[00:02:45] Daniel Mahncke: But before we get into macroeconomic details, let me break down Alibaba’s history, because I think that knowing where it came from and how fast it became the Chinese company helps us understand a lot of what comes later. Alibaba was founded in 1999 in a small apartment in Hangzhou. It was a group of 18 people, led by the former English teacher Jack Ma.

[00:03:10] Daniel Mahncke: As we all know, a humble beginning in a small apartment or garage seems like the perfect setup to create something big. Alibaba is no exception here. It came at the perfect time. The Chinese middle class was among the fastest growing in the world, and the gross national income per capita has increased tenfold since 2000.

[00:03:32] Daniel Mahncke: This fueled the consumerism of Chinese households. The global rise of the internet and online marketplaces also opened new opportunities in China. Another advantage was China’s relatively isolated position in the global capital markets. While the dot com bubble severely impacted American and European companies, Chinese companies faced little consequences.

[00:03:56] Daniel Mahncke: One can say that Alibaba was in the right place at the right time. This was also noticed by investors. Alibaba collected 25 million in funding from American banks such as Goldman Sachs or Fidelity and other big investors such as the well-known Japanese holding company SoftBank. Initially founded as a business to business e commerce platform, Alibaba connected small and medium sized Chinese suppliers with global buyers.

[00:04:26] Daniel Mahncke: In 2003, however, Alibaba expanded its business model with the launch of Taobao, a consumer to consumer marketplace that quickly gained traction and permanently revolutionized how the Chinese middle class consumes. Taobao is similar to eBay, but it offers many functions that we do not know from eBay or other US or European retailers.

[00:04:50] Daniel Mahncke: These features include image search, live chats with sellers, and small online games. It didn’t take long until international customers became interested in Taobao’s products. Even today, Amazon users, often and without even knowing it, buy products originally offered at one of Alibaba’s marketplaces. It has become a common practice for Amazon sellers to buy cheap products from Alibaba and resell them for profit on Amazon.

[00:05:19] Daniel Mahncke: Some of these products are resold at 10 times the original price. Accordingly, it only made sense to buy directly from Alibaba marketplaces instead. To improve the buying experience for international customers, Taobao integrated translation and logistics services that made the buying and delivering process as easy as possible.

[00:05:41] Daniel Mahncke: Nevertheless, more generally, local e commerce platforms still perform better due to regulatory and cultural aspects. That’s why Alibaba later decided to expand with more locally targeted marketplaces in different regions in the world. We’ll get back to that in a minute. To this day, Alibaba’s biggest revenue, profit, and cash flow generator is the Chinese e commerce market, covered by Taobao and Tmall.

[00:06:09] Daniel Mahncke: Nonetheless, Alibaba has continually expanded its ecosystem and diversified its business portfolio. In 2004, they launched Alipay to be independent of other financial transactional services. Ten years later, Alipay was renamed Ant Financial, and eventually Ant Group, a company that will play a major role in today’s episode.

[00:06:33] Daniel Mahncke: In the same year, Tmall, Alibaba’s business to consumer marketplace, went global and became one of Alibaba’s first steps in expanding into international markets. Although it’s not Alibaba selling goods in other countries, instead non Chinese companies could now sell through Tmall to Chinese consumers.

[00:06:54] Daniel Mahncke: Since 2014, Tmall Global has gone from 100 international brands on its platform to 46, 000 from 90 different countries. Another business segment is Alibaba cloud, which will be another main part of today’s episode. It was established in 2009 but only started to gain traction a couple of years later when the overall cloud market started growing especially in China.

[00:07:21] Daniel Mahncke: Alibaba cloud quickly grew to become China’s biggest cloud provider and the driving force for innovation in this space. It is still the dominating cloud with a market share of 39%, but competitors are catching up, especially since Alibaba’s cloud growth has slowed down significantly in the last two years.

[00:07:40] Daniel Mahncke: Another growing part of Alibaba’s ecosystem is its 2013 founded logistics arm, Jianyao. In case we have Chinese listeners here, I hope I came at least close to the right pronunciation. The firm started as a joint venture between a number of delivery Korea companies and Alibaba as its biggest shareholder.

[00:08:00] Daniel Mahncke: In 2017, Alibaba acquired a controlling share of 51 percent. Since then, Alibaba’s stake increased to 64 percent and in March of this year, they actually announced their plan to buy the remaining stake of to gain full control of the company. This decision was made after the original plan to spin it off and create value for shareholders was put on ice due to the bad sentiment that would have probably resulted in just another low valuation.

[00:08:29] Daniel Mahncke: This decision was made for all segments that were initially planned to IPO this year. Jianyao isn’t a typical delivery company, since it does not engage in the physical delivery of packages. It’s a logistics service integrated into Taobao that simplifies the package ordering process for consumers by choosing the best career company, delivering details like parcel pickup times and real time tracking.

[00:08:56] Daniel Mahncke: Zhenyao also has a chain of pickup stations that are like little post offices in which clients can pick up packages that couldn’t be delivered to their homes. For merchants, Zhenyao offers productivity gains by utilizing their data to improve the warehousing and delivery process. It also operates warehouses in strategically important locations.

