Alibaba Has a Long Runway for Growth

Today's Stock Strategist continues Morningstar's initial assessment of Alibaba. Part 1 can be found here.

Following months of anticipation, Alibaba Group is now expected to price its initial public offering in early August. The company plans to list on the New York Stock Exchange under the ticker symbol BABA. Details about the offering's size have been limited, but multiple media reports suggest that the company is looking to sell a 12% stake with the offering. Our preliminary equity value for Alibaba is CNY 1,362 billion ($220 billion), which would equate to an offering of $26 billion and make it the largest IPO in U.S. history.

Alibaba offers several attractive features for investors, including an already powerful network effect in the relatively nascent Chinese e-commerce industry, which should drive meaningful market share gains in the years to come; a compelling blend of macroeconomic, socioeconomic, regulatory, and industry catalysts that should translate into an exceptionally long runway for growth; and strong free cash flow prospects based on an exceptionally leverageable business model. We believe Alibaba's IPO should be on the radar screens for investors seeking exposure to China's emerging middle-class consumers as well as its e-commerce, technology, and logistics industries.

We expect Alibaba to achieve average annual revenue growth of approximately 33% over our five-year explicit forecast period as a result of several macroeconomic, socioeconomic, government, and industry growth drivers. These include wealth creation and growth of China's middle class, favorable demographic and urbanization trends, government policy changes, and underpenetrated Internet and broadband adoption.

Wealth Creation and the Growth of China's Consuming Class
In our view, wealth creation in China will be a key catalyst for e-commerce growth over the next several decades. According to China's Ministry of Human Resources and Social Security, the average yearly wage in China grew at a compound annual rate of 13.8% from 2003 to 2013. Based on the Chinese government's plan to increase minimum wages by "at least 13% annually" as part of its five-year plan for 2011-15 and our conversations with management teams of consumer companies in the region, double-digit wage growth is likely to persist over the next several years, which should have a positive impact on disposable income trends in the region.

According to the China Institute for Reform and Development, the country currently has a middle-class population of 300 million (roughly defined as those individuals with annual incomes between $10,000 and $60,000). With the government's goal to double per capita income among urban and rural residents, the middle class is projected to double to approximately 600 million by 2020. This suggests that Alibaba could see its China consumer base double over the next several years and experience increased engagement levels from existing buyers.

Favorable Demographic and Urbanization Trends
We believe favorable demographic and urbanization trends are also key drivers for our longer-term revenue growth assumptions. According to the United Nations' Department of Economic and Social Affairs, China's population grew approximately 9% annually between 1975 and 1995. We believe this large cohort of more than 300 million individuals is significant for Alibaba, in relation to both supply (increased disposable income through wage rate increases and career advancement) and demand (rising personal consumption expenditures via family creation). This hypothesis is backed by China Internet Network Information Center data indicating that 56.4% of online shoppers in China are 20-29 years old. In addition, 69.7% of shoppers born in the 1990s consider Taobao their most frequently used online shopping site, compared with 60.6% of shoppers born in the 1960s. Although many of China's online shoppers are younger consumers with lower disposable incomes, we believe their loyalty to Taobao and Alibaba's other networks (not to mention a lifetime of potential transactions ahead) adds further support to our network effect moat source and our longer-term growth projections.

Population growth is likely to be a less meaningful catalyst in the years to come; U.N. data implies that China's population will grow only at a low-single-digit pace from 2015 to 2030 before slightly contracting in 2030-50. However, we believe this demographic will increasingly gravitate to Alibaba's platforms in the years to come, protecting the firm's network effect.

We also believe urbanization will be an important revenue driver for Alibaba. In March, China's State Council approved plans to move more than 60% of the country's rural population to urban locations by 2020, up from approximately 53% today. This will effectively shift 15 million-20 million rural residents--more than double the population of New York City--to urban locations each year through the end of the decade. Much of this migration will take place in lower-tier cities, which are conducive to increased e-commerce sales given current infrastructure limitations.

