Description

This write-up will be focused on the January 2020 call options with a $10 strike price. Currently these options are trading at 50 cents, which seems far too low given the stock was trading far above those levels so recently and the intrinsic value of the stock is so obviously far above the current price. This write-up will examine what has happened to the stock over the last 6 months (since the last write-up), then conclude with an analysis of the options at play.

This note follows-up on the one posted by Shoe on April 10. Since April the stock has plunged well over 60% to valuation levels (on an enterprise value basis) not seen since 2013 when the company's revenue was close to 10% of the current level. What precipitated this dramatic decline? VIPS did not deliver on the revenue growth acceleration that the market expected post-JD/Tencent tie-up, and as a result the stock has been forsaken by the "growthy cohort", and now finds itself plumbing the depths of the void. And plumb the void it has. It is now over 75% down from the high and trading near liquidation value. Is it time for the value crowd to step in?

Following the minority investment by JD and Tencent the market believed that VIPS would be able to re-accelerate its revenue growth back from the mid-20's perhaps back up above 30%. This is was not an unreasonable assumption given the relative scale of VIPS vs. Tencent and JD. However, it turns out that the past 2 quarters have been relatively disappointing (only meeting estimates), and more importantly guidance has been very disappointing - for example the company has indicated mid to high teens growth for 3Q18. The market did not like this as it was anticipating a re-acceleration of growth - and while growth investors in the US are exacting with their growth extrapolation of many hot companies, it seems that in China they are even more so. Maybe VIPS has been replaced by PDD, which is expected to grow revenue at 520% in 2018 (and therefore has a 18x EV/2018 revenue multiple). At any rate VIPS has a profile of 10-20% revenue CAGR right now, which is not enough for the growth community.

And, of course, while the revenue growth trajectory is uncertain, margins are also under pressure. Their gross margin has continued to decline from ~25% a few years ago to closer to 20% most recently. Even though they have scaled up it is hard to out-lever such a margin decline and so their earnings growth has stalled. This is because the competitive pressure in the ecommerce arena has been intense! Not everybody can grow at 520% per annum for obvious reasons.

So where does this leave us? Is it all doom and gloom?

·  First, the company does have its own niche as a partner to brands - they are a critical albeit nichey player in the ecommerce ecosystem as they are focused on liquidating off-season merchandise. So, the company does have a reason to exist and it does fulfill a purpose in the economy

• As evidence of this point, look at the number of brands selling product through their platform. Since 2010 this number has increased by more than 32x, and even in the last year the number of brands selling through their platform has increased by nearly 25%. They are obviously providing a solid value add for their 13,000+ clients.

·  The revenue is still growing mid-teens which is my mind is solid on an absolute basis

• Not only is revenue growing at a healthy rate, but the sustainability of current revenue appears to be getting more solid. 96% of revenue came from repeat customers, up from 93% in the prior year. 85% of customers are repeat customer, up from 79% in the prior year. Additionally, average revenue per customer increased by roughly 12% yoy and total orders increased by 31%. The point is that customer who try the product like it, they tend to use it again, and they tend to use it increasingly frequently for smaller orders. Although growth metrics have slowed, if the company is just able to sustain its advantages with its existing user base it probably is undervalued at its current low valuation.

·  It is still profitable.

·  Importantly for a Chinese company, it is definitively not a fraud. Aside from the fact that it is consumer facing and obviously a real company, the technology and value add has been validated by JD and Tencent

·  It has negative net leverage and the wherewithal to continue operating without any real capital structure pressure as they have 8.5bn rmb of cash and ST investment on BS. Given the company’s liquidity and the fact that it is profitable, it would appear to have a long runway to figure out a way to unlock value from its existing user base or start growing again.

·  It is now insanely cheap (see below)

Some other points

·  Margin pressure is somewhat overstated as recent accounting changes probably subtracted a point or so off gross margins recently. Of course, there is still real margin pressure. The company has indicated that they are going to refocus more on their core off-season apparel business and decrease focus on general in-season merchandise. This should result in slower growth but perhaps better margins, which is fine for a value investor

o Management indicated they are willing to take on more inventory risk to get better brands on the platform. Unclear what the risk profile of this is

·  The company's founder still controls the company and has not sold any shares. He owns over 10% of the company and is economically aligned

·  Validated valuation support - we have seen that Tencent and JD did their original transaction at $13.50. More importantly JD continued buying shares in 2Q at an average price of $14.1517 per share (i.e.. higher than the original deal price)

• Obviously these companies are capable of making bad investments, but it seems likely that they are privy to information directly from the company that we don’t have. Coupled with the data they generate themselves, they felt the company was a good strategic investment at more the 2x the current level. Importantly, the opportunity to sell out completely to these strategics probably sets a floor under the long-term value of the stock that is well above the current level. If you take the strategic value those companies have assigned to VIPS as a long term floor, then the options at play here present an incredible risk-reward.

·  Capitulation in share price probably based on the broader China bear market. If China was not in a bear market perhaps the shares would be trading higher than they are today, offering less insanely good risk reward

• Note that if you are extremely bearish on China the attractiveness of the shares materially declines. This is a consumer driven company based almost exclusively in China. A large recession there would be a major headwind for them.

·  FCF conversion still low because they are investing in capex

• Aside from the significance this normally holds for value investors, it may have some additional weight here because the market doesn’t seem to trust management to invest capital efficiently. For example, the rapid expansion of VIPS logistics network has obviously not had a significantly positive impact on the stock, but has been a material use of capital in recent years.

·  Did the JD/Tencent plug-in fail? It is unclear. Certainly, the results had not been as strong or sharp as the market expected, but it probably takes a few quarters for them to optimize.

