Description

We recommend a long position in JD.com, on the basis that JD will eventually emerge as the victor in the Chinese ecommerce war. We see it as a classic David vs. Goliath battle against Alibaba.

If this is to come true, JD will be a homerun success over the next 10 years. If we are wrong, the chances are high that JD will remain a strong Nr. 2 in a vast, secularly growing duopolistic market which should allow JD to still achieve decent returns. We certainly like the odds and risk-reward ratio of the investment (even though JD's stock has run up lately).

In our view, JD's competitive position and the increasing benefits coming for greater scale are still broadly underestimated and are an important reason for the existence of this opportunity. Furthermore, like with most great companies, the long-term growth potential is rarely priced in appropriately.  

However, this is not the first time since JD's IPO in 2014 that someone posted the idea on VIC. Paincap already laid out the thesis in a well written manner, backed with relevant historic information on JD's founder, JD's culture and the delivery industry roughly 1 and 1/2 years ago. We encourage anyone interested in JD to read it.

Before we delve into important details of Alibaba vs. JD, it helps to shed some light on the Chinese retail landscape to really appreciate the size of the opportunity in the long-term. This part is more or less copy paste form various sources:

China’s retail market is already at a large size:

• Overall Retail Sales: ¥33tn ($4.8bn) in 2016

• Retail Sales of goods: ¥30tn ($4.35bn) in 2016

• Online GMV of Goods and Services: ¥5tn ($0.73bn) in 2016

• Online GMV of Goods: ¥4tn ($0.58bn) in 2016

… but given China’s economic stage still destined to grow strongly:

GS forecasts to 2020:

• Overall Retail Sales estimated at 9% to ¥46tn ($6.7bn)

• Retail Sales of goods estimated at 9% to ¥41tn ($5.95bn)

• Online GMV of Goods and Services estimated at 23% to ¥12tn ($1.75bn)

• Online GMV of Goods estimated at 21% to ¥9tn ($1.3bn)

The traditional retail market is fragmented:

• Total sales of the Top100 brick and mortar retailers in China account for less than 8% of total retail sales of consumer goods.

• The Top20 even account for just ~4% in China whereas the Top20 in the US account for >20% of total sales of retail consumer goods.

… and underdeveloped:

• The number of shopping centers per million people in China is only 10-12% of that in the United States.

• China has a retail space of only 0.6 m2 per capita vs. US with 2.5 m2 per capita or UK, Japan and Germany with 1.3 to 1.5 m2.

Therefore, e-commerce continues to grow at a rapid pace,

• According to the National Academy of Economic Strategy of the Chinese Academy of Social Sciences (CASS), China’s e-commerce was up by 35.3% in H1 2017 crossing the ¥3tn mark for the first time in H1 of a year.

• Chinese e-commerce market is already the largest in the world, with a 15% penetration

… while traditional retailers struggle.

• Total sales of the Top 100s in 2016 were up only 3.5% year-on-year, the slowest growth rate since 2008. Total sales of the Top 100s accounted for 6.4% of the total retail sales of consumer goods.

• The department store sector has witnessed a significant slowdown in sales, dwindling margins and large scale of closure of underperformed stores in recent years.

Favorable demographics and greater internet penetration will drive e-commerce further:

• About 75% of China’s online shoppers are Millennials, mostly living in top tier cities. The group hast the fastest increases in incomes among Chinese consumers.

• The generation after the millennials will be even more likely to spend online.

• Almost half of China is still offline and “only” 60% of those who are online are also already shopping only.

… a world which is dominated by JD and BABA

• The 2 companies control roughly 80% of e-commerce sales in China, with Vipshop being a distant third.

• Amazon has lost out and has currently only tiny share of 1% in China

• Competition in fulfillment technology, logistics network and last-mile delivery capabilities and customer mindshare will continue to lift the barriers to entry higher.

JD vs Alibaba

We think better service, faster delivery, no counterfeit problems (compared to Alibaba) and the ongoing partnership with Tencent will drive more and more users and share to JD. We believe that JD mall will eventually surpass BABA’s Tmall. If one compares the two B2C malls based on BABA’s GMV reporting standards, JD mall’s GMV for Q1 2017 is already at ~70% of Tmall’s GMV. Considering JD’s higher growth rate, its currently still lacking, but inevitably expanding product selection and the existing user gap still to close, we think this conclusion is not far-fetched. In markets like Beijing and Shanghai where JD offers its highest service level and China’s most affluent customer demographic resides, JD is already ahead.

