Alibaba Group Holding Ltd (BABA) Stock Has a Secret Weapon

BABA stock - Alibaba Group Holding Ltd (BABA) Stock Has a Secret Weapon

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Alibaba Group Holding Ltd (NYSE:BABA) is often compared to, Inc. (NASDAQ:AMZN), which isn’t always accurate. Most notably, Alibaba doesn’t hold inventory like its larger U.S. peer, and it doesn’t have AMZN’s massive distribution capabilities. But, there is one notable similarity that doesn’t seem priced into BABA stock at the moment:

Alibaba Group Holding Ltd (BABA) Stock Has a Secret Weapon

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A large, fast-growing cloud computing offering.

Amazon’s cloud business, called Amazon Web Services (AWS), has been a major factor in the rise of AMZN stock from less than $200 to more than $800 over the past five years.

Alibaba Cloud is still much smaller, but its growth profile looks much like that of AWS back in 2011-12. That explosive growth — and the ability to be a legitimate competitor to and Microsoft Corporation (NASDAQ:MSFT) — has the potential to drive significant additional upside in BABA stock.

The Impact of Alibaba Cloud on BABA Stock

So far, the cloud business hasn’t done much for Alibaba’s revenue, or BABA stock, for that matter. BABA still trades around $100, basically the same levels at which it went public in late 2014.

Through the first nine months of fiscal 2016, cloud has generated just 3.3% of total revenue. Over the past four quarters, Alibaba’s cloud sales total just $765 million — likely less than 6% of what AWS will create in calendar 2016. And at the moment, Alibaba’s cloud business actually is a drag on BABA earnings. The business has lost $92 million in EBITA (not EBITDA; BABA uses EBITA for segment income) over the past four quarters.

But the gap to Amazon and the losses in the business have more to do with Alibaba’s relatively late start than with a lack of demand. Cloud revenue growth has been impressive, increasing 130% through the first nine months of fiscal 2016, and 115% in the December quarter, despite a pricing cut.

That follows a 138% increase in cloud sales in fiscal 2016. Most impressively, the number of customers nearly doubled year-over-year in Q3, and BABA added 114,000 new customers in the December quarter alone.

As for profitability, Alibaba isn’t worried, yet, with management saying on the Q3 conference call it was spending to gain market share. Profitability will come, but for now, Alibaba is looking to cement its dominance of the lucrative Chinese market.

Losses now are OK — AWS lost money until recently — because those new customers will provide high-margin recurring revenue going forward, possibly for decades.

The Impact of Alibaba Cloud on BABA Stock Going Forward

The good news for BABA stock is that it looks like the cloud business is nearing an inflection point. Losses are narrowing, but still represent a drag on overall earnings for BABA. Over the past 12 months, cloud has actually had a negative impact on EPS of about $0.03. That will change shortly, as Alibaba has said that the business will hit a profit around 1 million users, a milestone almost certain to be hit in 2017.

The question is what happens after that. If Alibaba’s growth looks anything like Amazon’s going forward, it should be very positive for BABA stock.

AMZN didn’t break out cloud revenue until 2015; it appears that the business generated about $1 billion in sales in 2011 and $2 billion in 2012. That then grew to almost $4 billion in 2013, $5.6 billion in 2014, and $7.9 billion in 2015. 2016 growth to date suggests a figure over $12 billion in 2016. AWS is now estimated by analysts to be worth (on its own) about $150-$160 billion.

Can Alibaba grow its cloud business to the same extent? Goldman Sachs analysts argued it could, projecting a value for Alibaba Cloud of $42 billion by 2019, based on $5 billion in sales. That growth alone would add almost 20% to the value of BABA stock over the next few years and it’s not as outlandish as it seems.

The Future Looks Bright for BABA Stock

Growth rates have been over 100%, yet cloud computing is still relatively unknown in China. On the Q3 conference call, Alibaba CEO Daniel Zhang estimated that, even assuming pricing discounts to lure customers using hard drives, the addressable market for cloud in China would be $30 billion. And in November, Alibaba added new data centers in four locations worldwide: Sydney, Tokyo, Dubai and Germany.

The concern might be whether a Chinese company will be able to compete internationally with Amazon and Microsoft. U.S. companies might prefer domestic providers, and elsewhere there could be worries about security.

But, the reverse of that argument is that Alibaba should have a huge advantage in marketing to Chinese consumers, as those customers might be similarly unwilling to use American companies for their cloud services. Even with BABA now worth approximately $250 billion, the $30 billion Chinese market is more than enough to provide a material catalyst.

AWS profit margins already are nearing 25% despite its own spending in that business. Assuming Alibaba can get half of the Chinese market at 30% margins, the cloud segment could contribute as much as $1.50 per share in EPS annually, enough to add $30 billion-$40 billion in market value. Any international success would simply add to that value.

Until now, the business hasn’t been a focus of BABA stock investors, but that seems likely to change. When the company hits the 1 million mark and turns cloud profitable in 2017, coverage of the business should likely increase. And, further awareness of that driver seems equally likely to drive upside for BABA stock. Investors should consider getting long in Alibaba stock before the rest of the market figures that out.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities. 

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