Please refer to our disclaimers, which can be found in the footnote of this page and here.
Performance for 1Q 2024 was+2.6% net (vs. the MSCI ACWI at +8.2%). Since inception, the portfolio has compounded at +18.4% gross / +15.7% net (vs. the MSCI ACWI at +12.8%), representing +5.6% gross (+2.9% net) annualised outperformance. Top contributors for the quarter were Salesforce, Meta Platforms, and Alphabet. The biggest detractors were Charter Communications, Twilio, and Snowflake.
In late 4Q 2023, we reduced our positions in Block, Twilio, and Salesforce. All three decisions were driven by strong price appreciation requiring an adjustment in position size. We also re-entered Visa, a company we have owned previously. In 1Q 2024, we reduced our positions in Meta Platforms (price above $500), Salesforce (price above $300), and Okta (~$108), again due to price appreciation and position size. We added incrementally to Charter Communications and Alphabet. Charter Communications was down -25% for the quarter. It sold off following an earnings report as residential broadband growth continues struggle while fixed wireless takes incremental share (discussed below). Alphabet was down mid-quarter (when we added) on the usual concerns around the impact of AI on search but finished the quarter up +8%. Alphabet also had a strong 1Q 2024 report and is up significantly post quarter-end. We began the quarter with 13% cash and finished with 10%. We continue to see markets as expensive, with the exception of China.
Returns Summary
Portfolio Statistics
We typically split our time equally between existing and new positions. Our most recent areas of new work in 2023 included architectural design and construction software, insurance software, carbonated beverages, and coffee. We underwrote several businesses in depth but made no purchases for valuation reasons. This quarter, we revisited the Chinese eCommerce landscape to re-underwrite our position in Alibaba. It also led to a potential new position that we have been underwriting in depth, and we hope to share more in our next letter. We also spent time this quarter re-analysing our position in Charter Communications, which sold off following its 4Q 2023 earnings report.
We have owned Alibaba since the inception of the strategy, and it has been a key detractor of performance. Our commentary here is intended as an update rather than an overview of the business. For those unfamiliar, Alibaba is a large conglomerate in China. Its primary business is China’s largest eCommerce marketplace (Taobao/Tmall), which attributed 141% of EBITA in FY2023. It has various other businesses including China’s leading public cloud business, payments, various direct sales eCommerce/retail businesses, international eCommerce, food delivery, logistics, and a long-form video business. A good summary of the business can be found here.
The principal reason for its underperformance, other than the macro, is the stalling of growth in its core domestic eCommerce business (Taobao/Tmall) and its cloud business. Taobao/Tmall have been impacted by the entry of Pinduoduo (another eCommerce marketplace) as well as Douyin and Kuaishou (both social / short-form video entertainment platforms with burgeoning eCommerce businesses). Additional factors included the cancellation of the company’s planned spinouts as well as the removal of former CEO Daniel Zhang.
We were first introduced to Pinduoduo in 2018, while it was still a private company, and have followed the company since then. As we mentioned in our last letter, we were sceptical of the sustainability of its aggressive advertising and marketing spending to buy market entry. We were wrong. As it turns out, the company had exceptional execution and it is now a fully scaled business with similar incumbent advantages to Alibaba’s Taobao. It is a remarkable feat as prior to its rise, the strength of the incumbent platforms should have enabled them to rebuff Pinduoduo’s entry. As we discuss in our business quality framework, network effect business models have some key vulnerabilities. In this case, Pinduoduo targeted a value proposition (“very low-price value-for-money”) and a customer segment (lower income / lower tier cities) that wasn’t being served adequately by Taobao/Tmall and others. This, alongside great execution, enabled the company to establish a strong foothold from which to expand. Pinduoduo also pioneered the team-purchase model, which enabled greater discounts for group orders and incentivised word-of-mouth customer acquisition, enhanced by smart use of social acquisition channels such as WeChat (at the time unavailable to Alibaba given competitive exclusion from Tencent). China’s economic hardship over the last 3 years also had a role to play as it meant a general shift towards lower-priced items just as Pinduoduo came to scale.
