Description

Are you looking to invest in one of the most dominant retail, logistics, and technology businesses in the world? Not only that, but what if I also told you that it has captured almost a third of one of the fastest growing markets in one of the fastest growing countries in the world? If any of that intrigues you, then look no further than JD.com.

Overview of Company

JD.com was founded in 1998 by Richard Liu, originally as a Beijing-based electronics store. After moving the business online, Liu made the decision in 2007 to begin heavy investment into the construction of warehousing and logistics services. Liu’s vision entailed owning the entire value system, from the search to the order, to the customer’s receipt of the product. Since its humble beginnings, it has grown into China’s largest online retailer, generating approximately $491.5 billion in GMV and $149.3 billion in revenues (up 27.6% YoY) throughout the 2021 fiscal year.

At face value, JD seems to be a business with razor thin margins which continues to burn cash even after reaching massive scale. Often seen as the little, annoying brother to well-known internet tech darlings such as Alibaba and Tencent, JD is used to being overlooked. But the real story is that it’s a sleeping giant that is obsessed with providing the best products through premium customer service, and it’s just a matter of time before the beast wakes up.

When I write about JD.com, I’m writing about a business that is severely under-earning on multiple accounts. The nature of the business’s operations creates an accounting mess that makes is difficult to wade through in determining how much money it truly makes. Management has touched on this by writing about the difference between the CFO and net income. These differences include non-cash expenses, such as share based compensation, unrealized loss on fair value of equity investments, depreciation, amortization, and changes in net working capital (primarily in the form of accounts payable). Overall, the business is very healthy and cash generative, with the net income number not accurately reflecting its true cash earnings power. Even the cash flow is being suppressed, with the business passing on essentially all its benefits from scale to customers in the form of more affordable prices, quicker delivery times, and a greater product selection.

Current Market Price and Equity Investments

As of today (July 21, 2022) the stock is currently at $63.26 a share, denoting a market capitalization of $97.7 billion, and is down over 30% from the high of last November. Like its Chinese peers, the business has sold off due to concerns of the CCP’s iron fist and its ability to single-handedly wipe out entire industries (i.e., for-profit tutoring).

**Also note: whenever I speak about “shares” I am referring to the ADS

On a positive note, JD also has a significant amount of cash and equity investments. They have approximately $30 billion (or $19.63 per share) in cash, cash equivalents, and short-term investments on the balance sheet. In addition, they have major equity investments that they have maintained in companies they have spun off, with the most notable being JD Health (78% ownership) and JD Logistics (63.5% ownership), which have a combined market value of approximately $28 billion as of this writing. I decided to leave these equity investments in the valuation because JD owns a majority of the shares of both businesses and continues to consolidate the performance of each in their financials. Both spin offs also play key roles in many long-term pursuits and financial levers that JD will have access to in the future. So overall, considering the $30 billion of net cash and short-term investments, you are really buying a piece of the company for an enterprise value of $67.7 billion.

·      Other significant JD equity investments:

o   41.7% stake in JD Technology (formerly JD Digits) – $12.41 billion based on June 2020 private valuation of $30 billion

o   13% stake in Yonghui (SHA: 601933) – $750 million

o   1.49% ownership of Vipshop (NYSE: VIPS) – $86.79 million

o   33% of ATRenew (NYSE: RERE) – $191.93 million

o   Approximately 17.5% ownership of Xingsheng – based on $700 million investment in December of 2020, private valuation of $4 billion as of July 2020.

Considering the volatility of the market and that some significant valuations were determined privately, I have decided to continue including all of these equity investments in JD’s valuation to be as conservative as possible.

Cash Flow, Income, and some fundamentals

·      Cash Flow FY21

o   2.76% FCF margins

o   Generated $6.64 billion in cash flow from operations, resulting in $4.12 billion in free cash flow (Capital expenditures of $2.52 billion, net of property sale proceeds. Also adds back non-cash drag from receivable drop in JD Baitiao subsidiary).

