Last week’s New Yorker included an article prefaced by a cartoon image of a drone diving towards a village. The machine’s payload was a bright red package whose destination was a rural Chinese town on the outskirts of Suqian. The drone is part of a whirring fleet of hundreds intended to cut JD' delivery expenses by more than half over the next several years. Drone delivery and e-commerce draw natural and reflexive comparisons to Amazon. The question investors are asking, is are these comparisons warranted?
SumZero sat down with Dennis Hong and Michael Lamothe of ShawSpring Partners to discuss the company. ShawSpring published a comprehensive long on JD to SumZero’s research database in 2015. In the years since, ShawSpring has provided dozens of substantial updates to the idea, including notes from interviews with firm executives, and English translations of Chinese corporate filings and documents.
SumZero: What about JD initially caught your eye as a value investor? What sparked your interest in the name?
Dennis Hong, ShawSpring Partners: I’ve been studying various Chinese e-commerce businesses and their entrepreneurs for over a decade so I have actually long been familiar with JD. Our research on JD as a potential ShawSpring investment began in earnest in early 2015 when we traveled to China to research current and prospective investments. Any repeat traveler to China will find it impossible to ignore China’s transformation into a technology-driven, consumption-based economy. Throughout our trip, we saw red motorized delivery tricycles with JD’s logo - a cartoon dog named Joy - zipping through traffic everywhere we went. While many U.S. investors at the time were focused on Alibaba, it was clear that JD was also building something special. While Alibaba’s marketplace model is conducive to success in long-tail categories like apparel, it appeared there was room in China’s massive $5 trillion retail market for another business to operate a first-party retail model in standardized categories like electronics and home appliances. Because JD takes on inventory risk, it could achieve procurement scale over time and guarantee product quality in a country rampant with fake goods. Moreover, by operating logistics in-house - something that Alibaba is reluctant to do - JD could deliver goods far faster than the status quo. This seemed like a compelling value proposition to consumers with a scale-based, competitive-advantage flywheel to boot: as JD receives more orders, the cost per order declines, and JD passes these cost savings along to consumers, subsequently driving additional purchases - similar to the dynamic that Walmart enjoys. After conducting further due diligence on management, we became excited about JD’s founder and CEO, Richard Liu, who exhibited the characteristics of a hungry entrepreneur looking to build a massive business. Specifically, we appreciated his focus on creating value for the entire JD ecosystem of customers, suppliers, employees, partners, and investors.
From an investment perspective, our take on “value” is heavily influenced by long-term expectations for free-cash-flow generation. With JD, we believe the business did, and continues to trade at a very low multiple of future cash flow per share, driven by high revenue growth and operating leverage. While cash-flow projections are one thing, JD’s business quality gives us confidence that this free cash flow will continue to grow.
Schifelbein: How has JD matured since you posted your SumZero report in June 2015? Where has the company’s development most diverged from the predictions made in your original thesis?
Michael Lamothe, ShawSpring Partners: JD continues to exceed our projections for active customers, revenue growth, and category expansion, while operating profit is below our expectations. The latter is a result of JD reinvesting profits from mature product categories into newer ones - fast-moving consumer goods, otherwise known as FMCG, being the largest opportunity today. FMCG is a great adjacency for JD because of its standardized nature and high inventory turnover - making it perfectly suited for JD’s direct retail model. We believe FMCG will increase the purchase frequency and loyalty of the core JD customer. The average JD customer purchases around 7 times per year today, but FMCG can increase this to several times per month. From our standpoint as long-term investors, we’ll gladly trade a smaller amount of near-term profit for improved business quality and higher future profits.
Additionally, JD exceeded our expectations in finding alternative ways to monetize its competitive advantages and existing infrastructure. Two concrete examples are JD Finance and JD Logistics, which leverage JD’s competencies in consumer data and fulfillment, respectively. Stated simply, we believe because of these investments and initiatives, JD’s core earnings power is much higher than when we initially invested.