Alibaba unintentionally aided Pinduoduo by degrading the Taobao merchant value proposition over time. As higher-value products were sold through Tmall, with higher associated platform marketing spend, Alibaba was able to boost its profits by directing more traffic from Taobao to Tmall. That is, they did not create an even playing field for traffic acquisition spending between the two. Our channel checks indicated that this left merchants frustrated. It also made it harder for Alibaba to reverse this stance as it would hurt margins and cash flow. Alibaba was also slower to adopt the manufacturer-to-consumer model in its domestic business because of the disruptive impact this would have on 1688.com, its domestic wholesale marketplace. Both issues meant Alibaba faced a counter-positioning[1] problem from Pinduoduo. We think management now realises its error and is working to rectify this with its “Return to Taobao” strategy. Alibaba had also become a bloated organisation. Various former employees complained to us about too many mid-level managers, too much competition for shared tech resources, and too many hoops to jump through to execute on new things. In contrast, Pinduoduo is much leaner and has an aggressively entrepreneurial culture. This makes Alibaba much slower to adapt and change. Alibaba has been responding by reducing headcount, which may help, but we think this advantage is a hard-to-replicate cultural edge for Pinduoduo.
We think Pinduoduo, and others like Douyin, will continue to steal share from Taobao/Tmall. However, we do not think this is the end of Taobao/Tmall. They too serve a strong value proposition and continue to maintain strong user engagement as the largest platform by gross merchant value (“GMV”…i.e. sales) and timeshare. We have spoken with various merchants who sell through the platform. In fact, most of the brands we spoke with were very negative about selling through Pinduoduo as they did not want their brand associated with a discount platform. Some had indicated that they are closely watching the space and may consider offering only clearance items. When asked why Tmall’s growth was struggling, their view was that it was more likely due to the macro-economy and some impact from Douyin, where the branded merchants are allocating marketing budget. They argued that Tmall remains “the” platform for branded goods. While the macro-economy suffers in China, higher-priced branded retail is likely to remain depressed, but we do not see this as permanent. We had always underwritten a share loss for Taobao/Tmall, but we now underwrite a greater decline. At first (in 2018/19), we underwrote a stable margin in the core business, but we now assume a continued decline. It is hard to know exactly where the margin will stabilise, so we reverse the question and consider what we need to believe given the current share price.
Alibaba’s cloud business has also decelerated. We would expect this given China’s macroeconomic backdrop, but it has also been impacted by the migration of TikTok from its services after the US mandated TikTok to store data domestically in the US. That aside, Alibaba’s cloud business is complicated. The reported numbers are not purely public cloud. They also include its content delivery network (“CDN”) services and managed private cloud businesses, which are both lower margin businesses. The public cloud penetration in China remains well below the US but, according to China Chief Information Officer surveys, the public cloud remains a strong priority. These same surveys indicate Alibaba Cloud as a top beneficiary of this shift. As indicated by other positions in our portfolio, we strongly believe in the value proposition of the public cloud. As the public cloud part of the business continues to grow, it represents a greater and greater share of the overall cloud revenue. Management disclosed that it reached 70% of its 3rd party total cloud revenue in 3Q 2023. We think some of these issues are masking a good business underneath. We are now underwriting continued pressure on the cloud business in 2024 with a re-acceleration from 2025 as some of these issues roll off.
Alibaba currently trades on a low double-digit forward-free cash flow (“FCF”) yield. We think the overall business can very conservatively compound FCF in the high single-digits. Even without a compression in the FCF yield when the China macro-economic picture stabilises, this provides a high-teens IRR[5] over 5 years. There is a lot embedded in this, but in brief, we can achieve this even assuming flat revenue growth in the core eCommerce business (low single-digits GMV growth, equating to roughly 8% share loss, offset by compression in the monetisation rate due to competition) as well as further margin pressure. It assumes the cloud business recovers (as mentioned above) with modest margin expansion with scale, and reduced losses in non-core businesses (either through business improvement or divestment). We sense check this with a conservative sum-of-the-parts valuation. In essence, we only need to believe that the core eCommerce business can stabilise to produce attractive returns. We think it can.