Long: JD.com (NASDAQ:JD)

3 May 2017

Disclosure: I’m long JD in the low-$30s so all valuation numbers are based on my average cost. All figures are in RMB except for per ADS figures and otherwise noted. 1 ADR/ADS = 2 ordinary shares.

Recommendation: Long. The consensus regards JD.com as a complex, highly capital-intensive, perpetually loss-making retailer myopically focused on growth trading at an optically expensive valuation. My variant view is predicated on the belief JD.com has substantial latent earning power which is concealed by significant growth investments which are run through the P&L and cash flow statement. Even in a draconian scenario – assuming its direct-sales business operates at breakeven in the long-term, shares can be acquired at a mid-teens multiple of normalized earnings. With massive long-term capital-light reinvestment opportunities protected by terrific competitive advantages and funded with zero-cost financing, the risk/reward on the long side is extremely compelling, in my view.


At first sight, JD.com (NASDAQ:JD) (“JD” or “the Company”) appears highly complex, perennially loss-making, massively capital-intensive, focused on growth at all costs, and is optically expensive.

Analysis suggests the Company possesses irreplaceable logistics assets and insurmountable competitive positions. JD is nearing an inflection in profitability as gross margins continue to expand due to mix-shift to higher margin products in the 1P business and strong growth in the 3P business which carries very high incremental margins. This positive inflection should result in a reversal of its valuation allowance.

The proposed reorganization of JD Finance would unmask the highly free cash flow generative nature of JD. Free cash flow is also currently depressed. While skeptics may balk at the fact the vast majority of the Company’s cash generation stems from working capital, they ignore its steady-state economics.

With massive capital-light reinvestment runway, a favorable competitive landscape, no fraud risk, and remote risk of permanent capital impairment, I believe JD offers extremely compelling risk/reward over the long-term.

A long position in JD.com is merited by the following:

Variant Perception: Shares of JD are mispriced as the market sees losses since inception and high capital intensity resulting in negative cumulative FCF. Therefore, JD does not show up on traditional value investor screens. I believe the Company is close to an inflection point which should result in strong profitability going forward.

In addition, the consolidation of JD Finance which penalizes JD for the operating expenses of the finance arm without commensurate revenue benefit (note – this point on the revenue benefit is based on the 2015 20-F disclosure; it no longer applies with the 2016 20-F disclosure – JD does include the revenue benefit) is obscuring strong free cash flow while aggressive price investments in 1P, investment in fulfilment in lower-tier cities, and massive growth CapEx is depressing FCF.

While the sell-side is largely bullish, their analysts are focused on the near-term as well as metrics not related to profitability such as GMV and revenue, likely due to the absence of GAAP profits at JD. To the best of my knowledge, none of the sell-side shops have bothered to analyze and develop a well-founded view regarding its long-term economics. As a result, the fast-growing underlying cash generation at JD is vastly under-appreciated by the market, in my view.

Entrenched Competitive Positions: Business-to-consumer (“B2C”) eCommerce is generally split into direct sales (“1P”) and 3rd party (“3P”) sales. 1P sales involves the retailer sourcing inventory directly from suppliers and selling it to customers. 3P sales comprises of the retailer providing a platform for third-parties to sell to customers.

Dominance in the 1P market depends largely on economies of scale and brand equity. Scale results in higher procurement leverage, broader product selection, and lower per-order fulfilment costs. Brand equity is important as it reduces search costs and cultivates mindshare. Customer mindshare is won on the basis of low prices, delivery speed, and product authenticity.

The confluence of this pair of factors forms a compelling feedback loop – as per-order distribution costs decrease, profits can be reinvested into additional, broader SKUs (allowing volume leverage for suppliers), which attracts more consumers to JD, leading right back to lower per-order distribution costs, repeated ad infinitum. As a result, firms who are the low-cost operators, with large supplier and customer bases, and substantial mindshare can be expected to dominate the 1P market.

JD already has a massive lead vis-à-vis its logistics competitors. Management mentioned on the 4Q15 earnings call (page 15), “Recently two couriers, major couriers in China, I think they are called STO and YTO, went top in China so we did get a chance to see the numbers. If you look at their number their price per parcel on average in China is about RMB13 per parcel ­­ over RMB13 per parcel. And if we look at our internal numbers, as far as delivery is concerned, it’s lower than that.”

Once achieved, dominance is likely insurmountable as cost advantages are impossible to replicate and consumer mindshare cannot be cultivated due to the lack of capital stemming from the absence of scale. Replication would not only require 1) the attraction of large amounts of suppliers and customers, but 2) ungodly amounts of capital to invest in building a distribution network with sufficiently dense coverage, and 3) a reputation for low prices, fast delivery, and product authenticity; all of which are chicken-and-egg problems.

On the other hand, dominance in the 3P market depends largely on network effects. Network effects are present as suppliers look to increase their potential customer base while consumers look for wider product offerings. Thus, each incremental supplier and customer added to the marketplace increases the overall value of the platform. Dominance is similarly unassailable as a large network is nearly impossible to replicate as there is no reason for incremental suppliers/customers to flock to any networks but the largest – risk of replication is thus very remote.

China B2C by direct sales market share

China B2C market share

As seen above, JD shares a duopoly with Tmall (owned by Alibaba) in B2C eCommerce with the Company holding ~25% market share vs Tmall’s ~57% as of 2016. The Company however has an effective monopoly in the 1P market with ~57% market share as of 3Q15. JD has built a world-class distribution franchise which allows 85% of 1P sales to be delivered on the same/next-day.