As population density and high Internet penetration rates increase, we believe this will lower the incremental cost of shipping, particularly among last-mile deliveries, enhancing Alibaba's cost advantage relative to traditional retailers.

Government Policy Changes
A number of recent government policy changes could have positive implications for Alibaba. First, recent land reforms could make it easier for farmers to sell, mortgage, or transfer control of their land, which will help create wealth for Chinese farmers (many of whom are located in Tier 3 and below cities with limited retail options but access to Alibaba's marketplaces). Additionally, as part of changes to its recent hukou household reform policies, the government will provide basic housing and social benefits to migrant workers living in Tier 3 and below cities. This should drive higher consumption and e-commerce penetration rates for this group of more than 175 million individuals. Lastly, the easing of China's one-birth policies--couples will be allowed to have two children if one of the parents is an only child, in contrast to current legislation mandating that both parents must be only children to be eligible for a second child--could provide upside.

Underpenetrated Internet and Broadband Adoption
China's Internet penetration rate still lags that of developed countries. China had 618 million Internet users at the end of 2013 (according to CNNIC data,) representing a 48.5% penetration rate, and just 130 million residential broadband accounts (based on data from McKinsey). As fixed-line and mobile Internet proliferates across the nation, more of the population will have access to Alibaba's online marketplaces. Additionally, less than half of China's Internet users are online shoppers, compared with 74% in the United States. We believe the continuous development of logistic infrastructure, an improving user experience, and expanding product categories will attract millions more Internet users to Alibaba's marketplaces, which will further drive transaction volume growth. Alibaba's network effect also implies that user growth will attract more merchants, and vice versa.

One of the More Compelling Growth Stories in Our Coverage Universe
Given its combination of self-reinforcing network effect, scalable technology and infrastructure, and several favorable macroeconomic, socioeconomic, government, and industry growth drivers, we believe Alibaba offers investors one of the more compelling and sustainable growth stories across our global consumer and technology coverage universes.

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We model a 33% compound annual growth rate for 2014-19. This is primarily driven by Alibaba's e-commerce business in China, where we project a five-year CAGR of 32% due to an increase in new active users, heightened engagement among existing users, and a gradual increase in the average take rate (revenue as a percentage of gross merchandise volume). These estimates also imply that Alibaba's GMV will outpace China's overall e-commerce growth (which we estimate at about 26% using data from iResearch), suggesting a strengthening of its network effect.

As a third-party platform operator, Alibaba has potential for operating leverage as its revenue grows. Some of the fixed and semi-fixed costs from information technology infrastructure and personnel can be spread over a greater revenue base. Over our five-year forecast period, we forecast approximately 20 basis points in annual improvement in gross margin, from 74.5% to 76.3%, and 40 basis points in annual improvement in operating margin, from 47.5% to 49.4%. Our profitability estimates factor in increased platform, infrastructure, technology, and personnel investments over the next few years to defend Alibaba's leadership position from rivals.

Alibaba achieved returns on invested capital of 36.3% in 2013 and 68.4% in 2014, well above our estimated weighted average cost of capital of 9.7%. We are confident that the robust revenue growth and steady margin expansion can help the firm generate excess ROICs over the long term, supporting our wide Morningstar Economic Moat Rating.

Based on our valuation model and assumptions for Alibaba, we've arrived at a preliminary total enterprise value of CNY 1,345 billion ($217 billion) and a total equity value of CNY 1,362 billion ($220 billion). We acknowledge that this valuation looks aggressive when applying traditional price/earnings and enterprise value/EBITDA multiples to 2014 estimates, but we believe Alibaba's tremendous free cash potential and wide economic moat warrant a premium valuation. If we apply traditional valuation multiples to five-year estimates, our preliminary valuation estimates become much more palatable.