[00:09:19] Daniel Mahncke: Merchants who do not have any warehouses in these regions can store products there to speed up the delivery process. The main benefit for delivery companies is the optimization of routes, enabled by the huge volume of orders. Alibaba also decided to increase its global presence beyond the scope of Tmall and Taobao by building up or buying international e commerce marketplaces.

[00:09:45] Daniel Mahncke: Originally integrated into Alibaba’s ecosystem as International Digital E Commerce, the business section is now called Global Digital Commerce Group. I just mention this in case you want to research Alibaba further and get confused by the often changing names of Alibaba’s business segments. The latest restructuring took place last year.

[00:10:07] Daniel Mahncke: Many of the business sections got renamed, and some businesses, mostly small ventures, switched categories. But this didn’t change much, if anything, on the business or operational level. The global e commerce of Alibaba operates via different marketplaces, each targeting a distinct geographical market. The four marketplaces are AliExpress, which has become a big player in Russia, Lazada, whose main customer base sits in Southeast Asia, Tuendyal, which is focused on the Turkish market, and Daraz, which is another, in fact the biggest player in the South Asian market, with a dominant position in Pakistan and Bangladesh.

[00:10:49] Daniel Mahncke: Combine these marketplaces with 240 million active annual users last year, up from 180 million in 2022. Each of these business segments has a similar impact on Alibaba’s revenues. Last year, they contributed between 11 and 12 percent each. Over the course of this episode, we will get into more detail on each of these segments.

[00:11:12] Daniel Mahncke: But first, Let’s take a look at Alibaba’s stock development in recent years. Shawn, do you mind taking us on a journey of Alibaba’s stock development?

[00:11:20] Shawn O’Malley: Sure. Alibaba’s stock has been China’s poster child for many years. Basically, since its IPO in Hong Kong in 2007 and even more so after its New York IPO seven years later in 2014.

[00:11:33] Shawn O’Malley: It was one of the first Chinese stocks that drew major international attention, and its New York IPO raised $21.8 billion at a valuation of $168 billion, making it the world’s most valuable tech IPO. On the first day of trading the stock immediately gained over 40%, going from a starting price of $68 to $96 per share.

[00:11:58] Shawn O’Malley: For comparison, Facebook’s IPO, which raised 16 billion in 2012, had held the record for the highest valued tech IPO until Alibaba came along. Alibaba’s success story continued for over six years, and it became the second most valuable Chinese company, reaching a market cap of 858 billion in October 2020.

[00:12:19] Shawn O’Malley: Unfortunately for Alibaba shareholders, this marked a top that seems unreachable, looking at the stock chart today. Alibaba is currently trading at a market cap below 200 billion, resulting in a stock price of 80 per share, which is 16 cheaper than it was at the end of the New York IPO 10 years ago.

[00:12:38] Shawn O’Malley: Despite the stock price’s decreases, Alibaba’s outstanding shares have decreased by 100 million compared to the share count back then.

[00:12:46] Daniel Mahncke: There definitely have been easier times for Alibaba shareholders. Many of them come from the value investing community, since it became quite a popular contrarian investment, and yes, I know there’s an irony to that.

[00:12:59] Daniel Mahncke: The excitement for Alibaba was fueled by Charlie Munger, who started heavily investing in the company back in 2021. At the time, he paid well above 200 per share. He later referred to his Alibaba investment as follows. I regard Alibaba as one of the worst mistakes I ever made. This is quite the statement and it left a lot of investors confused since the original thesis of buying a Fundamentally strong company that is unloved by international investors was seemingly still intact and Potentially even getting stronger the lower the price went Munger also said that he missed the fact that Alibaba in the end was still a quote damn retailer.

[00:13:43] Daniel Mahncke: I can understand the investor’s confusion with these statements by Charlie Munger. Alibaba’s business model is pretty straightforward despite its many ventures and business segments. What is relatively easy to see is that Alibaba remains very dependent on its core business, Chinese e commerce. And this is an easy to understand business model and market.

[00:14:06] Daniel Mahncke: It seems unlikely that Munger misjudged the nature of this business, especially considering his conviction and position sizing when he established his Alibaba investment. After analyzing Alibaba’s business, I do not think that its main problem has been the retailing business. Yes, more competition, a weak economy, and lower than expected competitive advantages did reveal the weaknesses of Alibaba as a retailer.

[00:14:32] Daniel Mahncke: But I consider other factors more important in Alibaba’s recent downturn. But before we get to them, let’s take a more detailed look and see what exactly changed in Alibaba’s core business in recent years. Taobao and Tmall are Alibaba’s cash cows. Over the last year, they were responsible for over 46 percent of revenues.

[00:14:55] Daniel Mahncke: And, even more important, they were responsible for 118 percent of profits. And while this might sound unintuitive at first, there’s a simple reason for that. Many other segments of Alibaba are still loss making, therefore, Taobao and Tmall are basically subsidizing their losses. The Taobao app has over 920 million monthly active users and Tmall has another 850 million.

[00:15:23] Daniel Mahncke: For comparison, Amazon has only an estimated 310 million. All of these uses result in a combined market share of Taobao and Tmall of somewhere around 40 percent of the Chinese e commerce market, which is by far the largest in the world. With over 3 trillion in annual e commerce sales, the Chinese market is responsible for more than half of the global e-commerce sales.

