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Alibaba Widens Its Moat by Cozying up to NetEase With $2.7 Billion in Deals

Leo Sun, The Motley Fool

Alibaba (NYSE: BABA) last week agreed to buy NetEase's (NASDAQ: NTES) cross-border e-commerce platform Kaola for $2 billion. Kaola, which was launched four years ago, lets Chinese consumers buy luxury goods from overseas markets.

Alibaba will also acquire a minority stake in NetEase's music streaming platform, NetEase Cloud Music, for $700 million. Let's see how these two deals could widen Alibaba's moat and strengthen its core business.

Three connected jigsaw puzzle pieces.

Image source: Getty Images.

Understanding Alibaba's business

Alibaba is the top e-commerce player in China. It controls about 56% of the market, according to eMarketer, with four core marketplaces: its consumer-to-consumer platform Taobao, its business-to-consumer platform Tmall, its business-to-business platform Alibaba.com, and its overseas marketplace AliExpress.

Those businesses are firing on all cylinders. Alibaba's core commerce business posted 44% annual revenue growth last quarter, and it added 34 million mobile monthly active users (MAUs) across its marketplace to reach 755 million mobile MAUs.

Alibaba's core commerce business is consistently profitable and supports the growth of its other unprofitable businesses, including its cloud, digital media, and innovative solutions units. These businesses widen Alibaba's moat against ecosystem rivals like Tencent (OTC: TCEHY) and Baidu.

Alibaba's digital business has been a money pit for years due to the high costs of acquiring content for its Youku Tudou video platform and Alibaba Music streaming music platform. Both platforms are underdogs -- Baidu's iQiyi and Tencent Video dominate streaming videos, and Tencent Music (NYSE: TME) leads the music market.

How these deals help Alibaba

Alibaba's core commerce business faces two long-term headwinds: competition from Tencent-backed rivals like JD.com and Pinduoduo, and the gradual slowdown of the Chinese economy.

It's addressing these challenges by expanding its reach beyond China with its Southeast Asian marketplace Lazada, AliExpress for overseas buyers who want to purchase products from Chinese merchants, Alibaba.com for overseas businesses that want to buy products from Chinese suppliers, Tmall Global for connecting international brands to Chinese buyers, and Tmall International for direct cross-border sales.

Research firm Analysys claims that Tmall International currently leads the imports market with a 29% share, followed by NetEase's Kaola with a 22.6% share. Earlier this year Kaola was reportedly in talks to merge with Amazon (NASDAQ: AMZN) China, which controls 6% of that market. That deal is likely off now, but the combination of Tmall International and Kaola should still enable Alibaba to control over half of the cross-border imports market.

A tablet displaying an e-commerce icon.

Image source: Getty Images.

That's a smart move for two reasons. First, it reinforces Alibaba's reputation as the top e-commerce partner for luxury brands like Kering's Gucci and Burberry, which already sell their products on Tmall Global and Kaola. Second, affluent customers still make big luxury purchases during economic slowdowns, which could offset softer sales of cheaper products.

As for music streaming, Tencent Music controls over two-thirds of the market, while NetEase Cloud Music ranks a distant second with a market share in the mid-teens. Alibaba Music controls a much lower single-digit share of the market.

Therefore, buying a minority stake in NetEase Cloud Music could allow Alibaba to pool some of its streaming music resources (like content licenses) with NetEase, which could reduce the long-term operating expenses at its money-losing digital media unit.

How these deals help NetEase

NetEase generates most of its revenue from online games, but 28% of its sales came from its two e-commerce platforms -- Kaola and Yanxuan -- last quarter. The e-commerce unit's revenue rose 20% annually during the quarter, with Yanxuan growing at a much faster rate than Kaola.

Yanxuan's business model is more controversial than Kaola's since it sells "unbranded" versions of brand-name products, which come close to being full-fledged knockoffs. Yet NetEase seems comfortable taking that risk, and it clearly prefers to sell its slower-growth cross-border marketplace to focus on Yanxuan's growth.

NetEase could apply the proceeds from Kaola's sale toward expanding Yanxuan or developing new games -- which would widen its moat against Tencent, the 800-pound gorilla of China's gaming market.

Meanwhile, Alibaba's streaming music investment could boost the operating profit of NetEase's "innovative businesses" unit (which includes NetEase Cloud Music and other smaller businesses), which finally achieved an operating profit last quarter after years of losses.

A win-win deal

Alibaba's deal with NetEase benefits both companies. Alibaba expands its e-commerce and streaming platforms, while NetEase streamlines its business as its least profitable business gains a much-needed boost. Moreover, the deal widens both companies' moats against Tencent's ever-expanding ecosystem of services.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon, Baidu, JD.com, and Tencent Holdings. The Motley Fool owns shares of and recommends Amazon, Baidu, JD.com, NetEase, and Tencent Holdings. The Motley Fool recommends iQiyi. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com