Alibaba: Solid Growth Prospects In Each Division, Uni Marketing Adds Optionality

Summary

• Alibaba has a diversified business where each division is exposed to strong secular growth trends.
• I expect all these divisions to continue to deliver high growth rates, although some of them are exposed to significant competitive pressures.
• Uni Marketing is a recently announced launched service that offers Alibaba an interesting source of additional growth.

Alibaba (NYSE:BABA) is one of China’s three Internet giants, together with Baidu (BIDU) and Tencent (OTCPK:TCEHY) (OTCPK:TCTZD). In this article, I am going to update my thoughts on each of the company’s divisions, and I will comment on the recently announced Uni Marketing service.

Core Commerce

Core Commerce is the main business segment (accounting for about 87% of sales) and continues to drive the company’s high growth rates. Besides the obvious organic growth in e-commerce that results from the increasing penetration of this “way of shopping” in China, Alibaba benefits from other collateral factors that contribute to push the segment well beyond the growth in e-commerce. We know that Alibaba’s recent revenue growth was simply outstanding for a company of its size. Last quarter, the company managed to beat revenue estimates by $400 million and delivered the strongest YoY growth since the IPO, with revenue growing 60% over the corresponding period of 2016. The strong performance in the division was a result of both international expansion and domestic growth, which was helped by a significant rise in mobile active users for Alibaba's core platforms. A large portion of the segment’s growth was a consequence of paid-click growth, which was driven by algorithm optimization, improvement in product relevancy and content page personalization. I think this is resulting in a higher amount of spending-per-user on the e-commerce platforms, and also higher advertising revenue. According to eMarketer, Alibaba is now the number one internet company in China in terms of revenue generated by digital advertising. Seeing such a strong trend in the core commerce business, which has accelerated last quarter, it is obvious that Alibaba’s strategy is working well, and I think it’s strengthening its competitive position against other e-commerce players. After all, we know that the bigger it gets, the more buyers and sellers these e-commerce platforms will acquire and retain, strengthening the network and the company’s moat.

I remain positive on the segment’s growth prospects because I see many factors that will drive growth in the long term - from the secular growth in digital commerce and advertising to the improving algorithms that will drive revenue-per-user higher. Regarding the last point, just like Baidu (BIDU) is starting to target user with personalized ads in order to get more clicks-per-user, Alibaba can target customers with the products they are more likely to buy, increasing click-through and conversion rates.

Cloud Computing

This is a fast-growing business where Alibaba has a leading position in China, servicing more than 35% of websites in the country. In Q4, management said that paying customers for cloud computing grew to 874,000, from the 765,000 in the previous quarter. Given the company’s leading position and the secular growth in the industry, we can be sure the segment will be an important driver of growth in the short and long term. Nonetheless, given the promising long-term prospects of the business, Alibaba is not focusing on improving profitability, as the division is still reporting negative operating margins (-8% EBITA last quarter), but will focus on expanding customer base and consolidating its strong position, also taking advantage of the opportunities in PaaS and SaaS markets. Moreover, Alibaba is sparing no efforts to grow its cloud business outside China and has recently expanded its global footprint with new data centers in many regions, including Japan, Germany, the Middle East and Australia. As I said, Alibaba has a dominant position in the Chinese cloud market, but outside its country of origin, BABA will have to face fierce competition from giants such as Amazon (NASDAQ: AMZN), Microsoft (NASDAQ: MSFT) and Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), to name a few. Anyway, the market is expected to grow at a 27% CAGR for at least the next 10 years, so there is a huge opportunity to grow outside the country even without gaining customers at the expense of competitors.

Digital Media And Entertainment

As I said in my previous articles, the media and entertainment business is a tough one, especially for those companies that operate through pay-per-view or subscription-based models. Alibaba is trying to take advantage of the secular growth in online video entertainment, mainly through its platform Youku Tudou, which it bought in 2016 for $5.4 Billion. Due to the need to invest in content, the division’s growth is more than offset by rising operating costs, as the fall in margins confirmed last quarter, when adjusted EBITA margin declined from -17% to -44%. In video entertainment, where many companies are competing for the same cake, it’s difficult to generate decent margins, and all the players try to become the leader in order to generate scale advantage and report acceptable margins.

