Alibaba: New Structure To Increase Shareholder Value (NYSE:BABA)

I am assigning a strong buy rating to Alibaba (NYSE:BABA) stock.

Despite trading at its cheapest ever valuation, I will discuss 3 other reasons as to why I am buying Alibaba stock.

1. E-Commerce growth rate acceleration

The Chinese retail e-commerce industry is expected to grow at a CAGR of 12.36% in the period from 2023 to 2027. I expect the recent double digit revenue growth in the Taobao and Tmall group to be sustainable over the next 5 years based on improved consumer sentiment as China returns to normal, improved user behaviour on Taobao and Tmall and growth in value for money areas such as Taobao deals.

Over the last decade, Alibaba’s revenue growth has compounded at 29% a year, however, due to covid-19 lockdowns, macro headwinds, competition and increased regulation revenue has decelerated meaningfully over the past 3 years and in FY 23 revenue decreased by 1%. Despite weakened buying trends due to Covid lockdowns, Taobao and Tmall maintained their DAU/MAU stable demonstrating the progress they have made on their key initiative to create an engaged user base. In Q2 DAU increased 6.5% and I expect that to accelerate modestly throughout the year. I believe this renewed attraction of users is down to new value for money programs such as Taobao deals attracting lower tier city consumers as Alibaba becomes more price competitive and increased consumer confidence throughout. I expect this progress to continue in the coming quarters and years as consumer confidence gradually returns.

In Q2 of 2023, revenue dramatically accelerated 12% despite increased price competition demonstrating Alibaba’s ability to adapt to the competitive landscape. The 20% increase in the number of daily advertisers on the platforms was even more impressive as they successfully attracted more merchants. Over the coming years, I expect Taobao and Tmall to successfully retain these merchants and users and increase purchasing frequency as they enhance user experiences resulting in double digit revenue growth as consumer confidence recovers.

2. New structure

In march 2023, Alibaba announced a new organizational structure “1+6+N”. Under this plan Alibaba will have six businesses each to be independently managed by its own chief executive officer and board of directors. I expect this new corporate structure to accelerate revenue growth and increase capital returns.

Revenue growth

I believe there are 2 reasons that this new organizational structure will enhance revenue growth. Firstly, each business leader now has the flexibility to take whatever strategic path it decides, rather than being told what to do by those above. This increased flexibility will result in faster and better decision making by leaders who are closer to the action, which will allow them to compete with competition far more effectively, while being able to pursue opportunities that might not have been apparent to head office. Alongside this, each business will have the ability to raise capital to fuel this growth. I believe part of the reason Q2’s revenue growth was significantly improved was due to this enhanced operating structure, and I expect it to continue to benefit them going forward.

The second factor is improved incentives. Under the new organisation Alibaba will IPO or raise external capital for each business while still maintaining a majority ownership. This majority ownership means Alibaba will still have the control to set incentives to align with those of investors, which Alibaba now is. I believe this will be good for shareholders as investors and Alibaba both want to do one thing, increase the market value of the business. The way to increase the market value in my opinion, is to grow the business, for which Alibaba now has the correct incentives to do.

Increased capital returns

In recent years, Alibaba has been returning capital to shareholders through share buybacks. I expect these share buybacks to continue and increase as a result of the new structure.

In 2022, management returned $10.9 billion to shareholders, which amounted to 44% of free cash flow. In Q2 they bought back 1.4% of shares which is a run rate of almost 6%.

Part of the new governance framework is the creation of a newly established Capital Management Committee. Their goal is to improve shareholder returns. Within this goal the objective is to

“implement EPS accretive activities including consistent share buybacks to reduce our outstanding share count” – Daniel Zhang, former CEO.

At the current share price Alibaba can retire 10% of shares outstanding with the remaining buyback authorisation and I expect the buyback rate to increase this year to do so.

