Summary

• Alibaba's stock jumped nearly 50% in a month, fueled by AI optimism from the DeepSeek news and a potential AI partnership with Apple in China.

• The company's core retail business is stabilizing, and overall revenue growth has accelerated on a year-over-year basis in 2Q FY2025, driven by strong performance in the cloud segment.

• While increased spending on AI infrastructure has impacted FCF, down 70% YoY in 2Q, it is expected to drive higher cloud revenue growth, helping to diversify Alibaba's revenue mix.

• The recent rally has pushed its non-GAAP P/E fwd to 13.9x, which still looks attractive, despite potential near-term consolidation.

• I believe BABA's multiple expansion will be driven by AI innovations, despite geopolitical risks and a slower-than-expected macro recovery in China.

Robert Way

Investment Thesis

Alibaba Group Holding Limited's (NYSE:BABA) (OTCPK:BABAF) saw its stock jump more than 50% in one month amid growing investor optimism over its AI boom, pushing it into overbought territory. As a high-quality stock with a distressed valuation, I'm not surprised by the magnitude of the rally. BABA's low valuation reflects two key factors: subpar growth in its core retail business and geopolitical risks associated with China.

That said, I believe the stock still holds tremendous upside potential. BABA represents a long-term transition play, shifting from a retail-driven business to AI innovations, supported by its accelerating capex growth on AI infrastructure. Additionally, it benefits from policy tailwinds from PBOC. The recent rally was also fueled by a submitted proposal regarding a potential partnership between Alibaba and Apple for iPhone's Apple Intelligence ("AI") services, though a final decision is expected to take several months.

In my last article in 1Q FY2025, I maintained a Buy rating on the stock, citing a potential reacceleration in its core retail revenue in 2H FY2025. Since then, the stock has rallied more than 50%. Despite the ongoing AI-driven momentum, BABA’s revenue growth outlook is being driven by a rebound in its core retail business. In 2Q FY2025, we saw stabilization in core retail revenue, signaling a potential inflection point. Therefore, I strategically maintain my Buy rating on BABA but anticipate some near-term consolidation.

AI Optimism Is a Turning Point for Market Sentiment

Although sentiment around Chinese stocks remains heavily influenced by geopolitical headlines, including Trump's tariff policies against China, I believe investors are increasingly focused on BABA’s long-term growth potential. The stock’s valuation should be discounted to reflect the slowdown in its core retail business due to intensified competition, particularly from rising star PDD Holdings Inc. (PDD). To drive long-term growth acceleration, BABA must continue diversifying its revenue sources.

A few weeks ago, the DeepSeek news created a temporary shock in the U.S. tech sector. As investors debate whether there are more cost-effective ways to develop AI technology, we are seeing a gradual shift in attention toward Chinese tech stocks. From a sentiment perspective, this is a positive catalyst for BABA. I see it as an inflection point that could drive the stock higher, as Chinese stocks have largely traded based on sentiment in recent years.

Core Retail Business Shows Signs of Stabilization

The company model

In 2Q FY2025, BABA’s China Customer Management segment showed early signs of a growth rebound, with revenue increasing approximately 2.5% YoY, indicating stabilization. However, its direct sales and other revenue declined by 5% YoY, primarily due to weaker appliance sales in China.

The macro backdrop in China remains weak but is gradually improving. China’s online retail GMV grew 6.4% YoY, down from 9% YoY in the previous year. During the 2Q FY2025 earnings call, management expressed confidence that government stimulus measures, including appliance trade-in programs and platform coupons, will help drive growth over time.

As shown in the chart above, overall revenue growth accelerated, reaching 4.9% YoY in 2Q FY2025, up from 4% YoY in 2Q FY2024. This improvement was largely driven by a favorable revenue mix from the cloud segment, boosted by AI innovations.

Strong AI Cloud Growth Fuels Revenue Rebound

The company model

BABA's Cloud Intelligence Group segment remains robust, with revenue growth reaccelerating to 7.1% YoY, the highest since 1Q FY2023. Meanwhile, the segment's adjusted EBITDA margin also improved sequentially to 9% in the last quarter. During the earnings call, the management highlighted that revenue from AI-related products maintained a triple-digit growth for the fifth consecutive quarter.

As BABA continues investing in Alibaba Cloud Infrastructure, FCF was down nearly 70% YoY in 2Q FY2025. However, investors should focus on the "J curve" effect of these AI investments. I believe Alibaba Cloud, as a leading AI cloud service provider in China, will be the biggest beneficiary from the ongoing AI boom (especially as Jack Ma scandal has faded). Moreover, Apple recently announced a partnership with BABA for its iPhone AI services, choosing BABA over its AI competitor Baidu (BIDU), which further boosts investor sentiment.

AI Partnership with Apple: A Game-Changer?

Although we do not yet know when Apple Intelligence will receive regulatory approval in China, the market is excited about the potential partnership. More details are expected at Apple’s Intelligence Developer Event in China on March 24th. I believe this partnership presents a "win-win" scenario for both companies. On the one hand, Apple could boost its sluggish iPhone sales in China by offering consumers access to Apple Intelligence features, making its products more competitive against Huawei. On the other hand, BABA would benefit from increased demand for its AI cloud services, further strengthening its cloud revenue outlook.

Valuation Remains Cheap, But Near-Term Consolidation Expected

Despite a 50% rally over the past month, BABA is still trading at an attractive multiple. Its non-GAAP P/E fwd is currently at 13.9x, which is 20% below the sector average, according to Seeking Alpha. Additionally, with its P/E also 11.5% below its five-year average, I think BABA's valuation remains reasonable and not overly stretched. While its P/E multiple is higher than BIDU 9.4x and JD.com's (JD) 9.6x, this premium reflects stronger AI growth optimism as seen with most U.S. AI mega-caps trading at over 30x P/E. Of course, geopolitical risks will likely continue to compress BABA's multiple in the foreseeable future.

There are some other downside risks for BABA. In the near term, I expect the stock to remain volatile and likely trigger some technical consolidations. Its 14-day RSI is currently at 84, significantly above the overbought threshold of 70. At the same time, the stock is approaching its 52-week high of $127, a key resistance level. As a result, any pullbacks could present an attractive buying opportunity for investors.

Another downside risk is the reversal of multiple expansion due to faded AI optimism, driven by the rejected approval of the Apple partnership. The stock remains heavily influenced by market sentiment, primarily tied to its AI initiatives. As previously mentioned, its core retail business remains weak, with the Taobao and Tmall Group segment growing only 1.4% YoY in 2Q FY2025, down from 4.2% YoY in 2Q FY2024. However, I believe that as long as BABA continues to accelerate its cloud revenue growth on a QoQ basis in the coming quarters, it can sustain higher multiple expansion despite a potentially slower-than-expected recovery in its retail business.

Conclusion

In summary, BABA's recent rally can be justified by its strategic focus on AI innovations. While Chinese stocks are currently impacted by bearish sentiment due to geopolitical risks, recent bullish sentiment has been fueled by the DeepSeek news and the potential partnership with Apple's AI services in China. However, the stock could still experience volatility and be heavily influenced by headline news. While BABA's core retail business has not yet seen a clear inflection, growth has stabilized, and I expect a gradual rebound in 2H FY2025. The recent growth acceleration in overall revenue was largely driven by its cloud intelligence segment. Despite being bullish on the stock, I do expect some near-term consolidation, which could present a buying opportunity for investors.

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