PDD - What You Need To Know About Alibaba's New Organizational And Governance Structure

2023-03-29 12:02:45 ET

Summary

• Alibaba Group Holding Limited announced earlier this week that it intends to restructure the company into six separate units eligible for independent capital raising and IPOs subject to regulatory approval.
• The company is preparing for a detailed press release pertaining to the change on March 30th, which could be key to confirming the market's cautious optimism observed in the stock's rally.
• While the restructuring could potentially unlock incremental value to the stock, management's follow-through on the development, which would be critical to sustaining the recent rally, remains to be seen.

Alibaba Group Holding Limited's ( BABA ) market cap has more than halved over the past two years. This was due to the downward valuation adjustment to account for idiosyncratic risks spanning maturing growth at its core domestic e-commerce business, a regulatory crackdown by Beijing on big tech's influence, as well as other geopolitical challenges facing the stock's U.S. listing. The stock has been trading in the range of 10x estimated earnings in recent weeks after the early-year rally resulting from China's reopening trade fizzled on a modest domestic economic environment so far.

Alibaba's market value has trailed domestic peers like JD.com, Inc. ( JD ) and PDD Holdings Inc. ( PDD ) (formerly Pinduoduo) despite a leading market share by wide margins, as the smaller rivals benefitted from a growth advantage unleashed from Beijing's crackdown on Alibaba's former grip on big brands like Starbucks ( SBUX ) and Estee Lauder ( EL ) through exclusive vendor agreements. Meanwhile, the Chinese tech juggernaut's valuation also trails its American counterparts like Amazon ( AMZN ) as markets price in the impact of incremental idiosyncratic risks.

Yet, Alibaba's surprise announcement earlier this week regarding the split of its consolidated business into six individual units - each with the potential for raising funds and exploring IPOs independently - is drawing hopes for an upward re-rate that would better reflect a "sum of the parts" value. While geopolitical and regulatory risks remain an acute overhang on Chinese tech stocks, the announcement of a new organizational structure at Alibaba could potentially unlock incremental value, while also maintaining compliance with the government's efforts in keeping big tech influence at bay. The stock now trades at just under 2x estimated sales and about 11x estimated earnings following the restructuring plan's announcement, which is reflective of markets' optimism on a potential release of "pent-up value" across some of Alibaba's faster growing and more profitable units on a standalone basis. However, any further upside potential at a sustainable trajectory would be dependent on catalysts such as the confirmation of the units' respective spinoffs as an act of follow-through on the development and ensure confidence in the stock.

An Overview Of The Six Newly Announced Units

The newly announced organizational structure at Alibaba would involve restructuring its current business profile into six reporting units. The development aims to "empower all (of Alibaba's) businesses to become more agile, enhance decision making, enable faster responses to market changes, and promote innovation." Each of the six divisions would have rights to "individually raise funds and explore IPOs," thus providing an opportunity to unlock incremental value that otherwise would have been pent-up in the consolidated business.

• Global e-commerce: The division would house all of Alibaba's international commerce units, including North America- and Eastern Europe-focused AliExpress, Southeast Asia-focused Lazada, and Turkey-based platform Trendyol. The separation of said platforms into a separate unit categorized for Alibaba's international footprint is expected to enhance the group's focus on ambitious goals to capitalize on secular growth opportunities in e-commerce outside of China. This includes Alibaba's recently proclaimed aims to quintuple Singapore-based Lazada's gross merchandise value to $100 billion over the longer-term while also eyeing a potential IPO for the platform.
• Cloud: Alibaba Cloud is currently a market leader in the provision of public cloud-computing services in China and across Asia. The newly announced independent unit will fall under the leadership of Alibaba Group CEO Daniel Zhang, suggesting the company's ambitions in capitalizing on growing AI momentum (further discussed in the below sections).
• China core commerce: This division will encompass Alibaba's core Taobao and Tmall Chinese e-commerce platforms, as well as its local retailers including the recently acquired Sun Art Retail , Idle Fish consumer-to-consumer marketplace, and Freshippo groceries.
• Cainiao Logistics: In the ten years since its founding, Cainiao has become a critical driver of Alibaba's success in global e-commerce. With more than 500 global fulfillment partners, Cainiao aims to eventually fulfill local deliveries within 24 hours and global deliveries within 72 hours.
• Chinese services: The unit will house Alibaba's Ele.me Chinese meal and grocery delivery app, as well as the Amap navigation and Fliggy travel apps. Specifically, Ele.me has become one of the most popular meal delivery apps in China alongside Meituan ( MPNGF / MPNGY ), commanding almost a third of the country's market share with accelerated improvements to its economics after new regulations for online food ordering platforms to provide at least local minimum wage among other benefits to gig workers. Paired with Amap's revamp into a sort of all-in-one navigation app with offerings spanning "search discovery and fulfillment" for anything from finding gas stations to booking hotel reservations, and Fliggy's post-pandemic demand recovery, the unit shows prominent prospects of accruing value that can be subsequently unleashed into upside potential in the Alibaba stock should the group announce a spinoff.

