Alibaba's Data Advantages Open Up Growth Opportunities

Over the past few years,

Alibaba’s Internet services affect the vast majority of Chinese Internet users in some way, including a 70% penetration rate for the Taobao/Tmall e-commerce marketplaces. This provides Alibaba with an unparalleled source data that it can use to help merchants and other consumer brands develop personalized mobile marketing and content strategies to expand their target audiences, increase click-through rates and physical store transactions, and improve return on investment. While Alibaba has temporarily suspended certain merchant fees against an uneven macro backdrop, its marketplace monetization rates have generally trended upward, indicating that sellers are becoming increasingly dependent on its marketplaces and payment solutions. Retail revenue per active user continues to outpace other China rivals, owing in part to an emphasis on higher-quality merchants.

While we view Taobao/Tmall marketplaces, Cainiao, and Alipay as Alibaba's core cash flow drivers, we also believe Ant Financial, AliCloud, globalization, digital entertainment, and Ele.me (food delivery) offer long-term potential. While AliCloud will remain in investment mode in the near term, we believe accelerating revenue per user trends suggest a migration to value-added content delivery and database services that can drive segment margins higher over time. Third-party merchants are successfully reaching Lazada's users across Southeast Asia, something that should continue as the company rolls out incremental personalized mobile marketing and content opportunities. While early, we share management’s views about Ele.me and digital entertainment being important user acquisition and engagement tools.

Wide Moat Comes From Strong Network Effect We assign Alibaba a wide economic moat rating based on its strong network effect, where the value of the platform to consumers increases with a greater number of sellers, and vice versa. Despite recent macroeconomic uncertainty, we expect China and Southeast Asia's digital commerce industry to have a very long runway of growth based on consumer disposable income and consumption trends, increasing Internet and mobile adoption rates, and a highly fragmented brick-and-mortar retail industry. This is in contrast with other network-based industries, which have often reached a more mature state by the time leading players fully establish a meaningful network effect.

Alibaba's "ecosystem" is made up of three leading Chinese online retailing platforms: Taobao Marketplace, China's largest online consumer-to-consumer shopping site; Tmall, China's largest third-party business-to-consumer platform for branded goods; and Juhuasuan, China's most popular group buying marketplace by monthly active users. We estimate Alibaba’s China retail marketplaces (Taobao and Tmall) will generate gross merchandise volume of CNY 6.3 trillion ($942 billion) in calendar 2018, more than Amazon AMZN and eBay EBAY combined (where we forecast $406 billion and $96 billion, respectively) and representing a significant portion of China's CNY 7.5 trillion online shopping industry based on data from iResearch.

Because Alibaba's various online marketplaces are interconnected, we believe this compounds its network effect, which then breeds other competitive advantages. By operating China's two most popular online shopping marketplaces, Alibaba has developed a powerful brand intangible asset moat source, in our opinion. Millions of Chinese consumers consider Taobao and Tmall as their default go-to options when seeking products and services online. Based on several online shopping surveys, we believe more than two thirds of China consumers consider either Taobao or Tmall as their most frequently used online marketplace. Additionally, Taobao users with a strong appetite for branded products can shop Tmall for a better shopping experience and assurance of higher quality, whereas Tmall's shoppers looking for a wider product selection can search Taobao. In fact, we believe Taobao diverts user traffic to Tmall, thereby lowering Tmall's customer acquisition costs. We're also starting to see a number of new growth opportunities for Alibaba's China retail platform, including 88VIP Loyalty Membership program engagement, short video brand content, and retail formats like Hema, Intime, Sun Retail, and Tmall-branded convenience stores. Taken together, we now expect Alibaba's China retail segment to deliver 33% average annual growth the next five years.

Moreover, through its cooperative logistics affiliate Cainiao (in which Alibaba increased its ownership stake to 51%, up from 47% previously, and began consolidating in its financial statements in October 2017), the company operates as a third-party platform without taking control of inventories--something that is unlikely to change, in our opinion--adding another layer of cost advantages and driving margins above those of JD.com JD, Vipshop, Amazon, and other competitors in the region. While the decision to consolidate Cainiao and invest more heavily in new smart warehousing and other logistics technologies will shift Alibaba away from a delivery data model (where merchants assume responsibility for order fulfillment from their warehouses via couriers backed by Cainiao data) to a more traditional fulfillment model (where Cainiao assumes responsibility for fulfillment through owned or partner warehouses) and could weigh on near-term margins, it will create fulfillment and inventory storage bundling opportunities (similar to Fulfillment by Amazon), which should drive improved monetization rates. We also believe the enhanced logistics capabilities stemming from its partnership with Suning and other retailers (which allows for greater next- and same-day delivery opportunities for consumer staples products across a greater number of cities) and other omnichannel investments (including mobile ordering and payment capabilities in more than 180,000 offline stores) strengthen this platform's network effect and make it a more compelling platform for buyers and sellers alike.

