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Over the last three months, our firm analyst that specializes in the Chinese economy has performed extensive due diligence into Vipshop's business model and earnings numbers. In our opinion, the company may be misleading in its customer counts and we find a large discrepancy in the media metrics verses the company's reported results. We believe that now the timing is appropriate to share our internal research due to Vipshop's plans to market (A deal road show?) in San Francisco with Stifel Nicholas next week. If this is a deal road show, we would like our questions to be addressed. This would be the second offering this year where both insiders and the company have sold stock. We wonder why they are so anxious to sell.

Vipshop Holdings Limited (NYSE:VIPS) operates as an online discount retailer for apparel and other consumer goods in China. This recent IPO had little street credibility. The price for the deal was reduced from 10.50 down to 6.50 and the size was reduced to 11.2 million shares. In other words, just 12 months ago, there was very little institutional investor interest in the company. Then suddenly in September 2012 everything changed. Now the stock trades at sky-high multiples - Price/Book Value is 11x, Price to 2013 Estimated Earnings is 78.0x (JP Morgan Report). Why the sudden sky-high valuation with the stock price accelerating from 5 to 37? VIPS "reported" phenomenal growth of 24,700% over four years. In the ultra-competitive E-commerce retail industry in China, it begs the question - Are the numbers real?

Here are some of the comments on Vipshop from an investment banker colleague in China with vast experience in Chinese IPOs:

· Business friends in China think the financials are misleading.

· The business model doesn't work in China. Cannot get enough supply of high end good because high-end retailers don't want their products sold via this type of channel, therefore VIPS ends up selling knock-offs and low-end goods.

· Very competitive market, very low sustainability of margins. Comps have 6%-7% margins. VIPS gross margin defies explanation.

· Could not find many people in China who have heard of the site, let alone shop at it.

· The number of customers, their churn and average spend numbers did not add up.

· Mr. Bao, an H.K. / Mainland promoter, is involved somehow with this company. I see this as a very red flag.

VIPS recently reported 1st Q 2013 results. Among the highlights are net revenue increased by 207%, active customers increased 170% and total orders increased 187%.

This growth is nothing short of phenomenal. But is it real? VIPS is an online retailer. Most all of its orders come from its website. Alexa is a service that analyzes websites, providing traffic analysis, global web metrics, and competitive analysis and benchmarking. It is widely accepted as having complete data and producing accurate results. Alexa currently ranks VIPS #884 most trafficked website on the internet globally and #123 most trafficked in China (lower is better, e.g. Google is #1 globally). The chart below displays the reach and the unique daily visitors to the Vipshop web sites as reported by Alexa.

VIPS Traffic

Daily Unique

Date

Reach (%)

Visitors (MM)

Jan-12

0.031%

0.43

Feb-12

0.071%

0.99

Mar-12

0.062%

0.87

Apr-12

0.060%

0.85

May-12

0.055%

0.77

Jun-12

0.054%

0.76

Jul-12

0.055%

0.77

Aug-12

0.054%

0.76

Sep-12

0.061%

0.85

Oct-12

0.064%

0.90

Nov-12

0.080%

1.12

Dec-12

0.083%

1.16

Jan-13

0.078%

1.09

Feb-13

0.078%

1.09

Mar-13

0.092%

1.29

Apr-13

0.084%

1.18

Source: Alexa

If we take this data and compile it into averages for each quarter, we can compare it to the results reported by Vipshop.

Alexa vs. VIPS-Avg. Daily Unique Visitors (ADUV)

Q1 2012

Q2 2012

Q3 2012

Q4 2012

Alexa ADUV

0.77

0.79

0.79

1.06

VIPS reported ADUV

1.10

1.50

1.80

2.10

Difference

0.33

0.71

1.01

1.04

The numbers aren't even close. The Alexa data is essentially flat for the first 3 quarters of 2012 - i.e. no growth. Then it increases in Q4. Interestingly, the discrepancy gets larger over the course of 2012 - the number of additional visitors claimed by VIPS inflates over the year. But - what's the big deal if VIPS misreported visitors? Well, it calls the other numbers that VIPS has reported into question.