·      Income FY21

o   0.44% operating margins, $650 million in operating income

o   $(701) million in net income, negative margins

·      Multiples

o   10.19x EV/CFO

o   16.43x EV/FCF

o   104x EV/OI

o   Net Income multiples irrelevant (negative)

·      569.7 million customer accounts as of December 2021

·      Currently has 29.6% market share in Chinese business to consumer (B2C) retail ecommerce

Commentary on Business Structure

One of the main questions that intrigued me was related to how JD achieved scale in such a difficult environment. Being in China, especially in the early 2000s, capital in any form was extremely difficult to come by. This is why first mover advantages have been so important and why the companies that made it out of the trenches alive tend to exemplify such a dominant market position (i.e. Alibaba and Tencent). The only difference is, these two tech giants started by creating a cash cow that had extremely low start-up costs, and then moved into more capital-intensive projects after they had a base layer of money to reinvest and operate from. JD was (and still is) completely different. They dove head-first into one of the most capital-intensive industries in the world: logistics and fulfillment. Not only this, but their “base layer of cash flow” they operated from was generated through their online retail business, which is an industry that has always had razor thin margins.

So how did they do it? JD is unique for its geographic market (but similar to Amazon from the US) in the sense that its core business started and operates from a negative working capital position. This means that it consistently exhibits current liabilities that are greater than its current assets. Although this may seem a bit counterintuitive at first, there are really two main aspects of the balance sheet that need to be focused on when it comes to JD. One is inventory and the other is accounts payable. Essentially JD, being a retailer, must order products from suppliers. They then mark these products up and sell them to customers on JD’s respective websites. The products they have on hand before selling are noted as “inventory” and what they owe suppliers for this inventory is denoted as “accounts payable.”  JD discusses these a bit in their annual and quarterly reports and notes their average accounts payable turnover and inventory turnover. As of last year, the average accounts payable turnover was about 45.3 days, whereas inventory turnover was 30.3 days. This means that JD sold their inventory at an average of just over two weeks faster than they must pay their suppliers for these same products. So, due to this fundamental attribute, the company has a consistent “float” (to quote Warren Buffett) that is the equivalent of the cost of their inventory plus any extra net cash flow from selling the products. This leads to the retail business essentially running itself on a gross basis! What’s more, with growing demand and scale, this float will continue to grow and compound on itself. This strategy also describes how the business was able to build up an immense cash position (almost $30 billion) over the years. It will also continue to aid JD into the future as they use the excess cash to pay back shareholders through dividends and buybacks, but more importantly, as they use the cash to fund pursuits in fields that will allow them to leverage their massive user base and scale.

Market Overview and Competitive Landscape

In a general sense, even with all the issues that have arose over the past year and half regarding the CCP, the Chinese economy is still an extremely attractive market for businesses to operate in over the long term. As it goes with all analyses of Chinese stocks/businesses, there is the general focus on the long-term continued resilience and growth of the Chinese consumer. This comes via the wealth creation that is steadily compounding throughout all levels of society, but most prominently in the middle class. Because it is a topic greatly discussed, I will list just some of the main facts that I think will play an important role in the improvement of JD’s business fundamentals over time. Here are a few of those factors:

·      China has the most rapidly growing middle class in the world, with 60% of urban consumption expected to be driven by the upper-middle income class by 2030, compared to just 35% today

·      The current hotspots for companies hunting for consumers are in major urban areas of China, such as Beijing and Shenzhen. And as of now, they are right to be looking here, considering that individuals in the nation’s 30 largest cities spend over 80% more than the national average on a per capita basis. But looking beyond this, many more rural cities are exhibiting household income growth that is multiple times faster than the larger, more urban areas.

·      China’s retail ecommerce market has grown to over $2.4T in trade volume as of 2021, with about 24.5% of all retail transactions made online. This value is expected to increase to $3.6T by 2025. This implies a compound growth rate of just over 14%.

·      Chinese nationalism continues to grow and maintain its prominence. Many citizens in China are much less likely now to place extra value on foreign brands as compared to the early 2000’s. A study of 5,000 citizens in 15 Chinese cities showed that, in 2020, 85% of them would purchase Chinese brands over foreign brands. This compares to just 15% who said the same thing in 2011. This greatly benefits ecommerce retailers like JD, which tend to sell a majority of products created by Chinese companies.

·      Consumers in China have proven to be one of the most willing populations when it comes to experimenting with digital innovation. They are ahead of the game in a lot of digital technology, and as it invades more aspects of everyday life, this provides businesses like JD with a vast amount of customer touchpoints and data.