However, there are a few aspects of our original investment thesis that have not come to fruition. JD, similar to Amazon, augments its 1P business with a 3P marketplace where the apparel category, Alibaba’s bread-and-butter, continues to struggle. JD is candid that its third-party merchant and personalization tools were lacking in the past and the company has been investing to improve these capabilities. While we remain optimistic on JD’s future in apparel, the category only accounts for ~10% of the company’s total gross merchandise volume and gross profit, so we don’t believe our thesis will change materially either way.
SumZero: What negative impacts could escalating trade tensions between the US and China have on JD?
Hong: Despite persistent trade tensions over the last year, we haven’t seen any meaningful impacts on JD’s business. Granted, a protracted trade war could lead to slower Chinese and global economic growth, which wouldn’t be an ideal backdrop for any company’s near to medium-term revenue and earnings growth. However, what’s more important for ShawSpring’s investment approach is appraising the competitive advantages and the long-term free cash flow trajectory of the business. We acknowledge that JD’s revenue growth could slow under less-than-ideal macroeconomic conditions. Nevertheless, the underlying structural tailwinds of JD’s business which include internet penetration growth, offline-to-online commerce trends, a rapidly-growing Chinese middle class population, and so on, haven’t changed, and should continue boosting JD’s growth for quite some time even with trade-related headwinds.
SumZero: What is your take on APS’ highly publicized short at Sohn Hong Kong? Could you detail your response to APS’ claims about the inability to grow 3C / 1P gross margins?
Lamothe: We always welcome opposing viewpoints on our investments because they serve as talking points for productive internal and external debates, which help us avoid costly mistakes. With respect to the APS reports, and any other “bear” theses, we read them closely for any legitimate points. At this point, we continue to disagree with APS’s evaluation of JD’s business quality and financial model.
First, APS’ short report is predicated on JD never generating sustainable operating profits due to its exposure to the “3C” vertical of consumer electronics - a low margin category. APS is correct in noting that retailers selling commoditized products usually struggle to generate consistent profits, but JD’s integrated model enables it to be more efficient than competitors and be profitable at lower gross margins. JD accomplishes this feat by replacing layers of the traditional retail supply chain with technology and scaled logistics, which allow it to undercut the competition. The result is that similar to Walmart or Costco, operating at low margins is a huge barrier to entry, and a strength - not a weakness.
Second, we believe investors are often overly focused on metrics like gross or operating margin percentage - instead of absolute gross or operating profit. The reason focusing on percentages is misleading is because this number doesn’t reflect the profitability per transaction, return on invested capital, or differences in accounting between businesses. JD is a low-margin business based on high inventory turnover. What’s most important is how much total cash the business can generate - even if sometimes this means trading some margin for increased volume.
For example, if we assume JD’s 3C average sales price is RMB1,000 ($150) then a 5% gross margin would result in RMB50 ($8) in gross profit. We estimate JD's 1P fulfillment costs at RMB20 per order ($3), which means even at a 5% gross margin, JD's 3C operating margin would be 3% (RMB30 in operating profit for a RMB1,000 sales price) and its gross profit-to-operating income conversion would be 60%. For the 3C category, the average sales price is high, which enables JD to achieve net margin targets at a lower percentage margin because of the amount of gross profit generated per transaction.
SumZero: Could you detail your recent meeting with JD’s CFO Sidney Huang? What feedback did you give him regarding JD's investor relations? Do you think those points are broadly representative of frictions that international investors face in China?
Hong: At ShawSpring, our goal is to build a partnership with our operators, and add value wherever we can. Sharing research or insights that may be of value to the company or helping management with investor communications are areas where we frequently look to help. We’ve been fortunate to have built a strong, productive relationship with Sidney and his team over the last three years. During our most recent meeting with Sidney in June, our feedback was focused on the several misconceptions that we believe investors have of JD and ways in which we believe the company can resolve these through increased disclosure. Most pertinent is the difference between JD’s consolidated income statement and the profitability of the various product categories or business units. We think by providing increased transparency into the core e-commerce business’ profitability, investors would potentially become more comfortable with JD’s approach of investing current profits into newer categories or divisions.
