Originally submitted as my VIC application.
What if I told you that you could buy into one of the two players in China’s e-commerce duopoly, growing 30%+ YoY, led by a founder-owner-operator who built the company into a $30B business, at 0.2x sales and 3x gross profits? If that sounds interesting, I’d recommend a long position in JD.com.
JD.com is China’s largest online retailer. It was founded in 1998 by Richard Liu, originally as an electronics store in Beijing, which then moved online. In contrast to competitor Alibaba, it made the decision in 2007 to build out its own warehousing/fulfillment/logistics infrastructure to handle the entire order-to-delivery pipeline for customers. JD is now the No. 2 e-commerce site in China, with around 25% market share in B2C e-commerce after Alibaba (by gross merchandise value).
JD.com has been written up twice before on VIC, most recently about two years ago, but there have been some material changes in both price (down almost 50%) and company results, so I am writing it up again. However, both write-ups do an excellent job of giving an overview of JD’s business model and story. I would recommend you read those write-ups first.
The stock is down 50% off its high of ~$50 per share last January. Like most Chinese stocks, it has sold off due to concerns related to slowing economic growth in China. Founder and CEO Liu was also arrested on rape charges in the U.S. last November, and although he was cleared of all allegations, the overhang has remained.
JD has a substantial portfolio of equity investments in which it does not have a controlling interest. These investments + net cash account for almost $15/share of value of the roughly $24 share price ($23.96 at the time of writing). The majority of these investments are publicly traded. For a detailed listing, please see: here.
Subtracting these out puts the value of JD’s e-commerce business at around $13B. I’ll focus on valuing this core business.
The Chinese middle class is rapidly growing and is a consumption machine. The size of its e-commerce market hit $1.1T this year and is expected to grow to $1.8T by 2022 (double the size of the U.S. market).
China already has the highest online sales penetration in the world at 20%, but there is still ample room to grow.
Chinese customers have shown a much greater willingness to experiment with new retail technology (e.g. social commerce, mobile shopping), so the online penetration rate likely has a much higher ceiling than in the West.
As China’s middle class grows to 550M people by 2022, the size of the overall retail market will increase rapidly.
Chinese household debt-to-GDP ratio is half of the that in the U.S., so there is capacity for further debt-fueled consumption.
Ultimately, (higher online sales penetration) x (increased retail sales) = large e-commerce market opportunity.
As the middle class grows and moves up the income ladder, they will be focused on quality/authentic products, good customer service, fast delivery – not just the lowest price. We’re already seeing evidence of this in the shift away from low-cost, grey market C2C platforms like Alibaba’s Taobao to B2C platforms selling authentic, pricier wares like Alibaba’s Tmall and JD.com.
Taobao (Alibaba): largest C2C online marketplace in China; anyone can go on and start selling. Pros: extraordinary product selection (Boeing 747s have been sold on Taobao), good prices. Cons: lots of counterfeit items, inconsistent/untimely delivery, product review manipulation.
Tmall (Alibaba): largest B2C e-commerce platform with 50-55% market share; only authorized merchants can sell. Merchants handle fulfillment/shipping of orders. Pros: wide selection, competitive prices (especially in apparels). Cons: slower delivery, occasional counterfeit and quality issues, higher prices in electronics and appliances.
WeChat Stores (Tencent): C2C platform similar to Taobao; many banned Taobao sellers moved to WeChat and sell through private messages. Pros: low prices, social shopping experience due to the WeChat platform. Cons: counterfeit items, inconsistent delivery, review manipulation.
Pinduoduo: Social shopping app similar to Groupon; pull in friends to get bulk discounts. Pros: low prices, social shopping. Cons: similar to Taobao/WeChat.
There are other competitors, of course, but these are the main ones which have significant market share. Of these, Tmall is JD’s main competitor, since it is the only other major B2C player. The primary difference is that JD sells its own inventory directly (like Amazon) while Tmall is merely a platform.
JD’s Value Proposition to Customers
Authentic, quality products: “one-strike” counterfeit policy, which is very strict compared to Alibaba.
