JD.com: little downside, big upside

JD trades at the low end of its valuation on a price to sales basis since its IPO. It has rarely traded below a P/S of 1, and currently can be bought for a P/S below 0.9. Even the most pessimistic analysts forecast average revenue growth of at least 20% for the next two years, and consensus pegs revenue growth at 30% for 2018 and 25% for 2019.

I have difficulty envisioning a scenario where sales growth turns negative in the near future. I also have difficulty envisioning a scenario where the P/S declines even further to 0.7 or 0.6, yielding maybe a 30-35% downside. However, I think it’s fairly probable that JD delivers at least 20% top-line growth for the next couple of years, and that the P/S normalizes to something like 1.2-1.3, yielding an upside around 100% for the next two years.

The Price to trailing free cash flow is only 17.9, but I would argue the cash flow is imperfectly calculated at JD because of the impact of JD Finance’s credit products. I don’t think the P/E ratio is an appropriate valuation measure for JD.

The stock has been punished for its inability to execute on profit margins, slowing sales growth, the threat of a trade war between the U.S. and China, a general environment of China slowing in early 2018, and general weakness in financials globally.

It hasn’t grown profit margins as much as it said it would, and the company has maintained this is because they are continuing to invest in the logistics network. In mid-2017, it appeared that JD would be largely done with its logistics investments by the end of the year, and the profit margins would widen out as a result. However, the company has chosen to continue logistics investments, probably in preparation for a spin-off of the logistics business. Management claimed that these investments will pay out by the middle of 2018, and that the operating leverage that investors were expecting by 2017 YE should become apparent then. Credit Suisse slashed margin expectations for the full year 2018, and I don’t blame analysts for not trusting management’s guidance anymore.

But I do think these investments are prudent. Logistics in China are a nightmare, and I think JD has built a sustainable competitive advantage with its heavy investments. The need for same day delivery in China is even greater than in the U.S. I remember buying a wifi router in Beijing. I looked up the nearest electronics superstore, which was 20 minutes away without traffic, but over an hour away during rush hour. It was nearly impossible to get a quality product at any sort of reasonable price in local stores. JD was the most efficient option, and at that time they were only offering 2-day delivery services.

The third-party services should also allow management to the company to fetch a higher price in any spin-off. I would say the investments were validated by the success of the recent JD Logistics fundraising, which valued the logistics arm at $13.5 billion, or close to a third of its $42.8 billion market cap. Such a spin-off might reveal the profitability of the commerce operations.

Slowing sales growth mostly relates to a slowdown in apparel. While growth in JD’s core appliance and electronics market has remained steady, apparel sales have dropped and management expects continued weakness for the next several quarters.

Alibaba has likely pressured numerous major clothing brands to quit JD and sign on exclusively with Alibaba. Over 100 major brands left JD’s platform in late 2017. JD has filed formal complaints, however I do not expect the Chinese government to do anything about it.

“Unfair competition still exists,” Wang Bingnan, a deputy director at China’s Ministry of Commerce, said in a June speech about China’s e-commerce market. “Behaviors like forced ‘choose one of two,'” he added, “are hard for regulators to define, prove or deal with accurately.”

This is a sign that the competition between the two is becoming increasingly nasty. Unfortunately, I think it means margins will remain under pressure for some time. I believe JD’s recent increase in logistics investments is a bid to attract a bigger third-party business over time and to provide some additional value over Alibaba’s T-mall. I think it will be some time before Alibaba is able to offer a logistics solutions that will be able to get goods to the customer same-day. The question is whether the strategy will work.

I think that U.S. companies are less likely to play ball with Alibaba’s tactics. A more recent story details an American clothing company’s battles with Alibaba after refusing to sign an exclusive contract with Alibaba. Alibaba then down-listed the company’s listings on the T-mall site.

The recent trade negotiations between the U.S. and China have centered on abusive practices in China towards U.S. corporations. If this doesn’t constitute an abusive practice, I don’t know what does.  While I don’t expect China to take action, I think U.S. exporters might voluntarily choose to list on JD rather than Alibaba as a result.

JD has proven to be much more friendly to U.S. exporters. The company maintains that, despite signing some exclusive deals, it doesn’t strategically push for such deals:

“We support fair and open competition because greater choice is always better for brands and users,” JD.com said in a statement. “We are winning over customers by providing a superior shopping experience, rather than by limiting the options of brands or consumers.”

