Alibaba (NYSE:BABA) has been in the spotlight lately amid constant trade war headlines and some investors have thrown BABA stock in the gutter as a result, but now might be the time for investors to take a second look.
The company recently reported yet another quarter of close to triple-digit growth in the cloud segment. The cloud business grew from RMB 2,975 million to RMB 5,667 million or $825 million in the latest quarter. This has increased the revenue on an annualized basis to over $3 billion.
Alibaba CEO Daniel Zhang mentioned in a CNBC interview that in the future, the cloud computing business would be the “main business” of BABA. And Alibaba stock should gain a strong tailwind as the cloud segment delivers better margins in the next few quarters.
BABA Stock and the Long Road Ahead
The growth potential within the cloud segment is immense. BABA has a number of advantages in this segment. Chinese regulators do not allow international companies to set up independent cloud business within China. This reduces the competitive field for Alibaba. It is only competing against Tencent (OTCMKTS:TCEHY) and Baidu (NASDAQ:BIDU) for cloud customers within China. BABA already has a close relationship with thousands of small enterprises through its commerce platform. Hence, it becomes easier for the company to develop cloud business from a client-centric perspective.
Over the past few quarters, Alibaba has been expanding rapidly in international regions. It has numerous subsidiaries in South Asia and Southeast Asia. Most of the investments made by Alibaba are in tech-heavy sectors like e-commerce, digital payments, online grocery, media, logistics and more.
It has invested billions of dollars in companies like Lazada, Tokopedia, Paytm, Big Basket and others. Most of these companies will have heavy cloud computing needs. Alibaba would generally be the first choice for these startups while expanding their operations.
Alibaba is also expanding in Europe. It recently opened two cloud computing facilities in London. There are data centers in other key locations like Frankfurt in Germany and Dubai. In these international regions, the cloud business of BABA is still in the early stages. We can expect a long growth runway for the company as it increases the cloud locations and adds new clients in these regions.
There is a lot of macro tailwinds for BABA stock in the cloud segment. Gartner has forecasted that the public cloud services will grow by more than 20% over the next few years.
Fig: Growth in cloud services. Source: Gartner
The fastest growth will be in Infrastructure Services called IaaS. This is one of the biggest business verticals for Alibaba’s cloud segment. Alibaba provides massive scale for businesses looking to use public cloud options. Gartner also estimated that the top 10 cloud providers will corner 70% of market share by 2021, up from 50% in 2016. This means we should see more business going to already established players.
Earlier this year, it was reported that Alibaba has displaced IBM (NYSE:IBM) in cloud market share rankings. There are only three other major cloud companies bigger than Alibaba. They are Amazon, Microsoft and Google. Earlier this year, Google CEO, Sundar Pichai, mentioned that the company was hitting $1 billion revenue per quarter or $4 billion in annualized revenue. But the growth rate of Google is lower than Alibaba. If BABA keeps the current growth trajectory in the cloud segment, it should surpass Google in 2019. This will catapult BABA among the top three cloud players.
Improvement in BABA’s Margins
Alibaba is still reporting losses on the cloud segment. The EBITA in the cloud segment went from RMB -164 million to RMB -232 million. However, due to faster revenue growth, the EBITA margin improved marginally from -5% to -4%. But the bigger story is the future trend within margins of this segment.
Amazon’s (NASDAQ:AMZN) AWS has shown that larger scale helps in rapid improvement in margins. In Q4 2014, Amazon started showing a massive jump in margins of its AWS business. In Q3 2014, AWS revenue was $1,169 million and operating income of $98 million. In Q4 2014, AWS revenue was $1,420 million and operating income was $240 million.
Hence, the operating margin went from 8.3% in Q3 2014 to 16.9% in the next quarter. Since then, the margin improvement continued even as the revenue growth was high. This was the main reason behind the bullish run in the stock from $300 in early 2015 to $1,500 by mid-2018.
Alibaba stock is also close to this revenue rate. The cloud segment of BABA should be hitting over $1 billion in revenue in the next few quarters. At this rate, we should start seeing substantial improvement in the margins of this segment.
The Impact on the Valuation of BABA Stock
In the recent quarter, Amazon’s AWS reported revenue of $6,679 million and an operating income of $2,077 million. This shows that the operating margin of this segment was 31.1%. Alibaba’s cloud business is very similar to AWS. This should allow the company to deliver margins close to AWS as it scales up.
By 2020, Alibaba’s cloud business could be close to $10 billion revenue rate. A modest 20% margin on this revenue base would give BABA’s cloud an income of $2 billion. For a business that is growing at a rapid pace and has a long runway for growth, the valuation multiple should be quite high. Taking a conservative estimate of 50 to 70 times the income, the stand-alone valuation of the cloud segment should be $100 billion to $140 billion.
Currently, Alibaba stock has a market cap of less than $400 billion. As the cloud segment becomes a bigger part of the total revenue base of Alibaba, Wall Street could give greater focus on cloud performance. Improvements in cloud margins along with faster revenue growth should increase the bullish sentiment toward BABA stock.
Alibaba’s cloud business is at an inflection point. It is reporting over $3 billion in revenue on an annualized basis with close to triple-digit growth. With this trajectory, the cloud segment should hit $10 billion revenue rate by 2020. At the same time, higher scale improves the margin performance of the cloud business. This has been shown by Amazon’s AWS in 2015.
Even with a much lower margin than AWS, Alibaba’s cloud could be worth more than $100 billion by 2020 on a standalone basis. This should provide a good bullish momentum to BABA stock.
As of this writing, Rohit Chhatwal did not hold a position in any of the aforementioned securities.