Excellent experience: fast delivery (with premium options) – relies on in-house logistics network. The “211” delivery service ensures that orders placed before 11am are delivered by 6pm on the same day, and orders placed before 11pm are delivered by 3pm the next day; Tmall orders usually take 2-5 days to arrive. White-glove and scheduled delivery are available for higher-end customers. “Flash delivery” available in certain metro areas with delivery times of <1 hour for certain products.
Easy returns: also relies heavily on in-house logistics. If there is a quality issue, JD will pick up the product for free from the customer and issue a full refund within 100 minutes of the refund request. No packing or shipping is required on the customer’s part – much easier than Tmall.
Competitive prices (particularly in standardized product categories). Electronics and home appliances have a low number of SKUs and little customization (standardized products), so JD buys bulk and negotiates lower prices; 61% market share in appliances vs. 25% in overall B2C e-commerce is evidence of this. This price advantage is spreading into fast moving consumer goods, which are also fairly standardized, resulting in 40% YoY general merchandise GMV growth.
Increasingly: wide selection. 200K+ third-party merchants give wider selection, particularly in long-tail categories like apparels (high customization and lots of SKUs). Selection has traditionally been JD’s weakness vs. Tmall, but bringing vetted third-party sellers into the marketplace is remedying this.
This value proposition focuses on quality and customer experience (particularly around delivery/returns), so JD naturally skews upmarket. JD has more young customers and customers in tier 1-2 cities vs. Tmall. As incomes rise in lower-tier cities and their spending habits begin to match their tier 1-2 counterparts, this will be a good place to be for JD.
So what do we get for $13B?
A core e-commerce business with a long runway for growth
A growing third-party marketplace
A highly monetizable trove of shopping data from 300M+ customers
China’s most extensive and efficient logistics network
A top-tier management team and corporate culture
A core e-commerce business with a long runway for growth
This is key. JD has consistently grown revenues 30%+ per year for a while, but a high growth rate must be maintained to build economies of scale and market dominance. There seem to be doubts that JD has runway, but I strongly believe that it does.
Tmall is JD’s only real competition
The offline retail market is fragmented and nobody really has the scale to compete as Walmart and Target do in the U.S. The top 20 retailers have a combined 14% market share vs. 47% in the U.S.
Alibaba and JD are far ahead in e-commerce R&D. They are tit-for-tat in drones, unmanned delivery, smart grocery (7Fresh vs. Hema), food delivery, unmanned stores, etc. Traditional retailers are getting their lunch eaten.
Online competitors can only compete in C2C or private label/unbranded goods. Big brands don’t want to sell on these platforms alongside grey market sellers. They will sell only on Tmall/JD, where their brand value will not be diluted.
JD has a unique value proposition vs. Tmall that will allow it to continue to attract shoppers
Tmall has wider product selection with more brands (particularly in apparels) but slower delivery, less consistent experience, and harder returns. This attracts first-time shoppers, lower-income shoppers (lower tier cities), older shoppers, anyone looking to buy apparels/other long-tail products.
JD offers the above value proposition, appealing to: younger, wealthier customers in top-tier cities and customers who care about experience/quality. JD is dominant in electronics and appliances (standardized categories).
There is ample room to grow for both JD and Tmall
As explained earlier, increased online retail penetration combined with a growing middle class/growing retail market will create broad e-commerce growth. The pie is growing, and just by holding its share, JD can capture the 10-15% CAGR in Chinese online retail.
Both have international expansion opportunities in SE Asia (e.g. Indonesia, Thailand, Vietnam) where both have been investing heavily. Much of JD’s recent logistics CapEx has been in Indonesia, where JD.ID/J-Express is competing with Alibaba’s Lazada.
It’s much easier for JD to take market share from Tmall than the other way around
Traditionally, moats for platform businesses like Tmall’s have always been due to network effects, but this sort of competitive advantage begins to fall apart when a competitor attracts a relatively large and loyal following among an overlapping buyer pool. Then, merchants naturally begin to sell on both platforms, and the same network effect works for the competitor.
As a result, it is much easier for JD to eat into Alibaba’s core business than it is for Alibaba to do the reverse. By offering access to its 300M+ customers, JD can entice merchants to cross-list on both platforms, but it is far more difficult for Tmall to take on inventory and compete with JD’s economies of scale in direct retail. Tmall’s steadily declining market share and JD’s growing third-party marketplace are evidence of this.