On your second question, we don’t necessarily think investor misconceptions surrounding JD are symptomatic of general frictions institutional investors face in China. For example, the two largest technology companies in China measured by market cap, Alibaba and Tencent, are both valued at more than $450 billion. Even smaller players, such as iQiyi and Ctrip, have cultivated strong interest from the international investor community. To us, JD’s situation appears more idiosyncratic and a result of a misunderstanding of the underlying profitability its business model generates. This is not much different than the scrutiny Amazon faced for many years prior to AWS becoming a meaningful part of the business. We believe JD will experience plenty of demand from international investors once they better understand JD’s model and profitability.
SumZero: What misconceptions do you feel are playing into JD’s stock being undervalued by the market?
Lamothe: When approaching valuation we like to understand where the market may be wrong in its financial expectations - either around growth, free cash flow margins, or both. With JD, we believe the market is significantly underestimating both revenue growth and steady-state operating margins over the medium-term. In terms of profitability, we believe some investors extrapolate JD’s consolidated 1-2% operating margin into perpetuity - or at least as the trend for the next several years. However, our opinion is that JD is investing profits from more mature, profitable product categories into newer, higher-growth categories, like FMCG. If JD decided tomorrow that it wanted to exit FMCG, which is earlier-stage and loss-making today, we forecast JD would be generating around 3-4% operating margins from electronics, home appliances, and other more mature categories. We expect JD’s 1P net margins to approach this range over the next several years as FMCG scales. We are also of the opinion that the market is ascribing little value to JD’s advertising business, potential recovery in apparel, and third-party logistics business, which makes use of JD’s extensive shipping network to provide distribution and fulfillment services to other merchants.
Using our financial estimates, we triangulate the implied competitive advantage period that the current market price implies. This is a technique for measuring how long investors are implying the business will create value, formalized by Michael Mauboussin and Al Rappaport in their book Expectations Investing. Based on our free cash flow projections, we estimate the market is implying JD’s competitive advantage period will only last 2-3 years. Generally speaking, dominant technology companies will trade with implied competitive advantage periods in excess of 10-15 years. So to us, this demonstrates that the market believes JD lacks any type of sustainable advantages that will enable durable free cash flow necessary to warrant a longer competitive advantage period. We disagree, but fortunately for our investors this should mean that we only need JD to produce a few years of solid results for our investment to generate satisfactory returns.
However, we recognize the market disagrees with our evaluation of JD’s business quality so the question we then ask internally, beyond debating if our assessments are wrong, is “Okay, well what will JD have to do to change the market’s mind?” We think there are a few things.
First, we believe it will take FMCG reaching scale which will result in all major categories achieving profitability. At that point, JD will then be the largest direct retailer in each category among its Chinese competitors.
Second, JD Logistics added significant warehouse capacity over the past few quarters which impacted gross and net margins this year. JD nearly doubled its warehouse square meterage year-over-year in Q1, while total gross merchandise volume grew at 30%. Historically, capacity growth has roughly mirrored gross merchandise volume growth; however, JD has accelerated its fulfillment footprint as it scales its third-party logistics business. As JD Logistics begins to absorb warehouse capacity and utilization rates increase, JD’s consolidated profitability should improve and JD Logistics’ business model should become more clear to the market.
Third, evidence of continued share gains against Alibaba in tier 1-2 cities and signs of success in lower-tier cities. JD has successfully won over many consumers in the larger cities, including Shanghai, Beijing, and Tianjin, but most of the online shopping population growth will occur in lower-tier cities going forward. We think JD’s ability to replicate its success in larger cities in the lower-tier markets would be well-received by the market.
SumZero: Liu was quoted in the Economist last month as saying that JD’s drone fleet could cut the company’s delivery expenses 70% at scale. Is same day drone delivery to rural Chinese villages more than a marketing exercise?
Lamothe: We believe there are real-world applications for drones to be utilized at scale in China, particularly in the lower-tier cities. Many of the tier 1-2 cities likely won’t see drone adoption because of the population density - these areas already have very efficient logistics so there’s not as much of a use case. However, many areas in rural China still lack the basic infrastructure we take for granted in developed countries, such as paved roads and rail access.
