LongRiver Investments, an investment management firm, published its second quarter 2021 investor letter – a copy of which can be downloaded here. A quarterly portfolio return of 23.6% was recorded by the fund for the first half of 2021, outperforming its benchmark that delivered a 13.5% return for the same period. You can view the fund’s top 5 holdings to have an idea about their top bets for 2021.
In the Q2 2021 investor letter of LongRiver Investments, the fund mentioned Alibaba Group Holding Limited (NYSE: BABA), and discussed its stance on the firm. Alibaba Group Holding Limited is a Hangzhou, China-based e-commerce company, that currently has a $569.4 billion market capitalization. BABA delivered a -11.71% return since the beginning of the year, while its 12-month revenues are down by -17.34%. The stock closed at $205.48 per share on July 12, 2021.
Here is what LongRiver Investments has to say about Alibaba Group Holding Limited in its Q2 2021 investor letter:
“There are a few new learning positions too, as I described I would make in my previous letter. I’ve written on my blog about Alibaba (here).
Alibaba’s mission is “to make it easy to do business anywhere” (“让天下没有难做的生意”). This subtle and elegant statement perfectly encapsulates Alibaba’s closed loop of services, which has the potential to assist merchants with every part of their business, from product design; to branding and marketing; to consumer acquisition and engagement; to logistics and fulfilment; to computing and IT; and even to consumer and business finance. Each of these services grew organically as Alibaba responded to merchants’ pain points, with the data shared between each arm of the business weaving one of the most comprehensive pictures of consumer behaviour ever seen. Merchants embracing Alibaba’s ecosystem must remake themselves around it to take full advantage of its potential. The reason to be bullish about Alibaba therefore isn’t just eCommerce; it’s the digitisation of China.
The reasons to be bearish, however, are that Alibaba faces an intensely competitive landscape and, now, regulators with a mandate to make it even more so. Times have changed, and it’s not clear to me what the future will look like, nor what it means for Alibaba’s future growth, profitability and competitive advantage.
The Chinese government has moved swiftly since it cancelled Alibaba’s sister-company Ant Group’s IPO last November to articulate and action a tighter regulatory stance towards Tech and Fintech. The former was codified by the State Administration for Market Regulation (SAMR) in a new and expansive set of anti-monopoly guidelines to specifically target internet platforms. The latter aims to reduce systemic risk to the financial system and is being managed by a quartet of financial regulators including the China Banking and Insurance Regulatory Commission (CBIRC) and the People’s Bank of China (PBOC).
We’ve had two major announcements in the last few days relating to Alibaba and Ant which give some clarity as to the scope and degree of intervention, but which also raise a lot of questions.
First, the SAMR issued an RMB18.2bn fine under its new guidelines to penalise Alibaba for forcing exclusivity on merchants. This practice (“二选一”) was brought into the spotlight in 2019 when Alibaba was sued by microwave maker Galanz for forcing it to choose between Alibaba and JD. The fine was less than the maximum allowable penalty (10% of revenues versus the 4% imposed) and less than the market’s expectations (as judged by the positive share price action which followed).
Alibaba’s CFO Maggie Wu also said on a call subsequent to the announcement of the fine that to make good, the company will also “reduce fees and charges to help merchants and brands; at the same time, also invest and spend more for them. So the impact [is] going to be both reflected in both top line and bottom line. So overall, we have reserved billions of RMB in additional annual spending to support initiatives in the future year”. If we read “billions of RMB” as in the range of RMB3-5bn, it would equate to just ~2-3% of the last twelve month’s adjusted core commerce EBITA.
Alibaba will take the fine and this lost income in its stride, and may have even planned to reduce certain fees anyway. But the ruling also means the end of a pressure tactic China Tech analyst Matthew Brennan (only somewhat facetiously) says “might be the key way Alibaba maintains its dominant position in eCommerce”.
Second, Ant has agreed with the financial regulators to restructure into a financial holding company, which will almost certainly require it to hold more equity against the loans it originates. There are other details too such as “removing the improper connection between Alipay and financial products like Huabei and Jiebei” and “breaking [Ant’s] information monopoly”, which imply a profound and qualitative change to Ant’s business model. These will surely lower Ant’s prospective valuation (and thus the value of Alibaba’s 33% interest). Tighter lending could also impact consumers’ willingness and ability to spend on Alibaba’s marketplaces.
Could there be more to come? My guess is as good as yours. There have been reports of Alibaba being forced to divest its media assets, and of the government forming a joint venture to control consumer data. As I write this, it’s just been reported that the SAMR has given 34 Chinese Tech firms one month to self-regulate or face penalties similar to Alibaba’s.
