Description

“It’s always darkest before the dawn” – Thomas Fuller

It has basically come to the point where we are either going to war with China and the likes of AAPL, NVDA and TSLA will implode, or tensions will settle (which seems to be the case) and implied costs of capital for JD will dissipate – driving a potentially dramatic stock price appreciation. We think conservative underwriting suggests a doubling of the stock in the next couple years and we expect JD to generate 100% of its EV in FCF over the next 6 years.

We feel like it has been the perfect storm for China ecommerce stocks and JD in particular. We also realize that this is a very controversial and unpopular call to make – often an indication of where you can make the most money. We believe the bad news is more than priced in and that at the very least, the incremental micro and macro datapoints going forward will be less negative (potentially materially) than they have been over the last few months.

JD’s GMV growth and user growth remain strong, highlighting the health of the platform. We like JD’s owned infrastructure network, expansion of categories and merchant potential, low user base versus BABA/PDD, and potential under monetization versus peers. As we progress through 2023, JD’s revenue growth should converge with GMV growth, such that revenue growth goes from flat today to double-digits (%) at the end of the year and into 2024. Management just supported this view earlier this week at a conference in Hong Kong, but the sell-side has gone from overly aggressive to potentially overly conservative – projecting peak quarterly retail revenue growth of 8% from 4Q23 – 4Q24.

Management has been hyper focused on two KPIs – user growth and margins. Both metrics have demonstrated dramatic improvement over the last few years. Management this week again reiterated that Retail margins will hit 5%-6% in 3 years. The Street is at 4.3% four years from now, barely up from today. We expect revenue growth in the 8% range (~400bps below management forecast) and moderate margin expansion to JD’s target, 1-2 years later than expected, will drive 20% EPS growth for the next 5 years.         

What has happened to get us here on a macro and a company specific front? 5 key factors:

·   Macro

o   Terrible geopolitical headlines, which were put into overdrive by the China balloon incident in late January. JD is down 45% since the balloon incident. We think China concerns are very warranted, but that the US has now pushed it close to the edge and if we go much further, there is risk of something bad happening. We believe that the US economy and the global economy are much too intertwined to not pull back the aggression.

§  We think getting a meeting back on the schedule with Secretary of State Blinken would be a major sentiment shift for the stock.

§  Of note, the China Commerce Chief just met with his US counterpart last night in DC. This is the first high-level Chinese official visit to the US in more than two years. Both sides agreed to “strengthen communications” and that the meeting was “constructive”. Further, Biden has recently amped up the message that he wants to improve China ties.

o   Chinese property market concerns. We do not think the property market is going to make a V-shaped recovery, but we have now seen three months of sequential home price improvement in China after 16 straight months of declines. Appliance manufacturers expect a modest 2H recovery and recent real-time weekly data supports sequentially better trends with a very strong April and May, although we admit month-to-month dynamics will be volatile in 2023 given comp effects of the shut down and a hot summer last year. Appliance sales typically lag the property market by 6-9 months, so this 2H23 sustained improvement expectation would make sense.

o   Chinese economic growth is ramping slower than initially expected. The lack of a big GDP target (ie 5%) from Xi at this year’s National People’s Congress in March reduced expectations for a huge stimulus package to supercharge consumer sentiment and spending. April economic data ticked down from March and has caused investors to extrapolate forward. Given the growth in M2 and credit in China, we think economic growth will continue and that if things slow too much, Xi will stimulate. At the end of the day, he does not want high youth unemployment and low confidence.

·   Company specific

o   1P to 3P shift lowers revenue. Despite GMV recently growing in the high-single digits (%), 1P revenue (92% of Retail revenue) has been hit by the slowdown in electronics and appliances. 3P, which encompasses the longer tail of categories that are doing better on a comp basis (clothing, cosmetics, etc), is not large enough due to accounting math for 3P to move the needle on revenue.

Furthermore, in 4Q22, JD shifted certain uneconomic business from 1P to 3P and pulled back from regions that were not generating an appropriate return. This proactive shift alone is going to drive a temporary 5%+ hit to 2023 revenue. JD will lap this self-inflicted top-line revenue impact in 4Q23.

§  JD just comped its last difficult appliance and electronics quarter in 1Q23.

§  Recent reports from smartphone and appliance manufacturers suggest that while recent trends are certainly not robust, the sequential trend should certainly be one of improvement (as a comp datapoint, China smartphone sales were down 14% in 2022) with acceleration into 2024. Notable new phone launches in 2H23, improving home prices, easing comps, and higher employment and consumer incomes are drivers for more positive trends ahead for JD’s key categories.

o   Subsidy program. JD is creating an image of “everyday low price”, which should create higher demand outside of the shopping holidays. Furthermore, consumers like the idea of feeling like they are getting a deal. JD has always highlighted and prided itself on quality and speed of delivery, but highlighting to customers that they are getting a deal was not stressed enough.

§  The margin impact from this initiative is immaterial, but investors immediately sold the stock on competitive concerns. Competitive intensity is certainly different versus the past, but this is more than reflected in JD’s Street forecasted high single digit (%) revenue growth in the future versus 25%+ in the past.