In the last 6 quarters, JD has on average acquired >18 mio. new active customers/Q vs. BABA with ~11 mio. new active costumers/Q. Over the last 3 years, BABA’s customer growth has decelerated (however not too surprising given its size), while JD’s has accelerated. Based on the released numbers of JD’s recent annual sales event ‘618’ (more on it later), we believe JD’s customer growth continued to remain high.

While BABA already has a relatively high active customer penetration of ~60% of China’s current internet population, JD has still a decent runway ahead with a penetration of only ~30% to date. Due to JD’s superior customer service and the current aggressive expansion into rural China in combination with its exclusive partnership with Tencent and the resulting vast reach (JD acquires roughly 25% of new customers via WeChat and QQ), we think it is more a matter of when, not if JD catches up. Given the fact that still less than 60% of China’s 1,3bn people are connected to this thing called internet, we think JD’s long-term TAM is massive.

Over the last years, BABA has seen a GMV shift from Taobao to Tmall, while both platforms were growing. Four years ago, Tmall contributed only around 23% to GMV, but it edged up to 45% of GMV today. Since Taobao's C2C platform will likely continue to lose share to B2C platforms (due to ever increasing numbers of more demanding customers in China and the more limited nature of Taobao’s business), JD has even a shot at overtaking BABA in terms of its total GMV all together. Much like Amazon’s asset heavy and highly customer focused approach outgrew Ebay over time. We think it pays handsomely to get your hands dirty with inventory and to own highly efficient logistic assets – and in case of JD, even hand over the goods to your customers at their doorsteps yourself.

An asset light 3P marketplace at scale is a wonderful business model, but only as long as nobody else has a 1P + 3P business with in-house logistic assets including last mile at scale. Our bet is on the integrated asset backed model, but one must admit that BABA with Tmall and its broader ecosystem is certainly a more powerful competitor than Ebay.

Nonetheless JD’s recent growth rates, continue to show favourable trends against Tmall and due to Taobao’s slower growth, also to BABA in general. Based on the published commentary of JD’s recent June ‘618’ sales event, we believe JD continued to gain solid ground, maybe even at an accelerated pace. In the 18 days of the sales event this June, JD’s GMV grew well over 50% and JD showed the highest growth rates in important strategic areas like new active female customers (JD has still more male (55%) than female (45%) customers), apparel (makes up 40% of Tmall’s GMV vs. ~12% at JD) and FMCG while not losing ground in 3C and home appliances (link).

BABA’s decision to stop reporting quarterly GMV and its increasing focus on ad driven revenue growth and other areas, also give us confidence that JD’s important catch up will continue.

JD’s competitive advantages

JD has taken the less travelled tougher road and built a nationwide e-commerce fulfillment infrastructure. It currently encompasses an area of 5.8 mio m2 but will certainly expand further quickly. So far JD established 7 large fulfillment centers in 7 different major cities consisting of multiple warehouses, including warehouses to handle bulky items, sortation centers and special cold chained warehouses for fresh/frozen FMCGs. Apart from the 7 large fulfillment complexes, JD has established a total of over 260 warehouses and 6700 delivery stations across China and is building more of its large sized fulfillment centers. JD handles the last mile primarily itself (close to 100% of 1P and 20% of 3P), which is a crucial differentiator in China’s highly fragmented, franchised and inefficient run package courier world.

In addition to the warehouses, JD operates close to 7000 delivery and pickup stations in 2655 out of the roughly 2800 counties in China. JD’s warehouse and delivery staff combined make up over 80,000 employees. Most of the warehouses are currently leased, but JD is increasingly building its own highly efficient automated fulfillment centers and cold chain facilities.

JD CEO Richard Liu in July 2016: “Goods in China are on average moved/transported seven times before reaching the consumer. We want to reduce that to two times. This generates significant social value, and will not be able to be done by a normal express delivery company”.

JD is developing and experimenting with new technologies to build out a best in class highly automated e-commerce backbone in China. Take this sortation center for example: https://www.youtube.com/watch?v=futkHNni3Es, or the fulfillment site in Beijing: https://www.youtube.com/watch?v=Uu0qBZY4pgk. There are more videos on JD’s corporate site about upcoming automation like drone delivery and more: http://corporate.jd.com/resources. As a side note, we also like the fact that so many of the videos have less than 30 views…

With 10,000 employees in R&D, JD already has, even compared to tech-savvy but “all over the place shooting” Goliath BABA with 22,000 people in R&D, an impressive number of people dedicated to drive its e-commerce innovation forward. When mentioning employees, it is also noteworthy that JD and BABA have roughly the same number of people employed in customer service (assuming all BABA “operations and customer service” employees are working in customer service), while still having a sizable gap in total GMV (Taobao + Tmall).

