2018 is a year to forget for JD.com's shareholders
With the big drop in the share price of JD.com (JD) this year, 2018 is without a doubt a year to forget for most shareholders. I did an overview of JD.com’s 3Q 2018 results in the inaugural Chinese Internet Weekly newsletter a fortnight ago. A reader requested for a more comprehensive take of what had happened to the company and the stock in particular. Hence, the motivation for this article.
JD.com started the year on a strong momentum, riding on the various initiatives from 2017. These initiatives included the opening of over 1,000 fresh food stores in China and the recruitment of Pei Jian, a renowned big data researcher and computing science professor at Simon Fraser University in Canada, to lead JD.com's then newly created data platform and product research and development department. In mid-January, Reuters ran an exclusive story on JD.com's fundraising round at its logistics unit with a target of at least $2 billion.
Throughout the first half of the year, favorable developments continued to flow out from the largest retailer by revenue in China. The climax probably came in the middle of the year, with record sales achieved during the company-initiated 618 shopping extravaganza in June, followed by the announcement of an investment by Alphabet’s Google (GOOGL)(GOOG).
The $40.50 pricing paid by Google was a small discount to the then traded price, an indication that the search giant did the deal with the intention to collaborate, rather than a focus on ROI. The potential opportunities from the synergies between the two internet giants boosted market interest in JD.com. In particular, it was hoped that the deal would help in the international expansion of JD.com, with Google helping to open doors for the former into the lucrative North American market. Unfortunately, things started to unravel beginning in June. I discuss the various incidents driving the share price downwards and explain why I think the selldown is overblown.
Other Chinese internet stocks fell as well
It would be unfair to attribute the fall in the share price of JD.com entirely to the management. The stock markets in the US and China have turned weak in recent months. JD.com’s peers such as Tencent (OTCPK:TCEHY)(OTCPK:TCTZF) and Alibaba (BABA) have also seen their market valuations shrunk considerably in the past months. While the drops have been largely due to specific issues at the respective companies, the general market swoon on concerns over a slowing economic growth is a key factor in the selloff in the Chinese names and JD.com is no exception. Of course, the infamous rape accusation of its CEO played a significant part too and I will elaborate on this in the following section.
Business growth unimpeded by the rape allegations against founder Richard Liu
The investigation on Richard Liu regarding a possible rape offense is still pending a conclusion. The possibility that the seemingly all-important founder cum CEO of JD.com going to jail is hanging like the sword of Damocles on the stock price. Regarding the local perception of the case in China, whether it was rape or not did not matter as much as the likelihood that an act of infidelity was committed. The healthy image of Richard Liu as the poster boy for the rags-to-riches story is shattered. He would never garner the same respect at the local talk shows as a guest speaker like the manner he used to command.
Not that it matters to the business. Unlike in the US where disgruntled users would boycott a platform, like in the case of Uber (UBER) with the #DeleteUber movement, Chinese consumers don’t shop based on the morality of the founders or the management teams; they spend where there are good deals. An exception would be when it hurts their pride, like in the recent case of Dolce & Gabbana. The Italian luxury brand ran a marketing campaign deemed to be demeaning to the Chinese. To make matters worse, one of its co-founder, Steffano Gabbana, apparently made derogatory remarks directed towards China on Twitter (TWTR). While he later defended himself by saying his Twitter account was hacked, nobody was convinced.
Both co-founders eventually appeared in a nearly 1.5-minute video posted on Weibo (WB), a Chinese version of Twitter, to apologize and seek the forgiveness from the Chinese. Unfortunately, the damage has been done. A major event was called off and goods from the company were removed from Alibaba's Tmall and JD.com. D&G should expect sales to drop off a cliff.
Another way which a company can land into hot soup is the invocation of taboo subjects. A blotched marketing campaign conducted by Bluegogo, the former third-largest bike-sharing operator in China, was attributed as the trigger for its eventual failure. In early June 2017, it made an attempt to exploit the anniversary of the 1989 Tiananmen Square incident by creating a promotion titled “Bicycle and tanks are more compatible”. Users who rode on selected Bluegogo bikes could stand to win five Beats (owned by Apple Inc (AAPL)) headsets and 20 Mi wristbands (made by Xiaomi (XI)). A promotional advertisement purportedly showed a row of bikes depicted as tanks lining along the road plying Tiananmen Square.
Source: TLD by MW
The availability of Bluegogo bikes was reportedly "reduced dramatically" after the marketing campaign. The founder was also said to be unable to secure any funding subsequently. The insensitive marketing ploy ostensibly backfired on the company.