First let's look at some revenue and growth statistics as reported by VIPS.

VIPS Reported Avg. Daily Unique Visitors (ADUV) vs. Other Data

Q1 2012

Q2 2012

Q3 2012

Q4 2012

VIPS reported ADUV

1.10

1.50

1.80

2.10

VIPS reported Net Rev

101.3

135.3

155.9

299.6

VIPS reported Tot Act. Custs.

1.0

1.5

1.7

2.6

VIPS reported Total Orders

3.1

4.7

5.4

8.8

Again, these include ADUV that VIPS reports. We can then look at the growth rates in all of the data on a quarter-over-quarter basis:

Quarterly Change

Q2/Q1

Q3/Q2

Q4/Q3

VIPS reported ADUV

36%

20%

17%

VIPS reported Net Rev

34%

15%

92%

VIPS reported Tot Act. Custs.

50%

13%

53%

VIPS reported Total Orders

52%

15%

63%

The increases look suspect, but perhaps explainable. Q2/Q1 results are all in the 34% to 52% range. Q3/Q2 results are 13% to 20%. Q4/Q3 range from 17% to 92%. These appear a little odd - that the number of unique daily visitors would only increase 17% while total customers would increase 53%, total orders would increase 63% and revenue would increase 92%. The relationships are a little suspect - that revenue would almost double while ADUV only increases 17%. But the company could possibly explain this away by claiming better efficiency - a higher "conversion rate."

Finally, we can calculate the total change from Q1 to Q4. Again, it looks somewhat suspect - ADUV increases 91% while the other metrics increase substantially more.

Total Change

Q4/Q1

VIPS ADUV

91%

VIPS reported Net Rev

196%

VIPS reported Tot Act. Custs.

160%

VIPS reported Total Orders

184%

But now let's do the same analysis with the Alexa ADUV data instead of Vipshop ADUV data. We'll still use the revenue and growth as reported by Vipshop.

Alexa vs. VIPS Data

Q1 2012

Q2 2012

Q3 2012

Q4 2012

Alexa ADUV

0.77

0.79

0.79

1.06

VIPS reported Net Rev

101.3

135.3

155.9

299.6

VIPS reported Tot. Active Custs.

1.0

1.5

1.7

2.6

VIPS reported Total Orders

3.1

4.7

5.4

8.8

Quarterly Change

Q2/Q1

Q3/Q2

Q4/Q3

Alexa ADUV

3%

0%

34%

VIPS reported Net Rev

34%

15%

92%

VIPS reported Tot Act. Custs.

50%

13%

53%

VIPS reported Total Orders

52%

15%

63%

For example, in Q2 ADUV increases only 3%, but revenue increases 34%, customers increase 50% and orders increase 52%. In Q3, ADUV is flat but the other metrics increase 13% to 15%. Finally in Q4, ADUV increases 34% while the others increase substantially more. We don't see how revenue, customers and orders can realistically increase so much while ADUV stays flat or increases slightly.

What about the total change from Q1 to Q4?

Total Change

Q4/Q1

Alexa Avg. Daily Unique Visitors

38%

VIPS reported Net Rev

196%

VIPS reported Tot. Active Custs.

160%

VIPS reported Total Orders

184%

Comparing Q4 to Q1, ADUV increases 38%, yet revenue increases 196%, customers increase 160% and orders increase 184%. So how can Vipshop achieve such growth without the number of website visitors increasing? We don't know.

But the staggering growth numbers aren't the only ones that look odd. Here are the changes in Gross Margin as reported by VIPS over their 4-year history:

2009

2010

2011

2012

Gross Margin

8.2%

9.8%

19.1%

22.9%

VIPS explains the gross margin improvement to improved negotiating with manufacturers. Really? Were the previous deals that bad so that you can now command an extra 12% - 14% margin. Let's compare the margins to an appropriate competitor. The closest competitor to VIPS in nature and size is Dangdang (NYSE:DANG).

Dangdang has historically produced most of its revenue from books but now gets more than half from retail products like VIPS. Here are the 4th Q 2012 numbers:

4th Q 2012: $US

VIPS

DANG

Net Rev

299.6

259.2

COGS

230.9

77.1%

224.5

86.6%

Gross Profit

68.7

22.9%

34.7

13.4%

VIPS gross margin is 9.5% higher than DANG! Apparently, DANG should take negotiation lessons from VIPS.