The most radical idea floated is to break up the walled gardens of China Tech into an open internet, upending the playbook whereby firms compete in virtually every field to attract and retain traffic (for illustration, see this slide below from Alibaba’s 2018 Investor Day). The easiest way to do this would be to curtail M&A, denying large players an important means by which they’ve built their ecosystems and maintained their moats (the other being unashamed copying of new products and services). The SAMR also seems intent on ending the practice of shutting out rival services. Alibaba has already launched its Taobao Tejia (淘宝特价) bargain deals app on WeChat, something unthinkable just a few months ago. Perhaps we’ll see WeChat Pay accepted on TMall next! These changes might not be a bad thing – how much money has been burned on defensive acquisitions, for example? – but the devil will be in the detail and implementation of the new guidelines. From my point of view, we’re sailing into unknown waters.
The irony of these anti-trust measures is that they come at a time when competition has never been more intense for Alibaba. Despite almost unlimited resources, the company’s closed loop looks sclerotic next to the dynamism unleashed by Tencent’s Wechat mini-programs, which since 2017 have seamlessly connected traffic and payments to best of breed players (and Tencent investees) like Meituan in local services, Pinduoduo in low price eCommerce and Kuaishou in live streaming. As a result, Alibaba faces stiff competition in all its key domestic businesses and traffic acquisition channels.
I admit I’ve been slow to accept just how much the landscape has changed. I wrote in mid-2019 that in my opinion, “the trust Alibaba has earned from the two sides of its network, consumers and merchants, is perhaps its most under-rated strength. This trust catalysed Alibaba’s network effect and remains an important hurdle for new rivals, specifically Pinduoduo… Unfortunately, Alibaba is a victim of its own success: nowadays, trust is high across the internet and most people in China don’t think twice about buying things online from strangers. In a way, Alibaba lowered the barriers to entry for eCommerce for everyone… However, Alibaba still has an edge in merchants’ trust and since Alibaba’s is a two-sided platform, this is just as important a part of the equation.”
Pinduoduo’s breakaway growth proved me unequivocally wrong: just eighteen months after my post, it reported an astounding 780m annual active buyers (over the last twelve months), 2m more than Alibaba. Looking back, I implicitly assumed all merchants were the same – high end, branded; essentially those shortlisted for TMall – and that this was what all Chinese consumers wanted as they upgraded their consumption. Wrong! Both merchants and consumers are heterogeneous – D’uh! – and Pinduoduo tapped into a reservoir of demand for low-price products Alibaba had surrendered when it cleaned up Taobao. And for all my gloss about trust, as described above, Alibaba did play tough with merchants to force exclusivity. The anti-monopoly guidelines will reduce switching costs for merchants and put more power back in their hands.
At the same time, Pinduoduo illustrates how not all consumption scenarios are the same. A friend from ValueAsia drew a map of retail for me along four dimensions: 好, 多, 快 and 省 which I translate as service, variety, convenience and price. Alibaba dominated eCommerce when the market was less sophisticated and more homogenous. But now these four dimensions are best represented respectively by JD, Alibaba, Meituan and Pinduoduo. And even that is too general; the market has fragmented along scores of battlelines drawn along customer type, segmentation, age, product type, purchase frequency etc. Thinking still about China eCommerce as a monolithic market is therefore simply wrong, as is the idea that Alibaba’s network effects are somehow a monolithic moat across all use cases. Again, this is where the SAMR ruling on forcing merchant exclusivity could have profound consequences. as other consumption scenarios (i.e. Alibaba’s competitors) will be boosted by greater variety.
Thinking about retail along these dimensions begs the question, why should any one company dominate all of them? Is ‘variety’ (i.e. a long tail of goods) even the most defensible of the four? And if Alibaba’s culture was optimised to compete along one dimension, why should it be able to fight and win across the others? Recent evidence from ele.me, Lazada and elsewhere suggests we should not make this assumption lightly.
Lillian Li surveyed the competitive pressure on Alibaba, writing “My take here is that if we segment the Chinese consumer market into high-end, mid-tier and lower end, Alibaba faces intense competition from JD in the high-end, and Pinduoduo in the lower end. With the rise of internal circulation, Pinduoduo stands a better chance of taking over the middle-tier as their existing lower-tier customers upgrade their consumption. At the same time, Alibaba faces the innovator’s dilemma of being unable to move into the lower segments.”
Alibaba has responded with Taobao Tejia for less affluent consumers and management reports it has already reached 100m MAU. But is this truly incremental demand or just a shuffling of existing users? Now, Community Group Buying (CGB) has emerged as another new market segment for even less affluent consumers and Alibaba, Pinduoduo, JD, Meituan and others have said they will essentially spend whatever it takes to win (though this was before the SAMR came out and called for self-regulation, including a second demand to end wasteful investment in CGB).