We expect globalization will be a key growth driver for Alibaba in the years to come. In particular, we view Alibaba's controlling stake in Southeast Asia e-commerce platform Lazada as a positive for its international expansion aspirations. First, we believe Lazada is additive to Alibaba's network effect--the primary source behind our wide moat rating--and will give Alibaba's third-party merchants access to potentially 200 million active Internet users across Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Vietnam (based on Internet Live Stats). Second, while Alibaba has had limited success with its previous e-commerce endeavors outside China, Lazada has a higher probability of success given the lack of existing players in Southeast Asia with established network effects and an underpenetrated e-commerce market (collectively representing 3% of total retail sales versus almost 14% in China). Lastly, we believe the similarities between e-commerce in China and Lazada's key operating markets--including high mobile commerce adoption rates and a fragmented traditional retail marketplace--offer revenue growth and cost synergies by combining Alibaba's mobile commerce, payments, and logistics technologies with Lazada's existing HelloPay payment and Lazadaexpress logistics solutions.

Alibaba’s desktop and mobile monetization rates (revenue as a percentage of gross merchandise volume) have generally been on upward trends the past few quarters, which indicates that sellers are becoming increasingly dependent on Alibaba's marketplaces to reach Chinese consumers. We see the company’s recent user experience investments as prudent to maintain the network effect, particularly as other local and global players look to expand their presence in China. We believe Alibaba can increase its monetization rates over time via improved seller conversion rates from personalized search efforts, the embracing of data-enriched marketing tools by mobile sellers, and increased contribution from Tmall.

We believe AliCloud is likely to develop into a more significant cash flow contributor over time, given its early-mover advantages in Big Data and cloud computing in China--giving it distinct advantages over AWS and Azure in China--and increased demand from corporations and other government groups looking to reduce information technology expenditures. Management has said it believes AliCloud can eventually be as profitable as Amazon Web Services, which posted operating margins in the mid-20s in 2017. We share management's views about AliCloud's longer-term margin potential, but we caution investors from automatically assuming AliCloud will deliver the same growth and profitability trajectory as Amazon Web Services. We expect AWS-like margins will probably take at least five years due to ongoing customer acquisition efforts and technology investments, as well as potential competition from Tencent’s cloud service offerings.

Competition and Regulation Among the Risks In our view, the most pressing risks to the Alibaba investment thesis are a sustained slowdown in Chinese consumption patterns, digital commerce competition, increased regulatory scrutiny, and the possibility of ancillary businesses diverting management's attention from its core marketplaces, each of which contributes to a wide range of potential fair value outcomes.

China's digital commerce landscape has become more competitive in recent years, with JD.com positioning itself as a credible rival over the long run through its fulfillment capability, quality assurance, and its strategic partnerships with Tencent and Walmart. Additionally, Alibaba faces competition from Vipshop and Amazon, among others. These platforms might not have Alibaba's scale in the region, but they specialize in specific products, services, or markets, which might constrain Alibaba's growth aspirations.

Alibaba is also subject to increased online and mobile payment regulation. Financial regulators in China have continuously scrutinized online and mobile payment services. Considering that more than 80% of transactions on Alibaba's China retail marketplaces are settled through Ant Financial's Alipay, any type of regulatory tightening and supervision policy could affect Alibaba's business operations. In addition, as an operator of online marketplaces, Alibaba has persistently faced the issue of counterfeit and infringing goods. Although the company has been making increasing efforts to confront the issue, there is still room for improvement.

Other downside risks include expansion into peripheral businesses, which might distract management and may not materially improve Alibaba's ecosystem. While we're optimistic about Alibaba's ability to become a preferred partner for international retailers and consumer brands looking to sell in China, the firm does not enjoy the same network effect and brand recognition in other countries, and it may face challenges directly expanding in these markets.

Alibaba is in sound financial health. As of September 2018, the company had CNY 182 billion ($26.4 billion) in cash, unrestricted short-term investments, and investment securities on its balance sheet against CNY 138 billion ($20.1 billion) in short- and long-term bank borrowings and unsecured senior notes. Although Alibaba remains in investment mode, we believe the strong cash flow profile of its e-commerce marketplaces offers it the financial flexibility to continue investing in technology infrastructure and cloud, research, marketing, and user experience initiatives through its current balance sheet and strong cash flow profile. Additionally, we believe the company has the capacity to add leverage to its capital structure, which could allow it to take advantage of low borrowing rates to fund growth initiatives, introduce a cash dividend, or repurchase shares. We expect the company to pursue acquisitions that could further improve its ecosystem, including online-to-offline, offline retail, and increased logistic capacity or capabilities.