Alibaba's Cloud Ambitions Taking Shape for Investors

(Bloomberg) -- If there was one thing that stood out from Alibaba Group Holding Ltd.’s quarterly earnings report, it was a tripling of revenue from its fledgling cloud business.

Analysts have highlighted sales from its cloud division, known as Aliyun, which soared 175 percent in the March quarter to more than 1 billion yuan ($154 million). Alibaba now has more than half a million paying customers for its services and Chief Financial Officer Maggie Wu said it’s “getting very close to the break-even point” as it tries to build a challenger to Amazon.com Inc.

Like Amazon, Alibaba’s cloud service emerged from the enormous computational power needed to handle millions of online shopping transactions. But unlike its U.S. counterpart, it enjoys home-field advantage in a vast Chinese market where Internet-based computing is still novel to many enterprises. Its push into cloud, where software and services are provided to customers via server farms the size of football fields, prompted a second data center in Silicon Valley in October and preparation for its first in Europe.

“Many investors currently undervalue Aliyun’s long-term market opportunity, and we believe Alibaba is well-positioned to be the cloud computing leader in China due to preferential government policy, regional focus, domain expertise,” Colin Sebastian, an analyst at Robert W. Baird & Co., wrote Friday, adding that it could become the Amazon Web Services of China.

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Borrowing a Playbook

Alibaba is taking a page from Amazon, which developed internally and gradually expanded into a commercial enterprise that’s now the U.S. company’s fastest-growing and most profitable division. Along the way, Alibaba forged partnerships with industry giants like Intel Corp. and Nvidia Corp. In July, the division’s president proclaimed it could match or even surpass Amazon within three to four years. An Amazon spokeswoman didn’t respond to an e-mailed request for comment.

To be sure, Alibaba has only recently begun to make inroads beyond China and into a global market dominated by Amazon and Microsoft Corp. Cloud computing has matured in the U.S. and Europe, where margins have come under pressure in the face of heated competition.

For now, it’s the growth potential that’s impressing analysts. Even though Alibaba posted a better-than-expected 39 percent revenue rise in the March quarter, its e-commerce operation remains tied to a decelerating Chinese economy and hasn’t made great strides overseas. Investments into new areas such as on-demand services aren’t expected to contribute much to the bottom line for now.

RJ Hottovy, an analyst at Morningstar Inc., called Alibaba’s cloud unit a “notable standout” and wrote in a note that he plans to increase his fair value estimate for the stock based in part on a better long-term outlook for the business.

See also: From Alimama to Apsara, Alibaba Operates a Powerful Proprietary Cloud

Story of Potential

While cloud computing remains just 4 percent of Alibaba’s overall business, it could account for more than $1 billion of sales by 2018, according to SunTrust Robinson Humphrey Inc. By comparison, Amazon Web Services’ revenue rose 64 percent to $2.6 billion in the March quarter.

It’s got much more potential than the core business, according to Ray Zhao, analyst at Guotai Junan Securities Co. Its expansion will drive up Alibaba’s earnings multiple as investors place more value in the cloud unit, he said. Alibaba is valued at about 24 times estimated earnings compared with Amazon’s 63 times. The Chinese company said its customers hail from industries beyond e-commerce, and is betting on its potential in segments from health care and games to financial services.

“When it reaches tremendous scale, it has a tremendous amount of operating leverage,” Wu said on a post-earnings conference call. “We are looking at over the course of this year that this business will not require a lot of additional investment into the business as it’s generating cash flow.”