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Morningstar | Alibaba's 2018 Investor Day Reinforces Long-Term Optionality of Network Effect, Attractive Valuation

In our view, wide-moat Alibaba's 2018 investor day event accomplished three goals: (1) reinforcing the network effect underpinning our wide moat through impressive user engagement figures; (2) alleviating concerns about trade wars and other potential macroeconomic issues; and (3) giving us greater visibility regrading future investment priorities. While the event won't sway our $240 fair value estimate, we view Alibaba as one of the most attractively priced names among our global online retail coverage.

The power of Alibaba's network effect was evident throughout management's presentations, including both core and emergent businesses. We've previously discussed how integral Taobao/Tmall and Ant Financial have become in Chinese consumers' lives, evidenced by 634 million and 870 million active users, respectively, but we believe cross-platform engagement opportunities inherent with Youku (400 million-plus users), Ele.me (168 million), and Lazada (100 million) are often overlooked by the market. We're also encouraged by GMV per user trends, which drive strong vendor retention rates. Taken together, these support our five-year GMV and China retail revenue growth targets of 30% and 38%.

We also share Jack Ma's comments that trade wars represent a source of near-term disruption, but also a potential catalyst driving new trade partners for China (and by extension, potential Alibaba vendors). Additionally, we don't see structural changes in China’s consumer demand for global brands or their spending ability, as wage growth remains strong and any pullback in consumer credit should be neutralized by healthy Chinese household balance sheets.

Finally, while no new explicit revenue or profitably targets were provided, we believe Alibaba has identified the appropriate investment priorities--analytics/data-driven personalization, Lazada, local services, new retail/Hema, logistics/Cainiao--that are consistent with our five-year average adjusted EBITDA margin forecast of 28%.

Digging deeper into Alibaba's specific business units, we see continued evidence of a network effect across multiple marketplaces. With all of the company's emerging business units and other innovation investments, it's easy to lose sight of the company's core marketplaces, where we see signs of encouragement. User growth rates continue to accelerate, with 110 million new customers added to Alibaba's core marketplaces for the trailing 12-month period ended June 2018. Of these new users, 30 million were between the ages of 19-35, suggesting a lifetime of future transaction growth and cross-platform engagement opportunities, and 70% were from less developed (Tier 3 and below cities) and rural areas (customer groups that we believe Alibaba is uniquely positioned to address relative to other Chinese online retailers). With the new user growth across multiple demographic groups, it's not surprising we're seeing impressive growth from Tmall (where physical goods GMV has increased 45%, implying market share gains versus estimated China business-to-consumer growth of 39%, based on estimates from Analysys). Additionally, we believe this increase in annual spending per active customer (CNY 8,700 in fiscal 2018 versus CNY 8,300 in fiscal 2017) explains the strong retention rates for Tmall vendors (90%) and the impressive like-for-like paid GMV growth of 70% among the top 20 vendors on Tmall.

We believe the network effect inherent in Alibaba's core marketplaces will also extend to new growth opportunities for Alibaba's China retail platform, including 88VIP Loyalty Membership program engagement, short video brand content, and retail formats like Hema, Intime, Sun Retail, and Tmall-branded convenience stores. We're particularly constructive with Hema's long-term potential. Alibaba currently operates 64 Hema stores across 14 markets, with CNY 800,000 in daily sales per mature store (or CNY 292 million on an annual run rate). Taken together, we expect Alibaba's China retail segment to deliver 38% average annual growth the next five years.

Perhaps more critical from a longer-term cash perspective is that there is evidence that Alibaba's network effect has extended to more emergent business ventures. Ele.me's 168 million active customers are being served by 3.5 million merchants, with an impressive 19.8 orders per customer (running ahead of our customer engagement estimates for many of the U.S. meal delivery aggregators). We're also intrigued by the Ling Shou Tong platform, which help smaller convenience store merchants by allowing their customers to place orders though Alibaba's marketplaces; giving these merchants access to personalized mobile marketing, logistics, and content opportunities; and using their stores to help fulfill online orders.

We're also seeing accelerating engagement from Alipay's users, with 190 million of the group's 870 million active customers using all five categories of its financial services offerings (payments, wealth management, financing, insurance, and credit services). Additionally, 55% of users use Alipay for "lifestyles services" such as transportation, entertainment, and public utilities, reinforcing the company's ability to extend its network effect beyond traditional marketplaces. Alipay is seeing strong traction outside of China as well, with the number of Alipay customers using Alipay outside of mainland China rising 130% during the 12 months ended Aug. 31.

We also have increased conviction in AliCloud's ability to develop into a more significant cash flow contributor over time. AliCloud currently has a 45.5% share of the China IaaS market, roughly the same size as the next eight largest competitors combined (with Tencent as a distant number two at 24.7%). With increased demand from corporations (49% of China listed companies are on AliCloud, up from 40% a year ago) and other government groups looking to reduce information technology expenditures, we still forecast almost 55% average annual growth the next five years. Management still believes that AliCloud can eventually be as profitable as Amazon Web Services, which posted operating margins in the mid-20s in 2017. We share management's views about AliCloud's longer-term margin potential, but we caution investors from automatically assuming AliCloud will deliver the same growth and profitability trajectory as Amazon Web Services. We expect AWS-like margins will probably take five to 10 years due to ongoing customer acquisition efforts and technology investments, as well as potential competition from Tencent’s cloud service offerings.

Our fair value estimate assumes a consolidated revenue CAGR of almost 37% for fiscal 2019-23, including almost 61% growth in fiscal 2019 (consistent with management's 2019 revenue growth target of 60%, or 50% excluding acquisitions). We anticipate that higher spending among online shoppers, a growing user and seller base, and adoption of personalized mobile marketing services will all contribute to Alibaba's online retail revenue growth. Our five-year revenue forecast is largely a function of average annual China retail GMV growth around 31% from fiscal 2019 to fiscal 2023, monetization rates moving from 3.7% in fiscal 2018 to almost 4.2% in the next five years (aided by GMV from the B2C marketplace, a steady increase in mobile monetization rates, and new fulfillment and inventory bundling services from Cainiao), and greater contribution from cloud computing and digital media and entertainment (high teens). Our GMV outlook assumes 8% annual growth of Alibaba's China retail active buyer base over the next five years, implying 828 million active buyers by the end of fiscal 2023, and mid-20s annual average growth in average GMV per buyer over the same time frame.

We believe mounting digital commerce and cloud competition will force Alibaba to continue investing in technology infrastructure, logistics innovations, user acquisition, and personnel. As a result, we expect some margin contraction over the medium term, with consolidated adjusted EBITDA margins retreating to the high 20s the next few years (compared with 47% in fiscal 2017 and 42% in fiscal 2018), due to technology, logistics, product development, online/offline and local services, and marketing investments, as well as the impact of recently acquired businesses. However, we expect margin trends to inflect over the medium term as the current investment cycle winds down and Alibaba's more nascent businesses scale, bringing our fiscal 2028 adjusted EBITDA estimates back to the low to mid-30s.