[00:15:50] Daniel Mahncke: Part of the truth is that Alibaba used to have a market share that was a lot larger than 40%. In 2019, the market share was almost 70%. However, it’s more than natural that such a high market share is not sustainable in what is one of the most profitable markets to be in. Competition was inevitable. While Alibaba had a first mover advantage, this resulted in a head start at best.

[00:16:16] Daniel Mahncke: Competition will enter the market and they will eventually gain market share. These dynamics were already in full swing when Alibaba was still the celebrated Chinese tech company in the eyes of international investors. I find it hard to believe that this is the reason for Alibaba’s stock decline.

[00:16:35] Daniel Mahncke: Instead, the reason for Alibaba’s problems have been quite obvious in recent years. To break this down, let’s take a look at the timeline of Alibaba’s downward spiral. Alibaba’s stock price decline started when the Chinese government initiated a series of regulations on its national tech giants. With Alibaba as the best known and biggest player in the industry, it was at the forefront of this regulatory breakdown.

[00:17:02] Daniel Mahncke: It all began in November 2020, when Chinese regulators called off what would have been the largest IPO in the world, raising an astonishing 37 billion. This was the planned IPO of Ant Group, which would have valued the company at over 300 billion. Ant Group was also founded by Jack Ma and Alibaba held and still holds a 33 percent stake in the company.

[00:17:29] Daniel Mahncke: Therefore, the IPO would have added about 100 billion dollars to some of the parts valuation of Alibaba. That’s more than half of the current market cap. It doesn’t come as a surprise that investors received the cancellation of the IPO very negatively, initiating not only a series of regulations, but also a change in the narrative regarding Alibaba and Chinese stocks as a whole.

[00:17:55] Shawn O’Malley: That’s right, what didn’t help the overall sentiment was the reason for the sudden halt of the IPO. While the official reason was that there had been quote major issues at the company, the market didn’t buy that and suspected that a recent speech from Jack Ma critical of the government was the real reason.

[00:18:12] Shawn O’Malley: The stock reacted with an immediate plunge of 9 percent and instead of recovering in the following weeks, Alibaba ended the year with a 25 percent decline. Since then, the stock has been repeatedly hurt by bad news and has gone down a spiral of falling stock prices and new bearish news. Only a month after the Ant incident, China’s leading political party, the CCP, announced that it would prevent the, quote, rampant accumulation of capital and limit the influence and size of the Chinese internet industry.

[00:18:44] Shawn O’Malley: This was followed by an official antitrust investigation into Alibaba, which eventually resulted in the first financial fine of this regulatory crackdown.

[00:18:53] Daniel Mahncke: Exactly. All the regulations and announcements that we have discussed until now only, if one can even say that, hurt Alibaba’s reputation and therefore the stock price.

[00:19:03] Daniel Mahncke: But they didn’t create any negative cash flows. This changed in April of 2021 when Alibaba had to face the first tangible fine of 2. 8 billion dollars. A record fine that amounted to 4 percent of the 2019 revenues. This has been another sign to investors that the Chinese government is willing to hurt its biggest companies.

[00:19:27] Daniel Mahncke: The fine was imposed because Alibaba has been allegedly abusing its market position since 2015. This abuse was mainly the practice of forcing merchants to choose between platforms instead of working with multiple marketplaces. If merchants want to sell on Alibaba marketplaces, they are not allowed to sell on any other site.

[00:19:49] Daniel Mahncke: It is interesting to note that the market perceived this fine very positively. After the fine was announced, Alibaba’s shares in Hong Kong climbed by 9%. Investors thought that this would be a good sign because it implies the end of the CCP investigation into Alibaba. And with all the rumors about how bad the regulation could get, a 2.8 billion fine looked like a good ending compared to what could have been possible. Unfortunately for Alibaba shareholders, this positivity didn’t last long. Although Alibaba increasingly disappeared from the CCP’s crosshairs, the regulation and fines of other Chinese tech companies continued to worry investors and caused massive losses for the entire Chinese stock market, including Alibaba.

[00:20:37] Daniel Mahncke: The most severe impact was the regulatory intervention against the Chinese mobility platform Didi. Only a couple of days after Didi IPO’d on the New York Stock Exchange, the Chinese cyberspace internet regulator started an investigation and disallowed Didi to register new users to its main app. At the end of the one yearlong investigation, Didi had to pay a fine of approximately 1.18 billion.

[00:21:03] Daniel Mahncke: Once again, the financial fine was not the biggest problem. The severe losses Chinese stocks had to take were mostly caused by the uncertainty around the international listings of Chinese companies. Suddenly, there was a huge debate about the VIE structure of Chinese stocks and the possibility of a forced delisting of those stocks.

[00:21:24] Daniel Mahncke: VIE stands for Variable Interest Entity and it’s an investment structure used by Chinese companies to enable foreign investors to buy their shares, which has not always been possible. It is also used by Chinese companies to enable public listings outside of China. Under the VIE structure, the operating company is owned by Chinese shareholders who act as nominees for foreign investors.

