Description

Investment Summary

   JD.com is the biggest first-party e-commerce platform in China. Its stock since IPO has vastly underperformed the market because JD could not turn solid topline revenue growth into healthy operating margins. However, results from the last two consecutive quarters showed impressive efficiency gains, indicating a nascent trend of margin improvement that could keep going for an extended period. If the trend truly takes hold, the stock could rise significantly. 

   I thank all the previous authors on JD because their insight and research are of tremendous help in writing this piece. I will not spend too much time to rehash a lot of the excellent points made by them. For things like the CEO’s rags-to-riches story and the overall e-commerce growth story in China, please refer to the previous articles. Here, I want to mainly focus on the current development of JD and the competition.

Business Overview

I will narrow the discussion to the main revenue generator JD Retail which contributes about 95% of the total revenue and the promising JD Logistics(JDL).

JD Retail

Strengths

JD Mall is the biggest first-party e-commerce platform by revenue in China. It offers consumers the best online shopping experience. To achieve that, JD excels in three things in my view. Two of them have been discussed extensively in previous JD articles so I will just briefly reiterate them here. First, over the years, JD has established itself as a trustworthy retailer with authentic merchandise. This is especially important because over 50% of its revenue comes from selling big-ticket electronic items and home appliances. Second, since JD runs its own logistics services, JD’s delivery speed is the fastest in China. In the latest earnings release, JD touts that “By optimizing its expanding warehouse network with AI-driven technologies, JD Logistics is able to deliver approximately 90% of its direct sales orders within 24 hours in China.” This is much faster on average than its competitors. Although Tmall’s delivery service is also quite fast in tier 1-2 cities, in lower-tiered cities it gets much slower. Taobao’s delivery on average takes about 3-5 days and it varies on the third-party courier. Pingduoduo(PDD) is probably even slower because it is M2C(manufacturer to customer) and its majority of customers are based in tier 3-6 cities.

But JD’s service excellence extends beyond these two aspects. Another big differentiator is its return/exchange policy. While China recently introduced a consumer protection law that requires all retailers (including online 1-P and 3-P retailers) to accept customer returns without a reason within 7 days, many retailers are not fully complying with the law. Getting a refund on 3-P platforms is particularly bothersome because a lot of these small sellers will first refuse or purposefully delay the refund and buyers then must seek help from 3-P Platform’s customer service for arbitration. By contrast, JD has offered a 7-day moneyback and 15-day exchange for a long time with great customer satisfaction. Instead of the two-step process often required on 3-P platforms, customers talk directly to JD’s own service reps to solve their issues quickly.

Weaknesses

In order to cover the costs for all these in-house functions and returns/exchanges, JD usually marks its merchandises a bit higher than the other platforms do (although still cheaper than offline retailers).  And because JD needs to buy things in huge quantity for the economy of scale, 3-P platforms offers a greater variety of products than JD does.

In order to mitigate the merchandise assortment problem, JD Mall also hosts third-party sellers. However, these same third-party sellers usually own bigger virtual stores and offer more products on other 3-P platforms because JD charges a steep fee. Taobao’s commission charge Is about 2% compared to JD’s 5%.

Target Customers

JD Mall’s core customers are the people who are willing to pay a bit extra for a great shopping experience. Although the majority of JD’s customers are still in tier 1 or tier 2 cities, customers from lower-tier cities are joining JD’s platform at a very rapid rate.

Logistics Service(JDL))

In November 2018, JD announced that it will open its logistics network for third-party users (including both individuals and companies). Since then, the logistics division has experienced exponential growth. In the last earnings report, management boasted 300% revenue growth from the logistics service and the doubling of revenue contribution from third-party users to 40% over a two-year period. These customers are not just third-party vendors who sell on JD Mall – they also include international corporations that sell in China and online e-commerce players who do not wish to build their own on logistics infrastructure like NetEase. The logistics services go way beyond delivery – customers can store their merchandise in JD’s warehouses and manage their inventory across different locations via a cloud management system.

It’s quite likely that JDL will become a stand-alone business and seek IPO in the future, a development that can dramatically improve JD’s free cash flow. In 2018, Hillhouse, Tencent, and Sequoia China invested 2.5 billion USD into JDL, valuing it at 13.5 billion(JD’s stake is 81%). Another very promising development is the establishment of JD Property Fund backed by GIC(Singapore Sovereign Fund) that will purchase JD’s logistics facilities. This asset drop-down play will make JD Logistics itself more asset-light and more attractive to potential investors.

Major Shareholders:

Founder and CEO Richard Liu holds 15.4% of the total shares and 79% of the voting power. Tencent owns 18% and Walmart owns 9.9%.

