Alibaba Group Holding Ltd: Lessons In Profitability

  • Alibaba and Amazon have a lot in common, but there are two important differences.
  • This is why profitability is Alibaba's strong suit, but continues to elude Amazon retail.
  • What makes Alibaba Group Holding an ideal investment opportunity? And has the time come to buy into Alibaba stock?

You cannot deny the glaring similarities between Alibaba (NYSE:BABA) and Amazon (NSDQ:AMZN). Both companies have iconic founders in Jack Ma and Jeff Bezos. Both of them started before 2000 - in different areas - before venturing strongly into the retail space. And both companies are the e-commerce leaders in their respective countries.

But the similarities possibly end here.

Alibaba is wildly profitable, with operating profit margins staying above the 25% range for the last ten years, while Amazon has been barely profitable during all that time. It’s only recently - primarily because of their Amazon Web Services division - that they’re starting to be consistently profitable, but retail is still touch and go for Amazon.

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Source: Company Filings

As such, the difference in what filters down to the bottom lines of these companies can be directly attributed to their respective business models.

Alibaba is essentially a technology company that provides a virtual marketplace for buyers and sellers to meet and transact. Though Alibaba coordinates with multiple entities to provide the logistics and shipping support, fulfilment is ultimately up to the seller. Alibaba has simply perfected the art of the online marketplace, with the result that revenues have grown from CNY 2.16 million in 2007 to CNY 101,143 million as of 2016 - a fifty-fold growth in less than ten years. And they haven’t even crossed the Chinese border yet!

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Source: Export Now

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On the other hand, Amazon’s model is more similar to Wal-Mart than Alibaba in that it is primarily a “procure and sell” system. It is also a virtual version of Wal-Mart because there aren’t any physical stores that you can go and buy from. And for that reason, Amazon must pay the price, figuratively and literally speaking. Their shipping costs are extremely high, and have been growing even as they expand into new countries and markets.

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Alibaba's First Edge

And that brings us back to why Alibaba is so profitable. The marketplace model, by definition, means that they don’t participate in the transaction. They merely facilitate it, and partake of the transaction in the form of fees for using the service.

To draw an analogy, let’s compare a real estate broker with a real estate company. The broker merely leads the right buyer to the right property, facilitates the paperwork and pockets a commission. That’s Alibaba. The company, on the other hand, must buy a suitable property, renovate it, promote it, find the right buyer and make sure the sale goes through, while bearing almost all expenses related to the sale. That’s Amazon.

Of course, that does have its downside as well. For one, Alibaba cannot control the inventory the way Amazon can. Though product categories and the actual merchandize can be “vetted” to make sure they meet Alibaba’s terms and conditions, it has given rise to several problems.

For quite a while now, Alibaba’s many e-commerce portals have been plagued by counterfeit products that look just like the real thing. Because it’s a marketplace, it’s missing the level of control that Amazon can bring into its own platforms.

CEO Jack Ma has vociferously decried the presence of counterfeit products on his company’s web portals, but the problem persists. In fact, he recently back-pedalled on his own words when he publicly stated that the counterfeit goods were sometimes better than the originals - not something you want to hear as a seller. But, since most of Alibaba’s customers are Chinese, this problem hasn’t hurt the company that much - and it will likely take a long time for the problem to go away, if at all.

Nevertheless, Alibaba’s current position makes it the largest e-commerce company in the world in terms of gross merchandize value - 3 trillion yuan, or $475 billion at the time of the announcement.

Alibaba's Second Edge

The second reason for their high profitability is how they handle logistics for their platform. In and of itself, that is probably the most elegant coup anyone has ever pulled off in the world of e-commerce.

To give you a background, Wal-Mart spends billions on trucks and other resources just for procurement. Even without the headache of shipping products to customers, they struggle with wafer-thin margins because of overheads like warehousing, retail space, human resources, technology and so on. It’s the same with every other brick and mortar retailer - like Costco (NSDQ:COST), for example.

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As for Amazon, they have the additional overhead of shipping, as we saw earlier. Their constant battle to bring last-mile delivery costs under control is well known, but equally well known is the fact that they haven’t solved the problem yet. They continue to work tirelessly with shippers like UPS and Fedex to keep their costs down, but it’s an uphill fight as long as last-mile delivery exists.

In Alibaba’s case, they’ve found an elegant solution - keep control over the system without owning it. They bring companies together, provide them with the technology backbone to track their merchandize, and then leave the whole thing in their hands under the supervision of their own subsidiary, Cainiao Logistics. The right levels of control versus autonomy - and none of the monetary obligations that Wal-Mart and Amazon are saddled with.

The Investment Case

The moat that Alibaba has in China is probably one of the biggest in the world of e-commerce. No other player has the kind of invincibility that Jack Ma’s Alibaba enjoys. Not only does it dominate the e-tail space in the People’s Republic, but it also has that Republic’s blessings. Jack Ma has travelled with China’s Prime Minister on several occasions, almost as a business ambassador for the nation.

Unfortunately, Alibaba's stock price has gone down since its IPO on September 18, 2014. This is not the time to invest, but it is a time to look for a floor under the stock before it starts taking off again. At the current expected growth rate of 48% for FY 2016, this company isn’t going down any time soon. The problem was with high expectations at the time of the IPO that pushed the share price to unsustainable levels. It logically had to come down to a more realistic valuation, as early investors subsequently sold out after having found out the hard way.

A good analyst friend of mine calls this “IPO-itis”, and it eloquently explains the affliction of early investors in an IPO. They get excited about the company and drive demand for the initial offering; in the process, the high demand leads to multiple transactions until the post-IPO price dangles precariously from a ledge - waiting for reality to hit.

When that reality hits, the share price starts to slide. In Alibaba’s case, that’s been happening over the past year and a half since the IPO. Despite stellar performance on revenues, transactions and profitability, BABA stock has continued that slide until recently, when it seems to have stabilized.

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This could well be the preamble to the pullback that astute investors have been waiting for since the IPO nearly two years ago. It’s still too early to tell, but one more quarter and we should be able to get a very good pulse on the market sentiment regarding this stock.

I’ve had a BUY rating on Alibaba for a long time, and with the share price apparently showing signs of stability, this would be a good time to add more to your position.

Alibaba Group Holding Ltd. released an annual revenue forecast for the first time, projecting a 48% increase for the fiscal year ending in March as the Chinese e-commerce company seeks to alleviate investors’ concerns about its growth prospects.

Mr. Ma reiterated Tuesday targets to reach $1 trillion in GMV by 2020 and to serve 2 billion customers by 2036. He said Alibaba seeks to become the fifth-largest economy in the world in 20 years” - WSJ

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  • I do not have any business relationship with the companies mentioned in this post.
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