A growing third-party marketplace
JD now has 200K+ third-party merchants on its marketplace (all of whom are either manufacturers or authorized resellers of their products), and it collects commissions on every sale. JD also handles logistics for merchants, meaning they ship their products to JD pre-sale, and JD handles order fulfillment and shipment (similar to Amazon’s FBA). For merchants, this means less work, lower staff requirements, and higher customer satisfaction, and for JD this means additional logistics revenue and the same delivery and customer service guarantee for customers, regardless of seller. It also means products can be inspected before/during shipment to mitigate the counterfeit issues Alibaba deals with. Marketplace also helps JD make inroads into long-tail categories like apparels that are not as conducive to its direct retail model. Partly as a result, general merchandise has gone from 18.5% of revenue in 2015 to 26.4% in 2017.
There was some concern about the growth of the marketplace as the number of merchants stalled around 170K from Q3 2017 to Q2 2018. Part of the issue was Alibaba coercing merchants to leave JD, and part of the issue was JD’s subpar merchant tools compared to Tmall. Merchant tooling has improved (improved customer and product analytics) and it seems that coercion has decreased to some extent after an extensive PR campaign by JD; last quarter 20K+ new merchants joined.
Marketplace GMV is currently growing 40% YoY across all categories, which is faster than Tmall. As mentioned earlier, due to JD’s already large customer base, it makes sense for merchants to sell on JD as well as Tmall.
A highly monetizable trove of shopping data from 300M+ customers
This point was mentioned for Alibaba in macklowe’s Alibaba write-up on VIC, but a similar point applies for JD. Transaction data is the most valuable type of data because it signals the highest level of intent, more so than search history and social media history. If you know exactly what a customer has bought in the past, and what products they are currently looking at, you can predict with reasonable accuracy what they’re looking to buy next.
JD’s marketplace and advertising segment accounted for about 7% of revenue in 2017 and is growing around 40% YoY. As more third-party merchants come onto the platform, competition will increase and merchants will find advertising increasingly necessary. Amazon and Tmall have both capitalized on this dynamic in their marketplace advertising businesses, and JD should be able to do the same. This revenue is also significantly higher margin than the core business (exact margins are not broken out), so overall margin expansion will occur over time.
This customer and product data is also valuable to retailers, an opportunity that JD has been pursuing through its Retail as a Service (RaaS) initiative. This essentially comes down to selling data on customer preferences and product sales to retailers and to merchants on the platform. Recently, for example, JD partnered with Qumei (one of the top home furniture retailers in China) to help them determine which new products to add to their lineup, and to match customers to their online profiles upon entry into Qumei physical retail stores (using facial recognition). This kind of product and customer insight is incredibly valuable to retailers, and I see no reason why this will not be another successful monetization strategy for JD.
Lastly, JD is using its product demand insights to develop private label versions of popular products. This is a tried-and-tested strategy from Amazon, and allows JD to use its strong brand reputation and platform to sell competitively priced, higher-margin versions of best-selling products. JD’s Jing Zao brand currently offers only 38 products on the site, but Amazon private labels grew from $0 to $7.5B in sales within ten years of their 2009 launch. This is a difficult strategy for Alibaba to replicate since it requires significant fulfillment infrastructure.
China’s most extensive and efficient logistics network
Since 2007, JD has invested heavily in creating its own nationwide fulfillment and delivery infrastructure. In 2007, the majority of customer complaints revolved around slow/unreliable delivery, and given China’s largely fragmented, inefficient, mom-and-pop logistics infrastructure, JD decided that the only way to serve customers effectively would be to build out its own network.
The company now operates 550 warehouses covering 11.9M square meters. 2.5M square meters of this space are owned by the company itself, while the rest is leased. JD has 7,000 delivery and pickup stations, and its own couriers handle last-mile delivery to customers. JD also last year opened China’s first fully automated warehouse (which has 4 employees and picks, packs, and ships 200K orders per day). At the moment, this puts it far ahead of Alibaba or any other Chinese logistics provider in terms of technology. This infrastructure is what allows JD to offer its 211 delivery service.
