Alibaba: Early Innings

Alibaba is a sprawling tech giant whose tentacles reach into every corner of China’s economy. It owns dominant e-commerce, media, technology, logistics, and financial businesses in China. 

Alibaba has so many irons in the fire because building businesses is in its DNA. It’s what Monish Pabrai calls an “Apex Spawner.”

When most businesses face a problem, they outsource a solution to a third party. Alibaba, like Amazon, tends to build its own solution in-house. As its own first customer, Alibaba's start-ups instantly have scale competitors could only dream of.

Chinese Retail Marketplaces: Taobao & Tmall

Alibaba specializes in building marketplaces. Taobao and Tmall are the largest. Together they have 55% of the Chinese e-commerce market.  Both are B2C marketplaces where businesses sell to Chinese consumers. Taobao caters to small domestic businesses and individual sellers, while Tmall hosts larger domestic and international brands. Alibaba's namesake marketplace, Alibaba, is an international wholesale B2B marketplace and tiny by comparison.

Neither Taobao nor Tmall have an exact American analog. Unlike Amazon, they don't carry inventory or own warehouses. They're pure marketplaces, like eBay, Etsy, and Amazon Marketplace. Since neither Tmall nor Taobao need capital for stores, warehouses, or inventory, they have extraordinary economics, exhibit tremendous operating leverage, and quickly scale.

Scale is Alibaba’s defining feature. Taobao and Tmall have 811 million annual active customers (AAC) who buy $1.1 trillion of gross merchandise volume (GMV) per year. That’s more than 2.5x users than the entire population of the United States and more than 4x Amazon Marketplace’s GMV.

The Rise Of The Chinese Middle Class

Although Alibaba's GMV is already huge, it continues to snowball. It clocked 42% year-over-year growth last quarter. While this growth rate will moderate someday, the rise of China's middle class and its consumer economy provide a tailwind that could last decades.

China’s development may still be in its early innings. According to Mary Erdoe, JPMorgan’s CEO of Asset & Wealth Management:

China is twice the size of the Japanese market. It's 3x the size of the London market...it's got 3x the number of Internet users in the US. It's -- 40% of the population is already middle class, it's about 588 million people. It's expected to become 70%. That's another 453 million people.

Adding another 450 million consumers to Alibaba's addressable market would be like finding another 1.5 Americas. It's a huge opportunity. That opportunity lies in rural China. Alibaba is about 90% penetrated in China's developed urban centers, but only 45% penetrated in less developed rural areas.

China's GDP per capita is only 20% of America's. As the middle class emerges and gains wealth, they're likely to spend more on Alibaba's platform.

Network Effects Centralize E-commerce

Alibaba has a 55% share of Chinese e-commerce and has a good chance of maintaining that as the market grows.

The reason? Alibaba's e-commerce businesses produce network effects that strengthen its value proposition as it grows. According to Metcalf’s Law, the value of a network increases in proportion to the square of its user base. While this may be precisely wrong, it is roughly right. 

As Alibaba accumulates more buyers, it attracts more sellers. Likewise, more sellers attract more buyers. As Alibaba gains more users, it can amortize the cost of new features over more customers and further distance itself from the pack. Positive feedback loops like this are powerful because they’re exponential, not linear.

Brick-and-mortar retail is constrained by real estate. That’s why most traditional retailers specialize in one product type (like AutoZone) or one geography (like Meijer). E-commerce doesn’t face these constraints, which is why Amazon sells everything everywhere.

China modernized so recently that they largely skipped brick-and-mortar retail and went straight to e-commerce. Already 50% of Chinese retail sales in China are online, compared to 14% in the US. Alibaba led the charge and gained a first-mover advantage. They started spinning their flywheel before flywheel was a buzzword.

A Toll Road On Chinese Growth

The best business is a royalty on the growth of others, requiring little capital itself.