·      Some of the specifics above (along with other great China macro information) are from: https://www.mckinsey.com/cn/our-insights/our-insights/five-consumer-trends-shaping-the-next-decade-of-growth-in-china

The Elephant in the Room (CCP/government)

Buying stock in JD also means that you are entering a market that many deem as uninhabitable. There are thousands of articles and write-ups on the macroenvironment in China, and it’s clear where many of my Western peers stand in terms of their sentiment. Although we have drifted away from the point of max pessimism over the past couple months, many Chinese enterprises still offer some of the best deals on the market. I understand many of the counter arguments and I am as fond of the CCP as the next guy (which is not very much), but I do think that the Chinese government has a deep understanding of market dynamics and what it will take for China to succeed on a global scale. I believe they understand the importance of a market that is at least relatively free, and along with this also see the value that massive internet tech giants like Alibaba, Tencent, JD.com, and so on, have all created for the country over the past 20 years. I do not think they have the desire to completely squash out these companies or truly hinder their cash flow. This would be a net negative for society and would make it nearly impossible for Xi Jinping to reach his goal of doubling the country’s GDP by 2035. So, from a macro perspective, the investment comes down to the belief that the CCP may be power hungry, but they have goals, and these goals are not able to be achieved unless they work in tandem with (not against) private corporations.

Competition

Major competition manifests itself in the form of a few different beasts. These include Alibaba (more specifically Tmall), Pinduoduo, and Tencent.

·      Tmall: accounts for 62.8% of China’s total B2C retail ecommerce market and serves as JD’s most prominent competitor. It operates as a marketplace where higher end brands, such as Gucci or Nike, sell to Chinese consumers. Businesses tend to find it desirable to sell here because the website is associated with higher quality as compared to its sister-site Taobao where consumers sell to each other. Important to note that Alibaba does not own or purchase any of its own inventory, it simply acts as an intermediary for businesses to sell to consumers.

o   Some pros are that it has an extraordinary assortment of products for very reasonable prices. The main negative is that lower quality business merchants are still able to get approved to for the site, so there is still a fair share of knock-offs and the quality assurance is not at the same level as JD.

·      Tencent and WeChat Stores: poses a couple unique threats to JD. For one, there is WeChat stores. This first began as a WeChat mini program a few years back and has stuck as consumers can seamlessly sell and purchase products from each other via China’s most popular social application. The platform is a formidable opponent but not somewhere you would go to purchase high end or big-ticket items. The second threat relates to the control that Tencent has over JD and their ability to operate their digital platform. Tencent incubated JD.com early on and owned approximately one-fifth of the company for a long period of time. Almost all of JD’s platforms operate with the aid of Tencent’s services, and as a result they receive access to the 1B+ WeChat users. Within the past year, however, Tencent came out and stated that they were selling almost the entirety of their ownership in JD. There is speculation that it may have had to with the CCP, but it could also mean something deeper. Either way, Tencent now has a much smaller vested interest in JD’s success than they did previously. On the bright side, JD did just recently renew their strategic partnership along with level 1 and level 2 access to WeChat, where the deal would include JD providing Tencent with a consideration of up to $220 million worth of JD class A shares. This shows that the relationship is still thriving and strong.

·      Pinduoduo: A marketplace that gained its fame (and revenues) from selling mostly agricultural related products. The business has seen exponential growth over the past few years and mainly works to connect buyers and sellers for the lowest possible prices. Pinduoduo has potential but currently does not serve the same market (or at least offer the same value proposition) as JD, but it could expand its offerings in the future.

What makes JD.com Unique (Competitive Advantages)

·      First mover advantage

o  JD made significant capital investment early on to build out large fulfillment and logistics networks. It will be nearly impossible for another company (outside maybe Alibaba with Cainiao) to get to a level where they provide the speed of delivery, quality assurance, and cost efficiency that JD provides through their logistics subsidiary.

o  To compete would require an immense amount of money. Another attractive attribute is that the required capital investment for a new entrant grows as JD improves their services. So, it would cost a new entrant as much as it did JD plus the amount of incremental improvements JD has made over the past 15 years. The initial investment was roughly $1 billion dollars back in 2007-2008. But with 550 warehouses and millions of sq. footage of operations, it would take probably closer to $10 billion just to invest in the real estate, technology, and workers. This would provide all the infrastructure, but still no brand. This is the classic case of giving someone billions of dollars and trying to tell them to build another company to compete with Coke or Disney. JD.com is at a point where it is so entrenched in Chinese society that it will be difficult for another company to just pay their way into competing with them. It will take time and dedication.