Another interesting item in VIPS financials is fulfillment expenses. Here are the ratios as percent of net revenue over their 4-year history:

2009

2010

2011

2012

Fulfillment Exps.

21.8%

17.8%

20.0%

12.5%

Quite a dramatic improvement! VIPS has attributed the improvement to using regional and local delivery services and capacity expansion of regional warehouses. If capacity expansion is part of the reduction in fulfillment expenses, where does the increased cost of the expansion hit the income statement? We can't find it.

Even some of VIPS internally generated numbers don't support its story. For example, VIPS claims its success is largely due to its high retention rate and loyal customer base. In most every press release it touts its stable growing customers. From the 4th Quarter earnings call:

We experienced a very high and stable rate of orders from repeat customers accounting for over 93% of all orders

And

in the fourth quarter of 2012, we further expanded our repeat customers as a percentage of total active customers to over a new high of 72% from 69% a year ago. We believe these numbers truly reflected our high user stickiness and improving customer satisfaction as well as the rising brand awareness of the Vipshop platform.

From the recent F-1 filing:

We have built a highly engaged and loyal customer base that contributes to our growth and also enables us to attract new customers primarily through word-of-mouth referrals. A majority of our customers have placed orders to purchase products from us more than once. Orders placed by our repeat customers accounted for 66.2%, 86.7% and 91.9% of our total orders in 2009, 2010 and 2011, respectively.

But do the customer statistics support these claims?

VIPS has a unique way of defining repeat customers. Most retailers define a repeat customer as someone who has ordered in a prior period and who now places a new order in the current period. VIPS includes these customers as repeat customers but it also includes customers who order for the first time in the current period and who then order again in the current period. So, a customer can be a new customer and a repeat customer in the same period. VIPS further massages its repeat order numbers to include all orders from repeat customers. So, if a new customer in the current period places two orders, both of these orders will count as repeat orders even though the customer is a new customer (and is a repeat customer also). These practices make VIPS's repeat business appear to be a lot higher than it really is. To sort this out, we asked the company to provide retention statistics and received the following:

Retention rate(Total active customers)
2010Q42011Q12011Q22011Q3
2010Q4100.0%
2011Q155.8%100.0%
2011Q249.9%57.6%100.0%
2011Q345.1%47.6%56.0%100.0%
2011Q441.7%43.4%47.8%54.3%
2012Q135.9%37.7%40.2%42.6%
2012Q236.4%37.6%40.9%42.6%
2012Q335.2%36.1%38.7%40.5%

So, for example, of the customers who ordered in Q4 2010, VIPS retained only 55.8% in Q1 2011, i.e. the quarterly churn rate was 44.2%! By Q4 2011, the retention of this group was down to 41.7% (churn = 58.3%)! The retention and churn rates for the other cohorts follow a very similar pattern. Do these sound like results for a company with a "highly engaged and loyal customer base?" The truth is that most of VIPS customers do not continue on the website for very long and VIPS needs to constantly replace its customer base. When VIPS claims that 93% of orders came from repeat customers in Q4 2012, a large portion of these were in fact new customers who ordered more than once and therefore had all of their orders counted as repeat orders.

Even with the liberal definition of repeat business, the numbers appear suspicious. The table below shows the number of repeat customers and repeat orders as reported by VIPS. The number of orders in relation to customers seems to have increased dramatically. In Q1 2010, repeat customers ordered an average of 2.55 orders but by Q4 2012, each customer placed an average of 4.31 orders. So - for each customer that placed 2 orders, there exists another customer who placed 6 or 7 orders! That's a lot of orders.

Repeat Business

Repeat

Repeat

Repeat

Cust.