Building a logistics operation from the ground up requires significant investment, and this is where a significant portion of the company’s money has gone. To date, aside from the intangible benefits of superior customer experience and loyalty, investors have not seen a monetary return on this investment, instead seeing the lower margins and shaky profitability it has given JD as compared to Alibaba; no doubt, this has weighed on the stock.
Now that the logistics infrastructure is fairly mature (at least in China) there are a few monetization options. Last year, logistics was spun off into a separate business (JD Logistics) and 19% was sold to outside investors (including Sequoia and Hillhouse) at a $13.5B valuation (raising $2.5B for JD). This helps to highlight the immense value that has been created here.
Management has also said that in the next six months they plan to spin logistics real estate assets off into a separate business. As CFO Sidney Huang said on the Q2 earnings call, “as of the end of July, we already owned over 2.5 million square meters of completed warehouse space, which could unlock billions of RMB in value appreciation and a steady flow of future management income”. The goal is to sell this warehouse space at significantly higher values than is reflected on the balance sheet to highlight the price appreciation and then to collect management income. This is expected to begin to generate significant cash flow in the next six months.
Likely the most significant monetization strategy is to increase utilization of the logistics network. The heavy CapEx has been done, and incremental growth in flow going through the network is high margin (mainly just the last-mile cost). JD is already doing this with third-party fulfillment, but has also recently started providing 3PL services for non-merchants. The 151% YoY growth in 3PL revenues on a base of RMB 5.1B in 2017 is an indication that this will be a valuable service.
In October of last year, JD launched a parcel delivery service for consumers, which includes same-day intra-city delivery, as well as next-day and two-day delivery. Although the financial results of this have yet to be seen, I anticipate they will be solid. China’s major parcel delivery services (SF Express, ZTO Express, YTO Express, etc.) are far behind on technology and infrastructure as compared to JD (just search for photos of their parcel sortation and delivery operations vs. JD’s) and rely on local mom-and-pop couriers for last-mile delivery. As mentioned in Pluto’s JD.com VIC write-up from two years ago, this leads to an inconsistent customer experience, and is becoming increasingly untenable as labor costs rise. JD’s technology and network should allow it to be competitive on price and far superior in customer experience. Eventually, it’s very possible that JD could become the largest shipper in China.
Ultimately, these are all different ways for JD to recoup its logistics investments faster. There is high upside and limited downside since the fixed assets are in place and incremental volume is higher margin.
A top-tier management team and corporate culture
A competent and incentivized management team is essential to a long-term growth story like JD’s. Founder and CEO Richard Liu has a 15.5% stake and takes a $1 annual salary. He is an owner-operator visionary who built a $30B business from scratch. He has an excellent reputation for his strategic and executional acumen, and his upstanding treatment of minority shareholders.
JD reminds me of Amazon and Costco in the religious focus on the customer which pervades the company. It consistently ranks highest in customer satisfaction among Chinese retailers. Logistics was started as a direct result of customer feedback regarding delivery speed. If a counterfeit product is found on the site, the sourcing manager responsible is immediately fired. If a JD deliveryman gets too many complaints, he/she is immediately fired. Like Bezos, Liu’s ethos is customer-first.
Much has been made of the rape allegations against Liu in the U.S. in August. Clearly, this reflects negatively on Liu and JD, but ultimately, charges were dropped. At this point, I believe this allegation is in the rear-view and should not be a going concern for shareholders.
JD is Tencent’s retail play. Tencent owns 18% of JD as part of a 2014 agreement that gave JD level one access points in WeChat and QQ (while Tmall and Taobao links are blocked on Tencent’s apps). Chinese tech has essentially divided into Team Tencent and Team Alibaba, and JD being Alibaba’s main competitor makes it strategically important to Tencent. Tencent’s new retail software/data business will need JD’s data – Tencent’s broader user data is simply not as valuable as purchase histories.
The original 2014 agreement expires this March and there has been some concern about the cost of renewal. Some fear that Tencent will demand significantly more equity for continued level one access, especially given that WeChat now has almost 3x as many MAUs as it did in 2014. I have a few thoughts:
Any harm Tencent does JD gives its main rival Alibaba more business and more user data. Tencent understands this.
JD’s retail data helps Tencent build significantly more comprehensive and useful customer profiles and gives them product demand insights.
