Secular Growers Series Part 2: Baozun And The Rise Of E-Commerce In China

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About: Baozun Inc. (BZUN)
by: App Economy Insights
Summary

This is the second article in the Secular Growers Series: companies benefiting from trends likely to continue for years because of the fundamental societal disruption they embody.

Baozun is a leader in e-commerce solutions that helps big and small brands enter the Chinese market, often called the "Shopify of China."

The company is positioned to benefit from the rapid rise of an affluent middle-class, internet penetration and e-commerce in China.

The one-stop e-commerce shop just reported record-beating growth in merchandise volume, revenue, and earnings - and it's reinvesting in itself.

BZUN is very volatile, but don't miss the forest for the trees - at today's price, I believe it is poised to dramatically outperform the market over the next decade.

Investment thesis

Baozun (BZUN) is a high quality secular grower worth a prime spot in your portfolio.

The Chinese e-commerce solutions provider is continuing its shift, moving away from a distribution model with inventory ownership to more profitable models:

The company is benefiting from three leverages:

  1. Rapid growth for the next decade thanks to secular trends in China.
  2. Widening moat thanks to reinvestment in its operations and technology and an expanding list of international brand partners.
  3. Improving earnings and free cash flow despite the reinvestment.

If your time horizon is within the next quarter or fiscal year, you should stay away from the "Shopify of China." It has proven to be a widely unpredictable and volatile investment over the short term. The story at stake will play out over the next decade and goes beyond the current slowing Chinese economy, a potential trade war, or the next credit cycle.

Once you consider that Baozun has a market cap under $2 billion despite the inexorable path it's already on, I think you'll see why it's a top-five holding of the App Economy Portfolio and why today's price is a thing to be grateful for, if you are ready to invest in long-term opportunities.

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Why secular tailwinds matter

This article is the second in the Secular Growers Series following my write-up about Huya (HUYA) And The Rise Of Esports.

I'll provide more details on some of the framework I use to identify, research and invest in the best secular trends the world has to offer.

Going back to the definition of secular straight from Investopedia:

  • Secular refers to market activities over the long term or a stock that isn't influenced by short-term factors.
  • A secular trend, stock or market is one that is likely to continue moving in the same direction for the foreseeable future.
  • Secular stocks include technology firms such as Netflix (NFLX) and e-commerce leaders such as Amazon (AMZN).

Secular growth usually involves a constant growth of revenue and earnings above 10% over several years. The implication is usually that the trend is likely to stay the course over years to come, because of the fundamental societal disruption it embodies over the long term.

I have covered many secular trends in my first 30 articles on Seeking Alpha, from the rise of online dating to eSports. Many contemporary themes are obvious and all around us.

Here are a few examples of secular trends of the 21st century:

  • Digital payments overtaking cash.
  • E-commerce overtaking brick-and-mortar.
  • Streaming services overtaking cable.
  • Mobile ads overtaking desktop.

When possible, we want to capture a secular trend that also offers a potential exponential growth, the kind of growth associated with S curves.

You would typically see an exponential growth when technology is entering a sector and driving down costs, which then stimulates unit growth.

Image result for s curve definition

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Of course, finding a business that is embracing a secular trend isn't sufficient. For example, the rise of online food delivery is a secular trend, but that doesn't make any food delivery service a good investment (I'm looking at you, Blue Apron (APRN)).

Many secular trends are not worth exploiting to begin with, particularly the ones that don't have strong unit economics or a clear path to profitability.

The importance Of unit economics and retention

To reach the tipping point of the S-curve, also known as the "scale" phase, a company usually needs to see improving unit economics.

For example:

  • Customer Acquisition Costs are dropping over time (Marketing and customer acquisition costs dropping in % of Sales).
  • Dollar-based Retention Rate is superior to 100% (out of the same cohort of customers), also known as "negative churn."
  • Sales and gross profit growth are accelerating over time.

You'll see below why these concepts matter immensely in Baozun's case.

The three pillars of Baozun's secular growth

Now, let's talk about Baozun specifically.

Sentiment is pretty bleak for Baozun as an investment in the near term. The company is stuck between a potential trade war between US and China and a crowded tech space. On the flip side, that's what creates an opportunity to capitalize on Baozun's rising business at a cheaper price.

I covered previously what makes Baozun the ultimate growth play.

Here's a refresher on the three secular trends that can bring tremendous success to Baozun's business. Even with an average execution, management is likely to reap the benefits of these inexorable progressions.

1. Rise of Chinese Upper Middle Class

According to a study by consulting firm McKinsey & Company, 76% of China's urban population will be considered middle class by 2022, including 54% considered upper middle class. To put things in perspective, in 2000, just 4% of the urban population was considered middle class. ​

As a result, China's consumption growth is on fire compared to other leading economies and suggests more discretionary income dedicated to the brands for which Baozun is providing e-commerce solutions.

2. Internet user penetration rate in China:

Internet user penetration rate in China. Source: Statista.

Internet penetration in China was 56% by the end of 2017. That compares to 88% in North America. By simply catching up over time, the Chinese population exposed to Baozun's online stores is about to grow more than 50% in the coming years.

3. E-Commerce in China

Retail E-Commerce sales in China in millions USD. Source: Statista.

Statista is projecting e-commerce revenue in China to show an annual growth rate of 11% over the next five years. Online retail sales in China increased by 24% in 2018, according to the National Bureau of Statistics of China.

Meanwhile, the Chinese economy grew only 6.6% in 2018.

As explained by Chi Lo, BNP Paribas Investment Partners' economist for Greater China:

The Chinese economy is going through a phase of "creative destruction" as lively new economy sectors like e-commerce and online financial services coexist with still-dominant old economy sectors."