• Note, from the beginning that VIPS management toned down the short-term expectations for the partnership, even as they hyped up the potential long-term impact.

Insanely cheap

·  In my estimation VIPS is trading at around cash + receivables + warehouses. This is unheard of for a company that is profitable and growing at a double-digit rate. Particularly if they are profitable!

·  It is trading at under 0.3x EV/revenue, 15x LTM adjusted earnings (adjusted earnings are similar to GAAP earnings)

·  Value bridge:

o Equity value as of Friday's close is 28.2bn RMB

o Cash and ST investments of 8.5bn rmb

o Consumer accounts/loans receivables of 4.6bn (this is primarily related to consumer finance business and not other general receivables of which there are 3.7bn)

§ No credit for inventory - 4.6bn (value folds into the "free ecommerce business")

o Warehouses - Probably worth ~5-10bn at least

§ This is tricky because they own 1.8mm sqm and we need to apply some rough value to it – I’ve seen reports estimating at around 5k rmb psm and another estimating it at 1rmb rent pd psm @ 50% margin capitalized at 15x

§ No value for leased warehouses though of course the value of those fold into the "free logistics business"

o Land use rights - Probably 4.3bn

§ I've seen a report taking BV and grossing up based on location. Tends to result in a 25-50% uplift from book value

o Total - 27.4bn (assuming the 10bn for land)

·  Based on this you are getting for free:

o The core ecommerce business (i.e. the point of the thing), albeit at a somewhat higher cost base assuming they had to lease out all their warehouses

o Consumer finance business (which other players have been able to monetize)

o Logistic business (again other players have been able to monetize)

• So what’s the upside case for the stock?
• If you go by strategic value the company has already been validated as being worth more than 2x it’s current price by two of the three biggest players in the Chinese market.
• If you go by P/E multiple and assume that a profitable company growing at roughly 20% per annum deserves at least a 20x multiple, then the company should be worth nearly 2x it’s current price by the end of 2018.
• If the company is able to capitalize on its partnership with JD and Tencent – if revenue growth reaccelerates toward the 30% range – if margins can be sustained at the current level or increased back toward the levels from a couple years ago – then you are looking at a conservative multi-bagger. Very attractive in a market like this.
• What’s the downside from this level?
• Liquidation value is not far below the current stock value
• If strategics were happy to pay twice the current level not that long ago for this stock, you’d think they would be happy to take the whole thing if it sunk much lower. In a full-blown China crisis this liquidity probably dries up quickly but barring that it would seem the current valuation is well supported in the private markets.

Given all the factors listed above at play for the stock, we believe the best way to play this is with long term (January 2020) options with a strike price modestly above the current level. If the company reverts close to the value assigned to it by the strategics, you make 6x on these options. At its most recent peak, around when it was written up earlier this year, this is an 18x investment. Given the potential for upside in the stock in the short term, as the partnership with JD and Tencent pays off and revenue growth reaccelerates, there is additional upside from here. 

Aside from the better potential upside, this actually may be a better way to limit downside given the dynamics in the stock. Within the next 15 months it will become much more clear whether the partnership will pay off. Moreover, it will become more clear if margins are in a state of permanent decline, or if they can stabilize around current levels. Finally, if the downside case plays out, it will provide management enough time to evaluate a potential strategic bailout and decide whether they prefer to maximize value or retain control. The point is, if a bunch of these things play out really negatively, then the stock might be worth close to 0 (a probability the market seems to be taking seriously given the current stock price). In that case you are better off limiting your capital at risk. BUT, if even a few things go right for the stock, then the stock should pass $10 very quickly. Given how cheap the options are, they seem like the ideal vehicle to capture much of the upside on the stock over the next year with limited risk of capital loss in the event management decides to go down with the ship.

Risks

·  The company's moat is not the most robust - trends in consumer behavior in the ecommerce arena are subject to change quickly and this is absolutely a risk with VIPS. Valid concern but you have the shares trading so cheap that you have liquidation value protection

·  The more immediate risk is what happens with revenue growth and margins? For reasons explained it is probable that revenue will continue to grow in the teens which is okay by me but there is no guarantee. With a modulated growth profile perhaps the margin pressure will abate but who knows? FWIW the company has guided to a margin rebound in the intermediate time frame

• Important note: if revenue growth or margins disappoint in any given quarter, the stock could certainly drop dramatically from here. Insofar as there are still some growthy investors in the stock, it seems likely they sell en masse if revenue misses big.

·  Generic china macro risk

What would break the thesis?

·  If there is no improvement in growth stats, and the market takes too long to recognize the intrinsic value of the stock

·  If margins continue to compress while revenue growth slows and they swing to a loss-making operation

• If they then refuse to sell and continue burning cash expanding their footprint to defend their position, they could destroy intrinsic value to the point the current stock price would be justified. Note in this scenario it would be better to own the options than the stock!

Other thoughts on comps

·  TJX is the US comp, brick and mortar, see how it trades? To be fair it has higher gross margins (which translates into high net margins). Lower growth than VIPS (mid-high single digit to low double digit). More mature for high FCF conversion. 1.7x EV/revenue

·  M&A for similar stuff like Zulily in the US has been @ 2x revenue

·  VIPS has really been displaced as the one of the top ecommerce companies by PDD it seems. Just an anecdotal observation.

Catalyst

• Revenue growth accelerates as partnership with JD / Tencent pays off
• Market realizes liquidation value is too low for a profitable company growing at around 20% p.a. - rerates based off of profitability in 2018 and 2019
• Sell to a strategic