Alibaba Gains An Upper Hand As Arch-Rival Stumbles

Summary

• ByteDance recently filed an anti-monopoly suit against Tencent.
• Tencent’s ecosystem is much more vulnerable to anti-monopoly regulations compared to Alibaba.
• Alibaba also has a massive lead in the cloud business which can be a decisive factor in their rivalry.
• The competition between Alibaba and Tencent is very intense but Alibaba has a number of advantages in this battle.
• Alibaba is trading at a significant discount to Tencent in terms of valuation multiples which should give Alibaba stock more room to grow.

Alibaba’s (NYSE:BABA) arch-rival Tencent (OTCPK:TCEHY) has started facing anti-monopoly headwinds of its own. Recently, ByteDance, the owner of TikTok, has filed an anti-monopoly suit against Tencent. ByteDance has claimed that Tencent is using its market power to block Douyin, the Chinese version of TikTok, from its platform and is promoting Tencent’s own short-video app. Tencent has blocked Douyin for the last few years which severely limits the ability of its customers to seamlessly access this app.

A lot of coverage has been given to the headwinds faced by Alibaba due to new regulations in China. However, it is likely that Tencent will face equal or greater obstacles due to the new anti-monopoly regulations in China. Alibaba also has a significant lead in the cloud and advertising segment which will become more important over the next few quarters. Tencent has made significant investments in competitors of Alibaba like JD (JD), Pinduoduo (PDD), Meituan, and others. Any headwind for Tencent will boost Alibaba's ability to improve its own market share in a number of business segments. Alibaba is also trading at a much lower valuation multiple compared to Tencent. This can give Alibaba stock a bigger upside in the near term.

Tencent’s Regulatory Troubles

ByteDance has been the biggest social media platform to come out of China in recent years. Douyin, the Chinese version of TikTok, is widely popular among the younger crowd. ByteDance is looking to raise funds at a valuation of $180 billion and has estimated that its 2020 revenue is close to 200 billion yuan or $29 billion. Tencent has mini-programs within its apps which can be used to reach customers from Tencent’s ecosystem. However, Tencent has blocked ByteDance’s Douyin and news aggregator app called Toutiao. Tencent has instead promoted its own short video and news aggregator app. This can be seen as a major monopolistic move by the new laws enacted in China.

Alibaba’s own regulatory hurdles stem from the fact that it does not allow merchants who are registered on its platform to sell on other e-commerce sites. It is likely that Alibaba will need to open up its platform to all merchants and stop the practice of limiting merchant choice. However, the impact of this on overall revenue and earnings growth should be marginal.

On the other hand, Tencent has created a walled garden with its mini-programs where customers get all their entertainment, chat, social media, e-commerce, food delivery, and other requirements. If Tencent blocks ByteDance from these mini-programs, it will certainly be viewed as a major monopolistic behavior. Tencent opening its platform to ByteDance will also be a major headwind for Tencent’s own apps which directly compete with ByteDance.

Alibaba can see strong tailwinds from the regulatory obstacles faced by Tencent. If ByteDance keeps the pressure on Tencent then it is likely that we will start seeing a negative impact on Tencent’s revenue and earnings trajectory over the next few quarters. This will reduce the competitive pressure for Alibaba.

Cloud, Cloud, Cloud

The next major battleground between Alibaba and Tencent is the cloud segment. Alibaba has recently posted quarterly revenue of $2.5 billion in its cloud business with positive earnings. This equates to a $10 billion annualized revenue rate for Alibaba. Tencent does not give exact numbers for its cloud business but it reported cloud revenue of $2.4 billion in the fiscal year 2019 with a YoY growth rate of close to 80%. If Tencent is able to maintain this growth rate in the fiscal year 2020, it would have an annual revenue rate of $4.3 billion in the cloud business. This is significantly lower than Alibaba’s revenue rate of $10 billion.

Third-party estimates confirm Alibaba’s lead in the cloud market in China. In a recent report, Canalys has estimated that Alibaba Cloud has cornered 40.9% of the cloud service in China while Tencent Cloud’s market share is at 15.8%. Hence, Alibaba Cloud is over 2.5 times larger than Tencent Cloud which is reflected in the above calculations of their revenue rate.

Figure 1: Market share breakdown of cloud business in China. Source: Canalys

Economies of scale is very important in the cloud business. This is the main reason why Amazon’s AWS has been able to maintain its lead despite massive investments by Microsoft (MSFT), Google (GOOG), and others. We could see a similar trend in China where Alibaba’s market share continues to increase along with the margins as the top three cloud players improve their hold over this industry.