As I said in a previous article, Alibaba and its competitors know that reaching a decent scale will let them reach decent margins in their media and entertainment divisions, so they are throwing huge amounts of money to content producers to build a valuable service that can attract customers. but everybody is doing the same, and I believe Baidu’s iQiyi is positioned better than Youku Tudou at the moment, especially after the partnerships with Lions Gate Entertainment (LGF), Warner Bros and Netflix (NFLX). Nonetheless, the game is still in an early stage and it’s impossible to call a probable winner. On one side, Baidu has competencies in AI that can help target customers with the right ads when they search content on Baidu search engine. On the other side, Alibaba has its own platform that can help the video division get more customers – for example, customers can receive a free Youku subscription if they spend a certain amount of money on Tmall. So, both companies have tools to leverage their customer base to increase subscribers for their platforms, and I don’t think any of them will accept market share losses to avoid margin contractions. The problem is that investments in content will probably be very high for the foreseeable future, and I don’t think the platforms have the necessary bargaining power over content producers to generate margin growth through lower costs rather than a growing scale of operations. I see this division as a valuable long-term option, but I expect it to be a drag on profits for many years.

Innovation Initiatives and Others

This division also is growing fast, but it’s still a very small division, as it accounts for less than 3% of total revenue. The division includes several small projects with a low correlation with each other, so it doesn’t make sense to discuss the division’s prospects as a unique business. For example, it includes a navigation and mapping division (AutoNavi, bought in 2014), a smartphone operating system (YunOS), an enterprise messaging app (DingTalk), and other smaller projects. Autonavi is one of the two leading mapping services in China (together with Baidu maps) and is also exposed to a trend of secular growth, as the market is forecast to grow at a 14% CAGR globally in the next five years, helped by the positive growth in the autonomous driving market.

YunOs is the second most used smartphone operating system in China, with a 14% market share, which places it above iOS. The division clearly benefits from the fast-growth rate of the smartphone industry in China, which reports growth rates in the mid-teens. This segment will continue to grow at a good pace in the domestic market, but I doubt it can compete outside the country.

DingTalk also is worth mentioning. It’s basically a messaging developed to meet the communication needs of small and medium enterprises. DingTalk is obviously exposed to competition from several apps, mainly from market leader WeChat, which is trying to gain market share in the SME segment through enterprise accounts with higher security and some useful functions such as file sharing. I think that despite the fierce competition from Tencent, Alibaba can gain decent market share thanks to its huge network of sellers on its e-commerce sites, which it can leverage to reach potential customers for DingTalk.

Uni Marketing

Another growth driver worth mentioning is the recently released Uni marketing service, a unique solution that can help businesses make their marketing activities more measurable, giving brands the possibility to better identify, target, reach and retain their customers. The service will include several tools, but the main tool will be the Brand Databank. By integrating the data resources from Alibaba’s divisions, Databank has created detailed customer profiling for more than 500m active users within Alibaba’s ecosystem. Thanks to Uni-marketing tools, brands can monitor their marketing activities and access high-quality data about ad viewership, interest generation, purchases and so on, so that companies can improve their marketing efficiency. Thanks to Uni marketing, brands can identify their customers, segment them and target them with tailored ads. Although it’s early to tell what results this “new business” can achieve, I think Alibaba can leverage its huge ecosystem and network of sellers to improve and promote this service, and I think there is little doubt on the highly valuable tools the service can offer.

Final Thoughts

Each of Alibaba’s divisions is growing fast and there is no reason to believe that the trend is going to slow down beyond the physiological effect of a larger size. Each of Alibaba’s businesses is exposed to strong secular trends, but in every division, there are some competitive threats that have to be monitored. Anyway, I think the company can report revenue growth in-line with guidance of +45-49% y/y (which implies RMB233B at the midpoint) issued during last investor day. On the other side, I don’t expect high margin expansion, as there is no sign that the investments needed to grow these businesses are declining, especially in Alibaba’s non-core divisions. Content acquisition costs for Youku Tudou will continue to be high and offset revenue growth in the division. Investments to grow the Cloud business and gain more customers will also offset a large part of the growth in sales, but this business’ fundamentals are more attractive and I expect a modest improvement in margins in the next quarters/years. Uni Marketing is an interesting service that can add further optionality to Alibaba's fast growth.

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Analyst’s Disclosure: I am/we are long BIDU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.