on its online commerce platforms.  Again, completely appropriate.  Alibaba was telling merchants they had to sell exclusively on Tmall and Taobao.  This would not have been legal in the U.S. either.  
• July 2021 – China nationalizes the for-profit tutoring industry.  This event gave foreign investors the impression that any company was at risk of nationalization.  Understand that national exams for universities or civil service jobs have been going on for 1,500 years in China.  They are viewed as a way of elevating talented poor kids.  Wealthy Chinese kids were crushing university entrance exams by paying for expensive tutoring.  Regulators believed this defeated the purpose of the exam and eliminated for-profit tutoring.  This is an example of an industry that was upsetting cultural norms.    
• September 2021 – Alibaba and Tencent pledge $15.5b for investments in low-income communities after Xi Jinping’s call for “common prosperity”.   This is probably the most difficult to swallow. We view these investments as a mea culpa for years of rule-breaking and anti-competitive business practices by the tech giants.  This was announced shortly after Alibaba was fined for anti-competitive behavior.   The investments are being made over a 4-year period.  These are investments, not donations.  The capital is being directed by the companies. Additional major social investments by Alibaba and Tencent that are made before the end of the 4-year period (2025) should be deemed coercive.
• February 2022 – Chinese authorities announce that food delivery platforms should reduce their service fees charged to restaurants.  Monopolies have speed limits in China.  This is not particularly important for BABA as food delivery is a rather inconsequential part of their earnings stream.
• March 15, 2022 – SEC announces five Chinese firms may have their ADRs delisted if the companies fail to comply with audit requirements.  China is now saying they are working to comply with U.S. audit requirements.

The March 16 Statement

In mid-March regulators addressed the sell-off.  Below is the statement released by Liu He (one of the vice premiers) about regulations in the technology sector.  We believe this statement was a market-clearing event and an indication that the regulatory pendulum is swinging back in the favor of tech investors.  Sentences like following are strong by the standards of Chinese regulators.  “The meeting emphasized that the relevant departments should earnestly undertake their own responsibilities, actively introduce policies that are favorable to the market, and prudently introduce contractionary policies. Respond in a timely manner to hot issues that the market is concerned about.”

Liu He presided over the meeting of the State Council Finance Committee to study the current situation

On March 16, the Financial Stability and Development Committee of the State Council held a special meeting to study the current economic situation and capital market issues. The meeting was chaired by Liu He, member of the Political Bureau of the Central Committee of the Communist Party of China, Vice Premier of the State Council, and Director of the Finance Committee. Responsible comrades from relevant departments attended the meeting.

The meeting pointed out that under the current complex situation, the most important thing is to insist that development is the top priority of the party to govern and rejuvenate the country, adhere to economic construction as the center, adhere to deepen reform and expand opening up, adhere to the principles of marketization and the rule of law, and adhere to the "two Unswervingly", earnestly protect property rights, fully implement the spirit of the Central Economic Work Conference and the deployment of the National "Two Sessions", coordinate epidemic prevention and control and economic and social development, keep the economy operating within a reasonable range, and maintain the stable operation of the capital market.

The meeting examined related issues. Regarding macroeconomic operation, we must implement the decisions and arrangements of the CPC Central Committee, effectively invigorate the economy in the first quarter, proactively respond to monetary policy, and maintain moderate growth in new loans. Regarding real estate enterprises, it is necessary to timely study and propose effective and effective response plans to prevent and defuse risks, and propose supporting measures for the transition to a new development model. Regarding overseas listings, the regulatory agencies of China and the United States have maintained good communication and have made positive progress, and are working on forming a specific cooperation plan. The Chinese government continues to support various types of companies to list overseas. Regarding internet platform governance, relevant departments should improve the established plans in accordance with the principles of marketization, legalization, and internationalization, adhere to seeking progress while maintaining stability, and steadily advance and complete the rectification work of large platform companies through standardized, transparent, and predictable supervision. Both red and green lights must be set up to promote the stable and healthy development of the technology economy and improve international competitiveness. Regarding the stability of Hong Kong's financial market, the regulators of the Mainland and Hong Kong should strengthen communication and cooperation.