[00:21:50] Daniel Mahncke: This allows the foreign investors to take part in the economic benefits of the operating company pretty much exactly as if they would own the stock directly. This structure has been used without any major problems since the 1990s and early 2000s. The Chinese government accepted this practice and dozens of companies used it to collect money or list a board.

[00:22:13] Daniel Mahncke: But every now and then, mostly when it fits the general sentiment, it becomes a topic. Investors fear that the structure could be re-evaluated by Chinese authorities and claimed as illegal, resulting in a loss of their shares. This also became the dominant narrative from the second half of 2021 to at least the second half of 2022.

[00:22:35] Daniel Mahncke: Within this time frame, Alibaba lost another 60 percent of its market value. I think this is where we can discuss the last important regulatory incident and it’s kind of a full circle moment. We end where we started, with Ant Group. In July 2023, two and a half years after the call of IPO, Ant was fined close to 1 billion dollars for quote unquote corporate governance and financial consumer protection.

[00:23:04] Daniel Mahncke: Once again, this financial find was rather well taken by investors since it suggested the end of the investigation and regulatory breakdown. After almost three years of uncertainty, what remains for Alibaba are fines close to 3 billion dollars, a stock price decline of around 75 percent from its all-time highs, and a seemingly permanently damaged attitude towards Chinese stocks and this might be the main problem for Alibaba going forward.

[00:23:35] Shawn O’Malley: If we take a look at the capital inflows and outflows into Chinese markets from global investors, the picture is pretty clear. In absolute terms, in 2021, over 65 billion dollars’ worth of Chinese stock was purchased by global investors. In 2023, this number decreased to roughly 7.2 billion, which is a decline of 87%. Trust in the Chinese market and above all, the Chinese government has vanished, which is just a major problem for Chinese equities. From a fund manager’s perspective, holding Chinese equities has not only resulted in poor financial performance, but it also comes with a huge reputational risk and the constant need for justification from investors.

[00:24:22] Daniel Mahncke: The so called career risk, which basically describes how deviating from the crowd can cost an asset or fund manager his job when he proves to be wrong. Being wrong while going with the crowd is no reason to fire anyone, since everyone is in the same boat. But betting on a different horse and losing is a very bad look.

[00:24:42] Daniel Mahncke: Investors lose trust and withdraw their money and the manager becomes untenable for the company. Dynamics like these are fueling both boom and bust cycles. Professional investors cannot invest in what they think is the best opportunity. They are limited by their clients and thus forced to make the same mistakes as their clients.

[00:25:03] Daniel Mahncke: Selling when the sentiment is bad and prices are low and buying when the sentiment is good and prices are high. That’s one reason why Alibaba’s attractive fundamental valuation has not gained any institutional attention. However, besides the reputational damage and implications for institutional holders, there are also fundamental reasons for the failure to recover.

[00:25:27] Daniel Mahncke: I would categorize these into two levels. The first is the microeconomic level, which refers to problems within Alibaba’s business and operations. The second is the macroeconomic level, minus the already discussed regulations and politics. Let’s start by discussing the microeconomic level to paint a better picture of Alibaba’s financials as a whole.

[00:25:50] Daniel Mahncke: On the surface, Alibaba looks like a no brainer investment, judged by its fundamentals and, most importantly, the price you have to pay for it. But besides the uncertainty fueled by regulation and the political tensions between China and the U.S., there are also operational problems that worry investors.

[00:26:09] Daniel Mahncke: The biggest worry is Alibaba’s cloud. When Amazon’s cloud service, AWS, started to become more and more important to Amazon, investors hoped and expected that Alibaba’s cloud could have similar success. They had a comparable market position in their respective markets and the cloud market in Asia promised huge earnings potential and future growth.

[00:26:32] Daniel Mahncke: The truth is that after a very good start, Alibaba’s cloud experienced slower growth a lot earlier than investors and perhaps Alibaba itself expected. Its margins also fell short of investor expectations. It is currently the fourth largest cloud provider globally, which sounds great at first glance, but with a 4 percent market share, it’s far behind AWS with a 31 percent market share, Microsoft’s Azure with a 25 percent share, and Google Cloud with an 11 percent market share.

[00:27:04] Daniel Mahncke: Within China, Alibaba Cloud was able to gain the number one spot with 39 percent of the overall market. Its main competitors are Huawei which has 19 percent and Tencent which has around 16 percent market share. Maintaining leadership in the Chinese cloud market will be crucial since it would put the company in a pole position to benefit from a recovering Chinese economy and a cloud sector that is still expected to grow immensely in the long term.

[00:27:33] Daniel Mahncke: Last year, Alibaba was responsible for 12 percent of total revenues and 3. 5 percent of adjusted EBITDA, which is like EBITDA but without adding back depreciation. Adjusted EBITDA is a metric that Alibaba uses to adjust for expenses that it considers not reflective of its core operating performance. For comparison, AWS was responsible for almost 16 percent of revenues but an incredible 67 percent of operating income while growing 13 percent year over year.

