Positive Management Tone During Recent Call
As part of our coverage of Alibaba Group Holding (BABA), we ended its 4QFY19 (FY ending in March) earnings call last week. First of all, we want to say that the management signal on the earnings call is positive despite all the concerns, such as Trade war between the US and China and macro consumption in China. Specifically, the management referred 4QFY19 as a major quarter of revenue and profits that beat its expectations.
In addition, management was targeting the elephant in space at the beginning of the earnings call, which is the impact of the trade problem between the US and China on BABA. In short, the management sees the problem as a (long-term) positive in that the trade problem will lead to China becoming a more market-based economy or will accelerate the shift in the Chinese economy from an export-oriented to a domestic consumption-driven one. The middle class (estimated about 300 million people today) will continue to double in the next 1
In addition, for vacancies for Rmb500 billion revenue (33% top line) for short-term outlook (FY20) growth, YoY), with Gross Merchandise Volume (GMV) hit US $ 1 billion milestone. According to management, the 33% reflects the revenue growth guide a bullish perspective, as this would put BABA as an over-performance relative to its peers. By comparison, FY19 saw BABA after Rmb377 billion revenue (51% YoY or 39% YoY on organic basis / exclusive new buying effects). Unfortunately, there is no segment growth distribution given. And the management has been vague in commenting on which segment would drive the greatest growth, with the exception that Direct Sales (Direct Import and New Retail) would account for a larger part of the sale. As a management, management does not provide surplus guidance.
Which management doesn't tell us honestly
Enter the earnings call. We conducted an in-depth analysis (specifically detailed segment analysis including its 3-year trend analysis) to evaluate BABA's fundamentals. In our in-depth analysis, we found some nugget information, which we believe management does not tell us honestly (to be fair, to provide a positive focus on the company's prospects / fundamentals is normal for the management of public corporations). Specifically, we found three worrying measurements pointing to much slower growth narrative at sales and earnings level.
Metric No. 1: Organic Growth in the E-commerce Top Line
The core market segment accounts for 86% of BABA's revenue. Within the core business segment, there are seven sub-segments: China Retail, China Wholesale, International Retail, International Wholesale, Logistics Services, Consumer Services (ele.me, an online food delivery platform such as GrubHub (GRUB)) and others. China Retail (77% of core sales) is where BABA's dominant e-commerce platforms (Taobao and Tmall) are located. The China Retail sub-segment consists of customer administration, commissions and new retail trade (largely Direct Import and Hema-branded brick mills, whose sales are recorded on a gross / 1P basis, against net / 3P basis for customer administration and commission sales).
Since BABA has expanded into new strategic initiatives (including New Retail and online Food Delivery Platform) over the past few years, it is important that e-commerce revenue (classified as customer administration and commissions in China Retail sub-segment) is decelerated. growth line on the top line from 43-44% YoY in FY17 / 18 to 29% YoY in FY19. On a quarterly basis, core sales growth in e-commerce was as high as 54-55% YoY in 1Q-2QFY18 (June 2017 quarter-September 2017 quarter). In 2Q-4Q19 (September 2018 quarter-March 2019 quarter), average e-commerce sales growth averaged only 28% YoY. Therefore, the much stronger growth in the sub-segment China Retail has been on New Retail (155% YoY in FY19, versus only 29% YoY for core e-commerce). As a percentage of China Retail retail, core e-commerce accounted for only 84% in FY19, down from 98% in FY17.
Based on 33% growth turnover guidance from the FY20 management, we deduced the key e-commerce revenue growth would decelerate further to 20-23% YoY level. Thus, BABA's core economic growth in revenue will be halved in FY20 from 43-44% YoY in FY17-18 . The slowdown in GMV, driven by macro consumption slowdown, is a culprit. GMV growth in FY19 has been lowered to 19% YoY, the first under 20% growth in BABA's history.
In addition, we also note that the meteoric rise of e-commerce startup Pinduoduo (PDD), recently founded as in September 2015 and published in July 2018, has contributed to increased competition, especially in lower tiered (Tier 3 and Tier 4) cities (PDD's stronghold markets). PDD's GMV (on TTM basis) in 1Q19 has reached Rmb557 billion, from just Rmb141 billion in 2017 or virtually non-existent in 2015. Therefore, PDD's TTM GMV in 1Q19 has been 10% of BABAs GMV during the same period. In December 2018, PDD is the second largest e-commerce platform in China in the form of annual active buyers of 418 million, exceeding JD's (JD) 305 million.
Metric no. 2: Loss from new strategic strategies initiatives ballooning
As mentioned earlier, BABA has, within its core trading segment, expanded to new strategic initiatives. For example, in April 2018, BABA has fully acquired elme.me (from the previous 43% stake) and began consolidating ele.me in May 2018. As a company base, the second largest online food delivery platform in China is with 36% MS, behind the Meituan. Dianping's (traded on HK stock exchange with ticker symbol 3690 HK) 55%. The management believes that online food delivery is the next limit in terms of growth potential, with a market size (relative to gross transaction value) of over Rmb600 billion.