Imminent EBIT Inflection: JD is currently unprofitable on an EBIT basis, which has been the case for many years as implied by substantial accumulated losses on the balance sheet. I believe EBIT is set to positively inflect driven by the shifting of the Company’s 1P mix to higher-margin general merchandise, the growth of fat-margin 3P services & other revenues, and continued increases in minimum order sizes eligible for free shipping, as well as greater economies of scale.

JD’s initial foray into the 1P market in 2007 was focused on electronics and home appliances. These were fast-growing, high-volume markets at the time driven largely by global smartphone penetration. This allowed the Company to gain substantial scale in procurement, distribution, and customer base over a short period of time. However, electronics and home appliances are generally low-margin as there is substantial competition amongst manufacturers on the low-end and strong OEMs on the high-end such as Apple.

Beginning in the early 2010s, JD begun diversifying its mix into general merchandise (apparel, footwear, F&B, etc) which are relatively high-margin. Despite intense competition in these areas, they carry high incremental margins for manufacturers. Given the Company is a vital distribution channel for manufacturers, JD is able to extract a significant portion of the economics from them.

The mix shift is ongoing and has been a significant driver of gross margin expansion over the past years – general merchandise & others accounted for 20% of JD’s core GMV mix, increasing to 49% in 2016. A similar trend is occurring in 1P, where the mix of general merchandise & others is roughly high-teens. General merchandise & others continues to grow at faster rates as compared to electronics & home appliances, which should result in continued gross margin expansion going forward.

JD primarily acts as an agent in the 3P market collecting marketplace and payment transaction fees which carry very high incremental margins due to de minimis cost per additional transaction. 3P contribution has been growing as a proportion of core GMV from 9% in ’11 to 42% in ’16. 3P growth rates continue to exceed 1P, suggesting further room for margin expansion.

Besides fees, JD also offers warehousing and delivery services to its 3rd party merchants. Penetration for these services are ~25% as of 2015, suggesting a long run-way. The Company also offers marketing services to its merchants.

In addition, the Company benefits from a natural maturation of its customer base whereby its customers, if retained, tend to make more purchases with the passage of time. For example, JD’s 2008 customer cohort made an average of 3.7 purchases in their first year, increasing to 25.7 in their ninth year (i.e. 2016). If we assume no incremental customer additions but a maturing of the Company’s current customer base to the mid-point of its current average purchases and that of the 2008 cohort (i.e. ~16.5x average purchases from the current ~7.0x), JD would be able to more than double its revenues and realize significant operating leverage, all else equal.

Finally, JD has been raising the minimum order size required for free shipping every year. It was initially zero, but has increased to 29 yuan, 59 yuan and finally 79 yuan in 2015. Larger minimum orders encourages greater purchase values and are effectively price increases. This should also act as a margin tailwind in the future.

The Company recently demonstrated its potential for operating leverage, with per-unit fulfilment expense falling sharply in 4Q16 due to exceptional sequential growth. Fulfilment cost per order has also been declining from $20+/order to the low-$10s in recent years.

Near-Term Catalysts: In my view, there are significant catalysts which should reprice shares over the next few quarters – a possible reversal of the Company’s valuation allowance against its deferred tax assets and the proposed reorganization of JD Finance (“JDF”).

As of 2016, the Company has taken a full valuation allowance against its deferred tax assets. This is unsurprising given cumulative losses at JD. Its deferred tax assets mainly comprises of $6.1b in NOLs. Mix-shift to higher margin products and services should lead to EBIT inflecting positively and management reversing said valuation allowance.

JD Finance is the Company’s internet finance business, which mainly provides consumer, supply chain, and business financing, as well as ancillary services such as crowdfunding, insurance, and wealth management.

JDF has been complicating the Company’s reported financials and obscuring the highly cash-generative nature of the core 1P and 3P businesses. Changes to loan receivables are run through net cash from operations (this has been appropriately reclassified to investing activities as of the 2016 20-F) along with originations and repayments (which are nestled in accounts receivables, payables, advance to suppliers, etc). Given JDF’s astounding growth, it is a gigantic cash drag on the Company.

On 1 March 2017, JD entered into agreements to dispose its 68.6% stake in JDF for $14.3b and 40% of JDF’s future pre-tax profits subject to positive pre-tax income on a cumulative basis, and the option to convert said profit-sharing right into a 40% interest in JDF.

Importantly, the reorganization will result in the deconsolidation of JDF from the Company’s reported financials and thus remove the aforementioned cash drag and expose the strong free cash flow generation of the core businesses.

Specifically, it would remove the net originations/repayments of JDF – which are massive at $10.6b in ’15 (over 6x net operating cash flow) and $11.3b in ’16 (~1.3x net operating cash flow) and cash outflows from loan receivables – which are still relatively big at $3.5b in ’15 (~2x net operating cash flow), from the Company’s reported net cash from operating activities. As a result, net operating cash flow should benefit massively once the reorganization is complete.

The Company already provides these adjustments in its non-GAAP financials but skeptics have questioned these adjustments, believing them to be inappropriate as they assert JDF is core to conducting business at JD. This skepticism is unfounded as there are many other alternatives to JDF available (e.g. Tencent’s WeBank and Alibaba’s Ant Financial), even if JD did not utilize JDF’s financing services.