§  The subsidy program is not degrading margins, but seems to be helping user acquisition:

Source: Questmobile

§  And JD has a lot of user and monetization upside to come:

Source: Morgan Stanley

Since the Last VIC Write-Up Less Than 1 Year Ago

DWcapital deserves a lot of credit for an excellent description of JD and why its business is so good. In addition to DWcapital’s description, the beauty of JD’s owned distribution centers and logistics assets is that JD can skate to where the puck is going by tacking on merchants that want to be associated with quality and great service. JD will likely be a much more diversified platform 3 years from now versus 3 years prior, gaining more shoppers and more frequent shoppers along the way.

The last VIC write-up was less than a year ago, JD was trading at nearly double today’s share price. Since then, out year estimates (2025/2026) are down about 15% on revenue and earnings. Analysts are now underwriting margins meaningfully below JD’s 3-year targets and revenue growth below JD’s 2024 guidance, which was just reiterated at a conference this week. We think that earnings projections are fairly washed out now and that any incremental estimate revisions will either be immaterial or potentially materially to the upside, especially as we progress into 2025 and 2026.

Rehashing Guidance

This year:

·       2Q23:   

o   Roughly flat Retail revenue growth with high single digit (%) GMV growth (inline with Street)

o   Year/year stable Retail EBIT margins and +50bps Group EBIT margins

·       2023

o   -5% Retail revenue impact for the year from a self-imposed shift of low margin SKUs from 1P to 3P and emphasis on 3P in general to expand category selection

o   Stable Retail EBIT margins and +50 bps Group EBIT margins (Street up 30bps)

·       2024

o   Double-digit (%) revenue and GMV growth (Street +8%)

·       3-Year Forward:

o   Retail operating margin to reach 5% to 6% in the next 3 years (Street at 4.3% in 2026)

o   Continue to gain share in core categories like home appliances, consumer electronics, mobile phones and certain FMCG products

Valuation – It’s Getting Nutty

We think if JD can achieve 8% revenue growth over the next several years (GDP + some modest user growth and monetization), versus their own expected return to double-digit revenue growth in 2024, and JD can hit the midpoint of Retail operating margins in 2027 (two years later than guidance), JD would generate around $6.50/sh-$7.00/sh in EPS (Street at $5.30). Earlier this year, JD traded at a high-teens 2-year forward P/E multiple and over the last couple years, tended to trade at a slight discount to US big-cap tech. The 1-5x historical P/E discount to US big cap tech has widened to 15x today, demonstrating how hated the stock is right now. If JD were to rerate back to earlier 2023 multiple levels, we could see a $120/sh stock in a couple years (3.6x today’s price). This is not what we are banking on.

From a cash flow perspective, even being punitive and backing out the payables benefit of retailers from cash flow, we think that the unlevered FCF yield on JD will go from 8% this year to 18% in 2025 and then quickly go parabolic to 34% in 2026 and 75% in 2027.

Even a $70/sh stock today would result in a 12% uFCF yield in 2027 and 10x levered FCF. This type of multiple (12% uFCF yield) seems to be what the market is underwriting at today’s prices looking 2-years out. Therefore, even with no multiple expansion from here, we can say that at YE2025 the market should see a $70/sh JD stock – equating to 116% upside in a little over 2.5 years and a 34% IRR.

US retail slow-growth comparables (TGT, WMT, TJX, BURL, KSS, HD, LOW) trade at 14x/13x 2024/2025 EBIT vs JD at 8x/6x. This also does not give credit for JD’s premium cash flow.  Assuming JD does not squander its FCF into bad investments, in less than five years we would be left with a $9b EV company ($24b adding back payables) that is generating $11b in annual EBIT and $10b in annual FCF – you get the point. The numbers start getting nutty with the assumption of high-single digit revenue growth and Retail margins expanding up to their 5.5% target.

We think the implied cost of capital on JD has risen from 12% to 20% since the balloon incident. We think this is far too high, especially if one were to simply look at JD’s USD bonds trading at just over 5%. We think a lot of big cap tech in the US is trading with a cost of capital around 7%, highlighting how material the rerate potential is with some moderation in geopolitical rancor.

A Quick Comment on Monetary Policy Versus the US - China M2 Growth is Expanding Rapidly

Credit growth and M2 growth, coupled with declining unemployment (April was the lowest since the end of 2021) should bode well for improving consumption trends as the year progresses. Clearly the market wants immediate gratification, but the looseness of policy should bear fruit in due time. Furthermore, if April economic growth moderation does continue after a strong March, stimulating actions from the Chinese government are expected to continue. Bottom line, this is not a government that is trying to drastically cool things like most of the rest of the world.

China M2 Year/Year Growth:

Catalyst

• Moderating or even plateauing geopolitical tensions
• Revenue to GMV convergence in 2H23 and beyond
• Continued margin expansion over the next few years
• Robust FCF generation, especially in the latter three quarters of 2023
• Increasing share buybacks
• Improving trends in key categories like smartphones and appliances as we move further into 2023 and into 2024