Another new strategic initiative is worth noting is New Retail, which essentially involves omni-channel strategy. To provide a hassle-free online offline customer experience, Hema-branded grocery stores (brick and mortar) stores with state-of-the-art high-tech touch have been rolled out since 2017. In March 2019, BABA operates 135 self-operated Hema stores, primarily located in Tier 1 and Tier 2 cities. As a new retail initiative, BABA also operates Ling Shou Tong (LST) retail sourcing platform. The LST platform allows wholesalers (mostly mother-pop stores) to come from a wide variety of brands and products that can be delivered to their stores, increase their revenue potential and lower operating costs.
Therefore with all new Strategic Strategies Initiative Initiatives in the Nuclear Communications segment, the key e-commerce sales share has fallen from 83% in FY17 to 64% in FY19. In addition, the losses for all new strategic initiatives (ele.me, New Retail etc.) based on new information from adjusted EBITA for the core trading segment Rmb25.4 billion in FY19, almost tripled FY18's Rm8.8 billion losses. It is true that the consolidation of elme.me (beginning in May 2018) greatly contributed to the balloon pathways.
Nevertheless on apples for apples (since elme.me has been consolidated), 4QFY19 (March 2019) quarterly) losses from new strategic initiatives expanded to Rmb7.2 billion, from Rmb 5.84 billion losses in 2QFY19 (September 2018 quarter). This suggests that competition in the online food delivery market has been increased, which is validated by our channel that it (consumer) subsidies war between ele.me and Meituan continues. With regard to this market share, the BABA management stated that elme.me would continue its aggressive expansion, especially in lower tier cities in FY20, as only 20% of total orders come from such cities. As a side note, we do not compare 4QFY19 losses from new strategic initiatives to 3QFY19, because the quarter in December is an annual high quarter (when the promotion / grant is also the highest).
Metric # 3: Margins that Compress to a Record Low
Masked behind the positive leader tone in the 4QFY19 earnings call is that BABA's consolidated margins have compressed to a record low. Adjusted EBITA margin in FY19 stood at 28.4%, down 1,040 bps YoY (yes it is over 1,000 bps – not a typography). Compared to FY15-16 (the early days of BABA as a public company) the 28.4% adjusted EBITA margins were only more than half of what BABA published (48- 50% adjusted EBITA margins). Therefore, the adjusted EBITA in FY19 changed by only 10% YoY, against 40-42% YoY in FY17-18.
Given the adjusted EBITA degradation, the core trade adjusted EBITA margin declined significantly from 61.6% in FY17 and 53.3% in FY18 to 42.1% in FY19. As mentioned, losses from new strategic initiatives are a major factor for compressed adjusted EBITA margins for nuclear trading, as management said the adjusted EBITA margins for e-commerce remained stable.
Some investors argue that outside the core business segment, BABA has a cloud computing business on Amazon Web Services (AWS). However, BABA's cloud computing business, in contrast to AWS (highly profitable business of 30-40% OM), actually negatively adjusted EBITA margins (-4.7% in FY19). In fact, the margin improvement was pretty slow for BABA's cloud computing. Back in FY17 and FY18, its cloud computing had -7.1% and -6% adjusted EBITA margins, respectively. Therefore, the adjusted EBITA losses for BABA's cloud computing with such a slow margin improvement expanded from Rmb0.48 / 0.8 billion in FY17-18 to Rmb1.16 billion in FY19. Our channel check shows that the negative margins for the company's cloud computing are more of a China phenomenon where a high subsidy is required to get customers to get digital transformations through public cloud.
Another segment, digital media and entertainment (mainly The Youku online video streaming platform), even posted a staggered adjusted EBITA loss of Rmb15.8 billion in FY19, extending large time from Rmb6.5 / 8.3 billion losses in FY17-18. Management said it is currently focused on developing original content production capabilities to drive subscriber growth. In an easy way, this means that management places emphasis on market share over profitability. A look at video streaming competitor in the Qiyi (IQ) economy supports the view that profitability or even narrowing losses for an online video streaming service remains unpleasant for the foreseeable future. In 1Q19, IQ's net loss increased to Rmb1.8 billion, from Rmb685 million. Loss in 1Q18. In addition, for the whole of 2019, IQ only provides revenue guidance (no profit guidance), which means that the focus is on market share over profitability.
Conclusion and Valuation
Management maintains its bullish perspective / tone in the latest earnings call despite all worries (US and China trade war, China macro consumption). However, our in-depth analysis shows that growth (whether top line or adjusted EBITA) unfolding in FY19 does not give a similar bullish picture. In fact, we found that e-commerce growth slowed at the top line level, and new strategic initiatives, while providing some buffer against e-commerce's top line, have ballooning losses without any sign of improvement in the foreseeable future. A similar narrative (ballooning loss without improvement of vision) is also found in cloud computing and digital media & entertainment segments. As a result, BABA's adjusted proxy for earnings growth (EBITA) decelerated significantly to 10% year for 19 years delivering 25% YoY growth and 33% YoY growth for FY20 and FY21, respectively. Our in-depth analysis, especially with the FY19 EBITA growth, declines significantly (only 10% this year), which is not in line with Bloomberg consensus EBITA growth expectations. Our mini earnings model suggests 10-12% adjusted EBITA growth in FY20 as a more realistic expectation. With such a high risk that BABA lacks consensus expectations from FY20, we point to trading with 19x 2019E EV / EBITDA for (much) more share price downside risks instead of an upward risk, in our opinion.
Disclosure: I / We have no posts in the said stocks and no plans to start any positions within the next 72 hours. I wrote this article myself and express my own opinions. I do not receive compensation for it (except from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.