Warren Buffett

Alibaba has a dominant position in the large and growing Chinese e-commerce market. In 2015, Alibaba estimated that it accounted for 10% of total Chinese consumption. That's since risen to 18%. Alibaba makes money by providing merchants with products and services to reach Chinese consumers.

Taobao and Tmall’s revenues are a function of their take rate and gross merchandise value. Think of Taobao and Tmall like a toll road on Chinese consumption. Every time GMV flows from buyer to seller on their platform, Alibaba takes a tiny piece - currently about 4%. That's a pittance compared to eBay's 9%, Amazon Marketplace's 15%, Etsy's 17%, and JD's ~20%. Pinduoduo is the only e-commerce platform I'm aware of with a lower take rate (3%).

However, comparing these take rates isn’t an apples-to-apples comparison. Different platforms offer different services in exchange for their take.

Alibaba’s take rate is so low because Taobao doesn’t charge transaction fees. Transaction fees usually make up the majority of the take rate on other platforms. Apple’s App Store, for instance, charges a 30% transaction fee. 

Instead, Taobao monetizes with optional ads, search placement, and other services. Tmall uses a more traditional model. It charges an upfront deposit for access to the platform, an annual fee, and commissions on each sale.

Just as there’s room for Chinese e-commerce and Alibaba’s GMV to grow, there’s also room for Alibaba’s take rate to rise. The success of Amazon Marketplace suggests the market can bear a higher take rate than Alibaba charges. Untapped pricing power is one of the most desirable attributes a business can possess because price increases require no incremental capital and drop straight to the bottom line.

In 2014 Alibaba's take rate was 2.5%. By June 2017, it had increased to 3.3%, and today it is 4.0%. But, Alibaba's take rate didn't go up because they raised prices. Alibaba increased its take rate by offering more value-add services to its merchants. 

Scale Economies Shared

On the surface, a high take rate seems preferable to a low take rate. While a high rate maximizes profits today, that’s never been Alibaba’s game. Alibaba’s approach has always been to build value ahead of profits.

This is what Amazon and Costco have successfully done, and what investor Nick Sleep termed “Scale Economies Shared.” The principle is to achieve economies of scale and give the benefits to customers rather than shareholders. This results in lower margins but a stronger value proposition. A stronger value proposition drives greater scale, which can then be used to further increase value. The result is a positive feedback loop that compounds exponentially.

Early analysts criticized Costco for its low margins. Today, they praise them. Costco’s margins are understood to be a feature, not a bug. No retailer can match Costco’s margins and remain profitable because no one has reached Costco’s scale. By reinvesting into its value proposition, Costco achieved escape velocity and looks untouchable.

Alibaba is pursuing a similar strategy. On their May 2021 conference call, they admitted, "We're not aggressively monetizing the value we created for the merchants actually." They plan to continue rolling out new merchant services. As they do, they'll make the mature services free. While this will depress profits below their short-term potential, it will maximize the value merchants receive from selling on Alibaba and widen the gulf between Alibaba and its competitors.

Alibaba's goal is to "make it easier to do business anywhere." To that end, they offer all the services a merchant needs to launch an online business. True to form, Alibaba built these services as marketplaces. Rather than own a logistic company with trucks and warehouses, they built Cainiao. Cainiao is a platform that allows logistics companies of all sizes to bid on its delivery. So, it's more like a freight broker than UPS or FedEx.

Merchants can source products on Alibaba's B2B wholesale site, list them on its B2C e-commerce sites, outsource advertising to Taobao, use AliPay for transaction processing, and use Cainiao for delivery. A merchant using all of Alibaba's services will be hard-pressed to leave. They'd need to reinvent their entire business elsewhere. So long as merchants are making money on Alibaba and consumers like the selection and prices, they'll stick around.

Valuing Taobao and Tmall

Alibaba's stock price peaked in October 2020 at around $300 per share. Since then, it has fallen 30% to $210. That puts its value at $575 billion. What do you get for that price?

