We have studied Alibaba for a long time beginning with our investment in Yahoo, which represented a backdoor way to acquire Alibaba, not publicly traded at the time. In our year-end 2013 letter, we wrote the following on Alibaba:

“Founded by former English teacher Jack Ma, Alibaba is a phenomenon. The company dominates the world’s largest e-commerce market with a 49% share, compared to Amazon’s 20% share of the US online retail market. Approximately 73% of all online retail transactions in China utilize Alibaba’s online payment platform, Alipay. Alibaba possesses profit margins of 44% compared to 0.5% for Amazon.

It would not surprise us if in a few years’ time, Alibaba is amongst the world’s most highly valued companies.”

We visited the company again in our 2014 mid-year letter, as we outlined our rationale for purchasing Softbank:

“In short, we continue to believe that Alibaba represents one of the most compelling growth stories in global markets. With a nearly unassailable position within its business segments, enviable economics, and a long runway for growth, we believe Alibaba has a shot at becoming one of the most valuable companies in the world.”

It is fair to say our thesis on Alibaba has not changed. The company has a lot of things we desire in a business: network effects, switching costs, scalability, and latent pricing power.

Alibaba is a collection of business units, but is most well-known for its e-commerce segment consisting of Alibaba (business-to-business), Taobao (consumer-to-consumer and business-to-consumer) and Tmall (online shopping mall for branded goods). The group grew sales 54% year-over-year during the most recent quarter and counts 493 million monthly active users across its three platforms.

The supplanting of brick and mortar retail by e-commerce is happening more quickly in China than in the States due to less robust physical retail infrastructure. Chinese E-commerce sales grew 36% last year to approximately $900 billion and now represent roughly 18% of aggregate retail sales, compared to 12% in the US. With an 80% share of Chinese e-commerce, it is fair to think of Alibaba as a toll on online Chinese consumption. Chinese consumption trends should remain favorable with Boston Consulting Group predicting 20% annual growth in online spending over the next four years. According to eMarketer, a market research company, China’s online spending will be greater than the rest of the world’s e-commerce combined, providing ample runway for Alibaba’s ecommerce business.

Like Amazon, Alibaba’s multiple business units reinforce each other, creating a business ecosystem that grows more valuable with each additional user and transaction – a self-reinforcing business model. With one out of every three Chinese using Alibaba’s ecommerce options, the company possesses tremendous network effects. This provides Alibaba a platform for onboarding new services, such as Alipay (online payment), YunOS (second largest mobile operating system in China), Autonavi (China’s leading map service supplier), Tmall Supermarket (online grocer), Juhuasuan (group shopping) AliCloud (cloud computing) Youku Tudou (online video hosting and streaming) and others.

Alicloud and Ant Financial in particular are poised to emerge as lucrative growth drivers over ensuing years.

Alicloud is the leading cloud company in China with a 70% share. Like Amazon, Alicloud has aggressively lowered prices to rapidly scale, having dropped prices sixteen times last year. Increased economies of scale create a virtuous cycle with reduced prices attracting new customers, enabling greater scale and widening Alicloud’s competitive moat. In addition, Alibaba’s significant in-house demand for cloud computing services provides a natural platform to scale offerings and incubate new technologies, providing the company a substantial advantage over competitors.

AliCloud already has a $1 billion run rate and is expected to grow by a 100% compound annual growth rate over the next two years. However, because Alicloud is still in investment mode and sustaining operating losses, the market ascribes it minimal value. Amazon’s cloud business achieved operating margins of 22% once it reached $3B in sales, suggesting Alicloud could demonstrate profitability as early as next year. Once Alicloud demonstrates a profitability inflection we think the market will confer a rich multiple on its earnings stream. Ultimately, we believe Alicloud can be the Amazon AWS of China, but at its nascent stage of growth, the market does not yet recognize the potential. We saw a similar scenario play out with our holdings in Amazon and expect a favorable outcome with Alibaba as well.

While the market may not rerate Alibaba’s cloud business for a couple of years, a more immediate opportunity for monetization lies in Alibaba’s 33% stake in Ant Financial, a leading Chinese fintech company established by Alibaba in 2004. Ant Financial’s anchor product, Alipay, was launched by Alibaba to solve the core bottleneck to Chinese e-commerce, how to transact without widespread adoption of credit cards. With 450 million users, Alipay is now China’s most popular online payment method with a 68% share of the mobile payment market.

In addition to Alipay, Ant Financial offers a broad range of financial services and products including insurance, money market funds, wealth management, and credit scoring. Similar to its cloud business, Ant Financial’s scale provides the company an almost unassailable advantage. For example, Ant Financial’s wealth management unit, Yu’e Bao has 152 million active annual users compared to 9.9 million for Charles Schwab or 7 million for Chinese competitor Citic Securities. The company’s credit scoring service, Sesame Credit, is like FICO in the US and has scored 130 million credit profiles.

Established payment processors are typically difficult for new entrants to dislodge. New providers must navigate a trust gap with new users, which is difficult to do without scale. We are comforted by the fact that Alipay understands trust is its core product and key to its longevity – “No matter what kind of technology you’re using, trust is the most fundamental thing when it comes to financial services. Yes, you can use different ways of consumer marketing to get many users in a short period of time, but if you want to sustain a business, it has to be based upon trust.” – Eric Jing, Ant Financial CEO speaking at Davos earlier this year.

Beyond China, Alipay is making impressive gains abroad with 40 million overseas users transacting in eighteen currencies. Alipay is accepted by over 100,000 foreign merchants and has partnered with leading banks and payment vendors, such as Barclays, First Data and VeriFone. Perhaps most significant for Alipay’s opportunities abroad has been the company’s partnership with Uber, which accepts Alipay in 68 different countries. We expect Alipay’s overseas opportunities to expand considerably with the Chinese diaspora, as well as Chinese tourists, creating network effects to aid its adoption.

Ant Financial was valued at $60 billion during its last round of financing in April of 2016. Given its role as China’s de facto online currency, we expect a larger valuation upon IPO, rumored to be later this year. We expect Ant Financial’s IPO to be an important catalyst in highlighting Alibaba’s 33% stake in the company.

“Information is the oil of the 21st century, and analytics is the combustion engine.” –Peter Sondergaard, Gartner, Global Head of Research

Alibaba’s massive platform of users opens multiple pathways to monetize user data. Aggregation of data across media, e-commerce and entertainment channels provides a rich data set with myriad opportunities to cross-sell additional products and services to its large and growing base of customers. We expect Alibaba to monetize its data through the provisioning of merchant service and optimization tools. For example, Ant Financial utilizes Alibaba’s data to target personal loans and wealth savings vehicles to its customers.

Despite its dominant position and compelling growth opportunities, Alibaba does not have a demanding valuation. We think Alibaba’s core business should trade at least 25x forward earnings given its inherent operating leverage and projected annual sales growth of over 28% over the next few years. This results in a stock price of $114. If we add $15 per share for Alibaba’s investments and stake in Ant Financial, we arrive at a stock price of $129, 27% higher than today’s quotation. We expect emergent businesses such as Alicloud and digital entertainment to be material contributors to future economic returns providing downside support.

After Amazon, Alibaba is our second largest position.

The above post has been excerpted from a letter to partners of Coho Capital Management.