Orders

Ord/Cust

Q1

2010

20

51

2.55

Q2

2010

40

115

2.88

Q3

2010

65

193

2.97

Q4

2010

115

445

3.87

Q1

2011

194

712

3.67

Q2

2011

312

1,234

3.96

Q3

2011

439

1,964

4.47

Q4

2011

644

2,771

4.30

Q1

2012

737

2,773

3.76

Q2

2012

1,054

4,256

4.04

Q3

2012

1,265

4,966

3.93

Q4

2012

1,861

8,026

4.31

But what is VIPS really?

VIPS likes to promote itself as a high-end retailer offering great bargains. From the F-1:

VIPS Holdings Limited ("Vipshop" or the "Company") is China's leading online discount retailer for brands. VIPS offers high quality and popular branded products to consumers throughout China at a significant discount to retail prices.

Despite what Management and analysts say, VIPS's business model is completely different from Gilt Group - while Gilt and other flash sale sites are focused on luxury goods, VIPS is focused on the low-end. VIPS's average order size in FY 2012 was $31.58. Gilt's average order size is $123. Ideeli's average order is $98. Even Amazon (NASDAQ:AMZN) has an average order size of $49. VIPS is clearly focusing on low-end clothes. These are the clothes that nobody else wants to sell. You can't sell a high-end article of clothing next to a low-end article because most all consumers will choose the lower-priced article, with a relatively low profit for the seller. So, the high-end websites get the high-end products and VIPS gets what's leftover. I mean, go to the website - If I didn't know any better I'd swear that's a stripper on the front page.

As a result, its future gross margins and potential profits are capped significantly lower, and contrary to what analysts may believe, high-end flash sale sites are not good comparable companies for VIPS. 360buy's latest VC round valued the company at $7.3bn and it is doing over 20X the revenue of VIPS. VIPS is a marginal player at best and lacks the infrastructure to compete. Further, major competitors are building out massive distribution networks, including 360buy, which started building it in 2007 and spent more than $580mm in 2012, and Alibaba, which announced plans to spend $16.1bn on a countrywide distribution network.

VIPS is deteriorating into a standard e-commerce model rather than a true flash-sale model. It currently has over 100 brands for sale on a daily basis and the long list of products on its website simply cause consumers to lose focus-similar to the "deal/e-mail fatigue" occurring at flash sale and daily deal sites in the US. Increasing competition is accelerating the fatigue process by exposing consumers to even more offers. The average sale period has increased from 2 days to 6 days, and pricing on many products is no different from other non-flash sale websites. Further, contrary to its initial policy of demanding the ability to return unsold merchandise to manufacturers, VIPS has begun accepting significant inventory that cannot be returned from Adidas and Nike and greatly expanded its merchandise offerings that are specifically produced to be sold on its website. Where is all of the unsold merchandise that can't be returned? What are they going to do with it and how much of drag on earnings might it be in the future? How is it unsold inventory that can't be returned valued on the balance sheet?

Further, as competition increases, the prices paid to manufacturers for merchandise and the terms, especially the ability to return unsold merchandise, will change in an adverse manner and provide significant headwinds to future growth. VIPS's margins won't increase, they will decrease!

There is significant competition from e-retailers such as Tmall moving into the flash sale space as well as other flash sale companies such as Xiu.com, NetEase Premier, Glamour Sales, Shangpin.com, Shouke and VIPStore.com. Given the lack of its own distribution channel, VIPS causes consumers to take much longer to receive products as opposed to purchasing from 360buy or Tmall.

One primary reason for businesses to use other e-retailers to sell their merchandise is that the Chinese transportation and logistics infrastructure has been weak. One of VIPS's touted clients, Adidas, recently announced that it would stop selling through third party retailers and e-retailers in Europe - it is only a matter of time until this extends to China for a multitude of VIPS suppliers. Additionally, it will no longer be competitive with 360buy (initiated an RMB 10bn infrastructure project) or Taobao/Tmall

Equally as important, VIPS is part of a reverse cyclical industry that is headed towards a downturn. VIPS's truly discounted offerings (i.e. not those produced explicitly to be sold via VIPS's website) depend on a supply glut from the manufacturing side. There is currently an apparel inventory glut and this is providing a tailwind for VIPS growth and margin position. Gilt experienced a similar tailwind in 2009-2010 and after inventory level normalized, its valuation fell from $1.3bn to $400MM on the private market (data from Sharepost.com)