·      Customer service

o  “Culture eats strategy for lunch.” This is a quote that I love and one which embodies this sense of JD’s business perfectly. Out of all the different quantitative and qualitative factors that make JD special, this is probably the most significant one that has allowed them to reach 569.7 million users. And it’s not just a rule or a standard noted down on a piece of paper in the company office. This is the type of advantage that only comes from top-level management and is passed down through years and years of operation. In interviews and presentations, Richard Liu has always been found speaking with an obsession over the customer, and not surprisingly, like his American counterpart: Jeff Bezos. It is said that Liu’s main belief in business (even in the early 2000s) was that the Chinese consumer just wanted to trust that they were buying quality, authentic products that would be delivered in a reliable manner. This was polar opposite from the counterfeit scrounging that many participated in at the time. Liu believed in this idea so much that he based his entire business on it. From hyper-efficient returns to same day delivery, JD is head and shoulders above the competition when it comes to creating customer satisfaction.

o  “211” delivery method. Order before 11am and get order by 6pm on the same day. Order before 11pm and get the order by 3pm the next day.

·      Quality standards

o  “One strike, you’re out” standard, meaning that merchants found to be selling or attempting to sell counterfeit items on JD are immediately blacklisted. Much more harsh compared to requirements for sellers on other platforms such as Alibaba, Pinduoduo, and WeChat Stores. These sites are much more lenient and focused on selling as many products as possible, no matter how the product works or looks. This leads to knockoffs and lower quality when compared to JD.

o  Lower quality standards create nightmares and generate inefficiencies in other areas of a business system such as in returns, customer service, etc.

·      Scale efficiencies shared

o  Another important aspect of JD’s story is a business model first exhibited by companies such as Amazon and Costco and then greatly appreciated by Nick Sleep. Scale efficiencies shared is the name of an operational flywheel that involves attracting a large amount of customers, selling to them, ordering a larger amount of products at a lower cost, passing these cost savings on through to the selling price, and as a result attracting even more customers. The cycle then continues indefinitely and it is only really possible in an industry where major scale is beneficial, such as retail.

·      Network Effects

o  This manifests itself most prominently as a supply side benefit right now. It is significant when it comes to supplier relationships and the ability to buy from the best and most reliable providers of products for the 1P retail business. Because of JD’s scale, they represent an important and reliable customer for all their suppliers. The more customers they reach, the more products they can buy and sell, and the more suppliers want to sell to them.

o  This benefit is not yet as important for JD in the 3^rd-party marketplace portion of the business but it is growing rapidly. From the marketplace persepctive, it denotes the idea that the marketplace becomes increasingly more valuable since, as more customers use the platform, it brings on more merchants, which then brings on more customers, and so on.

JD Business Units and Market Opportunities

·      Retail business

o   JD’s main bread and butter is both home appliances and consumer electronics. This part of the business is where they started and continue to assert their dominance over the rest of the market. Although this is their most mature unit with the highest penetration, they continue to grow at over 20%. They also have been gaining traction when it comes to general merchandise, which primarily includes items like clothes, food, fresh produce, and household goods, all areas where Tmall historically excels. This newfound success can be attributed to management’s product offering expansion goals, where they are looking to use the trust they have built with customers to move into all categories of goods. This general merchandise unit is growing faster, at about 29% YoY. The retail business overall has massive future profit potential, and JD really only has competition at this point in time from Tmall, which even tends to struggle to keep up with more expensive items. This can be seen by JD’s market expansion over recent years (and especially during COVID), which has been mostly at Tmall’s expense. Considering JD’s market position and the current projections for China’s retail ecommerce market, JD should be able to at least retain their share of market, which means that the retail portion of the business will be able to grow at a rate over 10% for the next 7 years, even if the business does not gain significant share.