Limited JD Finance Risks: Despite limited disclosure regarding JDF, I believe the risks of blow-up is remote. Non-bank financials typically blow up for three reasons – credit risk, duration mismatches, and unstable funding. I believe all three issues are trivial at JDF.

As of year-end 2016, consumer finance loan balances account for ~67% of total loan balances. Credit risk should be minimal given low-dollar loan balances and a highly diversified customer base. Duration risk should be small given loan tenures range from 1 day to 36 months, with loans in excess of 6 months relating primarily to business financing. An unquantified amount of consumer finance balances are also securitized on a non-recourse basis.

Supply chain financing accounts for ~31% of total loan balances. Credit risk should be mitigated by a highly diversified merchant base as well as the fact supply chain financing is collateralized by the merchant’s inventory. Duration risk should be low given these are essentially working capital loans, suggesting a tenure of less than a year. An unquantified amount of supply chain finance balances are also securitized on a non-recourse basis.

Business financing accounts for ~2% of total loan balances and thus should not be a problem even if credit, duration, and funding risks are high; which they are probably not.

The most glaring risk is the wealth management unit which resells yield products to third-party investors. The total figure held on the balance sheet is roughly $28b – $11b are higher-yield while $17b are lower-yield. The unit retains the risk/reward on these products and is hence exposed to yield differentials. The major risk is interest rate risk and the possibility that a large portion of these products are simply worthless. However, at their current size, draconian scenarios can hurt JD but will not be lethal. These risks will also be further mitigated once JD Finance is spun off.

Capital-Light Reinvestment: JD operates a negative working capital structure with core NWC accounting for roughly -6% of ’16 sales. Negative working capital is driven by rapid receivables collection, low inventory, and substantial accounts payable.

Core NWC is fully funding CapEx (2% of ’16 sales), implying reinvestment into growth is zero-cost and capital-light, requiring almost no incremental tangible capital; despite 13-fold increase in sales, the sum of incremental net PP&E, net working capital, and capitalized operating leases has been very low and occasionally negative when adjusted for JDF.

Reported accounts receivable days have ballooned from 2.6 in ’13 to 24.5 in ’16. However, this massive increase in accounts receivable days is related to the growth of the JDF business. Adjusting for their loan balances, JD’s accounts receivable days averaged 4.5 from ’14 to ’16.

Reported accounts payable days have increased from 58.8 in ’14 to 72.7 in ’16. Similarly, this increase in accounts payable days is related to the growth of the JDF business. Adjusting for their loan balances, JD’s accounts payable days averaged 57.8 from ’14 to ’16.

In addition, I believe the Company has room to expand its accounts payable days by a substantial amount as it exploits its size and leverage over suppliers. Amazon, which operates a similar business to JD, have accounts payable days in excess of 90, suggesting significant room for JD to increase its accounts payable days. Competitor Gome is at ~128.

Management has also mentioned this potential in its 1Q15 earnings call (page 15), “I did mention in my earlier remarks about our working capital, our accounts payable base, outstanding was only 40 days this quarter which is probably the lowest in the industry. So we at some point this payable cycle will gradually increase which will certainly add a lot of cash flow to our business. So we haven’t really pulled trigger but the change should be moving up in the next three to five years…”

Management provided further elaboration, “If you look at payable situations at other offline retailers of the similar size they tend to have much longer payable days sometimes around 100 days we only have about 40 days and this shows our strong support to our suppliers. Having said that, it also indicates that we have lot of potential to further improve our cash situation and we’re not going to increase our payable days abruptly but I think over the next few years we do have potential to increase that by some days every year.”

Depressed Free Cash Flow: I believe the Company’s free cash flow is currently depressed due to substantial growth CapEx, the presence of JDF’s OpEx, aggressive price investments in new categories, investing in distribution for lower-tier cities as well as its 3P logistics offering.

JD has been increasing its distribution footprint in order to support sales growth. As of year-end 2016, its distribution footprint spans ~5.6m square meters. Management intends to grow this to 10m square meters in the future and has been investing substantial amounts as a result.

In ‘15 and ’16, JD spent ~$5.3b and ~$4.5b in CapEx respectively. Its distribution footprint was 2.2m square meters as of 2014; clearly substantial capital has been spent to grow this figure since then. I think depreciation is decent proxy of mCapEx and it would suggest ~$2.5b in growth CapEx for ’16.

As noted earlier, the Company’s consolidates JDF’s financials in its historicals. Thus, JDF’s revenues and operating expenses are run through JD’s income statement. The de-consolidation of JDF should remove approximately $1.78b in operating losses stemming from ‘New Businesses’ which comprises primarily of JDF.

Additionally, the Company is aggressively investing in lower prices for the FMCG category it entered recently. The strategy of price wars in individual product categories to drive competition out of the market has been executed by JD before and it has eventually resulted in the Company emerging as #1 and being profitable in said categories (e.g. books in 2009, large home appliances in 2012, source: 4Q’16 earnings call) as competitors fail to profitably match JD’s price-points.

Substantial price investments is confirmed by Baidu queries revealing slightly greater numbers of search results for “coupons” for JD as compared to Tmall despite having less than half the GMV. Casual usage of the JD app shows numerous promotions every couple of hours. Mix-adjusted gross margin comparisons with competitors lead to a similar conclusion.

I do not expect gross margin expansion to stem from significant reductions in promotional spending or increases in product mark-ups. Instead I believe JD would reinvest less of its incremental volume rebates from suppliers in lowering price or giving out coupons as it gains critical mass and thus is able to profitably maintain competitive pricing in individual product categories.