Competition:

JD Retail

Competition in tier 1/2 cities

Competitors include JD’s arch-rival Alibaba(Tmall/Taobao), offline malls, shopping centers, and offline-online hybrid retailers like Suning. I believe online retailers will continue to chip away the market shares of the offline competitors that fail to keep up with new technologies and JD is poised to benefit from this trend. Alibaba, on the other hand, is a formidable rival. Judging by the recent quarterly results of Alibaba, revenue growth, GMV growth, and user growth show no signs of a slowdown. As of Q3 2019, there are 693 million annual active users on Alibaba and 334 million annual active users on JD, indicating considerable user overlap. Both companies have a long operating history in tier 1/2 cities and consumers are well-versed in choosing the appropriate platform based on different needs. When consumers are in a hurry, when they want to buy a big-ticket item especially electronics/home appliances with a hassle-free experience, JD will probably be their first choice. But cost-sensitive buyers and discovery-based buyers who love browsing through the endless aisle (predominantly female) will most likely go to Taobao/Tmall. Alibaba has also been aggressively investing in its own logistics division and the difference in delivery is not as dramatic as it used to be, narrowing JD’s lead in this area. However, JD also has attracted more third-party buyers and broadened its selection. General merchandise revenue has been growing at a faster rate than the revenue growth of its bread-and-butter electronics revenue.

As JD further achieves an economy of scale in the future, it could partially pass on the saving to woo price-sensitive buyers. In the end, it’s my view that barring any irreversible blunders from either player, Alibaba and JD will co-exist and co-prosper. It’s unlikely to see either player take a huge market share away from the other.

Competition in rural and lower-tier cities (LTC)

Rather than big national retail chains, small offline local/regional players have a big presence here, nevertheless, their days are numbered. Wide smartphone and internet adoption have paved the way to shop online even in these less developed areas. Then, by injecting a massive amount of subsidies and running endless marketing campaigns, the new e-commerce player Pingduoduo(PDD) has acquired new online shoppers at an astronomical rate and profoundly disrupted the retail landscape in rural and LTC. Alibaba and JD also piled on this new growth opportunity and introduced their own PDD copycats. As e-commerce players continue their aggressive push into LTC, JD, Alibaba, and PDD will all be gaining market share at the expense of local offline retailers. These local retailers lack capital, pricing power, economies of scale, and technical sophistication to effectively compete with the online retailer giants. JD and Alibaba have both shown impressive growth numbers in these areas.

So how do JD’s strengths and weaknesses play here? With a network that can deliver goods to 90% of China within 24 hours, the logistics advantage in LTC is much more pronounced than in tier 1/2 cities. In general, infrastructure is less developed in these areas and goods from 3-P platforms will take at least an extra 1-2 days to deliver if not longer. So this roughly translates to 3-5 days of speed advantage versus Alibaba and PDD. Since counterfeiting is a major issue in China and there are not enough reputable physical stores in LTC, JD’s reputation for authenticity is also a big plus here for customers who want genuine goods. Alibaba’s platforms especially Taobao still have a trust issue and PDD is full of cheap but sketchy stuff.  The challenge here is how JD addresses its price and merchandise assortment. Big-data and machine learning can partially circumvent these problems by creating a personalized JD shopping experience that matches customers’ purchasing power and preferences based on customers’ geolocations and order histories. Further catering to people who prefer lower priced items, JD has also developed its own PDD-alike standalone app calling Jingxi. The merchandise on Jingxi is in general much cheaper than those on JD Mall. Yet despite the low prices, JD has insisted on product authenticity and quality on Jingxi, a big differentiator from its peers.  Tencent, a shareholder of both JD and PDD, just opened its first-level entry on WeChat for Jingxi(PDD also has been prominently featured on WeChat since its inception).

In the next couple of years, JD should see growth from LTC outpace that from more mature tier 1/2 cities. In the long term, once excessive subsidies and marketing fade out, JD’s advantages will still enable it to retain a good portion of the market share. JD should do especially well in relatively affluent cities where the cost of living is low and consumers’ disposable income is high. Shoppers new to the online experience will start with a small purchase to test the water. Then as JD gradually builds trust with them, they will commit bigger purchases. In addition to the average ticket size increase, JD should also command a bigger market share of the big-ticket items. These items include not only electronics and home appliances but also luxury items. Shopping centers in tier 1/2 cities are filled with luxury brand stores and electronics stores because many consumers there still don’t buy these high-value items online due to trust issues. Yet in LTC where are far fewer offline competitors, JD could become the primary destination for all big-ticket items.