The meeting emphasized that the relevant departments should earnestly undertake their own responsibilities, actively introduce policies that are favorable to the market, and prudently introduce contractionary policies. Respond in a timely manner to hot issues that the market is concerned about. Any policy that has a significant impact on the capital market should be coordinated with the financial management department in advance to maintain the stability and consistency of policy expectations. The Finance Committee of the State Council will, in accordance with the requirements of the CPC Central Committee and the State Council, increase coordination and communication, and conduct accountability when necessary. Financial institutions must proceed from the overall situation and firmly support the development of the real economy. Long-term institutional investors are welcome to increase their shareholding. All parties must deeply understand the significance of the "two establishments", resolutely implement the "two maintenances", maintain the long-term trend of the healthy development of China's economy, and jointly maintain the stable development of the capital market.

Following this statement, on April 3, 2022, China put out a statement indicating U.S. regulators will be provided with additional audit information so that Chinese companies can keep ADR listings on U.S. exchanges.

Online Retail

Alibaba’s online retail business consists of Taobao and Tmall.

Taobao caters to small domestic businesses and individual sellers (primarily C2C, best analogy is Etsy or eBay).  Millions of Chinese entrepreneurs sell through Taobao.  Taobao does not charge commissions on sales and primarily monetizes through ads and search placement.  Taoboa’s free model drove eBay out of China.

Tmall hosts larger domestic businesses and international brands (primarily B2C, best analogy is Amazon Marketplace).  If a western company wants to sell its products in China, step one is getting listed on Tmall.  Tmall charges an upfront deposit for access to the platform, an annual fee, and commissions on each sale.

Alibaba outsources logistics and is asset light.  Relative to Amazon, this results in better returns on capital, but arguably lower moats. Alibaba’s earns roughly 4% of GMV.  This compares to eBay, Amazon Marketplace and Etsy at 7-10%.  Alibaba is concerned about pushing prices because Chinese consumers are more price-conscious than American consumers.

BABA's online retail business looks strong in leading-edge data.  PDD took significant share in 2018 and 2019, but is slowing.  PDD's success in online retail through group buying is likely to fade as consumers in China become more affluent. 

Cloud

AliCloud offers a full suite of cloud computing services (e.g. data storage, computation, content delivery networks, databases). AliCloud is growing ~35% annually and is 20% the size of AMZN.   AliCloud is expected to achieve profitability in the next few years.  Mature cloud businesses typically have 30% EBIT margins.

In cloud computing, ARPU tends to grow over time as customers migrate from being IaaS to SaaS. Barriers to entry in cloud computing are high and growing.  The barries to entry in cloud are similar to those enjoyed by MSFT in the OS business.  Over time, more and more software is built atop the network.  Much of this software is built by users or consultants who deploy on the platform.  Users also become more familiar with a platform’s nuances over time and develop a preference for it.

China’s government has never harmed AliCloud.  China’s government supports the digitization of the economy and recognizes that AliCloud is competing against well-capitalized American tech companies.  AWS is present in China.  AWS is typically valued at 10x revenue.  AliCloud does $12b in run-rate revenue and is growing more quickly than AWS.

Alibaba has a 45% market share with 4mm paying customers.  Market share estimates understate BABA's dominance.  Tencent, BABA’s main rival in cloud has a 15% share, but 75% of that business is from the company's own subsidiaries/investments.  Huawei has a 12% share in China, but is mostly focused on government contracts.  Kingsoft and China Telecom (15% share) are focused on niche markets (gaming and media).  Smaller competitors such as Baidu, JD.com, Meituan and NetEase are gradually exiting the market. 

Valuation

We value BABA at $268/share.  

• 25x earnings for Online Retail
• 5x revenue for Cloud
• 25x earnings for Ant (ex. Lending)
• 5x revenue for Youku
• Public investments at market prices

Risks

• Additional regulations and/or souring of the relationship between the United States and China.
• Misuse of cash by management.
• Unproven profitability of Alicloud.

Catalyst

Continued earning growth and passage of time without onerous regulations.