Revisiting Alibaba: Margin Defense Shores Up Valuation

Summary

• We previously rated Alibaba a Sell due to rising competition, but now view it as more balanced risk-reward.

• Q3 results show slowing growth in core China ecommerce and cloud amid competitive pressures.

• However, profitability remaining solid with 46% ecommerce EBITDA margins and 8% cloud margins.

• Base case DCF values segments at $143B ecommerce, $40B international, $14B cloud - implying 140% upside.

• Upgrading to Hold as valuation compensates for competition concerns, but will monitor margin erosion.

Introduction

In our previous article, we recommended selling Alibaba stock due to increasing competition from Huawei and PDD Holdings. Although Alibaba is still the top cloud provider in China, Huawei has been growing its market share aggressively thanks to its close ties with the Chinese government and securing contracts from state-owned enterprises. PDD Holdings has also been taking domestic e-commerce market share from Alibaba and fiercely competing internationally.

Latest Earnings Review

Alibaba just reported its Q3 2024 earnings on February 7th. The results show that growth in its core China e-commerce and cloud businesses slowed to the low single digits. This suggests that Alibaba likely continued losing ground to rivals like Huawei and PDD last quarter. As a result of the disappointing growth, Alibaba's stock dropped 6% following the earnings announcement. So it seems our concerns about rising competition hurting Alibaba's business have started to play out. We'll have to keep monitoring the situation going forward. But for now, our view remains that investors should be cautious about Alibaba due to the increasing competitive pressures.

Source: BABA

Positives in the Earnings Report

There were a few bright spots in Alibaba's latest earnings report. Their cloud business saw good profitability growth - cloud EBITDA was up 86% and the margin is now close to 8%. So even if they are losing some market share to Huawei on the cloud side, it seems Alibaba still has strong bargaining power there.

Additionally, Alibaba's international commerce business grew 44% despite wider losses as they ramp up investment. The international growth also further fueled expansion of Cainiao, their logistics arm, which was up 24% and showed a 3.5% profit margin. This indicates Alibaba may still have room to grow outside China, even as PDD also taps into Southeast Asia.

So while the core China ecommerce slowdown is concerning in the face of rising competition, Alibaba does seem to be planting seeds for future growth - especially in the cloud profitability and continued international expansion. The key will be whether they can maintain strong positions in those areas despite the rivals like Huawei and PDD biting at their heels in China. But some of the growth signs outside their core business remain positive for now.

Valuation Analysis

Alibaba does have some other faster growing businesses like Cainiao logistics, local services, and media/entertainment. However, these are lower margin, non-core businesses that mainly play a supporting role to Alibaba's core ecommerce platform. So unlike some bullish analysts, we don't assign them huge valuations.

The core China ecommerce business is still generating solid 46% EBITDA margins despite losing share to PDD. This suggests Alibaba maintains strong bargaining power with merchants given its scale. Interestingly, Alibaba has now adopted PDD's "refund only" policy to improve consumer experience - a move we didn't expect based on our past analysis. In our PDD article, we argued this refund policy benefits the ecosystem long-term, though some merchants resist it. By adopting this policy, Alibaba closes one competitive advantage PDD had.

However, PDD should still gain share with its agricultural focus and traffic acquisition strengths there. So our base case assumes flat ecommerce growth for Alibaba over the next 12 months, and only 3% terminal growth. Applying a 15% long-term margin, we value this business at $143 billion.

Internationally, Alibaba has sourcing/shipping strengths from leveraging local platforms. We assume 40% growth in 2024, tapering to 3% terminal growth and 10% long-term margins. This implies a $20 billion international valuation.

For cloud, Huawei will likely keep taking share. We assume flat cloud growth for Alibaba, 3% terminal growth, and 10% long-term margins - valuating this at $14 billion.

In total, with $54 billion of net debt, our base case arrives at a $233 billion valuation, representing 26% upside and a 12% WACC.

In a bear case with lower 10% ecommerce margins 8% cloud margin and 5% international margins, we get $119 billion, $12 billion and $13 billion valuations for the segments. This implies $218 billion total equity value, just 18% upside.

Our bull case uses 15% blended margins across Alibaba's entire business, assuming no growth but 3% terminal growth. This yields a consolidated valuation of $264 billion, 43% upside.

Scenario	Ecommerce Margin	Ecommerce Growth	International Margin	International Growth	Cloud Margin	Cloud Growth	Valuation	Upside
Base Case	15%	0%	10%	40% tapering to 3%	10%	0%	$233B	26%
Bear Case	10%	0%	5%	0%	8%	0%	$218B	18%
Bull Case	15% blended	0%	15% blended	0%	15% blended	0%	$264B	43%

Investment Conclusion

Looking at the latest results, the risk-reward profile on Alibaba appears more balanced to us now. On the positive side, they are generating solid profitability in both the core ecommerce business and growing cloud segment. The 46% ecommerce EBITDA margins and approaching 8% cloud margins demonstrate Alibaba's ability to maintain strong profitability even in competitive markets.

However, the risks remain around both businesses losing market share in China - ecommerce to PDD and cloud to Huawei. But Alibaba seems to be responding tactically, as evidenced by adopting PDD's refund policy.

Overall, while the competitive pressures remain concerning, Alibaba has shown it can defend margins and even adapt some innovations from rivals like PDD. This makes us more constructive on the stock. Though growth is slowing, the reasonable valuations imply upside even on relatively pessimistic assumptions.

Given the improved profitability trends and more balanced risk-reward, we now rate Alibaba a Hold as we monitor their ability to maintain market leadership in China. We will watch closely for any additional margin erosion, but for now believe the valuation compensates for the competitive concerns.