Expanding Beyond China Could Be Challenging
Alibaba's stated goals for international expansion are focusing on "leveraging natural cross-border linkages to [its] ecosystem." It plans to do this by connecting overseas branded retailers to Chinese consumers (via Tmall Global) and connecting Chinese suppliers to international retail markets through AliExpress (a marketplace that allows global consumers to buy directly from wholesalers and manufacturers in China) and other international wholesale marketplaces. Generally speaking, we are cautious about the long-term prospects for Alibaba's overseas expansion efforts, given the intense competition posed by a number of global rivals with already established network effects. As such, Alibaba's global business does not play a large role in our economic moat rating.

We believe Alibaba has growth aspirations for the U.S. It recently launched a U.S. e-commerce website, 11 Main, an online retail site for unique goods and crafts by local U.S. vendors and boutiques. It also owns stakes in Shoprunner, an online platform that provides logistics solutions for a number of U.S. retailers and consumer brands; Lyft, a U.S. ride-sharing business; and 1stdibs, an online marketplace for antiques and luxuries. However, given Amazon's (AMZN) network effect in U.S. business-to-consumer e-commerce and eBay's (EBAY) network effect in U.S. consumer-to-consumer e-commerce, we don't expect Alibaba to evolve into anything more than a niche player in U.S. online retail.

Recent Acquisitions May or May Not Fit
Alibaba has completed a number strategic acquisitions that we believe might have a meaningful impact on its e-commerce and mobile commerce business. However, there is the possibility of integration risk as the company meshes acquired marketplaces and technologies with its existing offerings.

In June, Alibaba acquired the remaining stake of mobile browser developer UCWeb that it didn't already own. According to a 2013 CNNIC survey, UC's browser is China's most popular mobile browser; 46% of Chinese mobile Internet users identified it as their most frequently used mobile browser. We view the investment in UCWeb as a strategically important deal for Alibaba, as a mobile browser is usually the starting point for online shopping activities on mobile devices and will be instrumental in protecting the company's network effect as e-commerce gravitates to mobile and tablet devices. We believe the widespread popularity of UC's browser will allow Alibaba to control one of the major entry points of mobile traffic and gain significant search traffic for its online marketplaces.

Weibo was launched by Sina in 2009 and quickly became a highly popular social network platform for distributing and sharing original, user-generated content. Since inception, Weibo has accumulated 129 million monthly active users and 61 million daily active users as of the end of 2013. Alibaba invested $586 million to purchase an approximately 18% equity interest in Weibo. Following Weibo's IPO in April, Alibaba acquired additional shares and boosted its stake to 30%. Alibaba has been cooperating closely with Weibo by bundling Taobao and Weibo accounts and allowing Weibo users to browse and purchase products from Taobao marketplaces on the Weibo platform. We believe Weibo's active user base can serve as another important entry point for Taobao's marketplace and enhance the company's overall network effect.

Alibaba acquired AutoNavi, China's leading provider of digital map content and navigation and location-based solutions, in February. AutoNavi is China's most popular digital map for mobile devices, accounting for 31% of user market share in 2013. We have a positive view on this deal as AutoNavi could bolster Alibaba's multiservice ecosystem, allowing the firm to expand its business to a location-based, online-to-offline mobile commerce business model.

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In March, Alibaba invested HKD 1,661 million for a 9.9% equity interest in Intime and a HKD 3,706 million subscription of convertible bonds, which upon conversion would give it approximately a 26% equity interest in Intime. Intime Retail is one of China's leading department store operators, with 30 department stores and six shopping centers in 2013. We believe this investment is a complement to Alibaba's offline channel as Intime specializes in merchandising in the midrange to high-end market with an emphasis on premium shopping experiences. Alibaba will integrate its online marketplaces with Intime's brick-and-mortar network, creating an online-to-offline ecosystem that can provide customers with shopping solutions both in store and online.

China's Regulatory Uncertainty Is a Risk
Alipay, analogous to eBay's PayPal, provides online payment processing and escrow services in China. Although not owned by Alibaba, Alipay has been a crucial component of Alibaba's e-commerce business operations--78.6% of GMV on Alibaba's retail marketplaces in China was settled through Alipay. The online payment business is highly regulated by the Chinese government, exposing Alipay to regulatory uncertainties. Financial regulators in China have been placing increasing emphasis on online and mobile payment services. Any type of regulatory tightening and supervision policy could significantly affect Alipay's business and disrupt the payment system for Alibaba's marketplaces.