Complaints about VIPS are abundant. This report states VIPS has a 41.35% customer complaint rate. It quotes from China E-commerce Research Center's 2012 China e-commerce user experience test reports and complaints. Vipshop topped the list with 41.35% of customers complaining. The report states that many complaints include selling merchandise that is fake and is of substandard quality. As an example, this article tells the story of Ms. Lee Zhihou who ordered Winnie the Pooh shirts which were backed by an insurance policy guaranteeing their authenticity. The clothing arrived, was of terrible quality and clearly counterfeit, with a phony brand tag sewn into the collar. When Ms. Zhihou tried to recover through the insurance, she was told the policy had expired in 2010. After following up aggressively, she was told that the insurance would be honored but only if she paid for an appraisal of the clothing and for return shipping. These costs being clearly prohibitive, she finally gave up, swearing never to purchase from Vipshop again.

VIPS - The OSTK of Tomorrow

We believe that VIPS is a dramatically overvalued business with flaws in its model that have not been exposed to investors. There are specific catalysts that we believe will materialize in the near future and drive down the price of the stock to our target of $5 per share. These include the introduction of superior transportation and logistics systems by competitors, a surplus of competitors and deficit of inventory from suppliers, deal fatigue among Chinese consumers, and impending insider sales.

The first flaw in the business model is that flash sale sites are not a sustainable business. Like other industries such as automobiles and recreational products, it is a cyclical business, except in this case, it relies on supplier inventory cycles rather than customer cycles. Those supplier inventory cycles are counter-cyclical, since the apparel industry is cyclical and flash sale site cycles are based on excess inventories from the apparel industry. We believe that the recent inventory glut in China is not sustainable, and that VIPS and other online discount apparel retailers will soon begin to feel the effects of that. Currently, VIPS is trading at high-growth multiples when it may be near the peak of its current cycle. Below is a quote from Management's latest investor call, addressing the inventory issue:

"Okay. The apparel industry is actually RMM1 trillion market in China and you may know that their static [sic] is saying that by 2013 the total apparel market will be RMB2 trillion which will be increased to 2.7 trillion by the end of 2016. So if we look at the mature, efficient apparel markets such as the US, where discount retailer's inventory, it typically accounts for approximately 20% of the overall market. In China, where the market is not nearly as efficient, we get as a percentage would naturally be higher. So in other words, let's be more specific, even by this very conservative estimation, our addressable market for monetizing apparel inventory would work more than RMB400 billion this year and almost 550 billion by 2016."

This is extremely misleading. To begin with, the domestic apparel industry in China is very segmented-and internet retail as a whole is 14% of it:[1]

The existence of a large market for discount retailing is hardly justification for VIPS's current market capitalization. This top-down market sizing is an ancient trick used to convince investors that the opportunity is far greater than it really is by ignoring key factors that shrink the market size significantly. In the ordinary course of business, clothing manufacturers would sell their goods to brick-and-mortar or online retailers, who would then sell them to consumers at a mark-up to the price paid to the manufacturers. VIPS sells at a discount to end-consumers because it is purchasing at a discount from suppliers. Therefore, VIPS is a distributor of last resort for inventory that could not be moved through ordinary channels. If anything, suppliers have extra incentive not to sell to VIPS because of the potential damage to the brand: if a brand is frequently seen selling merchandise at a discount, consumers will become less likely to pay full price in the future. We believe that Overstock.com (NASDAQ: OSTK), a US-traded name that experienced a similar meteoric rise in share price in 2004, provides an accurate indication of VIPS's future.

Overstock.com

Flash sales are hardly a new business model - they are simply a twist on age-old version of online liquidations designed to capitalize on the manufacturer inventory gluts. The pioneer of online liquidations in the US was Overstock, whose CEO described the company's goal as "being the premier company selling excess inventory through the internet." Sound familiar? Investors all know how that turned out. After IPOing in May 2002 at $13/share, it peaked 1.5 years later around $70 with a market capitalization of over $1.3bn, followed by a rapid plunge. It went down to $6 before recently bouncing back.