[00:28:07] Daniel Mahncke: And this was a relatively weak annual growth rate for AWS. In the first quarter of 2024, Alibaba’s cloud revenue share decreased slightly to a little over 11%. Additionally, Alibaba reported a slow year on year growth rate of 3 percent for its cloud. The company stated that this was caused by a strategy shift to focus on the most profitable parts of their cloud business and cutting down less profitable ones, which results in less revenue, but also in higher profitability.

[00:28:38] Daniel Mahncke: As mentioned before, the cloud market is a typical winner takes it all market. And losing its dominating position within the Chinese market would make the future development of Alibaba Cloud even more complicated. And Alibaba’s main competitors in the cloud market, Huawei and Tencent, were both able to achieve respectable growth.

[00:28:59] Daniel Mahncke: Huawei’s cloud increased revenues by 17 percent in 2023. Tencent doesn’t disclose the exact numbers for its cloud since it is part of the fintech and business service section but was supposedly the main driver for the business sector to achieve a growth rate in the teens. It might have been around 16 percent since this has been China’s cloud service market growth overall in 2023.

[00:29:23] Daniel Mahncke: Whatever the exact numbers are, it is very clear that both competitors outperformed Alibaba’s cloud by quite a wide margin. However, Alibaba’s cloud’s core products supposedly grew by double digits and adjusted EBITDA grew 49 percent year on year because of the higher impact of profitable products. If this becomes a trend over the coming quarters, Alibaba’s cloud could once again become a strength instead of a disappointment.

[00:29:50] Daniel Mahncke: I consider the cloud to be the main catalyst for Alibaba on a microeconomic level. Other businesses in Alibaba’s ecosystem perform well and they are growing quickly, but none of them excite investors enough to change the narrative. Two of those businesses are the International Digital E Commerce and Changyao Smart Logistics.

[00:30:11] Daniel Mahncke: Each of them makes up around 11 percent of revenues, just as the cloud. But they show growth rates of 45 percent and 30 percent respectively. These are the kind of growth rates investors would like to see with the cloud, since there’s a lot more earnings potential in the long term. Also, both segments are not yet profitable, and therefore, currently, growth comes at a cost.

[00:30:35] Daniel Mahncke: The main driver of profits and cash flows remain the Chinese e commerce platforms, Taobao and Tmall. That’s where investors mainly focus on those when earnings are reported. And this part of the business, just like the cloud, went through a couple of quarters of slow growth. Mainly because of a slower than expected recovery from COVID and a weaker consumer in recent quarters. Year on year growth from Q1 of 2023 to 2024 has only been 4%.

[00:31:05] Shawn O’Malley: Alibaba’s cloud really has been disappointing in recent history. Why do you think that has been the case? Is it a problem within the Chinese cloud market or a business problem on Alibaba’s side?

[00:31:17] Daniel Mahncke: If we look at the numbers, it seems to be a bit of both. First, we have to understand that the Chinese cloud market is different from the American market. In general, there are three main types of cloud services. Infrastructure as a service, platform as a service, and software as a service. Infrastructure services are offerings in which the cloud provider supplies the client with on demand access to computing resources such as networking, storage, and service.

[00:31:45] Daniel Mahncke: Within the provider’s infrastructure, the client can run its own platform and applications. This provides a flexible hardware resource that can scale depending on the client’s storage and processing needs. Platform services are offerings in which the cloud provider gives the client access to a cloud environment to develop, manage, and host applications.

[00:32:07] Daniel Mahncke: The client also has access to a range of tools through the platform to support testing and development. The provider is responsible for underlying infrastructure, security, operating systems, and backups. Software services are the best known cloud offerings. The provider gives the client access to their cloud based software.

[00:32:28] Daniel Mahncke: Instead of installing the software application on a local device, clients can access the provider’s application using the web or an API. Bye. While it’s not important to understand the technical details here, knowing that there are different types of cloud offerings is important to understand the difference between the Asian and Western cloud markets.

[00:32:48] Daniel Mahncke: We will get back to this in a minute. The reasons for the bad cloud performance from within the company are hard to pinpoint. But judging from the repeating changes in the leading position of the cloud segment, it’s obvious that there will have been problems. While it’s unclear how this affects the cloud business, I’m pretty sure that it had a negative impact, even if it’s just the lack of direction or a shared strategy.

[00:33:13] Daniel Mahncke: The now changed course towards the core product and profitability is another indicator of this. On a macro level, the slow economic recovery after COVID caused companies to decrease their expenses, which also resulted in fewer investments in cloud services. In 2022, the Chinese cloud market only grew by 10%. However, last year, growth accelerated to 16 percent and from 2025 to 2032, growth is expected to be 20 25 percent annually.

[00:33:46] Shawn O’Malley: But it wasn’t only growth that slowed down. The margins also contracted due to price reductions initially started by Alibaba in April of 2023. Tencent and Huawei followed suit and decreased prices too in order to attract more customers.

[00:34:02] Daniel Mahncke: That’s right. And in February of 2024, Alibaba actually announced another 55 percent price reduction for many of its core cloud products. I think this strategy makes sense in the long term, considering the accelerated growth rates and the potential of the Chinese cloud market, attracting a big customer base now can prove valuable in the future when there’s the potential to raise prices again.