When most people think of drone usage in logistics they think of delivery to the home. However, in our opinion, this doesn’t seem to be a practical use case or even the most necessary use case. Ultimately, we expect drones to be best utilized in transporting goods from a centralized warehouse to a local fulfillment center. Let’s take a closer look at this use case. When breaking down the costs to fulfill an order from the warehouse to the customer’s front door, about 30-35% of costs go to warehousing, another 20-25% to transporting products from the warehouse to local delivery hubs, and 40-45% to last-mile delivery, which is mostly human labor costs and transportation costs. However, this cost structure is mostly indicative of urban, densely populated regions that have large fulfillment centers and dedicated last-mile delivery staffs.
Most rural cities are quite different in that they don’t have sophisticated layers of network infrastructure. For example, large fulfillment centers are replaced by small delivery depots or mom-and-pop shops acting as pick-up centers. Since most consumers pick up their packages at these centralized locations, large last-mile delivery staffs are not required. It’s hard to say if drones would result in cutting logistics costs 70% on its own, but overall the fulfillment process could achieve significant savings.
Additionally, unlike the US and other developed markets, China’s government has been ahead of the curve compared to other governments in allowing logistics companies, like JD, to test drones in certain regions to see if there are practical mass market use cases. We believe the combination of government support and the economics of drones demonstrates that Richard’s comments are more than just marketing talk. What the ultimate adoption or use case is for drones remains to be seen, but we think there’s the potential for a real-world use case in China.
SumZero: This week an article in The New Yorker focused on the ‘local deliveryman’ delivery system that JD has employed in rural China. Is the widespread Chinese rural adoption of e-commerce a predictive model of the future growth of e-commerce in other parts of the developing world? If so, how can investors take advantage of this trend?
Hong: As we look out to other emerging markets where a JD model could be replicated, such as India or Southeast Asia, it will likely depend on the current infrastructure in place and the characteristics of the local jurisdictions. Outside of the population dense urban markets, the type of strategy JD is employing could be a viable model. These rural regions are tight-knit communities where it makes more strategic sense to partner with the local mom-and-pop store owners and enhancing their operations through better supply chain management instead of disrupting them.
From an investment perspective, we think it’s important to identify e-commerce companies that are willing to make the necessary upfront investments to build out nationwide logistics infrastructures. This won’t mean necessarily owning every part of the value chain. For example, in some lower-tier cities this might not make economic sense. However, having sufficient control of the distribution channel is critical to creating a great customer experience.
SumZero: How durable is JD’s moat in the notoriously cutthroat e-commerce industry? What differentiates JD’s e-commerce business?
Lamothe: You’re right that e-commerce is notoriously cutthroat, as competitors selling similar or identical products are vying for winner-take-most markets with low customer switching costs. The result of this battle is often intense price competition, which is particularly true in China because of the win-at-all-cost mentalities of the founders. Interestingly, the question we’ve been asking internally is, “How does a business stay ahead of the curve as current differentiators become future table stakes?” We believe the answer lies in a relentless customer focus and increasing the value proposition by bundling additional products or services. What consumers want when shopping for goods has not changed. It’s convenience, selection, and price. What changes, however, is how a consumer defines each over time. Convenience was once a nearby store, selection was a bigger store than everyone else, and price just had to be good enough. Now convenience is two-day delivery, selection is millions of online SKUs, and price needs to be the lowest in the country if not the world. Moreover, leading businesses like Amazon are bundling services like video and audio streaming into their core e-commerce offerings.
JD has always approached its business from a customer’s perspective, utilizing an integrated retail and logistics model to provide a superior experience. In JD’s early days, 70% of customer complaints involved delivery service, since China’s logistics infrastructure was essentially nonexistent. To solve this issue, JD founder Richard Liu decided to take operations in-house, recognizing this would be a critical differentiator in providing the best customer experience. JD now delivers 90%+ of direct retail orders within 24 hours, an unfathomable achievement in markets outside of China. But as other businesses eventually catch up, the question turns to where future differentiation will lie.
One interesting avenue JD could explore is expanding its private label business in standardized product categories - akin to Costco’s Kirkland brand or AmazonBasics. Vertically-integrating deeper into the supply-side enables JD to leverage its vast amounts of consumer data to manufacture products specific to its customers’ preferences. In fact, JD is testing its private label brand, “Jing Zao” (which translates to “Made by JD”), across roughly forty different product lines, including household goods like luggage and towels. Chinese consumers already associate JD’s brand with quality so we believe it’s a natural extension and adjacency for JD. While private label is lower price for consumers, its also typically higher margin for the retailer, since there is no “brand tax” involved and an additional layer of the supply chain is removed.