Alibaba has also taken a lead in building its cloud business in Southeast Asia and Europe where it has set up several data centers. In the international regions, Alibaba has a major advantage due to its retail platform. On the other hand, Tencent does not have social media footprint outside of China which can make it difficult to show similar cloud business growth in international regions.

The cloud segment will be a pivotal point in the next few quarters. Alibaba Cloud has a 30 percentage point margin gap with AWS. As the company achieves greater economies of scale, we should see the margin gap with AWS shrinking.

Figure 2: Improving margins in Alibaba Cloud. Source: Company Filings

Advertising and Gaming

Advertising makes a big chunk of revenue and earnings for both Alibaba and Tencent. A recent eMarketer report states that Alibaba has a significant lead over Tencent in this segment. If ByteDance continues to show rapid growth in the next few quarters, it will further reduce the social media traction for Tencent which will lead to a decline in its advertising earning potential. Tencent has been using the profits from its advertising segment to fund businesses like cloud, content streaming, and others. A strong headwind to advertising should reduce Tencent’s ability to fund its loss-making businesses which will decrease the competitive pressure on Alibaba.

Figure 3: Advertising revenue in China. Source: eMarketer

Alibaba has also started making strong moves in the gaming industry after lagging in this business for a long time. Last year, Alibaba moved the gaming business into its Digital Media segment. This has been one of the reasons behind the massive decrease in losses from this segment. In the year-ago quarter, Alibaba reported a whopping 42% negative EBITA margin in Digital Media segment. In the recent quarter, the EBITA margin was negative 17%. Hence, there has been a 25 percentage point improvement in the margin of the digital media business. A big reason has been the inclusion of Alibaba’s gaming division within this segment. It is likely that Alibaba will continue to invest more in the gaming business and try to gain more market share from Tencent.

Upside Potential

Alibaba has seen a correction in the last few months since its failed Ant Group IPO. On the other hand, Tencent’s stock has moved to a much higher valuation multiple. It is possible that the market has overreacted to the regulatory headwinds faced by Alibaba while not pricing in the regulatory obstacles faced by Alibaba’s rivals. ByteDance’s anti-monopoly suit against Tencent could be just the first one as other smaller competitors use the new laws to question the market dominance of Tencent and the negative impact of its ecosystem on the competition.

Figure 4: Correction in Alibaba stock while Tencent’s stock has not seen a similar decline

As pointed above, Tencent’s regulatory hurdles are similar or higher than Alibaba. Over the next few quarters, Tencent should be facing these regulatory pressures which will be a major headwind for many of its business segments. At the same time, Alibaba’s regulatory issues have been priced in and we could see a better trajectory for Alibaba stock as the pressure on Tencent increases. Alibaba is trading at a PE ratio of 30 while Tencent is trading at a PE ratio of 48 which shows the massive discount at which Alibaba stock is currently trading.

Investors in Alibaba stock should closely look at the evolving regulatory laws in China and their long-term impact on Tencent’s business.

Investor Takeaway

Alibaba has been facing regulatory pressure but its arch-rival Tencent has also started getting anti-monopoly suits. Recently, ByteDance filed an anti-monopoly suit against Tencent because its own apps are blocked on Tencent’s platform. Opening up Tencent’s platform to ByteDance should lead to a big negative impact on Tencent’s own performance within social media, advertising, and many other businesses. It is likely that other rivals will also use these laws to question the dominance of Tencent.

Alibaba is already in a market leadership position within the cloud and advertising business. The headwinds faced by Tencent will help Alibaba by reducing the competitive pressure. Alibaba’s stock is also trading at a lower valuation multiple compared to Tencent. This gives Alibaba stock a greater upside in the next few quarters.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Comments

[tarmo.tamm]

Neither China nor the US can afford to do significant damage to their top tech companies. The race for AI supremacy will determine which country will dominate the world. It's not only a matter of economics but national security.

Currently, China is much more deliberate and organized in this race. Baidu, Alibaba, Tencent, and Huawei are China's top AI champions. Do you really think China is going to kill their golden geese? These companies are so undervalued in my opinion...

I highly recommend reading the recent report that the U.S. National Security Commission on AI published.

Summarizing article: www.cnbc.com/...
Full report: www.nscai.gov/...

