Alibaba’s Cloud Business Isn’t as Profitable as You Think

Alibaba (NYSE:BABA) recently posted fiscal third-quarter numbers that easily beat analysts’ expectations. The Chinese tech giant’s revenue rose 37% year over year to 221.1 billion yuan ($33.9 billion), topping estimates by $530 million. Its adjusted earnings increased 21% year over year to $3.38 per ADS — which also surpassed expectations by $0.13.

The company revealed that its cloud business, which grew 50% year over year to 16.1 billion yuan ($2.5 billion) during the quarter, was finally profitable after bleeding red ink for over a decade.

An illustration of a digital cloud.

Image source: Getty Images.

That revelation might instantly spark comparisons between Alibaba Cloud and Amazon Web Services (AWS), the profitable cloud infrastructure platform that supports the U.S. e-commerce giant’s online marketplace. But such comparisons would be flawed, since Alibaba Cloud is not nearly as profitable as AWS.

Decoding Alibaba’s definition of “profitability”

At first glance, Alibaba’s cloud computing results don’t seem to make any sense. The segment’s operating loss actually widened year over year from 1.8 billion yuan to 2.0 billion yuan ($313.3 million) in the fiscal third quarter.

But on an adjusted EBITA (earnings before interest, taxes, and amortization) basis, Alibaba Cloud squeezed out a slim “profit” of 24 million yuan ($3.7 million). That total also excludes the unit’s stock-based compensation expenses, which rose 41% to 2.1 billion yuan ($316.2 million).

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Therefore, it’s unlikely that Alibaba Cloud will turn profitable on a GAAP basis anytime soon. But investors shouldn’t dismiss the strengths of this business as revenue rose 56% in the first nine months of 2020, and its adjusted EBITA loss narrowed significantly over the same period:

Fiscal Year

2019

2020

Nine Months Ended
Dec. 31, 2020

Revenue

$3.68 billion

$5.65 billion

$6.65 billion

Operating Income

($821 million)

($991 million)

($1.17 billion)

Adjusted EBITA

($172 million)

($199 million)

($72 million)

Data source: Alibaba financial filings. Table by author.

Alibaba also controlled 40.9% of China’s cloud infrastructure market in the third quarter of 2020, according to Canalys, putting it far ahead of Huawei Cloud (16.2%), Tencent Cloud (15.8%), and Baidu‘s AI Cloud (7.1%).

During the earnings call, CFO Maggie Wu attributed cloud growth in the quarter to robust demand from China’s “internet, retail and public sectors.” Wu noted that Alibaba Cloud’s ongoing infrastructure investments, along with its massive scale, enabled it to turn profitable on an adjusted EBITA basis, but she didn’t address the unit’s rising stock-based compensation expense or widening operating losses.

Don’t confuse Alibaba Cloud with AWS

Alibaba is often compared to Amazon, but the two tech giants operate completely different business models.

AWS is firmly profitable, and its growth supports Amazon’s lower-margin retail business. Meanwhile, Alibaba generates all of its profits from its higher-margin “core commerce” business, which supports the expansion of its unprofitable cloud, digital media, and innovation initiatives segments.

The company usually generates stable growth, but its core commerce business has been depending heavily on its lower-margin segments — including brick-and-mortar stores, direct sales channels, cross-border marketplaces, and its Cainiao logistics unit — to mask the slowing growth of its higher-margin Taobao and Tmall marketplaces in China.

That’s why the core commerce segment’s adjusted EBITA margin fell seven percentage points to 34% during the latest quarter, which drove company-wide adjusted EBITA margin down almost four points to 28%.

Alibaba probably won’t be able to strengthen its core commerce margins near term, especially as China’s antitrust regulators probe its e-commerce marketplaces, so it needs Alibaba Cloud to pick up the slack. That effort might partly offset the ongoing erosion of its core commerce profitability, but investors shouldn’t expect Alibaba Cloud to become an AWS-like profit engine anytime soon.

The bottom line

The growth of Alibaba’s cloud business is encouraging, but investors should remember three things: Its revenue growth will likely decelerate in the future; its stock-based compensation is rising; and it’s only profitable if you exclude those and other expenses.

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Looking ahead, investors should track Alibaba’s progress in expanding the cloud segment’s EBITA and how well that business can relieve the growing pressure on its core commerce business. If the company fails to execute this balancing act, its earnings growth will suffer.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.


View more information: https://www.fool.com/investing/2021/02/08/alibaba-cloud-isnt-as-profitable-as-you-think/

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