Local consumer services adjusted EBITDA loss reduced by RMB 1.9 billion year-over-year to RMB 3.1 billion. Most of the loss reduction was driven by Ele.me business, while other major businesses within this segment also saw record reduced losses. Ele.me continued to improve its unit economics per order by increasing the average order value, reducing delivery cost per order.

Source: Alibaba F3Q23 Earnings Call Transcript

• Digital media and entertainment: The unit will house Youku, Alibaba's video streaming platform, as well as Alibaba Pictures, its film and content production and distribution platform, alongside other digital media platforms. Alibaba's foray in digital media and entertainment has been a direct victim of Beijing's sprawling regulatory crackdown in the past two years. Regulators' push to "curb anticompetitive behavior and open up closed ecosystems" has played a role in Alibaba's sudden decision to exit its minor share from Mango Excellent Media Co. in 2021. Growing pressure from Beijing's scrutiny on unhealthy influence stemming from digital media at the time had also encouraged Alibaba to briefly contemplate a potential divestment from its 30% stake in the local social media platform Weibo ( WB ). Meanwhile, the reference of digital games to " spiritual opium " by state media alongside Beijing's step-up in efforts to curb gaming addiction among youths had also been a challenge to Alibaba's peers like Tencent ( TCEHY ) and NetEase ( NTES ), while also shedding risks of a similar fate for the company's Lingxi Games. A potential spinoff of the unit could alleviate some of the regulatory overhang over the Alibaba stock and potentially restore incremental upsides stemming from some of the group company's other high-growth segments.
• Others: The catch-all unit will encompass all of Alibaba's smaller ventures, including "DAMO Academy," which is like an in-house incubator for next-generation cutting-edge technologies, as well as "Tmall Genie," which develops smart devices.

Implications Of The Breakup

Some of the key headwinds facing the Alibaba stock have been the combination of slowing growth in some of its core operating segments, uncertainties pertaining to Beijing's regulatory agenda for the private big tech sector, as well as geopolitical risks stemming from intensifying tensions between Beijing and the West:

• Slowing growth: The combination of COVID disruptions, as well as ensuing macro weakness in China and its key global partners, alongside the result of a sprawling regulatory clampdown enforced by the government has limited Alibaba's influence across its key businesses spanning e-commerce, cloud, digital media and entertainment, and others. The challenge was particularly acute in the company's core commerce operations, with management pivoting from a customer acquisition posture to customer retention, and redirecting the unit's focus towards growing its international footprint to compensate for slowing local demand. The impact of slowing growth was also observed in modest sentiment over Alibaba's flagship Singles' Day shopping event in recent years, and further corroborated by its first y/y sales decline since going public during the June quarter. The company's prized cloud unit has also been reeling from political challenges as state-backed peers benefit from the Chinese Communist Party's heightened calls for data safeguarding within government agencies.
• Regulatory Risks: As discussed in the earlier section and analyzed in detail in our previous coverages on the stock, Beijing's aggressive regulatory crackdown observed over the past two years has led to irreversible damage to Alibaba's growth story - especially given the disconnect between the company's sprawling influence and the doubling down of the Chinese government's call for common prosperity . The ensuing challenges include the removal of Alibaba's dominance in e-commerce, which was critical to its market share gains and the unit's lucrative growth and profitability; limits levied on Alibaba's presence in digital media and entertainment; and challenges to Alibaba's data-heavy units including the cloud and gig economy segments. Meanwhile, the stock also faced a discount to its valuation to account for delisting risks following Washington's stringent enforcement of the Holding Foreign Companies Accountable Act, which would require U.S.-listed Chinese companies to open up their books for PCAOB inspection. Despite having successfully completed PCAOB inspections on selected Chinese audit firms for the first time ever during December 2022, the U.S. regulators have warned investors to not "misconstrue (the announcement) in any way as a clean bill of health for firms in mainland China and Hong Kong," especially considering the "numerous potential deficiencies" identified that will need remediation, as well as the requirement for continued compliance with inspection requests under the HFCAA.
• Geopolitical Risks: As a key player in Chinese big tech, Alibaba is poised to be stuck in the cross-fire between Beijing and Washington's fraying relations. For instance, the U.S. government's latest enforcement of curbs on exports of advanced semiconductor technologies to China harbingers stiffening headwinds to Alibaba's cloud aspirations, and could potentially thwart its capabilities in capitalizing on the growing momentum in generative AI.

Last year, Alibaba introduced a new in-house-developed server processor based on 5nm processing technology, which marked a "milestone in China's pursuit of semiconductor self-sufficiency." The company had planned to integrate the in-house developed silicon into its data centers, and potentially commercializing it in the future. However, the only foundries capable of producing chips with the advanced 5nm process today are Taiwan Semiconductor ( TSM ) and Samsung Electronics ( SSNLF / SSNNF ) - both of which have been restricted from providing chip manufacturing expertise that is anything more advanced than 16nm technology to China in order to stay compliant with the U.S.' new rules. This likely means a big part of Alibaba's growth goals in cloud-computing has been held back.

