JD.com's Recent Results Benefit From Accounting Discretion, Not Fundamental Improvements
Summary
- Cash flows benefit significantly from increasing delays in vendor payments.
- Revenue deltas are materially supported by growth in accounts receivables, loan receivables, and related party receivables.
- Approximately 40% of revenue growth can be attributed to growth in accrual accounts.
- Our estimate is that the JD shares are worth $24, a discount of around 38% from current prices.
Recent analyst and media reports have heralded a turning point in the storied history of Chinese e-commerce company, JD.com (NASDAQ:JD).
After years of heady expectations and aspirations, it seems that China's largest retailer is finally coming into glory from a financial reporting perspective: continued hyper-earnings growth yes (39% yoy), but now, for the first time, profitability is on the horizon, and the all-too important metric of cash flow has recently accelerated (417% and 183% in 2016 and 2017, respectively).
Annual growth in revenues, profits and cash flow at JD.com
Source: Company reports
As impressive as these figures suggest, all is not what it seems. JD's financial improvements are less about fundamental strategic and operations success than they are about financial and accounting choices that serve to improve the look of the company's accounts. We challenge some of those discretionary accounting methods below and conclude that JD is still overvalued by 38%.
Cash flow enhanced significantly by delaying payments to vendors: Investors and JD cheered the recent uptick in both operating cash flow (OCF) and free cash flow (FCF). The company reported OCF of RMB 8.8 bn and RMB 24.8 bn in 2016 and 2017, respectively. These were impressive from both an absolute and growth perspective. Upon closer inspection, though, both figures are the result of the company's decision to further delay payments to its vendors.
Days payable outstanding (payables/revenue x # of days in period) is a metric used to analyze how long on average a company takes to pay its vendors. For the past 5 years, JD's DPO has grown considerably, from a low of 52 to a recent high of 75 days.
Annual growth in days payable outstanding at JD.com
Source: Company reports
The impact of the payment extension is considerable once we calculate the impact on CFO by maintaining DPO at the 2014 level. CFO for 2016 and 2017 would have been lower by RMB 7.2 bn and RMB 22.6 bn, respectively, nearly wiping out reported CFO for both years.
Adjusted cash flow from operations at JD.com
Source: Company reports; Mithra analysis
In addition, in computing CFO, JD adds back non-cash share-based compensation expenses for salaries to net income. While this is technically in compliance with Generally Accepted Accounting Principles (GAAP), it obscures the significance of these expenses and erroneously suggests that these costs have no real-world cash impact.
The only way that JD is able to pay a portion of its salary expenses is because of its highly valued share price. In fact, JD reports in its 2017 annual report that it is offering stock options for payment for non-employee consultants other well. Were the company's shares less valuable, the company would be forced to make these payments in cash. Hence, a more sustainable OCF calculation would reverse the add-back of these costs.
We further adjusted OCF for 2016 and 2017 by reversing the impact of non-cash stock options. This results in OCF of RMB (0.8) bn and RMB (0.6) bn, far less than the figures on which the company and analysts have focused.
In addition, JD recorded capex of RMB 4.2 bn and RMB 11.4 bn in 2016 and 2017, respectively. Hence, adjusted FCF for both years would have been a less impressive RMB (5.0) bn and RMB (12) bn in 2016 and 2017, respectively.
There is a potential argument to be made that JD's DPO reflects the company's relative position of power vis a vis its vendors. This argument suggests that as a larger corporation, JD has relative leverage over its vendors and therefore can dictate terms, such as longer payment cycles. The problem with this argument is JD and its existing supply chain have been around for several years. Why would the company only now begin to exert this leverage, and why would it exert in rapid jumps over the most recent two years.
One would expect that JD would exert its leverage immediately in an effort to preserve its limited capital. Instead, JD seemingly has increased its leverage position each calendar year and comparable quarters at a time when its revenue growth is decelerating.
We compared JD's quarterly DPO figures to Amazon (AMZN). Admittedly, these are two companies at different stages of maturity, but expected the companies to either maintain a limited range of DPO over time or consistent changes between comparable quarters. Amazon maintains a DPO in a narrow range and shows slight increases in comparable quarters.
Quarterly days payable outstanding at JD.com and Amazon
Source: Company reports; Mithra analysis
By comparison, JD exhibits a highly variable DPO. DPO ranges from a low of 49 days to a high of 74 days, a range of 25 days, whereas Amazon maintains a range of just 7 days. The average DPO at JD is 9 days higher than the average for Amazon.