By integrating deeper into the supply side, JD can continue to structurally lower its cost of goods and average selling prices. While Alibaba can spur competition between merchants, lowering their gross margins in the meantime, the fragmented nature of the supply side means there isn’t structural pressure to the cost of goods side of Alibaba’s model, meaning prices can only fall so much. As JD’s lowers prices, receives inventory on more of a “just-in-time” basis, it will turn inventory quicker meaning it can lower prices even more.
JD can also create a compelling bundle - especially with its JD Plus subscription offering. While JD Plus already offers free shipping along with discounts and rewards, JD could potentially bundle access to private-label products, financial services, or leverage its relationship with Tencent for access to services in the entertainment, local service, or transportation arenas.
SumZero: Is there downside risk of Alibaba (via Taobao / Tmall) using non-competitive or underhanded tactics to cannibalize JD’s share of e-commerce? Is the Chinese regulatory regime/culture powerful enough to prevent this?
Hong: So far, each time JD scaled a major category the incumbent fought back with a price war or anti-competitive behavior. This happened in 2009 with DangDang in books and in 2012 with Suning in large home appliances, among others. Each time JD’s model enabled it to come out a winner after the price wars subsided. JD utilized its lower-cost structure to operate at a gross margin as low as half of the category’s incumbent. This put the incumbent in a precarious position to either cut margins to maintain market share, or secede market share to maintain margins. Each option would ultimately end with JD coming out stronger than before.
As you mentioned, the most recent anti-competitive measures were at the hands of Alibaba. Unlike the previous examples though, Alibaba runs a marketplace model and cannot flex the same pricing levers as DangDang or Suning. What Alibaba does well though is drive traffic to merchants in its core apparel vertical, which is JD’s largest marketplace category as well. In this case, Alibaba gave its top 100 merchants an ultimatum of going exclusive or shutting off their web traffic during “Single’s Day” - the Chinese equivalent of Black Friday. Unsurprisingly, since Alibaba commands 80% of the Chinese online-apparel market, these merchants pulled their inventory from JD. However, Alibaba was unable to lure any large global brands, and most of the domestic merchants ultimately returned to JD for the incremental orders. Alibaba then tried similar tactics in the home category, but this time these merchants pushed back. Alibaba cut traffic for a short period before resuming normal operations, which we believe sets a precedent for future attempts in other key marketplace categories.
On the 1P side, we think JD is well insulated from anti-competitive attacks from Alibaba since JD will be the largest player in all major categories besides apparel by 2019 at the latest. In the same manner that Alibaba is instrumental to apparel merchants success, JD very much holds the upper hand in more standardized categories. While we believe JD can hold its own without intervention, the Chinese Government does put its citizens’ interests first, so it is very possible that there would be backlash if this behavior were to continue. However, we are not aware of any action thus far.
SumZero: JD’s WeChat e-commerce promotion agreement expires in March 2019. Is there risk of Tencent incubating an e-commerce rival to follow the expiry of the JD noncompete in 2022?
Lamothe: There are certainly risks associated with the Tencent partnership agreement not being renewed, especially since Tencent’s WeChat is the ubiquitous “all-in-one” app in China with more than 1 billion active users. Since the partnership commenced back in 2014, 20-25% of JD’s total acquired users were sourced via WeChat, a meaningful amount and potential risk if this agreement were to not be renewed. However, we think that there are several factors which mitigate this risk:
First, prior to partnering with JD, Tencent attempted to build its own e-commerce business, ultimately deciding that building warehouses, managing inventory, and employing thousands of employees to operate an e-commerce business at scale was too complex. This is largely in line with Tencent’s strategy of operating an asset-light platform similar to Alibaba’s strategy but in services (payments, ride hailing, food delivery, online travel, and so on). The time, capital, and complexity required to build out a nationwide logistics network makes it very difficult to replicate what JD has built, and Tencent realizes this better than anyone. Shortly before JD’s IPO in May 2014, Tencent decided that it would be easier to partner with JD. In exchange, Tencent received an 18% equity stake in JD. When considering the value of this equity stake (~$10B) with the costs to build up inventory supply and logistics ($9B as of March 2018), attempting to compete in e-commerce would be a huge undertaking and profitability dent for Tencent, a business with 30% free-cash-flow margins, $4B in property, plant, and equipment, and zero inventory.