In March, China's central bank released a draft of proposed regulations for online and mobile payment services. If implemented, the provisions would prohibit individuals from using the money in their online payment accounts with third-party payment providers, including Alipay, to make payments worth more than CNY 5,000 ($804) in any single transaction or more than CNY 10,000 ($1,609) in aggregate payments per calendar month. Provisions also call for limiting the amount of transfers unrelated to online purchases from an individual's account, with third-party payment providers to other accounts limited to CNY 1,000 ($161) per transaction and CNY 10,000 ($1,609) in aggregate transfers per year.

These provisions, if approved and implemented, will significantly disrupt Alipay's business. However, we're not overly concerned about the impact on Alibaba: Alibaba marketplace customers can still make payments through other methods, such as online bank transfers and credit cards, and this regulation draft is subject to public consultation and hearing. Whether these provisions will be approved remains to be seen.

Because of the transaction volume being diluted by third-party payment systems, several Chinese commercial banks have taken steps to limit the use of third-party payment systems, including Alipay. In March, several major banks reduced their existing limits on the amounts that may be transferred by automatic payment from customers' bank accounts to their linked accounts with third-party payment services. Several of these banks imposed lower limits on Alipay than on other payment services. We believe this type of transaction limit could compromise the convenience of Alipay's online payment system and, by extension, the convenience and attractiveness of Alibaba's marketplaces.

We believe Alibaba's corporate structure also is exposed to legal risk. Like many other Chinese Internet companies listed in overseas markets, Alibaba has adopted a variable interest entity structure, which is designed to let companies bypass Chinese legal restrictions on foreign ownership in certain sectors. Alibaba's foreign investors will essentially hold shares of Alibaba's VIEs domiciled in the Cayman Islands. We don't expect any legal challenges to VIEs by the Chinese government. However, if the legitimacy of Alibaba's related VIEs is found to be in violation of applicable law or regulation, Chinese regulatory authorities might take action, including revoking the business and operating licenses of Alibaba's subsidiaries or the VIEs, or discontinuing, restricting, or restructuring Alibaba's operations. Since the Chinese Ministry of Commerce has the jurisdiction to regulate VIEs, we believe overseas investors will have limited legal rights and are likely to lose their investments if this scenario unfolds.

Stewardship and Board Independence in Question
Alibaba has a capable and ambitious management team. Founder Jack Ma has been an inspiring leader since the company's inception in 1999. Under his leadership, Alibaba has emerged to become China's dominant e-commerce player, accounting for 84% of total transaction volume of the online shopping industry. Over the past decade, Taobao's ascendance has changed the shopping behaviors of millions of Chinese consumers. Management has also done an excellent job developing and strengthening Alibaba's wide economic moat by building several other leading online commerce platforms, including Tmall, Juhuasuan, Alibaba.com, and Alipay. We have little doubt that Alibaba Group can sustain its wide moat over the long term under the existing management's leadership.

Following the IPO, Alibaba Group will enter a voting agreement with two of its major shareholders--SoftBank and Yahoo--as they will agree to vote favorably toward the Alibaba Partnership director nominees at the general shareholder meetings. In addition, Yahoo, Ma, and Alibaba vice chairman Joe Tsai will all agree to vote in favor of one director, nominated by SoftBank. We believe these provisions could compromise board independence and increase the likelihood of conflicts of interest.

In 2011, the company transferred the ownership of Alipay to a new company controlled by Ma without the approval of Yahoo and SoftBank. Although a settlement has been reached among Yahoo, SoftBank, and Alibaba, we believe this is symptomatic of poor stewardship. We advise investors to take note.

Morningstar Institutional Equity Research Services offers more in-depth research on Alibaba, as well as deep sector and industry research, discounted cash flow models, and direct access to Morningstar analysts. To learn more, click here or email buysidesales@morningstar.com.