If the currently fragmented Chinese courier companies don’t follow JD in terms of automation, rising income levels will eventually bring high delivery costs in addition to poor service. One of the risks to the thesis is a scenario where China ends up having highly available, cheap high quality delivery and fulfillment services by multiple suppliers that can be used by BABA’s merchants and JD ends up having an undifferentiated e-commerce backbone/service that delivers poor returns. Given the current state of the courier industry and the large growth ahead, we find this scenario unlikely. Paincap also provided good commentary around dire state and problems of the industry.

In 2016, Sina Weibo counted the number of blog posts related to last mile delivery problems. There were over 4 mio. blog posts each related to poor services and damaged parcels. Close to 4 mio. posts mentioning long delivery, around 2 mio. for parcel loss and around 1,5 mio. concerned damaged goods. While the industry is improving, the quality issue remains. 

Courier companies themselves are already fragmented, as can be seen in the graph from ZTO’s recent IPO prospectus. Each larger company generally franchises the last mile (often including delivery outlets) to 1000’s of small franchisees to compound the task of providing high quality service. Among the bigger courier companies, only SF Express and EMS don’t franchise the last mile, but both are small in BABA’s ecosystem. YTO, which BABA has a stake in, has plans to in-house a portion in the future.  

Cainiao is BABA’s effort to improve the situation and digitalize the courier industry. BABA certainly makes progress, and has large headline numbers to show, but we think it will be very hard match JD’s services levels. In addition to blazing speed, JD’s recently launched special luxury delivery service for luxury goods is one example of a differentiated last mile service that is very hard to match with a franchise model. Yet, there is more hard to match stuff, like delivery to customers’ doorsteps and return at doorsteps even of large items (this is not industry practice and makes a difference with all the high risers in China), on the spot inspection of fresh food before hand off, cash on delivery payment options, generous and quick refund polices including pick-ups and even expedite doorstep return of large bulky items. These examples clearly won’t be the last “innovations” we will see from JD’s high quality in-house last mile. If JD were to offer something like Amazon’s just announced fashion wardrobe service, it could do good harm to BABA’s largest GMV category over time and BABA would have much trouble matching it with a franchised last mile and without in-house inventory.

Talking about in-house inventory, this is another major reason why JD can offer a better service. Almost everyone has experienced the difference in customer service when dealing with Amazon between 1P, FBA 3P and 3P goods that are not fulfilled by Amazon. Imagine the service if the last mile where properly controlled as well - that is what JD can offer. Now compare that to buying form a subpar 3P merchant. Apart from eventual outright fraud and faked goods, the very fragmented nature and large number of BABA’s merchants will continue to lead to less than joyful customer experiences every now and then and drive customers to JD.

On the other hand, a smaller number of merchants leads to a more limited product selection, which is JD’s major drawback. JD’s origin as a pure 1P player in 3C and the company’s rigorous focus on quality and product authenticity explain the slower build out of 3P. Increasing scale and a closing GMV gap to Tmall and to BABA more broadly, should allow JD to reduce and eventually eliminate this drawback against Tmall. In general, we believe it will be easier for JD to overcome its drawbacks than it will be for BABA to match JD’s advantages.

The recently announced plans to separate the logistics group shows JD’s ambition to ramp up 3P in combination with its complete fulfillment services. Currently only 10% of 3P business is stored in JD warehouses, while 20% is delivered by JD. We think this number will dramatically increase over the next 5 years and bring JD’s great service to a much larger selection of products. One issue to overcome in this area is the fact that merchants need to be convinced to store goods in JD warehouses, but thanks to BABA, for most of them this comes with the disadvantage of splitting their volume across warehouses, which is an issue with smaller merchants. However, unless BABA is bullying merchants aggressively, we don’t see a reason why increasing scale won’t give JD the necessary leverage to talk them into it.

