Description

I believe ZTO Express is perpetuating fraud on American investors.  I believe that its financial statements materially misrepresent its business and that the company is nowhere near as profitable as it purports to be.  Furthermore, it has just about every possible red flag that a potential China short can have.

ZTO Express is one of several large express parcel delivery services in China.  These are the guys that deliver all those packages BABA sells on Singles Day. They claim to have about 16% market share.  Other major players in the market are YTO Express (13% share), STO Express (10%) , SF Express (8%) , and Yunda (12%)- these are ZTO’s share numbers that don’t necessarily foot with reported financials.  Conveniently all of ZTO’s major competitors are also public companies listed in China.

Let’s have a looksy at what these companies that are purportedly in the same business have for margins (I am going to use 2017 numbers since the 2018 20-F isn’t out yet):

So let’s get this straight.  ZTO is in the same exact, extremely competitive business as five other local companies yet earns a net margin multiples of the industry average.  I don’t think so. Let’s go ahead and sanity check the margins against other major global package delivery companies UPS, Fed Ex, and DHL (Deutsche Post).  Oh wow their margins look similar to the low margin Chinese competitors. So this company founded in China in 2002 has found a way to make package delivery vastly more profitable and efficient than companies that have been at it for over 100 years and have more scale, or something else is going on here.  The answer, in my opinion, is financial shenanigans.

ZTO discloses in its 20-F that it’s model relies on “network partners” to complete last mile delivery for it.  It claims to have 3,800 direct network partners and 5,700 indirect network partners under its brand (pg. 7 20-F). As far as I can tell the indirect network partners are just subcontractors for the direct network partners.  The company also uses some partners for its line-haul deliveries. Apparently some of those partners are also owned by “certain employees” of ZTO.  From page 11: “We outsource part of our line-haul transportation needs to Tonglu Tongze Logistics Ltd., or Tonglu Tongze, which is a transportation operator that works exclusively for us. Tonglu Tongze had a fleet of around 1,200 trucks as of December 31, 2017. In 2015, 2016 and 2017, we incurred RMB703.1 million, RMB853.2 million and RMB809.4 million (US$124.4 million), respectively, of transportation service fees to Tonglu Tongze and its subsidiaries and had RMB84.6 million, RMB121.5 million and RMB105.8 million (US$16.3 million) of accounts payable due as of December 31, 2015, 2016 and 2017, respectively. Certain of our employees and certain employees of Tonglu Tongze beneficially owned 75.6% and 15.8% equity interest in Tonglu Tongze as of December 31, 2017, respectively.”

ZTO’s revenue is whatever its “network partners” pay them for delivery between hubs before the network partners take the packages the first or last mile.  So, if ZTO employees control ZTO and also control some of their partners, can’t ZTO just set the fees and therefore ZTO’s profits to almost any level they want?  I believe that from end to end package delivery when done well is a 10%ish EBIT margin business. It is capital intensive and competitive. Most of the Chinese competitors show these margins.  UPS and Fed Ex show these margins. So what I think ZTO is doing is basically running its partner businesses at breakeven or (more likely) significant losses to make ZTO look much more profitable than the actual package delivery business is.  

So, basically, I think ZTO has fooled investors into believing this is magically a super profitable business when the main costs that are required to provide the end to end service are happening “off the books” at the network partners or with related parties.  ZTO discloses that its network partners contracts only last 3 years, so if ZTO is gouging them so badly (and they must be to have these huge margins vis a vis competitors), why aren’t they all fleeing in droves?

So pretty much, this is where I think the “fraud” is happening.  I mean maybe it technically isn’t fraud- they just are showing you part of the business with favorable transfer pricing that they make up.  And I’m not saying there isn’t a real business underneath this- for sure ZTO delivers a lot of packages. I just think the profits appear to be wildly overstated.

Additionally, ZTO has almost every China fraud stock red flag I have seen.  The shenanigans would be enough to make even Howard Schilit blush.

RED FLAG #1: This is a Variable Interest Entity (VIE) company.  That means U.S. shareholders don’t own the company.  They own contracts that promise to pay them the proceeds from the company.  The ZTO insiders actually own the company in China and they just promise to pay the proceeds up to the Cayman Island company that US ADR holders own.  It’s against the law in China for foreigners to own a parcel delivery service, so the VIE is a “legal” workaround. The only problem is, there have been several examples of the Chinese founders just taking the assets of these VIEs and leaving the shareholders with nothing (see the story of ChinaCast https://www.reuters.com/article/chinacast-bankruptcy-idUSL1N1DB2ID and also Gigamedia https://www.chinalawblog.com/2011/06/vie.html).  Chinese courts aren’t going to enforce these contracts on U.S. shareholder’s behalf if something goes wrong.

