Alibaba (NYSE: BABA) has shown good growth numbers in the past few quarters from its cloud segment. In the recent quarter, Alibaba reported $962 million of revenue in cloud computing with year-on-year growth of 84%. This has had a positive impact on the sentiment around Alibaba stock. Cloud segment is a high growth business with a potential for good margins as shown by Amazon’s (NASDAQ:AMZN) AWS.

Hence, Alibaba’s management has announced their intention of focusing on cloud to drive future growth. CEO Daniel Zhang has also mentioned that cloud would be the main business of the company in the future.

But due to the trade tensions and the negative impact of Huawei fiasco, we could see additional scrutiny on Alibaba’s cloud expansion in several international regions. Financial Review has recently mentioned the security challenges faced by Alibaba in its cloud push in Australia. Similar issues will arise in Europe, Canada, India, and other regions.

Importance of Cloud Segment

The Cloud Computing segment of Alibaba is the fastest growing segment for the company. In the recent quarter, the revenue from this segment was RMB 6,611 million or $962 million, up from RMB 3,599 million in the year-ago quarter. Hence, the revenue share of cloud computing increased from 4% to 6%.

The EBITA margins for this quarter were negative 4%. This was a slight improvement from negative 5% in the year-ago quarter. Although all companies do not separately report their cloud revenue, Alibaba’s revenue pace puts it among the top players of cloud business. The industry leading growth rate in cloud is a major favorable aspect for Alibaba stock.

The company is rapidly setting up new data centers in international regions. It has recently opened two new data centers in UK and another in Indonesia. We should see a number of new opening in Europe and South Asia over the next few quarters.

Alibaba has the capacity to invest substantial amounts to improve the long term growth potential of its cloud business. The company can also decide to forego profits in the short term to provide more attractive pricing to customers. This should improve the market share and revenue growth at a rapid pace.

Last year, Wells Fargo’s Ken Sena estimated the standalone valuation of Alibaba cloud to be around $80 billion. If we look at the contribution to Alibaba’s ecosystem, the valuation could easily top $150 billion. This is over one-third the current market cap of Alibaba stock. Hence, any negative impact on cloud computing will hurt the bullish sentiment around Alibaba stock.

Trade Rhetoric and the Huawei Issue

Even if there is a win-win deal on trade issues between U.S. and China in the near term, the brand image of Alibaba cloud could take a beating. In addition, there has been the Huawei issue which is still unresolved. The sentiment against Huawei can be seen in a statement made by T-Mobile (NASDAQ:TMUS) CEO John Legere.

He said, “Let me be clear—we do not use Huawei or ZTE network equipment in any area of our network. Period. And we will never use it in our 5G network”

Corporate clients who are procuring equipment are more risk averse. They would like to prevent any upsetting of the business due to changes in the regulatory environment. The cloud computing business is different from 5G network but it also requires big contracts worth millions of dollars from corporate clients.

If these cloud providers want a risk-free cloud provider, they would always have an alternative to choose Amazon’s AWS or other tech companies.

The top management from Alibaba is yet to make a statement on this issue as they would be waiting for a favorable trade deal. However, investors need to look at the possible impact of these challenges on the long term potential of Alibaba cloud in international regions.

Options Available with Alibaba

Alibaba is trying to add new clients by aggressively pricing its cloud services. We can see this from the huge difference in the margins of Amazon’s AWS and Alibaba cloud. In the recent quarter, AWS posted an operating margin of 29.3% while Alibaba cloud showed EBITA margin of negative 4%. The company can continue to lower its prices in the near term to provide heavy discounts to clients compared to AWS.

Alibaba has also formed a strong partnership with Europe’s biggest department store, El Cortes Ingles. Alibaba would be providing payments supports, logistics, ecommerce and New Retail options to the Spanish company.

But the most important part of this partnership for Alibaba is the ability to add another big client for its cloud program. Having bigger brands on its client list should make it easier for Alibaba to add new clients in the future.

Alibaba is also a big cloud player in China where Amazon and Microsoft are very small. If a foreign brand wants to have a presence in China, Alibaba cloud would be the first choice. This gives the company a starting point to explore additional cloud service for these brands in their home country.

Impact on Valuation

The growth potential of cloud business in China is itself quite big. Hence, Alibaba will continue to deliver decent growth due to its domestic cloud services in China. But a few major hiccups in international regions could reduce the long term potential for Alibaba cloud. This should also impact the valuation multiple of Alibaba stock.

Alibaba stock is currently trading at forward P/E multiple of around 30. This is quite low for a company with revenue growth at close to 40% and improvement in EBITDA margins.

However, a big part of Alibaba’s valuation is tied to its ability to show continuous growth and improvement in margins in the cloud business. Investors need to watch the possible challenges faced by this segment to gauge the future momentum in Alibaba stock.

Investor Takeaway

Alibaba cloud could face security concerns similar to Huawei as it expands in international regions. The current U.S. administration has put pressure on allies to ensure that sensitive national infrastructure does not use Chinese technology. This will limit the usage of Alibaba cloud in many areas.

It also negatively impacts the brand image of Alibaba cloud. Corporate clients who are risk averse would rather pay a premium to get AWS or other cloud providers instead of using Alibaba cloud.

A long term trend towards poor reception of Alibaba cloud will limit the revenue growth of this segment in international regions. It will also force Alibaba in giving bigger discounts to lure clients which should reduce the margin expansion within cloud segment.

The cloud segment plays a vital role in the bullish thesis for Alibaba stock. Hence, it would be important to see how the management deals with any additional security concerns regarding its cloud business.