JD Logistics

On JD’s website, JDL is touted as “the only e-commerce platform in the world to provide small-to-medium sized warehousing, oversized warehousing, cross border, cold chain delivery, frozen and chilled warehousing facilities, B2B and crowdsourcing logistics.” Put in another way, it’s a one-stop-shop for supply chain management (I will call it LaaS-Logistics as a Service - for short). Different than the U.S. 1P seller Amazon, JD also runs its own last-mile delivery operations with around 100K employees. Companies can literally just use JD’s LaaS and be done with their supply chain. You can place your inventory in JD’s warehouses across the nation, run AI algorithms to predict demand and balance inventory levels between warehouses, and have JD’s courier deliver the goods. For grocers, JD offers cold chain; for international companies and importers, JD also handles cross-border shipping and handling.

China’s logistics market is highly concentrated with the top six in 2018 owning about 80% of the share. Five of the top six except S.F.Holdings (the Five) are your typical courier companies that focus only on delivery. Like UPS and FedEx, they command big volumes and enjoy good economies of scale. The cost to ship with these companies is extremely low. However, there are two problems with their services: because they operate on a franchise model the quality of service is inconsistent and because they want to fill the whole truck the delivery speed tends to be slow. Compared to JDL, the Five are ill-suited to support e-commerce companies because JDL is faster and has a comprehensive solution. JD Logistics will not lose on pricing either because as JD’s own purchasing volume keeps increasing and more third—party users join JDL, the economy of scale will only get better and the delivery cost will decrease further. A big headache for the incumbents is the delivery rush during the holiday season and the “6.18”/”11.11” sales events: volume goes way up and delivery cost skyrockets. They barely break even or even lose money in these periods of online shopping frenzy. In comparison, JD Logistics has been very successful in handling customer delivery during these periods with speed and excellent service, a big advantage over the incumbents in the eyes of other e-commerce companies. S.F.Holdings is the only one that refuses to handle a big volume during “11.11” due to cost concern and I believe the Five will sooner or later follow suit, yielding market share of e-commerce delivery to JDL.

S.F.Holdings is a much tougher competitor than the Five because it owns all of its operations just like JDL and the service quality of S.F.Holdings is top-notch. S.F.Holdings also provides solutions for the entire supply chain. One differentiator here for JDL is the technology. By using the massive shopping data generated on JD Retail, JDL can build accurate AI models to predict demand and balance inventory levels proactively. But how many companies really need such cutting-edge technology is still anyone’s guess.

Lastly, as far as competition goes, there is another big disruptor lurking in the corner: Alibaba’s Cainiao Logistics. Following Alibaba’s tradition of running businesses in an asset-light fashion, Cainiao owns much less physical infrastructure than JD Logistics does. Cainiao develops warehouses for Taobao/Tmall sellers and predicts/balances inventory levels across Cainiao’s different warehouses. However, all the inter-warehouse and 2C deliveries are still done by the traditional couriers. Cainiao is definitely a great choice for existing vendors on Alibaba’s platforms but JDL looks like a better choice for customers outside of Alibaba’s ecosystem.

Overall, JDL seems to be very well positioned in this space because it is the only company with a comprehensive solution and 100% in-house operation complemented by good technology. Just to briefly mention JDL’s tech advancement: In 2018, JDL showed off the world’s first fully automated warehouse in Shanghai. It also owns a fleet of drones for delivery.

Why invest in JD now?

Show me the money. I wasn’t impressed by JD’s operation because despite its revenue growth, the company was always operating at a loss. It couldn’t show a clear trend of improvement, which led me to question whether it could truly obtain economy of scale. Based on JD’s 2018 20-F, Revenue increased 80% from its 2016 level yet fulfillment cost went down a measly 30 bps to 6.9%. However, come Q2 2019, fulfillment cost improved by 60bps YOY and management declared that finally the logistics division broke even. In the just-released Q3 report, fulfillment cost again showed an impressive 90 bps YOY improvement. Management in Q2’s call contributed the big improvement to the conclusion of major logistics investment. In 2014, they took on the gargantuan task of building out the network that covers tier 3-6 cities and rural areas. In 2015, they started to expand the logistics network in order to accommodate FMCG(fast-moving consumer goods) – the existing network had been mainly built for larger items. In 2017, it was the investment for third—party delivery. Management admitted in the Q2 call that even they themselves couldn’t tell when the economy of scale would finally arrive in the past, but now these initiatives have come to an end. It doesn’t mean JD will stop investing but it seems that the pace should slow down. So, after 2 quarters of solid efficiency gains, I finally took a leap of faith and turned bullish on the company.