Going forward, the only source of funds will be from Taobao & Tmall Business Group which will continue to be 100% owned, and receive income from the occasional monetisation of businesses through IPO. In fiscal year 2023, Taobao and Tmall generated all of the groups free cash flow amounting to $25 billion. I believe this could be almost entirely returned to shareholders through buybacks, which at a current market cap of $215 billion would equal an 11% reduction in shares per year while maintaining a healthy cash balance of $50 billion. Any funds Alibaba receives from monetisation of businesses would be accretive.

3. Cloud

Despite slowdowns in the growth rate to only 4% in FY 23 due to initially losing a large internet customer which decided to go in house (widely believed to be ByteDance), delayed projects due to Covid lockdowns, 50% price cuts and the normalization of demand from Covid lockdowns lifting, Alibaba cloud has still grown sales at an average of 58% per year since 2014. I don’t think it’s realistic to expect the cloud business to accelerate back to this high growth, however, I do believe they can continue growing at market rates of which I expect to be in the high teens.

According to reports, China’s cloud industry is expected to grow by 20% annually, resulting in a market volume of US$137bn by 2028. When compared to the US cloud industry, IT spending accounts for only 1% in China vs 5% in the US. This represents a large opportunity for the cloud segment to catch up. I believe Alibaba can maintain its market share within the industry, thanks to its competitive advantages, which include its comprehensive offering vs its competitors and its technology advantages, making it the low cost provider. Daniel Zhang, Head of the cloud group at the time said,

As one of the world’s leading cloud service providers, we will continue to invest in forming a full-stack product and technology leadership across IAAS, PAAS and MAAS layers. This is key for us in capturing AI opportunities and sets a differentiating advantage for AliCloud vs. other players in China, which mainly focus on one of the layers.

Not only do they have the widest product offering, they also have a cost advantage due to investments in technology such as its proprietary compute software stack and its in-house chips division. I think these competitive advantages will result in clients choosing Alibaba as their primary cloud provider as the Chinese economy moves toward digitization over time. These advantages will allow them to keep the 34% market share they have which would result in $46 billion in revenue by 2028 based on industry growth rates. In Q2, Daniel Zhang said.

we have received strong demand for model training and related AI services on cloud infrastructure, which were only partially fulfilled due to the near-term supply chain constraints globally.

I expect this to be the start of the recovery, however, I expect growth acceleration to be gradual and patience will be required to capitalise on this opportunity.

Along with significant growth rates, I expect the cloud business to generate significant profits over time as they demonstrate operating leverage. Over the past couple of years, the cloud segment has become profitable. In Q2 adjusted EBITA grew to RMB387 million, representing year- over-year growth of 106%. I expect the growth rate in earnings to be higher than the revenue as Alibaba continues to focus on economies of scale, which I believe will reward long term shareholders over time of the new listing as its spun out in the near future.

Risks

Competition

Competition within the E-commerce space is fierce with established rivals such as JD.com (JD) and PDD Holdings (PDD), as well as upstarts such as Douyin and other live streaming platforms. This is demonstrated in Alibaba’s market share losses over recent years. Alibaba still holds just under 50% of market share and although I expect that to continue to decrease, I think it will decrease at a slower pace than it has in the past as other market places slowdown. In Q2 Alibaba demonstrated the platform is still as strong as ever with DAUs increasing 6.5% Y/Y. I do not expect these numbers to decrease.

Cloud leadership changes

One of the risks is that cloud growth doesn’t recover. In September Daniel Zhang stepped down from the head of the Cloud unit. I believe that this isn’t due to a problem with Alibaba’s Cloud unit, Daniel Zhang has remained at the company suggesting this was planned. Eddie Wu who replaced him, has a technical background, which I believe will benefit the company as they shift their focus to artificial intelligence.

Conclusion

Along with a very attractive valuation, I believe that Alibaba has multiple growth drivers that will allow the company to continue growing at a very healthy rate once the macro landscape eases up. This attractive valuation and multiple growth drivers make me believe that Alibaba is a good stock to buy at today’s levels.