Please refer to our disclaimers, which can be found in the footnote of this page and here.
Update Only
We have owned Alibaba since the inception of the strategy, and it has been a key detractor of performance. Our commentary here is intended as an update rather than an overview of the business. For those unfamiliar, Alibaba is a large conglomerate in China. Its primary business is China’s largest eCommerce marketplace (Taobao/Tmall), which attributed 141% of EBITA in FY2023. It has various other businesses including China’s leading public cloud business, payments, various direct sales eCommerce/retail businesses, international eCommerce, food delivery, logistics, and a long-form video business. A good summary of the business can be found here.
The principal reason for its underperformance, other than the macro, is the stalling of growth in its core domestic eCommerce business (Taobao/Tmall) and its cloud business. Taobao/Tmall have been impacted by the entry of Pinduoduo (another eCommerce marketplace) as well as Douyin and Kuaishou (both social / short-form video entertainment platforms with burgeoning eCommerce businesses). Additional factors included the cancellation of the company’s planned spinouts as well as the removal of former CEO Daniel Zhang.
We were first introduced to Pinduoduo in 2018, while it was still a private company, and have followed the company since then. As we mentioned in our last letter, we were sceptical of the sustainability of its aggressive advertising and marketing spending to buy market entry. We were wrong. As it turns out, the company had exceptional execution and it is now a fully scaled business with similar incumbent advantages to Alibaba’s Taobao. It is a remarkable feat as prior to its rise, the strength of the incumbent platforms should have enabled them to rebuff Pinduoduo’s entry. As we discuss in our business quality framework, network effect business models have some key vulnerabilities. In this case, Pinduoduo targeted a value proposition (“very low-price value-for-money”) and a customer segment (lower income / lower tier cities) that wasn’t being served adequately by Taobao/Tmall and others. This, alongside great execution, enabled the company to establish a strong foothold from which to expand. Pinduoduo also pioneered the team-purchase model, which enabled greater discounts for group orders and incentivised word-of-mouth customer acquisition, enhanced by smart use of social acquisition channels such as WeChat (at the time unavailable to Alibaba given competitive exclusion from Tencent). China’s economic hardship over the last 3 years also had a role to play as it meant a general shift towards lower-priced items just as Pinduoduo came to scale.
Alibaba unintentionally aided Pinduoduo by degrading the Taobao merchant value proposition over time. As higher-value products were sold through Tmall, with higher associated platform marketing spend, Alibaba was able to boost its profits by directing more traffic from Taobao to Tmall. That is, they did not create an even playing field for traffic acquisition spending between the two. Our channel checks indicated that this left merchants frustrated. It also made it harder for Alibaba to reverse this stance as it would hurt margins and cash flow. Alibaba was also slower to adopt the manufacturer-to-consumer model in its domestic business because of the disruptive impact this would have on 1688.com, its domestic wholesale marketplace. Both issues meant Alibaba faced a counter-positioning[1] problem from Pinduoduo. We think management now realises its error and is working to rectify this with its “Return to Taobao” strategy. Alibaba had also become a bloated organisation. Various former employees complained to us about too many mid-level managers, too much competition for shared tech resources, and too many hoops to jump through to execute on new things. In contrast, Pinduoduo is much leaner and has an aggressively entrepreneurial culture. This makes Alibaba much slower to adapt and change. Alibaba has been responding by reducing headcount, which may help, but we think this advantage is a hard-to-replicate cultural edge for Pinduoduo.
We think Pinduoduo, and others like Douyin, will continue to steal share from Taobao/Tmall. However, we do not think this is the end of Taobao/Tmall. They too serve a strong value proposition and continue to maintain strong user engagement as the largest platform by gross merchant value (“GMV”…i.e. sales) and timeshare. We have spoken with various merchants who sell through the platform. In fact, most of the brands we spoke with were very negative about selling through Pinduoduo as they did not want their brand associated with a discount platform. Some had indicated that they are closely watching the space and may consider offering only clearance items. When asked why Tmall’s growth was struggling, their view was that it was more likely due to the macro-economy and some impact from Douyin, where the branded merchants are allocating marketing budget. They argued that Tmall remains “the” platform for branded goods. While the macro-economy suffers in China, higher-priced branded retail is likely to remain depressed, but we do not see this as permanent. We had always underwritten a share loss for Taobao/Tmall, but we now underwrite a greater decline. At first (in 2018/19), we underwrote a stable margin in the core business, but we now assume a continued decline. It is hard to know exactly where the margin will stabilise, so we reverse the question and consider what we need to believe given the current share price.
Alibaba’s cloud business has also decelerated. We would expect this given China’s macroeconomic backdrop, but it has also been impacted by the migration of TikTok from its services after the US mandated TikTok to store data domestically in the US. That aside, Alibaba’s cloud business is complicated. The reported numbers are not purely public cloud. They also include its content delivery network (“CDN”) services and managed private cloud businesses, which are both lower margin businesses. The public cloud penetration in China remains well below the US but, according to China Chief Information Officer surveys, the public cloud remains a strong priority. These same surveys indicate Alibaba Cloud as a top beneficiary of this shift. As indicated by other positions in our portfolio, we strongly believe in the value proposition of the public cloud. As the public cloud part of the business continues to grow, it represents a greater and greater share of the overall cloud revenue. Management disclosed that it reached 70% of its 3rd party total cloud revenue in 3Q 2023. We think some of these issues are masking a good business underneath. We are now underwriting continued pressure on the cloud business in 2024 with a re-acceleration from 2025 as some of these issues roll off.
Alibaba currently trades on a low double-digit forward-free cash flow (“FCF”) yield. We think the overall business can very conservatively compound FCF in the high single-digits. Even without a compression in the FCF yield when the China macro-economic picture stabilises, this provides a high-teens IRR[2] over 5 years. There is a lot embedded in this, but in brief, we can achieve this even assuming flat revenue growth in the core eCommerce business (low single-digits GMV growth, equating to roughly 8% share loss, offset by compression in the monetisation rate due to competition) as well as further margin pressure. It assumes the cloud business recovers (as mentioned above) with modest margin expansion with scale, and reduced losses in non-core businesses (either through business improvement or divestment). We sense check this with a conservative sum-of-the-parts valuation. In essence, we only need to believe that the core eCommerce business can stabilise to produce attractive returns. We think it can.
Like many Westerners investing in China, we have naturally asked why we bother given some of the geopolitical challenges, government regulation, and the natural disadvantage we face not speaking the language or being based locally. As is usually the case, the investment community worried more about China after the broad-based and deep market sell off than it did prior. These risk factors have always been present (e.g. China’s anti-monopoly regulation was well telegraphed for several years prior to Western investors raising it as a concern). The time to worry the most about such broad risks was when valuations were also high. Today, many Western investors have given up on China and this is reflected in current low valuations. Some investors now argue that China is not investable at any price due to the risk of major conflict with the West. We disagree with this and do not think any public equity market will be safe in that eventuality. At the same time, we must consider our opportunity cost. Western markets are significantly more expensive today and so the current opportunity cost is low. Despite the attractive valuation, Alibaba is still only sized at ~6%. We have always limited its size to respect some of the aforementioned risk factors.
Footnotes
[1] See Helmer’s “7 Powers: The Foundations of Business Strategy”
[2] Refer to our disclaimers, we make no guarantees of future performance, and our projections should not be relied upon