New businesses look promising. JD’s two big ones might finally come to fruition. First, now profitable and with the asset drop-down agreement in hand, JDL addressed potential investors’ two big concerns: profitability and cashflow, paving way for an IPO. JDL is valued at 13.5B USD and JD owns 81% of it. Second, JD Health just finished series A financing valuing the venture at 7B with JD owning more than 80% of the company. JD pharmacy is the largest online player in China by revenue. I believe JD’s reputable brand and its proprietary logistics network that supports the cold chain are huge advantages in healthcare. The traditional logistics players have been slow in investing in cold-chain technology and they cannot be trusted to deliver life-saving vaccines. Many medical tests that require cold-chain transportation for backend analysis could be administered by JD Health and transported by JD Logistics in the future.

Valuation

Because JD is still going through a growth phase, it’s hard to accurately predict its operating metrics in the short term. But I will attempt to put some rough estimates via some back-of-the-envelope calculations.

Long-term(7-10yrs): When asked about JD’s long-term net margin compared to Walmart’s 3-4%, management reiterated their belief that JD can achieve high single-digit net margin because JD’s 1P platform should ultimately generate 1-2% higher net margin than the best-run offline retailer and 3P sales have better margins than its 1P business. I found management’s argument reasonable and the questions is how fast JD can approach their long margin target. JD Retail(1P+3P) currently has about 2.5% operating margin based on the last 9 months result so it needs another 7.5% margin gain to get to 7.5% net margin(10% operating margin and 25% tax rate). I personally feel it needs another 7-10 years to reach that level because that’s when the e-commerce growth will probably slow and companies will focus on profits instead of growth.

Medium-term (3-5 yrs): The shift to online shopping in lower tier cities should continue to gather steam and sustain JD’s growth. Additionally, JD Logistics can participate in a few other exciting opportunities including grocery and pharmacy delivery. I think we will see healthy topline growth coupled with continued operating margin expansion. JD retail could reach 5-6% operation margin by the end of this period.

Short-term(1-2yrs): Honestly, I don’t know. Any major investment initiative can make a dent on margin and any short-term cost-cutting can exaggerate the gain. If someone has a clear picture on this, I’m all ears.

Here I present a crude calculation based on my reasoning above:

Base year: 2019, JD Retail Revenue (Product + Advertising revenue, 3 quarters of actual results+  Q4 quarter estimate based on management’s guidance): 544B RMB.

RMB to USD: 7:1.

Discount rate/IRR Hurdle: 10%

Medium Term (5 yrs): 6% operating margin, 4.5% net margin, 2% stock comp/annualized shares dilution, Rev CAGR: 20%, P/E 25X

Net Income: 8.7B USD, market cap 217.7, PV: 123B

Long Term (10 yrs): 10% operating margin, 7.5% net margin,2% annual share dilution, Rev CARG: 15%(20% CAGR for the first 5 yrs and then 12% CAGR for the next 5 yrs), P/E 20X

Net Income: 25.5B, market cap 511.5B, PV 164B

JD Logistics + Health: JD’s 80% stake of current valuation gives us about 16B

Upside: 5yr model PV + JD Logistics + Health vs current market cap: 193% gain from the current price

             10yr model PV + JD Logistics + Health vs current market cap: 281% gain from the current price

Freebies that are not included in the upside calculation:

JD has 16.4B USD in cash and investments on its balance sheet against 1.44B borrowings. Not included in the upside calculation because we don’t know how much of the cash is marked for future capex.

Amortization from business acquisition tops 100m per year that can be added back to the net income.

JD realized 0.4B asset-sale gain from its asset drop-down to the JD Property Fund. There will be future gains as JD sells more assets to the property fund.

Risk:

Competitors’ logistics service catches up

JD service quality decline or brand damage

RMB—USD Exchange risk

Slowdown in China

JD embarks on new giant infrastructure projects

Wrap-Up:

JD, as a company, is not the next Alibaba or Amazon. JD’s technology besides logistics is just not that strong. It doesn’t have an Ant Financial or an Amazon Cloud so it should not trade at similar multiples to these firms. However, sexy companies don’t always guarantee juicy stock returns. JD’s stock looks very appealing at the moment because JD does deserve a place in China’s e-commerce space and in a few other adjacent areas such as logistics. Jack Ma laughed at Liu’s boring infrastructure plays but finally JD Logistics has turned the corner. Maybe Liu is onto something. Maybe boring could be the new sexy.

Catalyst

Margin expansion: core + third party logistics

Consistent rev growth

JD Logistics spin-off

Growth in JD Pharmacy