·       JD Logistics

o  This is the area of JD’s business that excites me the most. In China in particular, there is no better company positioned to capture and dominate the logistics and fulfillment market than JD.com. This is a journey that has been grueling and first began in 2007 when Richard Liu decided to make the difficult decision of investing almost all of JD’s money into the industry. He saw the complaints and the inefficiencies, with essentially all issues in ecommerce related to delivery. The benefits are finally starting to show themselves, seeing as the logistics unit of the business generated $10 billion in revenue during FY21 and is growing at over a 50% clip.

o  There are two main possibilities I see for JD’s logistics network, which can each work simultaneously.

§  The first is a way they have already been utilizing it, which involves leveraging it for use in their own ecosystem and services. Because of their hyper-efficiency, JD has the ability to create a value proposition that no other business in the country of China can offer, and that is reliable same-day and next-day delivery of all their products in all major cities and even some rural areas. This is something not even Tmall can compete with, where their average delivery times are still in the 3,5, to even 7-day range. And because JD owns the entire value system, they are able to suppress costs enough to match prices of other major delivery services. This is a massive advantage that makes it more likely for customers to order from their platform as compared to ordering the same product from another that would take longer but cost the same (and sometimes even more).

§  The second possibility is an area that JD has more recently been scaling and something that management has had a fixation on for a long time: logistics as a service (LaaS). This is the next frontier of their business and will provide them with significantly higher margin income. Similar to Amazon’s FBA, JD can use their immense 550 warehouse footprint, their AI sorting and shipping technology, and their massive workforce to ship packages for individuals, small businesses, and even larger corporations. This is where JD will begin to truly outcompete even the tenured delivery service companies in China, seeing as they have an even greater reach than almost all of them. Delivery and management of other’s inventory is where they will make their money here, and as they continue to scale, each incremental package that flows through the system will become more profitable. The large majority of their cost structure in this space is found in fixed costs such as the warehouse real estate itself, factory technology, and machines. A large portion of this investment has already been made in major cities, so now they will be able to reap the rewards in a significant way. So, they have a low variable cost business growing at over 50%, and with the amount of purchases shifting online in China, it seems that shipping and logistics are going to be one of the most important necessities as we move forward into the future.

·      Marketplace and Advertising/Marketing Services

o  With 569.7 million users, JD has droves of high-level data that it can use to negotiate with advertisers and bring them onto the platform. Consumer purchasing history is one of the most important type of data that one can have access to as well, seeing as it shows direct intent and what a person actually bought to satisfy a need or a want. This is what JD is able to leverage to offer advertising and marketing services to 3^rd party sellers. These people can then buy spots on JD’s website and also use their customer management and digital storefront technology to become more effective in their own pursuit of selling products to customers. This portion of the business is the one that competes directly with the likes of Tmall. But it has benefitted recently due to the fact that the Chinese government has instituted anti-monopoly policies, meaning that Alibaba can no longer restrict individuals and businesses from selling on JD’s marketplace. On the other hand, Tencent (which provides the technology platform that JD uses for operations) now also must allow Alibaba links to be sent on their platform. So people are also more apt to shop on Alibaba via WeChat as well. This comes as a negative for the JD marketplace, but overall the effect will be net positive in the long term. This portion of the business generated $11.3 billion in revenue last year and is currently growing at a rate of over 30%. Not only this, but the segment is much higher margin than the core retail business, seeing as JD must hold no inventory. Over time this segment will also contribute to the margin expansion of the business.

·      JD Property

o   Segment involved in buying and selling different properties, such as warehouses, that are related to JD's other business units (especially the logistics unit). This creates another opportunity to generate cash flow off the massive investments the company has made in fixed assets.

·      JD Health

o   E-commerce platform that is pioneering the technological revolution in all categories of wellness, from pharmaceutical deliveries to well-being and yearly check-ups.

Is it worth it? Is it cheap? Different Cash Flow Levers

I believe that by buying JD, you are purchasing not only one of the best companies in China, but one of the best in world. On the surface, there does not appear to be a significant amount of appeal. But the business is severely underearning for a multitude of reasons. First, accounting causes a disconnect between the income statement and actual cash flow. The business is extremely cash generative and this does not show up in OI or NI. Second, they are reinvesting a majority of cash flows back into growth and strengthening their competitive advantages. They are not just strictly reinvesting cash, though. Instead, they are continuously offering consumers lower prices and attracting more users as a result, which will benefit them in the long run.