The Company has also been investing in fulfilment for lower-tier cities to increase penetration and gain scale, per its 20-F disclosure. However, the Company had $1.47b in other income in ’16 which, judging from historicals, probably stemmed from government incentives. This is unlikely to be sustainable and hence should be treated as non-recurring.

Secular Growth Trends: Analysts estimate continued double-digit growth for online shopping GMV in China, presumably driven by increased Chinese consumption and share-taking from offline retail. B2C is likely to continue taking from C2C as online shopping becomes more mature in China and consumers increasingly demand higher quality products and services.

Online shopping penetration in China is ~64%. Spending per shopper is $1,855 as compared to $3,428 in the U.S. suggesting substantial room for growth, especially since China has more than double the e-shoppers as compared to the U.S. (413m in China vs 174m in the U.S.).  Collectively, these data points suggest JD has massive reinvestment runway. As noted earlier, reinvestment is capital-light due to a negative working capital structure which also fully funds CapEx.

online spending per e-shopper by country

b2c c2c gmv forecast

china online shopping gmv forecast

Compelling Valuation: It is difficult to accurately value a firm which is growing as fast as JD. However, one only needs to establish JD is tremendously undervalued at current prices to initiate a long position. Below, free cash flow is adjusted for certain items, though not all – given they were not quantified by the Company, to arrive at a normalized figure.

In addition, the value of the Company’s 40% stake in JDF based on the value implied by the reorganization transaction (i.e. 68.6% – 40% = $14.3b), proceeds from the JDF proposed reorganization, 26% stake in Bitauto, 21% stake in Tuniu, 10% stake in Yonghui, 48% stake in Dada, and cash is netted against current EV to arrive at an implied FCF multiple for the core JD businesses. The value of JD’s tax advantage vs U.S. corporations and its NOLs is excluded due to difficulty of calculation and conservatism. A 25% tax rate is assumed for the add-back of interest expense.

reconciliation of fcf

implied core JD valuation

While the above analysis suggests a relatively cheap valuation, the usage of trailing FCF is highly aggressive as it implicitly capitalizes the ~$3b contribution from WC changes (~$14b before JDF outflows). For many companies, capitalizing what is essentially cash from vendor float is inappropriate, given it is frequently a one-time event. Furthermore, cash from WC accounts for the near-entirety of JD’s current FCF.

Clearly, cash flow from working capital is only sustainable if JD continues to grow. As JD eventually matures, the cash benefit from WC will decline commensurately. While this would obviously decimate cash flow, I believe the decline of cash contribution from WC would be more than offset by JD earning steady-state margins, implicitly assuming no net cash contribution from working capital. As a result, I value JD based on my assumptions on its steady-state economics.

My base case assumes the 1P business is only able to break-even on a steady-state basis. Such an assumption is highly pessimistic as it essentially implies the e-commerce model is much less efficient as compared to traditional retail, which is patently false. In such a scenario, the sole source of earnings would be derived from the 100% margin 3P business (excluding revenue from ‘new businesses’).

This results in ~$16.5b in normalized FCF which is defined as fully-taxed net profit + depreciation & amortization + net after-tax interest expense – share-based comp – maintenance CapEx (treating maintenance CapEx as equal to depreciation), and implies a ~14x multiple for JD Mall. 3P revenue is 100% margin given all expenses are assumed to be borne by the 1P business and also excludes revenue from ‘new businesses’.

I believe ~14x normalized FCF at steady-state margins for JD’s core businesses is immensely cheap given its remarkable secular growth potential and limited risk of permanent capital impairment. Permanent capital impairment is remote given the Company has net cash, whose recession-resistance diminishes the downside of high operating leverage, has no obsolescence risk, and is likely to grow free cash flow at very high rates going forward.

In order for JD to be fair value, growth needs to decline to U.S.-like GDP growth rates, which seems vanishingly unlikely given country-, industry-, and company-specific tailwinds. As a result, JD offers highly compelling risk/reward.

In my view, steady-state net profit margins for the 1P business of 2%-4% are highly reasonable, driven by 16%-19% normalized 1P gross margins, 12% normalized OpEx margins, 25% tax rate, and a 100bps haircut at both ends for conservatism (see Long-Term Economics). In other words, my base assumption (1P breakeven) is likely too conservative.

On ’16 numbers, this equates to ~$26b-~$31b in normalized FCF, using the aforementioned definition, implying a 9x-11x multiple of normalized FCF for core JD. If 3%-5% 1P net profit margins are used on ’16 numbers, it would equate to ~$29b-~$33b in normalized FCF, implying 8x-9x normalized FCF for core JD.

Favorable Competitive Landscape: In my view, the current competitive landscape is highly advantageous to JD due to its reputation for authentic products and high quality customer service and the fragmentation of third-party logistics (“3PL”) competitors.

JD has continually gained market share from Tmall over the past few years. According to William Blair, JD’s 4Q13 market share was 13.6% while Tmall’s was 63.4%. In 4Q14, JD’s share improved to 18.6% while Tmall’s contracted to 61.4%. As noted in an earlier section, JD’s share is currently 24.7% vs Tmall’s 56.6%. While difficult to prove conclusively, it appears the Company has been able to consistently gain market share over Tmall and others due to its reputation for product authenticity and high-quality customer service.