Second, JD and Tencent’s partnership seems to have deepened over the last year or so. An example of this is a recent joint marketing initiative that involved deeper sharing of data to provide brands and merchants better tools to target consumers. We believe some of the drive to operate e-commerce better stems from JD and Tencent sharing a common enemy: Alibaba. For this reason, both are more likely to collaborate on strategic initiatives to win consumers’ mind and wallet-share rather than compete directly.
SumZero: What do you perceive as the biggest risk to your thesis? What could go most wrong?
Lamothe: The risks to any investment thesis generally boil down to events and circumstances that would materially change the trajectory of future free cash flow generation and returns on invested capital. This ultimately depends on whether or not the business has a sustainable competitive advantage. For JD, its competitive advantage is a great customer experience derived from its vertically-integrated model - specifically, process efficiencies and economies of scale in retail procurement and logistics. We believe these advantages are durable given the time and capital necessary to build a model to rival JD’s and the complexities to operate at scale. However, if Alibaba or another competitor were to neutralize the components which differentiate JD’s customer value proposition, it would be a material risk to our thesis.
JD’s 1P scale in standardized product categories allows it to offer unparalleled price, selection, and quality that we believe will be difficult for Alibaba to match. Tmall has blunted some of these advantages by having large brands set up digital storefronts. However, where we perceive there to potentially be a more material risk is in logistics. We initially believed that JD’s self-operated logistics network would provide it with unsurmountable advantages in terms of delivery times and customer service. However, Alibaba’s logistics subsidiary, Cainiao, has invested significant capital and has improved the delivery times of its third-party delivery partners in tier 1-2 cities. We still believe JD’s model gives it a cost and customer service aspect that will be difficult for Cainiao’s modular strategy to replicate, but it’s possible Cainiao could eventually achieve a point that’s “good enough” for consumers.
Excluding frontal attacks on JD’s core model, Alibaba could find other ways to provide challenges to JD. For example, it could bundle adjacent verticals, like video, to create a more comprehensive offering than JD’s pure e-commerce model. If the overall bundle value offered by Alibaba is substantially better than the value JD provides then it could be a business model risk to JD. We think JD’s recent partnerships with iQiyi and Tencent mitigate this risk. Also, consumers have historically compartmentalized online video and shopping for physical goods differently which means it may not matter either way.
SumZero: Where else do you see value in the market today? Where else are you focusing your research?
Hong: We have pretty high return expectations for our individual investments so that naturally attracts us to fast-growing sectors like e-commerce, digital payments, online video games, and subscription software. The combination of network effects with asset-light business models leads to winner-take-all industry dynamics, and the structural shifts from offline-to-online provide above-average revenue and cash flow growth. We often leverage our knowledge of specific business models like internet marketplaces across different categories such as food takeout or home services. In fact, we own dominant players in both these categories through our stakes in IAC, which owns 87% of ANGI Homeservices, and Just Eat, the UK-based food takeout marketplace with leading operations across Europe, Canada, and Latin America.
We’ve also been recently refreshing our work on companies within online classifieds, the cousin of the transactional marketplace. These businesses can be as dominant as transactional marketplaces if the brands can garner reputations as the “go-to” for one vertical (like Zillow, for example) or across many verticals (like Craigslist) and provide solid value propositions for suppliers. Again, these businesses often end up being durable, winner-take-most franchises, which we find very appealing.
Most of the investments we’ve made since ShawSpring launched in 2014 have been in companies based in the U.S. or China, or are focused on serving customers in these geographies. We expect both countries will continue to provide attractive opportunities on a bottom-up basis, but also look closely at other emerging markets with attractive consumer dynamics. Two that come to mind are Southeast Asia and India. Both regions boast massive consumer populations and are in the early-stages of widespread internet adoption.