Below is a table comparing the current multiples, margins, and other relevant figures of OSTK and VIPS:

OSTK - 12/31/04

OSTK - 3/1/13

VIPS - 3/1/13

Market Capitalization ($mm)1

1,335.5

276.7

1,306.5

Enterprise Valuation ($mm)1

1,165.6

183.1

1,095.9

LTM Revenue ($mm)

494.6

1,099.3

692.1

LTM Gross Profit ($mm)2

65.8

198.4

100.6

LTM Gross Margin (%)

13.3%

18.1%

14.5%

LTM EBITDA ($mm)

(1.1)

28.3

(4.2)

EV/LTM EBITDA

Not Meaningful

6.5x

Not Meaningful

Net Income ($mm)

(5.0)

14.7

(9.5)

P/E

Not Meaningful

18.9x

Not Meaningful

Notes:

1 Per Bloomberg

2 Gross profit calculated to reflect impact of shipping & handling expenses

The resemblance between OSTK at the end of 2004 and VIPS today is striking. Market capitalizations, revenue, gross margin, all metrics were nearly identical. Over the eight years since 2004, OSTK has managed to grow its revenue by approximately 100% -- but its net income was under $15mm during the last year. eMarketer estimates that the total US sales of apparel & accessories was $41.0bn in 2012 - what VIPS analysts are failing to realize is that larger markets breed competition.

The similarities don't end with financial metrics. OSTK is infamous for its accounting, including errors in accounting for customer refunds and credits, improper accounting for recovery of an overpayment to a supplier as "income" discovered through an SEC investigation in 2009, and alleged improper EBITDA calculations that misled investors.[2] VIPS also has issues that should alarm investors. The ones that stand out the most are:

1) The fact that VIPS does not disclose its statement of cash flows with its quarterly earnings, including the most recent one (Q4 2012) which was issued the same day as an F-1 that did include the statement of cash flows-showing that Management had it together, but elected to try to hide it from investors deep within a shelf registration filing rather than presenting it within the earnings press release. It is reminiscent of Enron's similar failure to produce balance sheets when presenting its earnings prior to blowing up.

2) VIPS's unbelievably high reported return customer rate. According to an iResearch report, VIPS had the highest ratio of return customers as a percent of total customers in the first half of 2012 - 14% higher than the next highest company (82.4% vs. 68.6%).[3] Based on the figures supplied in VIPS's SEC filings, the average number of orders per customer was 1.9 in 2009, 3.4 in 2010, 4.9 in 2011, and 5.3 in 2012. 93.3% of customers in 2012 had ordered from VIPS at least twice. The average number of orders for repeat customers was 3.4 in 2009, 5.2 in 2010, 7.4 in 2011, and 7.8 in 2012. This fanatical repeat business flies in the face of the mediocre reviews VIPS has received from customers [http://finance.newssc.org/system/20130324/000978656.html]

3) VIPS does not disclose return rates

4) The dramatic decline in shipping expenses on each order is intriguing because VIPS attributes it to its "expansion." Any such expansion was minimal. Below is a table of VIPS's leases and capital expenditures over the past three years. We find these figures to be suspiciously low given VIPS's reported volume. On 6/14/2012, VIPS announced that it would be developing its own logistics network. At that time, according to the VP of logistics and customer service, this was expected to increase shipping costs by 20-30%. However, instead, the shipping expense decreased significantly, in direct contradiction to that statement.

5) VIPS failed to identify "related parties" that it received $6.7mm in revenue from during FY 2012.[1]

To an even greater extent than Overstock, there is a cap on the maximum possible gross margin VIPS will be able to squeeze out of its orders: firstly, because it is doing business in China, and secondly, because VIPS is dealing with significantly smaller average order sizes.

VIPS is focused on low-end goods. VIPS's average order size in FY 2012 was $31.58. Gilt's average order size is $123. Ideeli's average order is $98. Even Amazon has an average order size of $49. VIPS's average order has declined in value by 25% over the past 3 years.

Distributing through a site like VIPS should be a last resort for true premier brands. The damage to the brand and pricing power caused by consistently being associated with discount retailers is significant. The alternative is to produce separate, second-tier products exclusively for VIPS. This appears to be what many garment manufacturers are doing:

In the US, the largest e-retailer is Amazon, and the second largest is Overstock. In our opinion, VIPS will not even be the second largest e-retailer in China; not even close.