Management has consistently touched on their eventual goal to hit net margins of high single digits for net income, which would also translate into free cash flow at a similar rate, considering that the company has no debt. Due to the strength of its core retail business (contributing 12% growth) and its other promising ventures in services such as logistics, telehealth/online pharmaceuticals, and marketplace and advertising (contributing a cumulative average of 20% growth), I believe that the business can conservatively grow revenue at 13.5% as a whole for the next 7 years. This simply assumes that they maintain market share with their retail business and continue to grow with the Chinese consumer while also assuming that they are able to grow at half of what they have in the past in new and innovative industries such as logistics as a service and advertising/marketplace.

Where will JD be in 7 years - Valuation

I like math and mental models that are simple and easy to understand. JD is a corporation with plenty of operations, ventures, and cash flow levers. But at the end of the day, it’s really an online retail business with a couple other major opportunities within the service industry such as logistics and advertising. That is really what it comes down to. I’ve done some “back of a napkin” type calculations because I believe if the answer is obvious when I use simple, conservative assumptions and only need some simple math, then that means I can be pretty sure I’m right.

Using 2021’s full year operating results as a base and applying the 13.5% CAGR, the business would generate $359.4 billion in revenue in 2028, and trusting management’s word that they can reach “high single digit net margins,” I am assuming they can translate 7% of that (low end of the projected range) into net income, which has historically translated to even more abundant free cash flow. But for the sake of the exercise, I assume that the company will match free cash flow and net income, which means that JD will be producing $25.16 billion in free cash flow in the fiscal year 2028. This also means that investing in it today at an EV of $67.7 billion, then you would have effectively paid roughly 2.7x EV/FCF and you make your money back every couple of years.

Again, for the sake of conservatism, all of this uses the assumptions of only 13.5% CAGR of revenue over the next 7 years, which barely exceeds the growth of the Chinese retail B2C market, and there's also the services assumptions, which I have capped at 20%, or half of the historical numbers, to account for fierce competition from the likes of Tmall and any formidable opponents that may present themselves in the logistics space (even though the legacy and state-owned delivery services are years behind JD at this point). These assumptions, with the growth and projected cash flow, mean that you will be yielding 37% a year on your initial buy-in price, and this assumes no more growth after the year 2028. I find that highly unrealistic, but either way, I don’t want to guess exactly what Mr. Market would price it at that far down the road (because nobody could guess that), but I can assure you that it doesn’t matter if he’s ecstatic or depressed for this investment to work out massively in your favor.

Margin Outlook

The business as a whole currently operates from a low single digit FCF margin, around 2.76%. As they continue to mature and focus more on cost reduction, I believe that they can conservatively expand margins to the 5% range for the retail segment, from a level of 3.07% right now. As the newer businesses like logistics and marketplace begin to mature and monetization options begin to come to fruition, they will provide higher margin operations that will contribute to allowing the business reach a level of 7% net margins that I have assumed in my valuation. After reading into the possibilities, I believe 7% is a very reasonable target, and I can see why management has made the projection.

Possible Risks

I do want to address some of the possible risks that exist with investing JD.com.

·      Founder Richard Liu recently stepping down

o   Stepped down as CEO in April of this year but will remain chairman of the company’s board. He may not be as “hands-on” as he was previously, but he will still have significant input and be a presence within the company. Xu Lei, previously CEO of JD Retail, was appointed as CEO in his place and also given a position on the board. The company is still in good hands, seeing as Lei has been with the company for over the decade and has a slew of experience. For example, he is credited with leading the launce of the 618 Grand Promotion and also with the development of many supply chain and omni channel strategies that JD still uses to this day. 

·      CCP regulation

o   Discussed extensively within the report

·      China COVID policies and slower growth of consumer and middle class

o   With recent lockdowns and also the inconsistencies in the real estate market, China is currently on a bumpy road, and I am making assumptions they will be able to come out of these hard times in a position to thrive.

Catalyst

• Sentiment shift. most notably for Western investors and institutions
• CCP lifting lockdowns and providing stimulus
• Continued development and growth of the Chinese middle class