Tmall has a reputation amongst Chinese consumers of being riddled by fake products. While JD is not totally innocent, the Company has taken drastic measures to ensure product authenticity – it even shut down Paipai.com, a C2C platform which was merged into JD, in an effort to stamp out fakes. JD also fired employees who encouraged merchants to engage in ‘brushing’, a practice where vendors pay fake customers to order product and empty boxes are shipped to these customers, allowing said customers to leave them positive reviews. Furthermore, JD imposes contractual fines of up to $1m if vendors sell fakes, according to a post-IPO interview. Finally, if fakes were widespread on JD, the Company’s 1P business should be extremely profitable as fakes typically carry very high margins. As a result, it seems JD is viewed as more authentic as compared to Tmall.

JD is able to provide high-quality customer service because the Company owns its distribution network. Tmall, which is owned by Alibaba, operates an asset-light model where Alibaba uses third-party logistics firms for distribution and occasionally takes minority stakes in said firms. While this allows Alibaba to operate at low capital intensity and generate high free cash flow, it is impossible for it to ensure high-quality customer service as third-party logistics firms do not have the scale JD has to guarantee same/next-day deliveries at comparable cost.

fragmentation of 3PL industry

According to a dated sell-side report, the 3PL industry in China is highly fragmented, with the top 5 players commanding a mere 10.2% market share. In effect, this suggests there are likely thousands of 3PL providers with minuscule market share. As noted in an earlier section, scale and density reigns supreme in distribution, and it is clear JD has the greatest scale. It is hence difficult to imagine any 3PL provider able to distribute at lower per-unit costs.

A third-party survey conducted by FT Confidential Research shows increasing user preference for JD and declining user preference for Tmall and Taobao, as shown below. Importantly, JD is the only site which is gaining popularity; the opposite is true for all its competitors.

JD reducing users preference gap compared to Alibaba

Similarly to Tmall, Taobao has a reputation for widespread counterfeit products. Taobao is pure-play C2C and hence operates a model which is structurally-inferior due to the inherent lack of control over third-party sellers.

The majority of third-party sellers on Tmall and Taobao lose money as a result of the need to spend substantially on marketing services in order to gain traffic; a product of too much competition (Tmall/Taobao had over 10m active sellers as of ’16 compared to JD’s figure of over 120k). While JD does sell marketing services, its 3P business is not largely driven by advertising.

The lack of profitability for Alibaba’s 3P sellers becomes apparent if we consider the fact despite Alibaba having ~13.6x the 3P GMV as compared to JD, the Company’s average GMV per 3P merchant is ~6.1x Alibaba’s. Note Alibaba’s 3P GMV includes both Tmall and Taobao; Tmall hosts over 100,000 brands which probably generate above-average GMV, implying average GMV per Taobao seller is likely much lower than the combined average.

The FT article linked in the prior paragraph asserts, “only between 3% and 10% of stores on Taobao are making money” and “…in any industry…the top-ranked sellers is losing 10% [of costs] per month, the second-ranked selling is losing 8%, the third-ranked seller is losing 5%, and so on.

JD’s management also noted in its 2Q15 earnings call (page 12), “It is probably true that the GMV number the brands can get from our platform is lower than on competitors. But it’s probably also true for many of them, in absolute terms they’re making more money from our platform than our competitors’ platform…We’re not advertising based business. They don’t need to spend a humongous amount of money on JD to get traffic…Because of the nature of our platform, our traffic is of a high quality, meaning we have customers and buyers come to our site, it’s very easier for the brand to convert them. Typically customers won’t spend – waste their time”.

As a result, the Company’s marketplace platform is a much more attractive choice for third-party sellers as compared to Alibaba’s Tmall and Taobao, in my view. Relatively strong third-party seller profitability at JD also limits incentives for counterfeit products due to loss aversion as compared to Taobao/Tmall.

Recessions Likely Blessing In Disguise: While a recession would certainly result in significant quotational loss, such a scenario would likely be a long-term positive for JD. This is because the negative impact would likely be much greater on its brick & mortar competitors.

Total offline sales have generally grown at low single digit rates as compared to the ~30% of online. This makes offline sales more susceptible to a decline in sales relative to online in a recession; offline sales growth would likely go negative while online would probably slow, but not decline overall.

Because of the inherent high operating leverage of retail, even a small sales decline would push offline players to large losses. Aside from margin decimation, decline in sales would result in large capital calls due to the enormous payables and relatively high inventory days (as noted above) of offline players. Overall, significant losses and large capital calls could materially impair offline players.

In addition, due to Alibaba’s reliance on advertising revenue rather than commissions, where the former is more susceptible to general economic conditions, BABA’s profitability could also decline sharply.

Due to the impossibility of collectively deferring consumption and the lower propensity for online sales growth to turn negative, JD is likely best positioned in a recessionary scenario, in my view. While shares would most likely suffer, a recession could ultimately be a blessing in disguise for the Company.

Limited Dilution Risk: JD has more than doubled its shares outstanding from ’11 to ’16, which raises the question whether the Company would dilute shareholders further. I believe this is unlikely given the current high cash generation ability of the core JD business nullifies the need for external capital. In fact, JD’s core business is so cash-generative that management has authorized a US$1b share repurchase program, of which roughly $800m has already been spent repurchasing ~31m ADSs.

