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Alibaba Buys NetEase Unit for $2 Billion

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Alibaba’s (BABA - Free Report) relationship with NetEase (NTES - Free Report) continues to strengthen as the two companies are now in a mutually beneficial deal. That deal will see Alibaba taking over Netease’s online luxury retail platform, Kaola for $2 billion in cash.

Alibaba and founder Jack Ma’s Yunfeng will infuse an additional $700 million into NetEase Cloud Music’s latest funding round for a minority stake in the company.

Under Alibaba, Kaola will operate independently, but its CEO Zhang Lei will be replaced by Tmall Import and Export general manager Alvin Liu.

The deal has been rumored for months but was apparently delayed because of a disagreement of terms.

Amazon (AMZN - Free Report) China was also apparently in the running.

Good for Netease

With the Chinese government easing restrictions on the sector, constituent companies can now apply for approval of online games and also charge users for newly launched titles. Since this is NetEase’s core business, this is where it needs to focus. Disposing off non-core assets will make this possible.

Moreover, Kaola was a fast-growing business that needed significant and continued investment. It wasn’t making any operating profit. So disposing of the business allows NetEase to cut losses.

Third, the cash generated will allow the company to strengthen its portfolio of games and help it compete better with rival and market leader Tencent in the gaming segment.

The music business, which raised $600 million in November when Baidu (BIDU - Free Report) , General Atlantic and Boyu Capital became stakeholders, is getting another cash infusion, despite the fact that Alibaba owns a competing platform in Xiami. This should help it compete with market leader Tencent Music Entertainment Group (TME). Government pressure recently forced the two companies to relicense more than 99% of their music catalogs. TME is currently under antitrust investigation over its music licensing agreements.

Good for Alibaba

The country’s largest online retail platform is making a larger push into cross-border trade, which has always been a focus area for management. This market is expected to grow very rapidly to touch 12.7 trillion yuan, or close to $1.8 trillion by 2020. The acquisition takes Alibaba’s 25% share of this market and pushes it up to 52.7%, according to iiMedia Research. Research firm Analysys estimates the combined share at closer to 60%. Whatever be the case, it is a leading market share and helps it compete with emerging rivals like Tencent-backed Pinduoduo.

Second, it strengthens Alibaba’s position in luxury retail, which according to Jane Hali & Associates, is a huge market in China. The research firm estimates that Chinese consumers make up more than 45% of global luxury sales, and were responsible for the 4-6% growth in sales this year, particularly in things like high-end accessories, apparel and beauty.

Third, Kaola has a larger presence in smaller cities, which allows Alibaba to expand geographically and tap the next growth phase, which will have to include these cities.

Alibaba hasn’t had the best of relationships with some of the top brands and these companies have complained regularly about counterfeits on its platform. To a certain extent, it’s hard to track exactly when this happens, but brands have held that Alibaba hasn’t been as vigilant as it could be. The fact that Kaola has direct working relationships with 9,000 brands from 80 countries including Gucci, Shisheido and Burberry, could improve its own relationships.

There could also be things to learn here. Tmall and Kaola don’t operate in exactly the same way, i.e., Tmall allows brands to manage their own stores on the platform, while Kaola has direct selling relationships with them.

Alibaba has the significant resources to continue investing in Kaola the way that it’s required and the way that it was probably harder for NetEase to do. 

Conclusion

Both are Chinese companies and could therefore have been caught in the crosshairs of the trade war. But this is unlikely to happen, as they largely take foreign brands to China and therefore help leading brands to sell in the country.

Alibaba in particular has traditionally been on very good terms with the Chinese government, so the government generally protects its interests. That’s why both Alibaba with its Zacks #1 Rank (Strong Buy) and NetEase with its #2 Rank (Buy) are worth your money today. You can also check out the complete list of today’s Zacks #1 Rank stocks here.

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