Source: " Revisiting Why Alibaba is Uninvestable ."

While Alibaba's recently announced restructuring will not address and eliminate all of the aforementioned risks currently priced into the stock, it is at least compliant with the Xi administration's regulatory requirements while also providing an option to unlock incremental value over the longer term.

For instance, Alibaba's cloud-computing unit remains a market leader in China and across Asia, nonetheless. Despite the unit's decelerating growth from double- to single-digits in recent quarters, it remains a profit generator in line with the industry's high-margin nature as observed in global leaders like Microsoft Corporation's ( MSFT ) Azure and Amazon's AWS. Paired with growing momentum in generative AI, which is poised to expand the cloud total addressable market ("TAM") by driving incremental demand for compute capacity (discussed here ), Alibaba Cloud is likely to partially benefit from the secular trend despite potential technology setbacks due to intensifying Beijing-Washington tensions as discussed in the earlier section. This is also consistent with management's commentary in the latest earnings release to take advantage of the "exciting era of disruptive breakthroughs (in) generative AI," and reaffirmed by Alibaba group CEO Zhang's leadership of the newly separated unit:

Of the six new divisions, the burgeoning cloud business attracted outsized investor attention. Group Chief Executive Officer Daniel Zhang will head up Alibaba's cloud intelligence division, a nod to the growing role that artificial intelligence will play in the e-commerce leader's portfolio in the long run.

Source: Bloomberg News .

Should the newly announced independent cloud unit be spun out from the group, it could on its own warrant a larger valuation even after taking into account certain idiosyncratic risks facing Chinese stocks, including geopolitical and regulatory challenges. Cloud computing companies currently trade at an average of about 10x forward sales , which is almost five-fold of Alibaba's current consolidated valuation. Even taking into consideration a potential discount to the multiple to account for Alibaba Cloud's uncertain regulatory and geopolitical environment, there is ample margin for incremental value for the unit on a standalone basis, hence market's optimism on the recent restructuring announcement.

On the other hand, the restructuring would also prepare Alibaba's less appealing units for a potential spinoff, which would alleviate some of the downward pressure currently priced into the group's market value. As mentioned in the earlier section, maturing growth at Alibaba's core domestic commerce business, as well as acute regulatory challenges facing the company's digital media and entertainment segment have added downward pressure on the group's market value over the past two years. The restructuring would allow for the two units to potentially dissociate from the group, and allow for the remaining units to flourish and restore investors' confidence in Alibaba group's shares, thus "unlocking potentially billions of dollars in pent-up shareholder value."

Risks To Consider

Recall that one of the earliest regulatory overhauls implemented by Beijing was limitations on overseas IPOs and securities offerings undertaken by companies harboring significant user data. Specifically, a regulatory overhaul over data protection has required companies housing information on more than one million users to seek cybersecurity approval from government officials prior to seeking public listings or additional securities offerings overseas. While the Chinese government's stance on this matter has since been refined to a more supportive posture to ensure restoration of economic growth in the country, it remains a potential roadblock for Alibaba's newly restructured units to pursue independent capital raising and/or IPOs in the future.

Specifically, the essence of regulators' concerns over overseas listings remains on the protection of local user data as well as national security considerations, and to validate compliance may mean substantial time and cost hurdles for any potential spinoff/IPOs, and delay the release of anticipated incremental value to the newly separated units on a standalone basis and to the Alibaba group's shares:

The CSRC reiterated that Chinese companies seeking to sell shares abroad would have to register with the regulator after a transition period. Firms would need to abide by China's rules when disclosing personal data, and take necessary steps to safeguard state secrets. The regulator will block listings that may impede state security or involve companies or shareholders that have committed corruption, bribes or are under investigation.

Source: Bloomberg News .

With the spinoff/IPO of the newly separated units being critical to confirming sustained incremental upside potential to the stock, any regulatory-driven delays could potentially be viewed as a lack of follow-through and stall the valuation re-rate process that market participants have been speculating as a result of the latest development in Alibaba's organization restructure.

Final Thoughts

Admittedly, Alibaba's restructuring announcement is welcomed news, primarily because it would provide an opportunity to unlock incremental value pent-up in certain business units that otherwise would have been weighed down by other slower-growing, less profitable, and regulatory-risk-prone segments. But not all risks currently priced into the stock have been addressed by the latest restructuring announcement, implying that any ensuing upsides in the meantime will likely remain limited as markets stay cautiously optimistic while mulling on supportive follow-up developments.

We believe a subsequent IPO and/or capital-raising announcement for any newly separated unit will be a key catalyst to unlocking incremental value and sustaining the Alibaba Group Holding Limited stock's recent rally, as it would provide confirmation to the organizational restructuring's advantages speculated by markets. Yet, the risk of a lack of follow-through on the said anticipated advantages of Alibaba's restructuring may stall the stock's re-rate prospects and even backfire as what is left of investors' confidence wanes further, similar to previous market optimism on China's pro-growth posture that has since fizzled due to the lack of delivery.

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