Minimal Fraud Risk: Fraudulent companies tend to focus on showing amazing profitability by overstating revenues and understating expenses in order to attract investors. JD has made losses since inception which is inconsistent with fraud.

eCommerce firms which are aggressively promotional may attempt to engage in GMV inflation in order to show growth. Alibaba has a relatively aggressive definition of GMV – excluding apartment and vehicles orders above $500,000, products and services above $100,000, and aggregate single-day purchases exceeding $1,000,000 per buyer. However, JD defines GMV relatively conservatively, excluding transactions above $2,000 which are ultimately not sold or delivered. If the Company included the value of products and services regardless whether the goods are sold or delivered and excluded products and services with list prices above $100,000 and transactions made by buyers who purchase in excess of $1,000,000 in a single day, GMV would have been ~$939b in ’16, or ~43% larger as compared to the reported ~$658b.

High and growing levels of profitability is extremely valued by public market investors, who show their appreciation through their willingness to pay high multiples of earnings to own shares. Therefore, we would expect – and generally, this has been the case historically – the usual modus operandi of a fraud is to vastly overstate profitability by over-exaggerating revenues and under-exaggerating expenses. JD however has had vast cumulative losses, which is inconsistent with fraud.

Large variance in cash conversion cycle metrics could indicate aggressive accounting treatment. JD’s inventory days has remained between 45-50 over the past 6 years, only dipping to 37.3 in ’13 as the Company under-invested in inventory during that year, which it rectified the following year. Unadjusted, receivable and payable days have expanded significantly. However, this is largely attributed to the growth in JDF. As noted in earlier sections, adjusted for JDF’s loan balances, receivable days have averaged 4.5 over ’14-’16 while payable days averaged 57.6 over the same period. The Company defines cash conversion cycle slightly differently from convention, choosing average over the prior 5 quarters and dividing by 360 days. However, the value of reported metrics do not significantly differ from convention and thus does not present a problem.

To verify JD’s growing dominance, one can look to its competitors; if JD is taking share, its competitors should be suffering. Alibaba’s problems have been established in earlier sections. GOME, mainly a brick-and-mortar retailer focused on home appliances, started closing stores on a net basis in 1H’16. GOME is also suffering gross margin contraction in every product category despite higher revenue as it ramps up its e-commerce efforts. Revenue has been stagnant while sales per store have decreased from $56.5m to $52.8m or ~6.5% despite total sales area falling only ~3% over the ’11 to ’15 period. Dangdang, which focuses on books but have recently begun shifting to general merchandise, has similarly experienced gross margin contraction despite higher revenue over the ’13-’15 period. With major (i.e. Tmall) and minor (i.e. GOME, Dangdang) competitors struggling, JD prospering is the logical conclusion.

JD’s depreciation policies are either in-line or more conservative than Alibaba and Amazon. Alibaba depreciates computer equipment and software on a 3-5 year basis and Amazon does 2 years for internal-use software, 3 for servers, and 5 for networking equipment while JD does 3 years for electronic equipment and 3-5 for software. Software is the smallest component of JD’s PP&E and hence has minimal impact its financials. Thus, JD does not appear aggressive.

Alibaba depreciates furniture, office, and transportation equipment over 3-5 years and Amazon does 5 years for furniture and fixtures, 10 years for heavy equipment while JD does 5 years for vehicles and 5 for logistics and warehouse equipment. I believe Alibaba likely depreciates transportation equipment at the high-end of the 3-5 year range. Therefore, JD likely is not being aggressive.

Both JD and Amazon depreciates buildings at a maximum of 40 years while Alibaba’s maximum is 50 years. Alibaba’s minimum is 20 years but this is likely related to building improvements, which JD depreciates at 5-10 years. Amazon does not specifically disclosure its depreciation policy for building improvements. Ergo, JD’s policy is likely in-line with Amazon and more conservative than Alibaba.

Companies can fake cash balances if revenues and net profits are fake. Fake cash balances can sometimes be detected by observing the interest income earned on cash balances. Interest income as a percentage of C&CE has ranged from 0.9% to 2.7% over the past 6 years and is 1.8% as of ’16. This is consistent with HSBC China’s current 12-month time deposit rate of 1.75%, as seen below, suggesting JD’s cash balance is genuine.

HSBC time deposit rates

Revenue recognition practices have not changed from ’14 to ’15. However, JD recognizes revenue from its 1P business on a gross basis. The Company has arrangements with its suppliers to sell back slow-moving inventory, presumably at or near cost. This effectively results in inflated revenue and depressed gross margins. Importantly, it does not change net profit. JD could record 1P sales on a net basis and revenue will be deflated from current levels but gross margins will expand significantly but net profit will still be unaffected.

These conditions could result in JD selling back the majority of its inventory to suppliers while still recording the associated revenue – a very big red flag. This would result in scenarios ranging from very low growth to significant declines in gross profits despite revenue growth, depending on the amount of inventory sold back to suppliers. To determine if this is the case, one can look at the relationship between 1P revenue and gross profits. Assuming 100% gross margin for services, incremental 1P gross profits have been substantially positive each year and gross profits have generally grown in excess of 1P revenue over the past 6 years, suggesting the aforementioned situation is not occurring.