Alibaba's core e-commerce businesses, Taobao and Tmall, generated $26 billion adjusted operating income last year. The rest of its businesses lost a collective $7 billion. Netting these out and valuing Alibaba based on $19 billion of operating earnings implicitly ascribes the company's cloud, media, and other businesses a negative value. That would be a mistake since Alibaba is incubating large, dominant businesses outside of e-commerce.

To simplify things, momentarily assume everything Alibaba owns besides Taobao and Tmall is worth zero. On that basis, Alibaba trades for 28x earnings (assuming a 21% tax rate on $26 billion of operating income). That's not a demanding valuation for a business with a dominant position inside a rapidly growing market. It's about 30% above the market average (Value Line's median P/E of 21x).

Beyond Chinese E-Commerce

Alibaba has lots of valuable assets besides Taobao and Tmall. To start, they have $118 billion of cash and investments, net of debt. Alibaba's investment portfolio is 200 companies strong. They include 33% of Ant Group and 47% of Cainiao Network, among others. Backing these out of Alibaba's valuation brings its P/E down to 22x, in line with the median company in Value Line.

Alibaba strikes me as an above-average business at an average price. And we haven’t even discussed Alibaba’s cloud business, international e-commerce, wholesale, or media properties like Youku, the YouTube of China, or DingTalk, the Slack of China. Of these, the cloud is the most notable.

Alibaba’s cloud is the 4th largest in the world (behind Amazon, Microsoft, and Alphabet)  and the largest by a factor of three in China. Management thinks it will turn a profit this year. Cloud is a great business because it is sticky and has high barriers to entry. It’s also a huge, growing market.

In Confluent's recent S-1, they said:

Despite the fast growth in the global cloud computing market, over the past five years, only 17% of the system infrastructure software spend has been made up of spend from public cloud services. Many organizations continue to have massive on-premises deployments.

In other words, the cloud has a long runway ahead. Security concerns will probably prohibit Alibaba from ever gaining share in the west, but it should continue to dominate China and Asia. While China is the second-largest cloud market, it is a distant second to the US at only one-tenth of the size. As China continues to modernize, that gap will narrow. 

Last year Alibaba's Cloud did $9.2 billion of revenue and grew 50%. Cloud is rapidly becoming Alibaba's biggest growth driver. Since the cloud doesn't make money, it's difficult to say precisely what it is worth. 

Amazon’s AWS, the world’s largest cloud, sports 30% operating margins. If Alibaba’s cloud was equally profitable and paid a 21% tax rate, it’d generate $5 billion of after-tax profit. At Value Line’s median P/E of 21x, the business would be worth $106 billion. This is aggressive, considering that AWS has best-in-class margins and scale. However, Goldman Sachs values Alibaba’s Cloud at $93 billion, which is in the same ballpark.

Fortunately, Alibaba's current valuation doesn't demand precision. Alibaba's core e-commerce, cash, and investments justify the stock's current price as "an above-average business at an average price." Alibaba's cloud and other businesses only make Alibaba cheaper. If Cloud is worth $100 billion, Alibaba's core business only trades for 17.5x, a 20% discount to the market average. 

Further, Alibaba carries its 33% stake in Ant Group at $10.1 billion. But reports leading up to its IPO had pegged Alibaba’s share at $100 billion. Backing out another $90 billion of value would leave Alibaba’s core e-commerce business trading for 13x earnings, or about 10x pre-tax.

Why Does This Opportunity Exist?

Why does a dominant, capital-light business only fetch an average multiple? The short answer is China.

China is a one-party state. The ruling party calls themselves Communists, but the Chinese economy is anything but. Alibaba's core competency is creating marketplaces, and marketplaces are the bastion of capitalism. Alibaba's stated mission is to "make it easy to do business anywhere."

Governments, whether one-party or not, want to stay in power. The best way to do that is to keep citizens happy. Rapidly rising standards of living are a sure-fire way to appease citizens. Capitalism in general, and Alibaba in particular, have been instrumental in bringing about the rise of China’s middle class. In this sense, Alibaba’s interests are aligned with China’s government and citizens.