[00:34:26] Daniel Mahncke: And despite the price reductions, as mentioned earlier, Alibaba was able to improve the profitability of the cloud significantly by cutting out the low margin product. Of course, the most recent price reductions can have an impact on the results of the next quarter or two. But price reductions are not the only factor in the comparatively low margins of the Chinese cloud market.

[00:34:49] Daniel Mahncke: Now it’s time to return to the cloud market composition that we touched on a minute ago. While 80 percent of the public U. S. cloud market consists of software as a service and platform as a service, the Chinese market is dominated by infrastructure services, which make up about 74 percent of the entire market.

[00:35:09] Daniel Mahncke: And these cloud services offer significantly smaller margins. Do you know why these differences exist? Well, there are two main reasons for that. The first one is the development of the digitalization of records. For US companies, the digitalization cycle looked something like this. At first, everything was analog and on paper records.

[00:35:30] Daniel Mahncke: Then it evolved to documents, getting saved online. These online documents were turned into data, which led the way for complex IT systems, like the ones from Microsoft, IBM, Oracle, or SAP. With data already stored in these IT systems, the infrastructure was already there, and the cloud demand was mainly for platform and software services.

[00:35:53] Daniel Mahncke: In China, however, many companies, especially small and mid-sized companies, are still storing their documents in paper form or online but without any accessibility or the opportunity for further use by the average employee. Naturally, the next step would be the introduction of IT systems. But considering that cloud services have already taken over large parts of the market, many companies immediately use cloud services.

[00:36:20] Daniel Mahncke: However, without the same foundation as western companies, they have a focus on infrastructure and therefore mainly use infrastructure applications. A second reason is the historically low operational costs, and especially the cheap labor in China. As a result, manual labor has been the more cost effective alternative to cloud services for a long time.

[00:36:43] Daniel Mahncke: Chinese companies also prefer one off or upfront payments, instead of recurring cost models like software services. This is likely to be a cultural thing, but of course, recession fears also play a role. If you pay upfront, you can either afford it, or you can’t. If you enter into a subscription model, you might be able to afford it now, but in worse times, it could be too expensive, but the obligation to pay is still there. These are some of the underlying reasons for the different cloud markets.

[00:37:15] Shawn O’Malley: We’ve mostly discussed risks and narratives that caused the stock to struggle in past years. Yet we’ve said that it looks like a bargain from a fundamental perspective. Considering all we’ve discussed until now, what are the factors that make it so attractive in your view?

[00:37:32] Daniel Mahncke: Alibaba’s biggest strengths are its balance sheet and its ability to generate cash flows. Alibaba has a cash position of over 85 billion dollars. If we subtract the current and non-current debt and borrowings, we end up with almost 62 billion dollars in net cash. On top of that, Alibaba has another 85 billion in retained earnings.

[00:37:53] Daniel Mahncke: If we combine net cash and retained earnings, that’s 147 billion on a market capitalization of 195 billion. So there’s plenty of potential to buy back shares or pay dividends in the future. Alibaba started both in recent quarters. In terms of cash flows, Alibaba generated $25.3 billion of operating cash flows from Q1 of 2023 to Q1 of 2024, of which about $20.8 billion came out as free cash flow.

[00:38:26] Daniel Mahncke: The biggest cash outflow has been the repurchase of common stock with over $12 billion. Alibaba started its stock repurchase program in 2022 and has since bought back stock for 22. 5 billion dollars. However, Alibaba has relatively high stock base compensation. In the same time that they bought those shares back, they also gave out shares worth 10.8 billion dollars. This has been the case before. Alibaba has declared buyback programs of up to 10 billion dollars, but they weren’t fully utilized and the stock based compensation and the buybacks more or less balanced each other out. This time, it looks like the authorized 25 billion buyback program will be fully exhausted, since authorization in 2022, the share count declined for the first time and went from 2.65 billion to 2.4 billion, a share count decrease of almost 10%. If Alibaba’s management continues on this path, the buyback program will have a positive impact on the stock price sooner or later. And they have already authorized another 25 billion for share repurchases up until 2027. Combined with the rest of the latest program, this results in 35.3 billion available for repurchasing stock just in the next three years. If fully utilized and at current valuations, this would result in about 18. 5 percent of outstanding shares repurchased, before accounting for the future dilution through share based compensation. As we will see in the valuation later, with these fundamentals, Alibaba would even be cheap if we assume that growth will not regain any traction and it remains in the low single digits.

[00:40:14] Daniel Mahncke: But this is where one of the most discussed arguments from Alibaba bears comes into play. The question of how safe the assets of Chinese companies truly are. The regulation did show that the Chinese government can, if they want to, issue fines, freeze operations, IPOs and perhaps even assets. Some argue that while Alibaba’s balance sheet might look great, this could change quickly when Alibaba somehow falls out of favor with the Chinese government again.

[00:40:44] Daniel Mahncke: While this is a worst case scenario and unprecedented considering Alibaba’s size and importance, I believe this or a similar scenario is what scared the majority of international investors out of Chinese stocks. And considering the regulatory actions that we have seen, this might not be as much of a stretch as I would have thought prior to what we’ve seen in recent years.

