Alibaba: Buy E-Commerce And Cloud, Get The Strategic Investment Portfolio For Free

Alibaba (NYSE:BABA) has a lot going for it – not only is it a key beneficiary of secular drivers such as an ever-growing consumption-driven economy and the shift to e-commerce, but its ability to funnel that cash flow into profitable growth opportunities (e.g., cloud and logistics) leaves me incrementally bullish post-investor day. While the event is unlikely to result in major changes to consensus estimates, the long-term shift in focus toward a more balanced approach to growth and margins likely underpins sustained, long-term earnings growth, in my view. At current valuations, I believe the market is assigning value only to the core business and cloud, granting investors access to BABA’s ~$114bn strategic investment portfolio for free.

Outlining the Long-Term Drivers

CEO Daniel Zhang outlined the scale of his long-term vision at the event – this includes serving a massive 2bn global customers, facilitating the creation of 100m new jobs, and supporting 10m small businesses by FY36. In particular, three growth engines are in focus – domestic consumption, cloud computing, and data intelligence, backed by a secular globalization trend.

Source: Digital Presentation

I like Alibaba’s long-term focus and its willingness to leverage its capabilities to nurture and deliver innovations to boost future growth (at the cost of diluting near-term earnings). Its past strategic investments around key growth engines such as cloud and logistics have already begun to pay off (the former is turning profitable), and I expect more success stories to come out of its strategic investment portfolio.

Earlier-Than-Expected Profitability at Alibaba Cloud

Through the multi-day event, the sense was that management is incrementally more positive on the cloud – per management, China’s cloud market is set to catch up to the US, and Alibaba’s cloud margins should eventually reach AWS levels. This is positive, as after Alibaba’s 11 years of investment and incubation in AliCloud, the business now appears ready to step up to become a key profit-generating engine for Alibaba.

AliCloud’s improving revenue mix, with ~55% of its revenue contribution from higher-margin, value-added services in 1H20, supports the case for long-term profitability. The key, in my view, is the shift away from the intense competition in the infrastructure as a service (IaaS) segment, which often sees price wars breaking out in the fight for market share.

Source: Alibaba Cloud Presentation

Management’s base case is for the cloud business to turn profitable and generate positive operating cash flow in FY21. Plus, management also believes AliCloud’s long-term margin outlook should be comparable to that of its global peers, such as AWS, which generated 26% operating margins in 2019. These announcements should boost market expectations on the incremental valuation assigned to Alibaba Cloud.

Cainiao Also to Turn Cash Flow Positive

Cainiao, Alibaba’s logistics network, has increasingly evolved from an asset-light model toward a more asset-heavy approach, as evidenced by recent activity. For instance, the construction of central warehouses in transportation hubs, the acquisition of last-mile delivery firms, and investments in several listed logistics firms in China.

Management confirmed as much, stating Cainiao is not bound by maintaining an asset-light model – rather, it is open to exploring various approaches to better serve its logistics partners, merchants, and customers. In that regard, Cainiao is open to a range of options, including increasing its stakes in other logistics firms, as long as such moves can drive benefits (e.g., operating efficiencies) for all parties.

I think post-COVID, the view on Cainiao might have changed, convincing BABA to gain more control over its logistics assets, and thus, its operational performance through the cycles. While Alibaba’s e-commerce business was hit by disruptions to its logistics services during the lockdown period, in contrast, JD’s (NASDAQ:JD) approach to logistics allowed it largely uninterrupted services.

The good news is that Cainiao Logistics will generate positive operating cash flows in FY21. While management did not explicitly cite profitability, I suspect Cainiao is not far away, as shown by its narrowing losses in recent quarters. I expect the announcement and continued progress on the back to profitability will boost the market’s willingness to assign incremental valuation to Cainiao.

Source: Cainiao Presentation

Well-Positioned to Capture Secular Growth Opportunities

Alibaba’s scale is vast – its digital economy gross merchandise volume (GMV) amounted to CNY7.3tn on a trailing-12-month basis, representing ~18% of China’s total retail sales. BABA’s retail marketplace also has 742m annual active customers, with 90% penetration in consumers from developed areas and 45% penetration in less developed areas. In tandem, the blended take rate for its China retail business has also increased significantly to 4% in the June quarter, with ample runway for growth ahead.

Even with the ~742m user base today, BABA sees an even larger ~1.2bn addressable consumer base in the domestic market alone. Most of this will come from less developed areas, as its user penetration in developed areas is already ~90%. In less-developed areas, on the other hand, the penetration rate remains comparatively low at ~45%. Long term, BABA plans to further build out its digital ecosystem, with a long-term vision to serve 2bn consumers, create 100m jobs, and reach 10m profitable SMEs by FY36.

Source: Digital Presentation

Emerging platforms such as New Retail, Local Services, and Wholesale Marketplaces also represent incremental growth opportunities and are already seeing accelerated user and merchant growth. Trade/macro uncertainties remain a risk, but Alibaba’s long-term vision and global ambitions remain unchanged.

A Compelling Valuation Case

I think the best way to value Alibaba is to split the group into three parts – the core business, cloud, and its strategic investment portfolio.

Using a discounted cash flow approach for the core e-commerce business with a 10% discount rate and a ~15x FCF exit multiple, I value the core business at ~$230. On the other hand, I value cloud using a premium ~6x EV/Sales multiple (which accounts for its leading position in China’s public cloud space) on FY25e revenue, discounted back at the cost of capital of 10%, giving me a $70 valuation. In my view, both businesses justify the ~$300 stock price today.

Finally, assigning a 30% discount on the fair value of its strategic investments in public and private companies of $45bn (cited by management as of the June quarter) gets me to a value of $31.5bn. And including the ~33% stake in Ant Group (valued at ~$250bn), I get a fair value on the investment portfolio of Alibaba at ~$114bn. Given BABA currently trades at ~$300, this implies the market is assigning value to the core business and cloud, leaving free optionality on BABA’s strategic investment portfolio.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.