However, Alibaba has drawn unwanted attention from the government recently.

Alibaba And The Chinese Government

In April 2020, posts on Weibo (Chinese Twitter) began to speculate that an Alibaba executive was having an affair. An hour later, these posts were deleted. This was suspicious because Alibaba owns 30% of Weibo. The Cyberspace Administration of China accused Alibaba of directing Weibo to remove the posts. The government began to worry that Alibaba was using its media interests to manipulate public opinion to favor its business interests.

Last fall, Alibaba began to gear up for the IPO of Ant Financial. Alibaba owns a third of Ant, and the IPO was expected to value the company at more than $300 billion. Days before the IPO, Alibaba’s founder, Jack Ma, said: 

“Banks today still hold a pawnshop mentality…. It is impossible for the pawnshop mentality to support the financial demand of global development over the next 30 years. We must leverage our technological capabilities today and build a credit system based on big data, to get rid of the pawnshop mentality. We can’t use yesterday’s methods to regulate the future.”

The government didn't take this criticism well. On November 3rd, President Xi Jinping personally canceled Ant's IPO. The next day state-run media company Xinhua published an article titled, "Don't Talk Casually, Don't Do Things Casually, and People Should Not Be Casual." They wrote: "Everything has its costs, if you do not have the capital, please do not do whatever you want" and pictured a horse in the clouds. Jack Ma's name in Chinese literally means "Cloud Horse," so it's clear who the state was talking about.

The government subsequently launched an investigation into Ant. They were concerned that Ant’s was acting like a bank but regulated like a tech company. Politics aside, this seems reasonable. Rapidly growing banks and insurance companies usually achieve it by underpricing risk. That comes back to bite them down the road. Ant is the largest financial institution in China, so a mistake could jeopardize the whole economy.

Like Alibaba’s other business, Ant is a marketplace. It connects lenders with consumers and uses data to underwrite loans, insurance, and other financial services. Ant also owns Alipay, which is the largest mobile payments platform in China.

The government hasn't reached any conclusions yet. There is speculation that China may require Ant to reserve capital against loans it underwrites. This would make the business significantly more capital intensive and lower its valuation. Nevertheless, Ant would still be incredibly valuable. The company's consumer transaction data alone is worth billions. Alibaba insists an IPO is still coming, though when is anyone's guess.

Chinese regulators have also been scrutinizing Alibaba's e-commerce businesses. On April 10th, 2021, the government levied an anti-monopoly fine on Alibaba. 

They accused Alibaba of violating Article 17, Clause 4 of the Anti-Monopoly Law (AML). That says that a business operator with a dominant market position is prohibited from restricting business counterparties by requiring exclusive arrangements without justifiable cause.

Alibaba's practice of "er xuan yi" ("choose one out of two") was the culprit. The company punished merchants who didn't sell exclusively on Alibaba's platforms. This is clearly anti-competitive behavior that wouldn't stand in the US or Europe. It's hard to feel sympathetic for Alibaba or feel that the government was unreasonable.

Alibaba has accepted its punishment and will not appeal it. As a remediation, Alibaba will no longer restrict merchants from doing business on its competitors' platforms. It will also pay a $2.8 billion fine. The fine was based on 4% of Alibaba's 2019 Chinese revenues. Chinese law allows fines of up to 10% of revenues, suggesting some leniency from the government. The fine is enough to get the company's attention but not enough to slow it down. 

If there's a silver lining to Alibaba's troubles, it's that during these proceedings, the government tacitly endorsed Alibaba's platform business model. China doesn't have a problem with Alibaba's structure. It knows that the company is crucial to the nation's economy, and it remains the country's pride.

It's difficult to say how the regulatory crackdown will end for Alibaba. The Chinese government is also investigating the country's other tech giants. American and European regulators have launched similar inquiries into western tech giants, but those stocks remain at all-time highs. This doesn't seem right. Are western antitrust proceedings that much easier to predict than Chinese? I personally don't have great insights into either.