To The Moon

Summary

• Chinese tech equities remain vulnerable to US-China uncertainties, erasing Alibaba's gains from spinoff hype.

• Using the term state capitalism to describe China's economic model is inaccurate. Like every other nation, China has a mixed economy that blends capitalism.

• Alibaba's Cloud segment operating independently enhances its agility, allowing it to pursue growth initiatives and respond.

• Shareholders can anticipate a significant capital return through the stock dividend distribution resulting from the spin-off, depending on the valuation and future performance of the Cloud arm.

Hong Kong Street Scene, Mongkok District with busses

Investment Thesis

China's reopening surge collapsed at the end of January, and Chinese equities have slowly lost popularity, contradicting Wall Street analysts' strong conviction calls at the beginning of 2023. In addition, analysts have cut their growth predictions due to weaker-than-expected economic data, the weakening yuan, the debt challenges in the real estate market, and concerns over deteriorating relations with Western nations have further dampened the Chinese equities outlook.

As Alibaba Group Holding Limited (NYSE:BABA) narrows its main e-commerce focus while creating enormous value for shareholders, its plans to spin off the Cloud Intelligence Group act as a catalyst for long-term growth. Unfortunately, despite the value-unlocking plan, the market erased all the gains from the spin-off hype due to rising tensions in US-China relations. In this analysis, we will dive into China's mixed economy that blends capitalism and socialism, as well as Alibaba's cloud arm spin-off, which reaffirms the strong buy rating for the stock.

What Is Happening With Alibaba & In China

Despite the strong bull run, the two-plus years-long regulatory crackdown on the sector is easing. However, Chinese tech equities are still vulnerable to US-China tensions, and the geopolitical tensions are still weighing on the global sentiment toward China, which erased all of Alibaba's gains from spin-off hype.

After Beijing lifted its draconian 'zero COVID' policy restrictions that hampered the world's second-largest economy, investors had staked that consumer spending and the tech industry would recover. However, economists point to sluggish commerce and other indications that the fledgling recovery is waning. For example, the recent Golden Week holiday, a crucial barometer of general sentiment, showed a spending gap between booking numbers and overall expenditure.

The American depositary receipts, or ADRs, issued by Chinese companies were the subject of the US Public Company Accounting Oversight Board's initial audit inspections just a few months ago, easing the "delisting" fears. However, since late April, Chinese markets have been affected by concerns about escalating US-China relations. Following the G7 countries' pledge to remove risks from the global manufacturing hub, US chipmaker Micron Technology (MU) has become the first Western company to be sanctioned by China, further escalating the US-China tensions. As a result, Mr. Market sees that there is always something to worry about in China, but the reality is that China's growth has just resumed.

Cloud Q4 2023 Performance

During Q4 2023, Alibaba Cloud experienced a decrease in revenue from its cloud segment. Before inter-segment elimination, the total revenue from the cloud segment amounted to RMB 24,559 million or $3,576 million, indicating a 3% year-over-year decline. After inter-segment elimination, the revenue reached RMB 18,582 million ($2,706 million), reflecting a 2% decrease year over year.

The revenue decline can be attributed to several factors. Firstly, there were delays in delivering hybrid cloud projects due to the resurgence of the COVID-19 pandemic in January. These delays impacted project implementation and resulted in slower revenue generation. Additionally, the demand for Content Delivery Network (CDN) services normalized, reducing revenue compared to the previous year.

Furthermore, the Cloud segment experienced the impact of a significant customer phasing out the use of Alibaba Cloud's overseas cloud services for its international business due to non-product-related reasons. This customer transition further affected the segment's revenue performance.

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Despite the revenue decline, Alibaba Cloud focused on diversifying its revenue sources. As a result, the cloud segment saw steady growth in revenue contribution from non-Internet industries, driven by sectors such as financial services, retail, media, and the automobile industry. These industries accounted for 55% of the cloud segment's revenue after inter-segment elimination, indicating positive progress in revenue diversification.

Alibaba Cloud remains committed to advancing core technologies in big data, cloud computing, and AI. In addition, the company aims to expand its customer base and enhance cloud utilization through various initiatives. For example, the introduction of Tongyi Qianwen, a large language model (LLM), has garnered significant interest from enterprise users across different sectors. As a result, Alibaba Cloud plans to integrate Tongyi Qianwen into its ecosystem to provide customized LLMs for enterprise customers and enhance user experiences.