-Exclusive rights to sell selective products from 700 brands. This means that certain brands are producing "discount" merchandise specifically for them - similar to how Overstock functions.

Impending catalysts

-Possible secondary offering in the making

-Continued Proof that the company is misleading investors by massaging its user numbers

-Business is already turning into the next Overstock - more of a normal discount e-retailer, not a flash sale site.

-Increased competition from e-retailers and daily deal sites will compress margins

-Due to product expansion to build out its revenue for investors, Vipshop will no longer be perceived as a premium outlet for premium brands, and its brand will begin to deteriorate (similar to Overstock?). As it stands, Vipshop covers a significantly less valuable space than Gilt and other flash sale sites, which are focused on high-priced merchandise. Vipshop is focused on low-cost merchandise, narrowing its maximum profit margins and putting it closer to Overstock.

-Deal fatigue-similar to Groupon. This will be accelerated by the expansion of product offerings and the increasing perpetual status of some products

Consequences of Competition

We believe that competition within the internet apparel retailing segment in China is going to override the effect of the increasing market, just as it has in the US for companies such as Overstock. Consequences of intensifying competition include:

-lower margins

-increased consumer expectations regarding shipping

-lower ability to negotiate with suppliers

-removal of the clause allowing VIPS to return goods to suppliers

-delaying supplier payments as VIPS has been doing

-Impending removal of the sell-back clause. For instance, in the US, this is how TJ Maxx and Marshall's, the two largest brick and mortar discount apparel retailers, operate. It is only a matter of time until this becomes the standard in China due to competition

http://www.funggroup.com/eng/knowledge/research/industry_series21.pdf

Analyst expectations are largely built using market-sizing, and we believe that they fail to properly account for the movement of the dominant players into flash sales that will crush VIPS's growth. See US market.

During an interview earlier this year, the founder of Gilt pegged the gross revenue of the four largest flash sale websites - Gilt, Rue La La, Haute Look, and Zulily - during FY 2012 as $300mm to $700mm. Between those sites, the total market for flash sales in the US is less than $3bn. Why would China's revenue be any higher?

Now, in spite of all of this, JP Morgan and other analysts have produced research reports with a "buy" recommendation on the stock. But where is the research in the research reports? Where are the interviews with industry insiders? Where are the channel checks? If you read the JP Morgan report, many sections look almost exactly the same as sections of the F-1 recently released by VIPS. The JP Morgan report projects revenue to increase from US$693mm in 2012 to US$1.37B in 2013 and US$2.06B in 2014. In conjunction with dramatically increasing revenue, gross margins increase from 22.3% in 2012 to 23.8% in 2014, and adjusted operating margin increases from (-0.6%) to +5.1%. We just don't see it. We are talking about leftover apparel here. Where is all the revenue going to come from? The website is already overcrowded - the ":flash" is gone. We see margins decreasing rather than increasing. Do you really think manufacturers are going to give them better deals now that they see how much money VIPS is making? Once the manufacturing glut subsides as we move forward in the cycle, apparel makers will command higher prices for their leftovers rather than lower. VIPS's margins won't go up, they will go down.

If the future were as rosy as JP Morgan makes it out to be, where is the institutional ownership? Where are the Fidelity's, Oppenheimer Funds, and T. Rowe Price? Where are the hedge funds? They aren't here. The only large holders are the insiders and the two VC firms - Sequoia Capital and DCM. The insiders, Sequoia and DCM all sold shares in the recent offering at US$24.

VIPS is starting to sound similar to some of the other companies coming out of China that we've seen before - like Longtop Financial (NYSE:LFT), ChinaMediaExpress (OTCPK:CCME) and China Biotics (OTCQB:CHBT). But there is another similarity as well. In each of these three companies, insiders sold stock at inflated prices right before each of the companies imploded. So what has VIPS just done? They've just sold insider stock, and another marketing trip with Stifel is scheduled next week to San Francisco.