Trends in DPO over last 8 quarters
Source: Company reports; Mithra analysis
Revenue dependent upon company financing which has become more difficult to assess: Revenue growth year over year has fallen from approximately 60% in 2013, 2014, and 2015, to just under 40% in 2017. Most analysts will correctly rebut that it is difficult to point developed markets retailers posting revenue grown anywhere near those figures. But again, this impressive growth benefits significantly from JD's accounting and financing decisions. In recent years, JD has actively promoted a financing program in support of both customers and vendors. The financing has materially supported the company's revenue growth rates.
We analyzed financial statements for JD and noted that massive growth in accounts receivables, loans receivable, and related party receivables. In fact, when examining the differences between revenue year over year and deltas between these accrual accounts (AR, LR, RPTs), it is clear that, in 2016, nearly 40% of the delta in revenues can be attributed to growth in these accrual accounts which increased cash but not operating cash flows.
Comparison of delta in Revenue to delta in revenue accrual accounts
Source: Company reports; Mithra analysis
A similar analysis for 2017 is not possible because JD restructured its interest in JD Finance several months ago. As such, key input metrics for LR and full impact of AR, as detailed in cash flow statements relating to securitized receivable, are not available as this information is now no longer part of JD's consolidated results. At a minimum, it seems that at least 2% of 2017 revenue growth is attributable to financing. We do not believe however that JD has reduced its dependency upon financing now that JD finance is no longer included in the company's financial. In fact, given the trajectory of lower rates of growth in revenue, we suspect that JD has ratcheted up its dependence upon financing, not reduced it. The challenge is that such information is no longer readily accessible. We expect that at a minimum, 45% of revenue growth in 2017 is derived from loose credit to customers and vendors, in line with trends and 2016 figures.
So, what's wrong with a company growing by credit, you might ask. Nothing as long as growth is not materially dependent upon it. In the case of JD, 40%+ of total revenue growth is clearly material. In addition, loose credit depends upon a company's ability to access cheap credit. This renders financing dependent revenues unsustainable. There is no guarantee that JD will continue to have access to cheap credit and no assurance that customers will maintain an interest in the company's credit offers.
A further concern with financing-dependent companies is that they are able to report accelerated growth rates in the early phase of offering credit. However, as the revenue base gets larger, it becomes increasingly more difficult to maintain or exceed historical growth rates without also accelerating the levels of credit offered, often leading to company's loosening credit standards and underestimating potential risks in their credit portfolios.
JD recently responded to a Securities & Exchange Commission comment letter wherein it detailed information on outstanding AR and LR as well as the allowances for doubtful accounts. Despite the rapid rate of increase in revenues and receivables, JD's allowances are trending downwards based upon 2016 and 2015 data (again, 2017 not available due to restructure of JD Finance). This is usually not the case; as companies enter new markets or add new customers, they tend to increase allowances to reflect the increased level of repayment risk.
Trends in Allowances for doubtful accounts in accounts receivable and loans receivable
Source: Company reports; Mithra analysis
JD seems to be under-reserving for the possibility of non-payment which makes us concerned that the company may have a risk of higher non-performing loans outstanding to customers and vendors. This may impact future profitability (write-downs) and operating cash flows.
Lack profitability and adjusted cash flow makes valuation a challenge: Based upon our analysis, JD's adjusted cash flows are negative, it's reported revenues are enhanced significantly by unsustainable credit offers to its customers, and the company continues to generate net losses. Hence, valuation models requiring these metrics as inputs present challenges.
We have decided to value the company as a multiple of its adjusted revenues (non-financed driven revenue) which we conservatively estimate at 45% less than reported figures. This would result in a 45% decrease in the company's share price. In the days, immediately after the release of the 2017 results, JD shares traded at around $44/share. A 45% discount from this price would suggest a fair value for JD of $24/share, a 38% discount from current market value.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (82)
Also appreciate your comments Li Li and William Daniel ... meaningful rebuttals rather than meaningless negatives. Don
For the offline market, JD's pricing power and distribution channel would be pro over BaBa
It's my understanding is that WeChat is VERY popular as a payment
method. I'm long JD.
Dilly Dilly ! ! !