[Charles Ian Tan]

It’s already tough to value each individually seeing the spiralling web of businesses within, let alone attempting to compare valuation of both on a PE basis. Tencent for example, if you remove 100% of its marketable securities, the resultant PE to its earnings from core businesses is just 10x. While Alibaba, for all its troubles and deep current correction, has a core commerce earnings multiple of about 22-23x. One can even make an argument that Tencent has a cheaper valuation - and that’s mind boggling seeing how badly beaten Alibaba has been.

I am long both.

[Up and Away]

@Charles Ian Tan
Hard to valuate BABA since no one knows if the number they reported are accurate. At least Tencent follows our guidelines. Today smart investors use cash flow, not PE to compare companies.

[Charles Ian Tan]

@Up and Away on Baba - they appoint reputable auditors. If one cannot trust Baba's auditors, just don't invest in Baba at all I suppose. My views are of course based on fundamental belief that all figures and reports are honest and correct facts.

On cash flow - I fully agree. I usually use operating or free cash flow too. That's the only qualm I have with this piece comparing both businesses via the PE lens.

[Up and Away]

@Charles Ian Tan
The accounting is done in the Cayman Island where the company was incorporated. We have no jurisdiction there. The information is given to China and the auditors only see what they want you to see. Do we really know what we see is the truth. Jack Ma no longer has anything to do with BABA and Ant is also owned now by the CCP. Not sure I felt comfortable owning the stock so I sold it before it crashed. Just saying....

[Easymoneykingmaker]

Jack ma! Shut up and let’s us get rich....long live BABA

[Dsknj]

Comparing Alibaba and Tencent is like comparing apples and oranges at this time . IMO both companies have both equal risks and advantages over the other . Tencent has so much other businesses that they have a stake that likely to be profitable in the future , both long term and short term . Alibaba is definitely have better valuations in terms of their current stock price and their cloud services as you point out . In the end when all is said and done ,
I think both companies will be good investments for stock holders- in a couple of years time frame .

[Convoluted]

I noticed several comments about what Jack Ma said that upset the Chinese government. Personally, I don’t know what he said.

But, here’s the thing-if you want him to not make public statements, which upsets the government-and, in return lowers the value of subject stock-do YOU not understand that, in a small way, your acquiescence subverts your own freedom?

Perhaps the man hoped a few more people would show a little courage and not run away with their tail between their legs.

[luffyman]

Can someone shed some light into the different between owning BABA and BABAF? I can see one is listed on NYSE while the latter is traded OTC. Does BABAF have something to do with the Hong Kong listing?

[whoken]

@luffyman the main ticker is BABA and BABAF has nothing so to with Honk Kong. The honk kong ticker is 9988.

So get either 9988 if you can or the NYSE counterpart BABA.

[vanaik]

@luffyman Should not make much of a difference in practice, although the details might be important in the unlikely event of financial sanctions on China. One might add that both stocks only give you a share in a Cayman Island investment vehicle not direct equity. The reason is that foreign investors are not allowed to own any stocks in Chinese internet companies. This legal construct is not specific to Alibaba and a lot of Chinese companies do this.
Here is an article about the two types of stocks:
www.scmp.com/...

[SpliffMeister]

@whoken honk kong. Lols

[Admiral Risky]

"Tencent’s ecosystem is much more vulnerable to anti-monopoly regulations compared to Alibaba."

Sorry, but I strongly disagree with this assessment - as would almost anyone who has followed this space closely for years.

[Mario Silva]

@Admiral Risky in my view, I dont know if Tencent's ecosystem is more vulnerable, but I am sure that China without Alibaba, people would have a lower quality of life in terms less transactions, less confortability, less dynamic in its economy. China without Tencent, would not be so different as it is now. The e-commerce is something very critical, for China, Alibaba is KEY to its future growth perspectives (thanks to its e-commerce and cloud and all the businesses that could be developed having a strong piece of the market share in both )and that explain why the CCP was focused on Alibaba not in Tencent. Over time, the chinesse government will take care more to Alibaba than Tencent.

[Admiral Risky]

No.

[NoTimeToCry]

With 220 BABA shares at average of $220 I hope it will give me some good returns in a year or so.

[Jack Z]

@Motale it will for sure

[Fininho Da Vida]

@Motale depends mostly on whether Ma can keep his thoughts to himself. He should have kept his mouth shut.

[NoTimeToCry]

@Sascha Rado Agreee!! I sure hope he keeps quiet when it comes to criticism of China establishments.