Some might be skeptical regarding the ramp-up in FCF generation in ’16. Trailing FCF essentially more than doubled. At first sight, this increase in FCF might appear to be as a result of the ~$22.2b increase in accrued expenses and other liabilities. However, the rapid growth in this balance sheet item was primarily due to JDF’s wealth management arm. As disclosed in a footnote to the 3Q16 6-K, the majority of the increase in said item was due to liabilities payable to individual investors who purchased financial products. The increase in accrued expenses and other liabilities and largely (~83%) offset by an increase (~$18.5b) in other investments in current and non-current assets, which JD has disclosed to relate to investments purchased to support its financial products offering to individual investors.

Companies engaging in accounting shenanigans often attempt to game quarterly/full-year EPS. On a high level, this can be checked by analyzing the frequency of which quarterly EPS rounds up – the logic being if a firm is not actively manipulating the numerator (i.e. EPS) or the denominator (i.e. shares o/s), its quarterly/full-year EPS should have roughly equal chance of rounding up or down. This appears to be the case for JD, as seen below, and is consistent with the assertion JD is not manipulating its numbers.

strategic rounding check

As part of JDF operations, the Company securitizes loan balances. These securitizations are huge – a massive $28b in ’16, or >3x net operating cash flow. It could have boosted free cash flow significantly by classifying the proceeds in the operating section of the cash flow statement. However, JD runs the net proceeds from these securitizations through the financing section of the cash flow statement.

In FY16, ~1.6b orders were fulfilled by 83.5k fulfillment personnel (66k delivery + 17.5k warehouse). This suggests ~19k orders fulfilled per fulfillment staff. Assuming a 260 working-day year, this implies roughly ~73 orders were fulfilled in a day by per fulfillment personnel, which is reasonable.

Global Logistic Properties is one of the leading logistics providers in the world. According to its December 2016 presentation, its China portfolio had a completed area of 15.8m sqm which it valued at ~US$12.8b, representing ~$US810/sqm or ~$5.4k/sqm. Defining JD’s 2016 gross fulfillment PP&E as the gross cost (before depreciation) of vehicles, logistics & warehouse equipment, as well capitalizing its operating leases at a 7% rate, gross fulfillment PP&E per sqm is ~$7.7k/sqm.

While this is not an apples-to-apples comparison as JD’s gross fulfillment PP&E as defined above includes vehicles, warehouse equipment, and is sensitive to the capitalized rate assumption, the figures appear in a reasonable range. In addition, the sum of growth capex and incremental capitalized leases (also at a 7% rate) over incremental warehouse capacity is ~$9.7k/sqm in FY16.

The Company has many related party transactions. Firms engaging in fraud often utilize related parties in order to overstate revenue or understate expenses. However, JD’s related party transactions mainly concern a major shareholder (e.g. Tencent) or companies it has invested in, making accounting shenanigans unlikely as the net effect of these transactions on JD is zero due to cross-ownership. Note the Company backs out the revenue stemming from its business cooperation agreements in its presentations.

In March 2014, JD entered into a strategic cooperation agreement with Tencent where JD launched level 1 access on Tencent’s WeChat/Wexin and Mobile QQ platforms – the most popular apps in China – with the former having 889m MAUs and the latter having 868m. This agreement allowed JD to supplement its growth on mobile platforms.

As part of the agreement, the Company issued ~352m shares to Tencent (through Huang River Investment Ltd). Tencent also subscribed to JD’s IPO and was allocated ~139m shares for a total of ~491m. Tencent agreed to a 3-year lockup ending 10 March 2017. Tencent holds ~499m shares as of 2015. It has increased its stake since, holding ~517m shares as of August 2016.

In June 2016, Wal-Mart and JD entered into a strategic alliance. As part of the agreement, Wal-Mart gets to expand its opportunity in China eCommerce, providing its stores with potential traffic from JD.com and the Company’s same-day delivery network. JD acquires and gets to leverage on Yihaodian, an online grocer in eastern and southern China. JD also gains access to imported items from Wal-Mart. Per the agreement, Wal-Mart was issued ~145m shares of JD. The retailer has been increasing its stake, and holds ~289m shares as of December 2016. Wal-Mart has a 5-year lockup ending 20 June 2021.

Considering Tencent has insight into sales data through its WeChat/QQ platforms and Wal-Mart through its supply chain and online traffic patterns to its stores, if JD was faking its numbers, Tencent would have disposed its stake following the expiry of the 3-year lockup.

The fact both strategic partners have continued to increase their stake following their respective strategic cooperation/alliance agreements is inconsistent with the assertion JD is faking its numbers.

I note Haoyu Shen, who formerly headed JD Mall before leaving in late ‘16, is currently at Hillhouse Capital Management, according to Bloomberg. Hillhouse was one of JD’s earlier investors pre-IPO, and currently owns 6.8% of the Company, according to the ’16 20-F. In my view, it is unlikely Hillhouse would still own a large position if JD was fraudulent as it is highly likely they have insider knowledge of JD’s operations through Haoyu Shen.

Risks of VIE Structure: Major variable interest entities (“VIEs”) are Jingdong 360 and Jiangsu Yuanzhou, and Suqian Limao, among others. Non-Suqian Limao VIEs are 45% owned by the CEO/chairman and 30% owned by employee Ms Yayun Li, and 25% owned by Ms Pang Zhang. The Suqian Limao  VIE is 62% owned by the CEO/chairman and 38% owned by Ms Yayun Li. The majority owners of the VIEs once included Jiaming Sun – a former employee, which presented the risk of this employee making off with the VIE assets. As of the ’16 20-F disclosure, this risk is contained to the CEO/chairman.