Let's not forget that the rise of Chinese e-commerce only complements the growth path Baozun is already on: signing more brands and maximizing the performance of its existing brands.

The impressive financials

Baozun's performance is closely tied to two KPIs:

  • More partners, thanks to an increasing number of retailers that need to move their businesses online, along with new foreign companies trying to enter the Chinese market.
  • More revenue per partner, thanks to the introduction of new value-added services in business intelligence, marketing, customer service, and logistics.

Let's review the last financials posted:

Q4 FY18
Brand Partners 178 +12 in Q4
Net Revenues $320 million +41% yoy
Product Sales Revenues $142 million +25% yoy
Services Revenues $178 million +57% yoy
Operating Income $33 million +31% yoy
FY18
Brand Partners 178 +32 in FY
Net Revenues $784 million +30% yoy
Product Sales Revenues $366 million +12% yoy
Services Revenues $418 million +52% yoy
Operating Income $52 million +39% yoy

What should remain with you:

  • Brand partners: The company is adding customers at a faster clip than previous years (+32 in FY18 vs. +19 in FY17).
  • Net revenues: Top line is growing faster in Q4 alone than it did in FY18, showing that the company is in the "scale" phase of the S-curve.
  • The shift from product sales to services revenues continues, and this should improve Baozun's unit economics over time.
  • Operating income is growing faster than revenue in FY18, showing that the unit economics are improving.
  • There were more investments in Q4: additional investments in innovation, as well as additional technology-focused headcounts and online store operational staff.

Baozun has entered a virtuous cycle, with its existing portfolio of 178 brands making the company the obvious partner for newcomers entering the Chinese market. As explained by CEO Vincent Qiu:

As our reputation strengthens, so too are the number of global leading brands we are in talks with at the moment. We are seeing an increasing number of high-end brands approaching us to help them to execute their e-commerce strategies in China."

The additional investment in Q4 resulted in an operating income that grew slower than the top line - for once. This strategy toward reinvestment in technology and operational staff was explained by Vincent Qiu as a long term approach to capture most of the fast growing e-commerce market:

The growing array of exclusive end-to-end solutions we have on offer and our omnichannel capabilities were again critical this year in driving growth during the fourth quarter. Total net revenues were 2.2 billion [yuan] during the quarter, an increase of 41% year over year, which is the highest growth rate we've experienced over the past three years."

Despite the current macro-economic challenges, from the US-China trade war to the slowing Chinese economy, management's guidance for Q1 is a top line growth of 38% at the mid-range. This guidance is even stronger once you consider that they are projecting 45% growth year on year for the higher margin services revenues.

Valuation far behind

While Baozun and Shopify are only superficially similar and are targeting two different markets, it is striking to watch how close their current financial performance is.

I have shown these charts a year ago, and they are mostly telling the same story today.

Performance comparison:

Chart Data by YCharts

Baozun had a slower top line growth than Shopify over the last two years, but it's catching up. More importantly, Baozun has already reached profitability and has managed to improve its bottom line in FY18, while Shopify has increased its losses.

Valuation comparison:

Chart Data by YCharts

From a valuation perspective, Shopify is on an entirely different planet, with a $21 billion market cap. Forward-looking ratios indicate that Baozun has more than 700% upside potential if it ever catches up with Shopify's P/S.

One could argue that both companies are on extreme ends of the spectrum, but that won't change the fact that Baozun looks extremely cheap, given its fundamentals and the secular components of its business.

With a forward PE of 23, Baozun is undervalued, given its earnings growth of 39% in FY18 and its continued shift toward higher margin business models.

The risks to keep in mind

Baozun is a small high growth business that relies on recruiting new international brands. That growth could be challenged if Baozun loses some of its existing partnerships or struggles to add more over time.

Because it ultimately depends on GMV (Gross Merchandise Volume), Baozun is subject to the same risks as other e-commerce companies in China. Among other things: economic downturn, trade war, and softer consumer spending. All could impact Baozun's growth, at least in the short term.

Alibaba (BABA) is still the top e-commerce player in China, but Tencent (OTCPK:TCEHY) owns a big stake in its biggest rival, JD.com (JD). Tencent has also partnered with a growing list of retailers, including Walmart (WMT) and Carrefour (OTCPK:CRRFY), to expand its payments ecosystem. The way Tencent is evolving into an O2O (online-to-offline) ecosystem could also directly connect consumers with their favorite brands without the help of Baozun.

One thing I'll keep watching in the coming quarters is the progress made for the company to start generating healthy free cash flow. Cash and cash equivalents was up +$10 million in Q4 FY18, but Baozun used to burn a lot of cash in previous fiscal years.

Volatility is a good thing if you are here for a long ride

Since becoming public, Baozun has been a roller-coaster ride for investors.

By nature, BZUN is a young high growth company in an emerging country, which creates a wide range of expectations and baffling reactions to news or earnings reports. This opportunity is not for you if you can't look past 10% moves that appear random.

The chart below should help you identify the current opportunity at hand. It's the first time in almost three years Baozun trades below 40% off its high (it came close late 2016).

Chart Data by YCharts

That's it for the second company of the Secular Grower Series.

Baozun remains a winner of the App Economy Portfolio, even after the recent drawdown. It's a position I have built between 2016 and 2017 that has oscillated from multibagger returns to break-even at times.

I intend to hold my position for the years to come, and it is - I believe - an outstanding buying opportunity under $2 billion market cap.

Disclosure: I am/we are long BZUN, SHOP, AMZN, HUYA, BABA, TCEHY, JD. 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.