I’m not just making it up, ZTO describes this clearly on page 22 of the 20-F :

Under current PRC laws and regulations, foreign enterprises or individuals may not invest in or operate domestic mail delivery services. According to the Guidance Catalogue of Industries for Foreign Investment (most recently revised in 2017), foreign investment is prohibited in the establishment of any postal enterprise and in domestic mail delivery services. Postal enterprises refer to the China Post Group and its wholly-owned enterprises or controlled enterprises providing postal services, as well as other services including but not limited to mail delivery, postal remittances, savings and issuance of stamps and production and sale of philatelic products.

We are a Cayman Islands company and our PRC subsidiaries are considered foreign-invested enterprises. Accordingly, none of our PRC subsidiaries is eligible to operate domestic mail delivery services in China. It is also practically and economically not possible to separate the delivery of mail from the delivery of non-mail items in our day-to-day services. To ensure strict compliance with the PRC laws and regulations, we conduct such business activities through ZTO Express, our consolidated affiliated entity, and its subsidiaries. Shanghai Zhongtongji Network, our wholly-owned subsidiary in China, has entered into a series of contractual arrangements with ZTO Express and its 43 shareholders, which enable us to (1)exercise effective control over ZTO Express, (2)receive substantially all of the economic benefits of ZTO Express, and (3)have an exclusive option to purchase all or part of the equity interests and assets in ZTO Express when and to the extent permitted by PRC law. Because of these contractual arrangements, we have control over and are the primary beneficiary of ZTO Express and hence consolidate its financial results as our variable interest entity under U.S. GAAP.

The corporate structure is also very complex.  There are a lot of places for things to go wrong before cash flow makes it back to the ADR holders via the Cayman Islands.

RED FLAG #2:   ZTO is continuously raising money even though they have a ton of cash on the balance sheet.  First, they did the IPO in October 2016 where they raised $1.4 billion by selling 72 mil shares at $19.50.  Then in May 2017 ZTO announced that they would do a share repo of $300 million (the stock was $13 at the time).  They only completed $137 million of the repurchase in 2017. In May 2018 Alibaba and Cainiao (Alibaba’s in house delivery solution that routes orders to various express delivery services) announced they would purchase 10% of the company for $1.38 billion.  At the time ZTO claimed to have $1.424 billion in cash and ST investments on the balance sheet, so why did they need this capital? This seems highly suspicious to me. Did they actually need capital to keep their business afloat due to losses at the affiliated off the books companies?  It seems possible to me. In June 2018 ZTO then turns around and makes a $168 million in Cainiao’s last mile delivery service (all the other major express players also invested at this time). In November 2018 ZTO announced a $500 million buyback. We’ll see how much of it they actually execute this time.

RED FLAG #3:  ZTO uses Deloitte Touche Tohmatsu.  This is the same auditor that “audited” major frauds Longtop Financial and ChinaCast (https://www.businessinsider.com/china-stock-fraud-longtop-banks-complicit-2011-5 and https://www.sec.gov/news/press-release/2013-200).  Per the risk factors in the 20-F its auditors are not inspected by the PCAOB.

RED FLAG #4: ZTO had material weaknesses found in their financial reporting at the time of their IPO and in 2016.  They claim the deficiencies have been remediated for 2017, but how sure can one be, especially with Deloitte Touche Tohmatsu auditing as they have been fooled many times before?

RED FLAG #5: ZTO uses a dual class share structure so its Chinese owners maintain total control of the company.  The CEO Meisong Lai economically owns 213 milllion shares (29%) but has 84% voting power through a Class A and Class B (10 votes) share structure.