Growth and Profitability:
Alibaba has trained investors to evaluate it on revenue growth – not earnings – as it makes multi-year investments into initiatives like New Retail, Logistics, Local Services and International, which both have large TAMs and bolster its ecosystem. So it worries me to see revenue growth decelerating. In 3Q FY21 – the most recently disclosed quarter – the company reported organic revenue growth of 27% (i.e. excluding the consolidation of Sun Art), its lowest level barring 4Q FY20 when COVID struck.
Let’s look at this in more detail. Alibaba’s engine room is its set of domestic marketplaces, including Taobao, Tmall and Alibaba.com (a wholesale site). Revenue growth here has decelerated from the mid-50% level in FY18 to 20% recently, driven by a slowing combination of growth in annual active customers and revenue per active customer (note: I assume customer numbers disclosed relate just to these marketplaces). Slower active customer growth shouldn’t be surprising as penetration reaches its natural limit. But given that most revenue is payment for traffic, does slower growth in revenue per active customer indicate that traffic is becoming less valuable? Breaking this down further, in 3Q FY21, Tmall GMV grew 19% and Taobao’s GMV growth “was robust”. If we assume therefore that overall GMV growth was in the low-teens range, then Marketplace-based revenue grew only slightly faster than GMV – indicating weak growth in traffic related revenues. So is traffic on Alibaba’s marketplaces becoming worth less to merchants? Or are they simply bidding less if they have to spread a finite budget across multiple channels? I wish I had the data to know!
Growth is also slowing across new Commerce initiatives like New Retail, Logistics, Local Services and International. For example, excluding Sun Art again, revenue growth in the ‘China Commerce – Other’ segment (which includes New Retail) slowed to 38% y-o-y in 3Q FY21, it’s lowest ever performance barring 4Q FY20 when COVID hit. Is this the law of large numbers? Or does it suggest that some of these businesses are facing headwinds? The answer requires more digging than I have scope for in this post. In aggregate, the chart below shows the trend in aggregate for ‘Core Commerce’ (Marketplaces plus Other). Someone with fresh eyes might say that these are still very healthy numbers but I’d retort that the trend is worrying, especially given management claims that many of the new initiatives are only in the earliest innings.
The charts above also show that growth in Core Commerce adjusted EBITA has been slower than growth in revenue for some time, reflecting how loss-making new initiatives have diluted high-margin Marketplace-based revenues. Margins in the Marketplace-based businesses are also under pressure. It’s illustrative that the weak revenue growth I cited in 3Q FY21 was despite a 60% y-o-y increase in Sales & Marketing expense as Alibaba pressed into less affluent markets. Will Marketplace-based margins face further pressure against this backdrop of intense competition + a regulator mandated to increase competition even further + defensive “investments”? I think the answer is ‘yes’. On the other hand, it’s positive that losses in the new initiatives are narrowing.
This post would become too long if I added an analysis of Alibaba’s Cloud Computing segment too but I do note that its revenue growth has also decelerated from >100% y-o-y in FY18 to ~50% in the most recent quarter. I’m optimistic about the long term prospects of this business but wouldn’t go as far as to say that China will necessarily develop along the same path as America (and nor will AliCloud develop into the next AWS). For nuance, I’ve included Tencent President Martin Lau’s recent comments on the Chinese cloud industry below as they shed light on Alibaba’s performance too. The basic problem: enterprise clients simply don’t yet see the use case.
At a Crossroads:
Alibaba has never been short of controversy and the present is no exception. While some take an unabashedly bullish view on the company – especially at current prices – I see more nuance. Alibaba is at a crossroads and the way forward is not clear to me.
The company will certainly continue to benefit from one of the greatest trends in history: the rise of the Chinese consumer. And as management re-itereated following the announcement of the SAMR’s fine, almost 800m Chinese consumers use its domestic marketplaces every year, spending an average of RMB9,000 each. That in itself should be a huge draw to merchants, regardless of whether Alibaba forces exclusivity or not.
But will competition – and now regulation – allow Alibaba to maintain its profitability? What will its competitive advantage be if the regulator does force an end to walled gardens and proprietary data? The devil will be in the detail and the implementation, both of which are too early to call.
And finally, what should the valuation of the company be in this new world? It might be higher than the price today but surely not as high as it was when it was growing faster, was more profitable and a de facto monopoly.
Based on our calculations, Alibaba Group Holding Limited (NYSE: BABA) ranks 9th in our list of the 30 Most Popular Stocks Among Hedge Funds. Alibaba Group Holding Limited was in 135 hedge fund portfolios at the end of the first quarter of 2021, compared to 156 funds in the fourth quarter of 2020. BABA delivered a -15.05% return in the past 3 months.
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