[00:41:08] Daniel Mahncke: The rational argument would be that this makes little sense for the Chinese government since such a scenario, especially with one of the best known and most important Chinese companies, would actually weaken China’s economy and society substantially. However, some of the regulations that we have seen, for example the Didi situation, already prove that the Chinese government is willing to substantially hurt a company with all the macroeconomic consequences that are connected to this.

[00:41:37] Daniel Mahncke: Although it has to be mentioned that Didi was on a much smaller scale. Also, what I think is the most important factor is that sanctioning Didi’s IPO primarily hurt shareholders and not Chinese citizens. Didi might as well have been chosen because it has a huge media effect without lasting consequences for the Chinese economy.

[00:41:59] Daniel Mahncke: And while potential investors obviously prioritize the shareholder view, I think the smartest way to view Chinese investments is to take a look at what consequences companies and regulations would have on Chinese citizens. And wherever the interests of shareholders and Chinese citizens overlap, that’s a good place to be hurting Alibaba in a way that trickles down on consumers is a lot less likely than hurting Alibaba’s shareholders. Thus, the regulation that we’ve seen doesn’t seem as random as it might have looked at first glance. There were hardly any regulations that would have had consequences for Chinese consumers.

[00:42:40] Daniel Mahncke: The consequences for shareholders, however, were enormous due to the focus on regulation that hurt the reputation of these companies from a capital market view. 6. 3 trillion dollars. That’s the estimated number of wiped out stock market value since the peak in the Chinese market in 2021. And the vast majority of these losses are directly linked to the policies the Chinese government deliberately made, fully aware of the consequences.

[00:43:11] Shawn O’Malley: To give the listeners a perspective of this number, since dealing with the likes of Apple, Microsoft, and Nvidia might skew the perspective here, the combined market capitalization of the leading stock indexes from Germany, Italy, and the UK is roughly 6. 8 trillion. 6. 8 trillion. Now, imagine that 93 percent of the entire value of these three market indices is wiped out. This is the amount of money that the Chinese stock market lost in the last three years.

[00:43:38] Daniel Mahncke: Mind boggling to think about it that way. The question is, will this reverse? Can the Chinese stock market, can Alibaba get back to its old glory? Let’s talk about valuation and a possible future for Alibaba’s shareholders.

[00:43:52] Daniel Mahncke: I think the best way to start is to use one of the best known valuation tools in the financial industry, a discounted cash flow analysis. I know that this model has many flaws, among others due to the amount of assumptions that you have to make and the massive impact single inputs like determinant multiple can have.

[00:44:12] Daniel Mahncke: However, I do think that it can be helpful when the results are as clear as they are in Alibaba’s case. I also use three scenarios, a base case, a bearish case, and a bull case, in order to get a better idea of what can happen to the SOP depending on a range of outcomes. For anyone not knowing how a DCF works, let me explain it quickly.

[00:44:35] Daniel Mahncke: In a DCF, you discount all the future cash flows you expect a company to earn in a specific period, often 10 years. Back to today. The discount rate you use is, of course, a crucial input here. And there are many partially complex ways to come up with a discount rate. Banks usually use the weighted average cost of capital, the so called WEG.

[00:44:58] Daniel Mahncke: Buffett once said that he uses the 10 year U.S. Treasury rate. I personally use my annual return goal. I do this because this allows me to use the same discount rate all the time, which makes the results better comparable between different companies. Also, this is naturally a relatively high rate, which makes the result even more conservative.

[00:45:21] Daniel Mahncke: Now, before we discuss the results, my short disclaimer. Do not focus too much on the precise numbers. These are not price targets. Use them as a compass that shows the most likely direction if the assumptions of the case are met. Okay, let’s see what the results tell us. My starting point is the current free cash flow of roughly 20 billion dollars.

[00:45:44] Daniel Mahncke: In my base case, I expect a 4% growth weight over the entire 10 year period, a terminal multiple of 10, and I discount this at the high rate of 15%. This results in a value per share of $190 or an upside of almost 140% compared to today’s price. In my best case scenario, I assume that China’s economy recovers faster than expected.

[00:46:08] Daniel Mahncke: I therefore assume 10 percent annual growth over the next 5 years. From year 5 to 10, I increase this to 12%. I do this since in the best case scenario, the cloud will start growing again and become a significant part of Alibaba’s business and cash flows. These numbers would also shift the sentiment and I assume a terminal multiple of 20.

[00:46:32] Daniel Mahncke: This would give us a value per share of 412 or a 415 percent return. In my worst case, I assume zero growth over the first 5 year period. Over the second 5 year period, I did something that I’ve never done before, just to show you how cheap Alibaba currently is, measured by cash flows. I assume a decline of 2 percent per year.

[00:46:55] Daniel Mahncke: The terminal multiple is 5. Despite these inputs, this still gives us a value per share of 120. That’s a 50 percent upside from today’s price. So, from a fundamental point of view, Alibaba seems dramatically undervalued. However, we’ve spent a good amount of time today discussing the political and regulatory situation surrounding Alibaba.

[00:47:20] Daniel Mahncke: This is a very important part of Alibaba’s stock analysis. Since this is quite complex and many possible factors influence an investment decision here, it might help if I elaborate on my thought process and weighing of factors. First of all, and this is kind of the foundation, I hold the general belief that sentiment can change a lot quicker than people can previously imagine.