Now, it's easy to understand why the personal indiscretion of a CEO wouldn't evoke much reaction comparatively. In the early days following the release of Richard Liu’s mugshot, it was speculated the incident could ignite the #MeToo movement in China. Nothing came close to it and the Chinese lost interest in the case quickly. JD.com’s slower user growth rate might cause some observers to be skeptical of the ‘little impact’ argument. However, it is important to note that the weaker gain in user number was due to the deliberate move to focus on customer quality. It is a wise decision to give up on users who might be active simply to exploit 'loss-leaders' but the company is unable to entice them to purchase other higher margin products. Good riddance, in other words.
The decline seems to be overblown
Pinduoduo (PDD), the Chinese e-commerce player which was listed only in July this year is now within billions in terms of market capitalization with JD.com. In the past three months, the share price of Pinduoduo is higher by 12.5 percent while that of JD.com is lower by 27.0 percent. The contrasting price movements have led to the narrowing of their market capitalization to just slightly over $5 billion.
Pinduoduo came into prominence facilitating the bulk-purchase of low-value items like toilet paper and other household products with a particular focus on the rural markets. Critics of JD.com and Alibaba used to charge that the rural areas wouldn't be the panacea for revenue growth due to the low-income population. Pinduoduo, despite being a relative newcomer, managed to dispel the myth that e-commerce sales won’t amount to much in the rural regions. The tune quickly changed to become ‘OK, there’s potential in rural but Pinduoduo is already the dominant player’.
The argument is not without merit, as Pinduoduo has proven its mettle in understanding the needs of the rural population and keeping its users engaged. It has managed to increase its revenue by leaps and bounds since its operations. Revenue soared seven-fold in the third quarter of 2018, dwarfing the 21 percent increase achieved by JD.com. Unfortunately, at the same time, the company's total operating expenses jumped 8.3 times. The losses have reached $1.27 billion on a trailing-twelve-months ('TTM') basis, more than thrice that of JD.com but with a fraction of JD.com's revenue.
What Pinduoduo has accomplished thus far is undoubtedly commendable. However, put into perspective with JD.com side by side, it is obvious that the latter is being unfairly treated by the market. In addition, besides the core e-commerce business, it has an 81.4 percent stake in JD Logistics which was valued at around $13.5 billion in March following a funding event. It also retains an option to convert the right to receive 40 percent of JD Finance's pre-tax profit into a 40 percent equity stake should the regulatory environment change. JD Finance was last valued at nearly $20 billion.
Positive vibes from the earnings conference call
It's a cliche to say the market is forward-looking and the share price reflects the market expectation of the company outlook. However, based on the positive messaging of Richard Liu and the stock remaining near its multi-year low, it seems market players are still having their rear-view glasses on.
In response to analysts' questions regarding the growth strategy for JD.com posed during the earnings conference call, Richard Liu outlined several drivers for an improved net profit setup next year.
First, the profit margin could improve as the R&D cost "might not increase" next year, following the 88 percent yoy jump in 9M 2018, given the company has since determined where to focus its R&D efforts.
Second, Richard Liu said that the net profitability of JD Logistics will be boosted "a lot". Despite the third quarter being a seasonally low one, the volume still increased on a sequential basis for its warehousing business, leading to a higher utilization and narrowing loss ratio consequently.
Third, he guided that the company was expected to grow faster than the industry average, resulting in a higher market share.
Fourth, for its 7Fresh convenience stores, the CEO said the management was "actually pretty comfortable" that on a single-store basis the margin would be able to "break even and turn positive in a relatively short period of time".
Regarding cash flow, the CEO also said that he expected to see it improving "a lot" in 2019 since the heavy underwriting cost (for its planned IPO) and logistics investment have already been incurred this year. The transfer of some logistic assets to a fund that has received "very good initial investor interest" is on track. The company anticipates a transaction to happen "in the first half of next year".
Shareholders have also been concerned about succession planning. Richard Liu addressed that saying he would "personally focus on four things; one is strategy, the other is culture, then team, and then new businesses".
Internet titan Alibaba has traditionally served as the nemesis for JD.com in the bear story. Pinduoduo has now taken over its place, as investors turned their attention to the relatively new upstart, thanks to its skyrocketing revenue growth. However, it bears noting that Pinduoduo is nursing huge losses that seem incapable of benefiting from economies of scale. Furthermore, the management’s replies to Blue Orca regarding its revenue recognition largely fall under the category of motherhood statements.
Comparatively, JD.com looks undervalued. Its stock price is now near the lows of 2016 June but has rebounded off a technical support. The return to its all-time-high would be very tough. Nevertheless, the CEO has signaled a brighter 2019 and new investors would no doubt be coming on board when there is plenty of blood on the street.
What's your take? Are you bullish or bearish? Please freely share your thoughts, let me know if you found this article useful or provide your feedback in the comments section. For further reading, my recent write-up, "Alibaba: Where's The Bottom? - Part II", might be of interest to you. For more details on the challenges facing Pinduoduo, please check out my initiation article Pinduoduo: Good Concept But Plenty Of Challenges Abound.
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Disclosure: I am/we are long BABA, JD, TCEHY. 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.