In a recent interview, Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) vice Chairman Charlie Munger expressed enthusiasm for investing in China, claiming U.S. investors were under-exposed to the country, and that "the best companies in China are cheaper than the best companies in the United States."
In that light, it may be a good time to peer inside the second-largest Chinese company, Alibaba (NYSE:BABA), which just released its fiscal fourth quarter 2018 earnings report. Growth exceeded even optimistic expectations, rocketing 61% year-over-year, while non-GAAP earnings per share grew at a somewhat slower rate of 32%. How did a company so big grow so fast, and is the company's margin compression a concern? In order to better assess Alibaba's current state, let's dig in further.
Alibaba's core e-commerce platforms are its Taobao and T-Mall platforms. Taboao is where consumers and small businesses sell products to other consumers, while T-Mall is where larger brands and corporations reach customers. Despite having an already-huge scale and majority market share in China's e-commerce market, Alibaba managed to greatly grow both users and revenue on its core platforms.
Alibaba grew both annual active users, as well as mobile monthly active users by 22% year-over-year. On the back of that strong user growth, customer management revenue, which incorporates Alibaba's traditional marketing and advertising sales, grew an impressive 35%, due to higher prices-per-click. Commission revenue (fees Alibaba takes on goods sold on its platforms) grew an impressive 39% on gross merchandise volume (GMV) growth of 40%.
A newer part of Alibaba's commerce platform is its investments in "New Retail," which incorporates Alibaba's technology into physical retail stores. This segment includes:
- Hema: Alibaba's supermarket chain with 25 markets as of early 2018, with plans to open dozens more this year.
- Intime: A department store chain Alibaba bought for $2.6 billion back in January 2017.
- T-Mall Import: A physical storefront that sells imported goods from overseas.
New Retail grew from almost nothing in the year-ago-quarter to 5,825 RMB ($928 million) last quarter. In addition, Alibaba also has several minority investments in other retailers, including Sun Art Retail, in which the company invested a 36% stake late last year.
In addition to Alibaba's e-commerce platforms and "New Retail" initiatives, the company is also the leading cloud computing platform in China. Cloud is a perfect business for Alibaba, as only very large tech companies have the resources to become cloud infrastructure companies, and China protects its tech companies from foreign competition.
Last quarter, Alibaba's cloud computing business skyrocketed 103% to RMB 4,385 million ($699 million). That's far less than cloud market leader Amazon (NASDAQ:AMZN) Web Services' $5.4 billion haul last quarter, but still makes Alibaba a leader in China. Alibaba Cloud also announced 316 new features, many of which span artificial intelligence, data management, and security, including a new edge computing platform for the Internet of Things. The company announced several large customer wins, including China Petroleum, The Malaysian Government, and Cathay Pacific (a Hong Kong airline).
Alibaba has also launched itself in the streaming video wars, with its 2016 purchase of streaming service Youku Tudou. This quarter, video subscribers skyrocketed 160%, leading to a 44% increase in digital media and entertainment revenue, which includes both Youku as well as Alibaba's UCWeb browser business.
But growth comes at a cost
While top-line numbers are clearly impressive, investors should know that profits told a different story, with adjusted EBITA (earnings before interest, taxes, and amortization) margins falling from 39% to 27% in the recent quarter. Alibaba is suffering from the "good" problem of trying to expand meaningfully off an incredible core business (Taobao and T-mall).
For instance, its new retail segment carries lower margins than Alibaba's asset-light e-commerce platform, lowering core commerce EBITA margins from 59% to 43%. In addition, cloud and digital media each have negative EBITA margins, with cloud at negative (8%) and digital media margins a whopping negative (49%). Alibaba also has other cost centers such as its "innovation initiatives," which include a new digital map product and an enterprise messaging service. This segment had negative (87%) margins last quarter, which also weighed on results.
Not time to panic
But while these segments all weighed on profits, the future seems bright. Alibaba is attempting to revolutionize the retail scene in what will one day be the world's largest economy. In addition, streaming video services in other parts of the world (ahem, Netflix) have garnered high valuations despite negative cash flow, while Amazon and others have shown a more mature cloud business can be very profitable.
To me, Alibaba's growth outweighs its margin compression. Stick with this Chinese leader.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Billy Duberstein owns shares of Alibaba Group Holding Ltd., Amazon, and Netflix. His clients may own shars of some of the companies mentioned. The Motley Fool owns shares of and recommends Amazon, Berkshire Hathaway (B shares), and Netflix. The Motley Fool has a disclosure policy.