The largest and we think strategically most important e-commerce category in the long-term is FMCG. In China and with Amazon’s pending WFM acquisition, basically all around the world FMCG is where the next great battles are fought. However, this category is incredibly hard to scale, especially the fresh part which constitutes 40% of the category. It has very low unit prices, a terrible price-weight ratio, needs a special cold chain to keep the important fresh and frozen goods in shape and at the same time has the most demanding customer expectations in terms of speed – for those reasons it has had the lowest e-commerce penetration globally. However, once an e-commerce player can gain scale in this category, the large benefits of scale in combination with the high entry costs will likely create an attractive monopolistic, at best oligopolistic market structure. Apart from cost advantages, the high engagement/usage in combination with frequent delivery should lead to dominate user mindshare, which should carry over into other categories. Thus, the benefit of winning FMCG should far outweigh its early but substantial costs. We think JD is best positioned and certainly determined to go after the category to win. While FMCG makes up for more than 1/3 of the total retail market, its online penetration is only around 5%, with fresh at 2%.

We think BABA has lower chances to dominate FMCG due to the lack of a 1P business and strong in-house logistics. Product SKUs in FMCG are relatively low and everything else where JD is already particularly good at matters a lot in this category. Therefore, we think JD has favorable chances to win the bigger portion of the market.

Going forward/recent events

JD Finance will be deconsolidated from JD’s financials and will no longer give investors who don’t like the risk profile or the obscured cashflow financials a reason to stay away. Better still, JD keeps 40% of the upside of JD Finance, which we think will create a lot of additional value overtime. Richard Liu also has aggressive plans for JD Finance which we think has a decent position, given JD’s platform and valuable data. The stake of 28.6% that is sold in the reorganization, brings in ¥14.3bn / $2.1bn in cash.

• JD Finance started to operate on a standalone basis in 2013. Currently JD Finance has seven product segments: Supply chain financing, Consumer financing, Crowd funding, Wealth management, Payment, Insurance and Securities.

• Ending balances of its consumer financing, business financing and supply chain financing in 2016 were ¥25.3bn ($3.6bn), ¥0.7bn ($0.1bn) and ¥11.5bn ($1.7bn) respectively.

• JD Finance has a >50% market share in crowd funding business and the business overall served >100m users and >200k enterprises

In addition to JD’s ambitious e-commerce plans, JD also extends its reach into the offline retail world with brick and mortar locations that will be operated in an asset light franchise model. So far, JD has announced intentions to achieve 1 mio. convenience store formats in the next 5 years (link) and 30,000 mother & infant focused stores (link) plus 10,000 home appliance stores (link) until the end of 2017. The stores will primarily target rural areas and serve as e-commerce hubs.

Other notable recent developments concern JD’s drone program and publication of vision, AR & AI implementations into its app (link), smart predictive supply chain & pricing solutions (link) as well as a new and improved data analytics solution for merchants (link). A large strategic investment into luxury e-commerce company Farfetch and deals with other new big-name fashion/luxury brands like Swarovski (link), Gorgio Armani (link), Zenith (link) and a deeper cooperation with L’Oreal (link). David is certainly not asleep...

Some thoughts on valuation

While one can point to JD’s current subpar to non-existing near term profitability, doing so completely misses the nature of the business model and the bigger picture. However, there are still people who believe Amazon doesn’t make any money – even though the company spends tremendous sums to build its ever-expanding business empire plus larger and larger sums on discretionary things without requiring new equity…   

We strongly believe that JD can and will achieve higher margins than its offline peers over time, but timing is uncertain. While JD is in hyper growth mode, operates a negative cash conversion cycle and has lots of new categories to conquer that initially require losses to scale, delaying the day of having decent consolidated margin is a good choice.

However, JD’s gross margins, net margins and cashflows are destined to ramp up further.

1) There is room for growth in 1P gross margin (JD currently runs at a 10% difference to offline competition, while being more efficient than them)

2) Greater scale will give JD greater purchasing power. Richard and his team continue to stress the point there is room for improvement.

3) A higher mix of 3P business with a very high GM will carry the overall GM higher as well.  

4) Additional scale will improve fulfillment expenses, SG&A, marketing and R&D.

5) Monetization of untapped high margin ad revenue (BABA takes home 25% of the online ad market) and logistics in 3P and private labels in 1P.

We currently don’t worry about the timing and exact number too much – strong revenue and cashflow growth alongside a growing moat/competitive position are more important to us. Still, there is a good chance that we could see a decent ramp up in profitability over the next 5 years from now, if the FMCG battle with BABA doesn’t become too fierce and JD’s build out is not over aggressive (too much ahead of volumes).

Considering everything we have said, we find a price of around 1.2x this year’s revenue and a 0.5x GMV while currently growing at close to 40% into a yet to gain massive TAM certainly attractive and (way) too low if one truly takes a long-term view.

Catalyst

clean financials after JD finance reorg.

ongoing faster growth than Tmall

further GM and net margin expansion