RED FLAG #6: Most of their employees (28,000 as of the end of 2017) are actually contractors they don’t control.  The company may be held liable if the contractors they hire don’t provide benefits to these workers as required by Chinese law.  They only directly employ 16,023 employees according to the 20-F.  This was down from 17,324 in 2016 and 26,119 in 2015.  There appears to be a law in the PRC to limit the use of temp workers so maybe ZTO is trying to skirt it?  Why else would their direct employee numbers be falling as the business grows? (Pages 92, 56, 9)

RED FLAG #6:  They don’t own 92 of the buildings used by the company.  They hope to properly register ownership for 10 of their buildings by the end of 2018.  Also the owners of 26% of their leased properties haven’t been able to prove they own the properties. (Page 20 of the 20-F)

RED FLAG #7:  ZTO faces huge customer concentration risk. Per their conference call regarding the Alibaba investment,  Alibaba accounts for nearly 70% of ZTO’s volume.

RED FLAG #8:  This company uses a third party outsourced IR firm (Christensen) that seems extremely sketchy.  Check out the reviews on Glassdoor.

https://www.glassdoor.com/Reviews/Employee-Review-Christensen-AZ-RVW14434.htm

Even aside from all these red flags, express delivery in China is a brutally competitive business.  There are numerous articles and blog posts online talking about this. Here are some examples:

http://jefftowson.com/2017/07/why-the-race-to-become-the-fedex-of-china-has-just-gone-into-overdrive-pt-1/

http://jefftowson.com/2017/04/who-will-become-the-fedex-of-china-pt-2/

https://technode.com/2018/05/21/if-you-dont-want-us-to-throw-your-package-pay-for-insurance-parcels-in-china-still-manhandled-despite-prolonged-regulatory-efforts/

https://technode.com/2018/03/14/is-sf-express-nearing-the-end-of-paper-thin-profits/

The net of it is while there is a lot of demand (40 billion shipments in 2017, 50 billion in 2018) there are also thousands of competitors and low barriers to entry.  Alibaba plays all the delivery services off each other via Cainiao which routes packages to the most efficient option (http://www.chinadaily.com.cn/a/201805/31/WS5b0fa0a0a31001b82571d739.html)

while JD.com has actually built out its own delivery network (https://www.freightwaves.com/news/asia/china/jd-logistics-builds-last-mile-efficiency).

It is in no way clear to me that ZTO will be the eventual winner in this market.

By the way Amazon says it delivered 5 billion items (not packages) to its ~100 million prime members in 2017.  So for the most ambitious Amazon users they are buying 50 items per year which probably equates to less than 40 packages a year.  In China there are about 1.386 billion people so if you believe the 50 billion statistic their penetration rate is nearly as high (36 packages per man woman and child) as that for “high spending” Prime members.  How much bigger can this market actually get?

The bulls would argue that ZTO earns such high margins due to the franchise model where the network partners handle that last mile piece.  This would be fine, but the only company that is vertically integrated is SF Holdings (you can see that in their huge revenue number above), the other companies with the same franchise model still have super low margins.

So even if all the red flags don’t matter, I still don’t think this is necessarily a great business.

So I guess the real question here is, why short it now?  Much of this argument was true at the time of the IPO and last year.

I think now is a good time to short the company (or express a negative view with options that are readily available) because I do believe we are getting a slowdown in China. Apple is seeing it in iPhones.  Auto sales are down 18% y/y in January. Even the official GDP growth numbers are slowly rapidly. Who knows how long it will go on or if the government will intervene successfully as it so often has, but the risks are higher now than at any other time since ZTO has been public. Frauds tend to fall apart when things slow down.  

Additionally, the stock is flirting with 52 week highs despite BABA coming back nowhere near its prior highs, so this seems like an opportune entry point. Maybe there is one more pop on some kind of perceived US-China trade relations break through that provides one last hurrah, but in general it seems like now should be a good entry point.

Risks

• One risk is that BABA decides to buy all of ZTO and use it as its in house delivery service. Bulls would say the BABA investment shows they are strategically interested, but  I view this as unlikely. There are too many other competitors willing to do the job to take on this low margin business. Cainaio is specifically designed to play them off each other.
  
• Another risk would be a take private by management.  This has happened with a few US Listed Chinese companies, but often at super low valuations.  It seems very unlikely at 22x (supposed) earnings.
• The main risk is just that the fraud isn’t revealed in your investment horizon.  I am pretty sure something isn’t right here, but these things often take a long time to be revealed or recognized.  A little help from one of the excellent “short and publicize the bear case” firms would go a long way on this.

Catalyst

• China slowdown reveals chinks in the business model and/or fraud.
• Some well known China short seller does the work on this one and publicizes it. Carson Block or Kerrcap I’m looking at you.