[00:47:44] Daniel Mahncke: As fast as the money flew out of China when the sentiment got worse and returns were bad, as fast will money flow back into the market when the sentiment or the economic outlook changes, which results in better returns. As always, no one wants to sit on the sidelines when everyone else is making money.

[00:48:03] Daniel Mahncke: It’s the good old Buffett wisdom. It’s not greed that drives the world, it’s envy. Secondly, I believe that businesses that are massively mispriced will reach their fair value sooner or later. The larger the company, the sooner it should happen. But don’t get me wrong here. A fundamental undervaluation does not necessarily mean that Alibaba is in fact mispriced.

[00:48:28] Daniel Mahncke: I believe the market is fully aware of Alibaba’s fundamentals but it chooses to focus on the narrative of uncertainty and I think that’s fair. However, China has a history of very strategic and long term planned politics. And if we take a look at the results of the regulatory circle that we have discussed, there was very little tangible impact.

[00:48:51] Daniel Mahncke: We have 6. 3 trillion dollars of value wiped out, versus a few low single digit billion dollar fines. The big risk of ending the VIE structure did not originate as a threat by the Chinese government, but rather as a narrative of western investors. So, in the end, very few of the fears that investors rightfully had materialized.

[00:49:15] Daniel Mahncke: Instead, the narrative changed every time it became clear that the old narrative did not play out. The current narrative is about the China US trade war and the tension between China and Taiwan. Once again, legitimate concerns. In today’s episode, we have mostly focused on regulation because that’s something concrete that we could analyze and see its consequences.

[00:49:39] Daniel Mahncke: These new narratives are mostly based on speculation. Personally, I consider the China US trade war to be the less relevant narrative of these two. Not because it won’t have an impact, but I think the range of possible outcomes is larger, which makes any forecast worthless. What is clear is that there’s the potential for a long term drag on the Chinese economy.

[00:50:03] Daniel Mahncke: But China knew this would come and will have prepared accordingly. A look at China’s trade balance also shows how well they are connected globally. In today’s age, other countries are way more dependent on China than the other way around. Thus, potential pressure from the United States towards other countries to stop trading with China is less effective than it used to be.

[00:50:27] Daniel Mahncke: And with their technological progress, I think bands like the USS Semiconductor Band are only short term hurdles and perhaps even speed up the process of China making their own. From an investor’s perspective, I consider the Taiwan situation to be the bigger problem. Mainly, because finding a way out of this situation is difficult.

[00:50:48] Daniel Mahncke: In 2021 and prior, China’s opinion on Taiwan was the same as now, and investors didn’t really care. So, the best case scenario would be that China slows down its public pressure on Taiwan and the situation calms down. Any other scenario is a bad scenario, even if nothing more happens. With the uncertainty in the air, this could lay like a shadow over the Chinese market Preventing a positive outbreak and causing opportunity costs for investors.

[00:51:19] Daniel Mahncke: In the end, both the China US trade war and the Taiwan conflict fall on the too hard pile for me. I don’t know what will happen. I can only assess the worst case scenarios and the results for Alibaba’s stock. After doing that, it’s just about how comfortable one feels with taking that risk. And I think that’s a pretty good description of what an Alibaba investment is all about.

[00:51:42] Daniel Mahncke: Are you willing to take the macroeconomic risks to buy a very cheap company with a strong fundamental margin of safety and the potential to surprise huge on the upside if the sentiment changes? There is no right or wrong here. It’s about the individual risk tolerance. Shawn, do you want to add any last words to this?

[00:52:02] Shawn O’Malley: Sure, Daniel. Generally, I feel like all the negative sentiment and risks often overshadow Alibaba’s best argument, its price. Alibaba’s price combined with its fundamentals offers a margin of safety against many of the risks that we have explained in detail in today’s episode. That said, as a matter of principle, I try to avoid Chinese companies, but I don’t hold it against investors who do look for opportunities there.

[00:52:27] Shawn O’Malley: The frustration with Alibaba is understandable, especially for long term investors who have been invested for most of the downward journey. However, investment decisions always have to be made with fresh eyes. Prior gains or losses shouldn’t really be a factor, and at today’s price, it seems like a lot of that negativity is already priced in.

[00:52:47] Shawn O’Malley: Apart from the worst case scenarios that you’ve mentioned, namely a direct conflict with Taiwan and the US, it’s totally understandable that many investors put Alibaba in their too hard bucket given the geopolitical and regulatory risks.

[00:53:01] Daniel Mahncke: Well, I had a lot of fun. I hope you all did too. Alibaba’s case is complex, but I think that’s exactly why investors can learn so much from it, independent of whether they would invest in Alibaba or not.

[00:53:13] Daniel Mahncke: With that said, I hope you enjoyed today’s episode and I will close with a quote by one of today’s protagonists, Charlie Munger. Microeconomics is what you do, macroeconomics is what you put up with.

[00:53:26] Shawn O’Malley: Yeah, thanks for that quote, Daniel. And it’s been really great to have you on to co-host today’s episode. I know a lot of people will find this case study on Alibaba really fascinating. I just want to thank you for your time and we’ll see you guys again, real soon.

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