The largest risk is if the majority owner of the VIEs breach their contract in a way which results in JD not being able to derive substantially all of the economic benefits from the VIEs. I believe this risk is remote as Richard Liu, the CEO/chairman, appears to have very high integrity.

In the early years of JD, Tiger Management proposed to invest $200m into JD. Richard countered with $250m and Tiger immediately accepted. Richard thus realized he got low-balled. Even though he had a better offer of $300m from another firm, Richard felt he had to honor his agreements and chose to accept the Tiger deal, even despite one of his executives urging him to renege on the Tiger deal as it was only a verbal agreement. I believe the actions of the CEO/chairman speaks volume of his integrity and thus hold the opinion that the risks stemming from the VIE structure is remote.

In addition, consolidated VIEs accounted for 3.2% of JD’s sales in 2015. The main VIEs are Jingdong 360 which holds JD’s ICP license and operates the website www.jd.com, Jiangsu Yuanzhou which conducts the sale of books, audio, and video products, Suqian Limao which owns JDF, and Shangboguangyi which is the holding company of JDF. Therefore, non-VIE entities own the assets which comprise the near entirety of JD’s value. As a result, the incentive is not that large (i.e. they can’t ‘steal’ everything) for Richard to make off with the VIEs.

Current CFO Sidney Huang was the CFO of Longtop Financial Technologies from 2005-2006. Longtop Financial was exposed as a fraud in 2011. The subsequent lawsuit found the next CFO following Sidney’s resignation, Derek Palaschuk, liable for violating federal securities law.

I believe Sidney resigned from Longtop once he realized the firm was a fraud – CFOs usually take a year or so to ramp up and become familiarized with a firm’s financials and controls. This assertion is supported by the fact the lawsuit did not name Sidney as a defendant.

Aligned Management: Richard Liu owns 16.2% of the company and takes a RMB1.0 annual salary. In addition, he has a significant stock grant with a 10-year vesting schedule. I believe this speaks volumes of his long-term orientation and additionally reinforces the idea JD is unlikely to be fraudulent; if management was faking the numbers, they’ll likely try to cash out by issuing a ton of stock with rapid vesting schedules and selling them immediately after said stock have vested. With significant insider ownership and a long-dated vesting schedule, it can be concluded management interests are aligned with minority shareholders.

Long-Term Economics: Management expects 2%-4% net profit margins for the 1P business over the long-term. This assumes 16%-19% and 12% 1P gross margins and overall OpEx margin respectively, taxed at 25%, equating to 3%-5% 1P net profit margins. A 100bps haircut off the low-/high-end is given for conservatism.

Due to its massive scale, JD’s procurement power and first-mile pick-up efficiency is clearly superior to all offline retailers and its product mix is increasingly indexed to higher-margin general merchandise such as apparel and FMCGs.

Hence, I believe management’s estimate for the long-term economics of the 1P business as reasonable given top offline retailers achieve a 19% gross margin on average (Suning and Gome are largely electronics/appliances retailers while others like Sun Art are largely general merchandise players), as seen below.

JD gross margin vs peers

Skeptics dispute the suggestion that JD’s low 1P gross margins are the result of significant reinvestments in lower prices; instead they assert the reasons for the Company’s low 1P gross margins are structural in nature.

Specifically, they cite JD’s inability to grow non-3C mix and its high 3C exposure as a major margin drag. Leaving aside the fact JD’s non-3C 1P mix has grown at faster rates than 3C, which invalidates the former claim, the latter claim is easily falsified.

Querying Baidu for rebate coupons shows a slightly greater number of search results for JD as compared to Tmall despite the former being less than half the size of the latter in terms of GMV. In addition, reasonable estimates of category gross margins and the Company’s product mix imply JD’s 1P gross margins should be far higher than they are currently. In other words, JD’s 1P gross margins are depressed as the Company is passing almost all of the rebates it receives from its vendors on to customers in the form of lower prices and/or rebate/discount coupons.

In my view, it is difficult to argue why JD would not be able to achieve a similar gross margin profile as its offline peers; indeed an argument could be made for JD having relatively higher normalized 1P gross margins, considering its competitive advantages.

GS gross margin listed retailers

As shown above, retailer gross margin data compiled by Goldman Sachs show 14% gross margins for computer & electronics and a minimum of 23% gross margins for other product categories for China and HK.

As of ’16, electronics & home appliances are ~76% of 1P sales mix while general merchandise & other are ~24%, implying a minimum of ~16% normalized gross margins at the current mix using Goldman Sachs’ compiled retailer gross margin data. Moreover, vendor allowances are roughly 8% of the COGS among US supermarkets which disclose such figures, according to Fitch. If we assume JD is in a similar spot, vendor allowances would be roughly ~7.4% of total sales, based on implied 1P COGS.

Suffice to say, normalized gross margins will be higher given general merchandise & other is growing at more than double the rate of electronics & home appliances. As a result, a 19% normalized gross margin does not appear overly aggressive, in my view.

A 12% OpEx margin is reasonable given the Company has historically achieved a lower OpEx margin; at its trough in ’13, OpEx margin was ~11%. Furthermore, JD has been investing for growth since inception, suggesting OpEx margin at peak efficiency could be significantly lower.

Even during its growth phase, management noted on its 1Q17 earnings call (page 10) JD still enjoys “a 5 to 6 percentage point advantage on overall expense ratio” as compared to its offline competitors, which demonstrates the superiority of JD’s business model and also ensures the Company can perpetually offer consumers low prices.




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