On March 14, 7.2mm shares were sold at US$24.00 each - 4.0mm by the company and 3.2mm by selling shareholders - including DCM and Sequoia Capital. Interestingly, JP Morgan served as one of the lead underwriters in the sale. Is it a coincidence that they just published a research report touting the stock?

A total of US$172.8mm was raised in the offering. That's real money! But insiders still have plenty more stock to sell. Here are some grants issued to insiders in 2010 and 2011 from the IPO F-1:

Purchaser

Date of Sale or Issuance

Number of Securities

Consideration

Type of Securities

Elegant Motion Holdings Limited

August 27, 2010

20,000

Nil

Ordinary Shares

January 31, 2011

19,105,840

Nil

Ordinary Shares

High Vivacity Holdings Limited

August 27, 2010

12,500

Nil

Ordinary Shares

January 31, 2011

11,941,150

Nil

Ordinary Shares

Rapid Prince Development Limited

August 27, 2010

7,500

Nil

Ordinary Shares

January 31, 2011

7,165,090

Nil

Ordinary Shares

Dynasty Mount Enterprises Limited

August 27, 2010

5,000

Nil

Ordinary Shares

January 31, 2011

4,776,460

Nil

Ordinary Shares

Advanced Sea International Limited

August 27, 2010

5,000

Nil

Ordinary Shares

January 31, 2011

4,776,460

Nil

Ordinary Shares

That's a lot of stock to get for free.

And yet there is another similarity between VIPS and LFT, CCME and CHBT. They were all audited by Deloitte Touche Tohmatsu!

Remember the IPO in March 2012? They were trying to sell 11mm ADRs at a price of $8.50 to $10.50 per share. But the IPO was doomed because investors were skeptical about another possible fraud from China. It went to market, but only after the price was dropped to $6.50, and after DCM and Sequoia agreed to purchase more shares in the IPO (Sequoia invested $20mm more in the IPO), The IPO was broken on the first trading day, and within a week VIPS traded down to $4.25. So investors wouldn't buy the IPO at $8.50 and wouldn't hold the eventual IPO price of $6.50 because VIPS had such a weak business model, but now investors will pay $38 per share after they have published the numbers?

VIPS's corporate structure is rather interesting. From the F-1:

OUR CORPORATE HISTORY AND STRUCTURE

We are a holding company incorporated in the Cayman Islands and conduct our business through our subsidiaries and consolidated affiliated entity in China. We started our operations in August 2008 when our founders established Vipshop Information in China. In order to facilitate foreign investment in our company, our founders incorporated Vipshop Holdings Limited, an offshore holding company in Cayman Islands, in August 2010. In October 2010, Vipshop Holdings established Vipshop HK, a wholly owned subsidiary, in Hong Kong. Subsequently, Vipshop HK established a wholly owned PRC subsidiary, Vipshop China, in January 2011. Vipshop China established a wholly owned PRC subsidiary, Vipshop Kunshan, in August 2011.

The diagram on page 51 of the F-1 illustrates the corporate structure (diagram too large to be reproduced here due to SA limitations).

What does the diagram mean? It means VIPS shareholders don't really own much of anything that is tangible. They essentially own the contract to work with Guangzhou Vipshop and Guangshou Vipshop owns everything of material value. This convoluted structure was designed to protect the true business owners, the insiders.

VIPS was incorporated in the Caymans. The Caymans have little in the way of securities laws and provide significantly less protection to investors as compared to the laws of the United States. There is a risk for the potential lack of standing by Cayman Islands companies to sue before the federal courts of the United States. In addition, VIPS's organizational documents do not contain provisions requiring that disputes, including those arising under the securities laws of the United States, between VIPS, its officers, directors and shareholders, be arbitrated. As a result, it would be very difficult for a shareholder to effect service of process within the United States upon VIPS officers, or to enforce against VIPS or their judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

All of this, and investors are willing to pay 11x book value and 78x forward (2013) earnings. For a company that is misleading on the customer counts and may have topped out in opportunities to grow, we don't get it!


[1] See Note 15 to the financial statements, F-34, VIPS F-1 filed on 2/21/13.

Source: Vipshop's Misleading Financials: A Secondary On The Way