JD has 6x as many annual active customer accounts as it did when the agreement was signed, so it’s far less reliant now. Recent growth has come more from increasing GMV/customer than from customer account growth.
The Tencent partnership renewal will definitely come at a cost but I don’t think it’ll be as high as expected and it appears more than priced in.
Right now, Asian e-commerce is in a “land-grab” phase, and profitability will not be the main focus. Most operating cash flow will be reinvested, and investors need to be comfortable with this. I would rather have a company that is dominant in retail (offline and online) and logistics throughout Asia than just a Chinese online retailer.
When profitability becomes the focus, increasing prices for consumers and turning the screws on suppliers are not the only ways for JD to achieve this. Marketplace commissions, ads, logistics as a service, shipping, retail as a service, and increased logistical efficiency through automation are all other ways.
Just on the face of it, $13B seems like a low valuation for the No. 2 site in a $1.1T e-commerce market, which brought in $66.7B in revenue in the last 12 months and is growing 30%+ YoY.
JD is a business that is difficult to value on traditional metrics like P/FCF, P/E, etc. since it is growing so quickly and there are so many levers it can pull to increase profitability (margin and revenue growth projections on a segment-by-segment basis would almost surely be inaccurate). Instead, I’ll value JD based on comparison to Amazon, which has a similar business model.
Both Amazon and JD have a core e-commerce retail operation which passes almost all savings attained from economies of scale/logistics efficiencies onto customers. Both started with only direct sales, and then added marketplaces which bring in high-margin commission and ad revenue. Both have created premium membership programs for their most loyal customers. And like AWS did with Amazon’s tech stack, JD is opening up its logistics infrastructure and data to bring in additional high-margin revenue.
Since AWS is far more mature than JD’s RaaS operation, I’ll ignore AWS for the purposes of comparison. Amazon’s current market cap is $782B. Putting the value of AWS conservatively at $200B (~8x last year’s segment revenue) values the core retail operation at $582B. This is almost 3x sales from e-commerce and 17.5x retail profits (retail sales – cost of goods – fulfillment costs). Amazon’s retail sales are growing approximately 30% YoY.
As highlighted above, the core JD business is being ascribed a value of $13B. This is about 0.2x expected 2018 revenue, a little over 3x 2017 retail profits. JD was growing faster than Amazon before the recent Chinese slowdown (40% YoY, and even in Q3 2018 grew revenues 25% YoY) and has much more room for margin expansion than Amazon whose ads and marketplace are more mature.
Longer term, if JD can maintain 25% market share in B2C and B2C comprises 65% of expected $1.8T total e-commerce sales in 2022, this will mean ~$290B in fulfilled GMV that year. Assuming 50% of this is direct GMV and the other half is marketplace GMV gives JD approximately $145B (direct sales revenue) + ~5% take rate * $145B (marketplace revenue) = $152B in revenue. If operating margin improves to 3% (very possible given more third-party GMV and ad revenue; Walmart’s operating margin is 3.9%), we get $4.5B in operating profit in 2022. This does not include any contribution from third-party logistics, shipping, retail as a service, or selling/managing real estate. Nor does it include any potential margin improvements from more automated/efficient fulfillment, improved terms with suppliers, or price increases in electronics or appliances where JD is hugely dominant (the last, admittedly, is unlikely given Liu’s customer-centric focus). Less conservatively, operating profit could be $6B+ by 2022; although management may choose to use all of this to fund further expansion, it highlights the earnings power of the business. Mr. Market is giving investors the opportunity to acquire all of this earnings power for a mere $13B.
As a side note, JD Logistics $13.5B valuation in its most recent funding round implies that JD’s 81% stake alone was valued at almost $11B. Since the two businesses are so interdependent and JD has a controlling interest, I did not break out JD Logistics’ value separately. However, this valuation gives me more confidence in the margin of safety here.
JD.ID, JD’s Indonesia unit, is also reportedly close to raising funds at a $1.1B valuation. JD’s main China business should be worth many times this.
Management seems to agree with this assessment and recently initiated a $1B share buyback. While the buyback amount itself is not huge, given the number of places that money could have been invested, it is an important sign of confidence.