To make computing more accessible and cost-effective, Alibaba Cloud has implemented a product pricing strategy that offers savings of up to 40% for a new instance family. Furthermore, the prices of core utility products, including computing, storage, networking, and security, have been reduced by up to 50%. These measures aim to increase public cloud adoption in China and create opportunities for enterprises to leverage AI technology.

Also, partnerships play a crucial role in Alibaba Cloud's strategy. The company has introduced initiatives to integrate its proprietary technology and products into its partners' solutions, delivering value to enterprise customers. In addition, Alibaba Cloud is moving towards strengthening its ecosystem by promoting collaboration and innovation within its partner network.

DingTalk, Alibaba Cloud's intelligent collaboration workplace and application development platform, has integrated intellectual capabilities based on Tongyi Qianwen LLM. This integration allows users to access AI capabilities such as article creation, meeting note summarization, image generation, DingTalk mini-app building, and robot training. Serving as a PaaS platform, DingTalk supports customers and ecosystem partners in harnessing the potential of AI capabilities.

Spin-Off's Vital Benefits Το Alibaba Shareholders

Alibaba's recent announcement regarding the complete spin-off of its Cloud Intelligence Group and the distribution of stock dividends to shareholders has sparked a range of reactions in the market. While the move is expected to bring certain advantages, it has also raised concerns and left some needing clarification about the company's long-term strategy. The value of the distributed stock dividends will depend on the valuation of the Cloud Intelligence Group, currently valued at $30 billion by some analysts.

The strategic focus of the spin-off is one of its key benefits. By separating the cloud business into an independent entity, Alibaba can sharpen its focus on its core e-commerce businesses, namely Taobao and Tmall. In addition, this strategic realignment enables the company to allocate resources more effectively and pursue growth opportunities within its primary business segments.

Operating as an independent entity can also enhance the agility of the Cloud Intelligence Group. By being separate from Alibaba, the Group gains greater flexibility to pursue its growth initiatives, forge strategic partnerships, and respond to market dynamics. This increased agility can strengthen its competitive position in the rapidly evolving cloud computing industry.

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As the Cloud Intelligence Group becomes publicly listed, it can attract strategic investors and potentially command a higher valuation as a stand-alone entity. However, following the stock dividend distribution, some investors in Alibaba may decide to hold onto the more potential cloud business shares while reducing their holdings in the company, primarily comprised of the sluggish Taobao/Tmall division. Nevertheless, this value unlocking can benefit shareholders who receive shares of the spun-off entity, allowing them to realize the actual value of the cloud business.

Preserving synergies among business groups is a priority for Alibaba. Alibaba's commitment to business cooperation and data-sharing mechanisms within the Group indicates its intention to preserve synergies among its various business groups. This collaboration fosters innovation, efficiency, and cross-selling opportunities, ultimately benefiting shareholders by leveraging the collective strengths of the different business units.

In order to be ready for a spin-off and potential IPO, the cloud subsidiary of Alibaba has started a round of layoffs that might result in a 7% personnel reduction of its 235,000 people as of March. However, a large part of the personnel will be transferred to other parts of Alibaba's Group, as the conglomerate announced 15,000 new recruits.

However, before the stock dividend distribution, the cloud intelligence group plans to raise private capital and issue a stock-based compensation (SBC) plan, which may dilute Alibaba shareholders. Nevertheless, SBC, when used wisely and not excessively, is a successful strategy for motivating employees and aligning shareholders' interests.

Alibaba's Cloud market estimate of $30 billion implies a 2.58x Price to Sales (P/S) multiple on 2022 sales. To put this into perspective, comparing it to Hang Seng TECH Index, Alibaba's shares (9988) in the Hong Kong exchange currently trade at 1.66x P/S, Kingsoft Corp at 4.55x, and SMIC at 4.23x. Thus, reaccelerating the Cloud segment's growth in the next year or two can rerate the stock closer to the 4x-5x range, suggesting a $50-60 billion valuation.

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Takeaway

The regulatory onslaught on the Chinese tech sector appears to be easing, providing some relief to investors. However, US-China tensions and geopolitical factors continue to pose risks for Chinese tech equities, as demonstrated by the erasure of Alibaba's gains from spin-off hype. Finally, the mixed economy of China blends elements of capitalism and socialism, with SOEs playing a significant role in supporting economic expansion.

Shareholders can anticipate a significant capital return through the stock dividend distribution resulting from the spin-off, depending on the valuation and future performance of the Cloud Intelligence Group. However, considerations include the potential dilution of Alibaba shareholders through private capital raising and employee stock ownership plans. Until the geopolitical tensions clear up, Alibaba might continue trading significantly below its intrinsic value, giving more time to long-term investors to increase their positions.

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