I think that the likely outcome of the “trade wars” of recent weeks is a rebalancing of the U.S.-China trade relationship, however I believe this will be achieved through an increase in U.S. exports rather than a decrease in Chinese exports to the U.S. Steve Mnuchin has said this was the Trump Administration’s goal, and this would fit within Xi Jinpeng’s goal of growing the Chinese consumer economy. If U.S. players view JD as a more friendly partner than Alibaba, this may disproportionately benefit JD over Alibaba.

Chinese exports have been slowing so far in 2018, and this has worried many China watchers. I would guess this has a lot to do with the recent strength in the Chinese yuan. However, China’s expectations for GDP growth have not come down dramatically, and the authorities are expecting strong consumer spending to help them achieve their GDP growth goals. The banking sector has been pushing consumer credit products, and recently the household debt-to-GDP has been expanding rapidly in China. The PBOC recently reduced reserve requirements, which should provide fresh liquidity for the banks to continue lending, and should mitigate some of the upward pressure on the currency. If the consumer economy is as strong as the authorities expect, I’d guess this would be a very positive macroeconomic tailwind for both Alibaba and JD.

The JD Finance unit is a big wildcard for me. I don’t understand the unit as well as the retail or logistics units. My best understanding is that it provides credit to companies in the supply chain, and obtains the capital by packaging these into credit obligations and selling an asset-backed security. Revenue in the unit is up in the triple digits, so it is a strong growth driver, but the business appears to have a number of risks, with some outsized risk in a potential Chinese credit crunch. I think part of the pressure on the share price has been related to the generally weak environment for financials this year, which I believe is related to the unexpected spike in LIBOR over the fed funds rate. This pressure may not let up any time soon.

However, the JD Finance reorganization appears to move these risks outside of the company. My understanding of the reorganization plan is that JD receives a little over $2 billion to sell off its current equity stake, and will retain the right to receive 40% of profits of JD Finance when profit is positive. It also has an option to receive a payment equal to 40% of the equity interest in the event of a JD Finance IPO. This exposes it to the upside of the business, but not the downside.

It doesn’t completely remove the risks from JD Finance however. If there is some unforeseen blowup, I could imagine the entire supply chain freezes up and sales tank. However, in such an environment, I would imagine we would see macroeconomic implications for all of China, since I would expect similar issues simultaneously at Ant Financial and because JD and Alibaba now make up a huge percentage of Chinese commerce. I’d imagine I could figure out a way to hedge such risks. Moreover, the PBOC moved last week to quell such risks in the finance sector, by reducing reserve requirements. I think the authorities are aware of the risks and are actively managing the situation. Whether they are successful or not remains to be seen.

A generally unacknowledged risk comes from JD’s increasingly intertwined relationship with Tencent. I think Tencent bears the risk of being too successful. Pony Ma is probably the second most powerful man in China after Xi Jinpeng, and I don’t think this has gone unnoticed in the communist party. Though Pony Ma has done his best to remain obsequious to Xi, I’d imagine there will be an impending reckoning, possibly through increased regulation of Tencent. How this might impact JD I can only imagine, but I wonder if Tencent may become pressured at some time in the future to lighten up on its 18% stake in JD.

This tie-up is a double-edged sword. WeChat is an integral piece of Chinese life. It is the most important app on one’s phone, and in many ways is like an OS within an OS. Tencent has become increasingly focused on driving its payment system, WeChat Pay, and JD is the dominant retailer that accepts WeChat Pay. As the battle plays out between WeChat Pay and AliPay (Alibaba’s payment system), JD has some upside if WeChat “wins”.

I think JD is well positioned to grow in Southeast Asia. It has more experience in complicated logistics than any other e-commerce company, and the infrastructure in Southeast Asia is much worse than China, so the region will require complex solutions. I am not aware of homegrown competition of size (I am sure there are some), but I don’t think other international players like Alibaba or Amazon will be able to enter Southeast Asia as easily as JD.

As an aside, I think it is interesting that the investor base in JD appears to care much more about net profit margin than Amazon’s does. While JD fetches a P/S well below 1, Amazon trades at a P/S above 3. I think a general anti-China bias is part of the problem. I saw a recent WSJ article that China has been pushing to have more of their successful internet companies open a second listing at home, as the tremendous growth in these companies has benefited only foreign investors and not Chinese investors. I wonder if Chinese retail investors would value JD the same way that a largely western investor base does.