Tiger Global (which originally invested in JD pre-IPO at a $200M valuation) bought 7.5M additional shares in Q4 2018, bringing its stake to $1.2B. Hillhouse Capital, which was another early JD investor and one of Asia’s largest investors, still holds a $314M stake and reportedly invested ~$1B in JD Logistics’ round last year.
I see this as an opportunity for investors to invest in Amazon circa-2006, when the core e-commerce business was 1/20th of its current size and just as AWS and FBA were getting off the ground. At the time, investors did not appreciate the power of the e-commerce business, nor did they appreciate the massive revenue contributors that programs like AWS, FBA, and Prime would become. As Bezos said in his 2006 letter to shareholders, it typically takes 3 to 7 years for new business lines, even if they are runaway successes, to meaningfully contribute to overall company economics. He was talking about AWS, FBA, and Prime, but in JD’s case, these are logistics as a service, RaaS, marketplace, etc. As JD Mall continues to grow, and these other tangential business lines grow into significant contributors, JD will experience significant revenue growth, margin expansion, and multiple expansion.
Why does this opportunity exist?
Overhang from rape allegations against Liu
Slowing revenue growth due to the economic slowdown in China
Concerns about shortening growth runway due to competition (from Alibaba in particular)
Upcoming Tencent partnership renewal
Continued strong revenue and GMV growth
Increased operating cash flow from growth and the monetization strategies mentioned above
Short seller points/risks:
JD’s revenue growth slowed this year. This is evidence that it is losing share to Alibaba.
A few points:
Revenue growth is not the correct metric – as marketplace expands relative to direct sales, revenue growth will naturally slow, but GMV and operating cash flow will continue to improve. This is exactly what we are seeing. Operating margins, however, will not necessarily expand immediately due to logistics CapEx, and this is what the market is focusing on.
As management has pointed out, large-ticket electronics and appliances have been hit harder by the recent economic slowdown, which has impacted JD more than Alibaba. This is a temporary headwind. As mentioned earlier, general merchandise GMV is still growing 40% YoY.
By most estimates, JD has been gaining B2C market share over Alibaba. Third party marketplace GMV growth of 40% is better than Tmall.
Liu holds 80% of voting rights. This is a governance mess.
Liu is a visionary owner-operator, but there does exist a key man risk here that was highlighted by the recent headlines. This kind of voting control on the part of the founder is common in U.S. tech companies as well (e.g. FB, Snap, Google). Liu also has a reputation for acting ethically towards minority shareholders (in sharp contrast to Jack Ma), but ultimately, Liu’s level of control is something investors need to be comfortable with.
Alibaba will be able to replicate JD’s logistical prowess and this source of differentiation will disappear.
Jack Ma recently pledged RMB 100B (~$15B) in fulfillment/logistics investments over the next few years. Alibaba has been buying a lot of land and constructing warehouses rapidly as of late.
With this level of spending, Alibaba will likely be able to significantly close the delivery gap between JD and itself. There are some caveats, however.
Alibaba has close to zero experience managing logistical infrastructure, so ironing out issues will take some time.
Alibaba is a platform company, and Taobao/Tmall merchants fulfill/ship their own orders. Current Tmall policy only requires that orders be shipped within 72 hours, since anything tighter would greatly pressure smaller merchants. Even if Alibaba improves shipping times, the time from online order to “in transit” is out of Alibaba’s hands unless they fulfill merchant inventory themselves, which will require far more infrastructure than they have right now.
It will be a long time before Alibaba’s logistical efficiency reaches JD’s levels. Currently, Alibaba is subsidizing shipping for Tmall merchants, and as long as they use third-party shipping partners who need their cut, costs will remain higher. Alibaba’s shipping partners are also not automated even close to JD’s level, so they will be heavily impacted as labor costs rise. Alibaba will need to in-house shipping and automate significantly to match JD on efficiency, which will require significantly more than $15B (acquiring ZTO Express, which Alibaba owns a 10% stake in, would alone cost $14B).
In the meantime, JD should be able to continue to grow its market share, and increased operating cash flow will fund further logistics improvements to stay ahead of Alibaba. JD should also be able to maintain a pricing edge in standardized product categories thanks to its direct sales model, even as delivery times converge.