We will move right to the essence: the investment thesis. Why do we consider JD.com (JD) a strong buy at this point?
The thesis is built on strong historical and sustained future revenue growth in a highly profitable business, resulting in free cash flow generation. These streams of free cash flows, and thus the company, will soon have to be valued differently as sentiment on the company transitions from being a 'high growth China play' to 'a boring cash generator'.
What follows is a short summary of the fourth quarter numbers from the latest earnings report:
- Net revenues for the fourth quarter of 2018 were RMB134.8 billion (US$ 19.6 billion), an increase of 22.4% from the fourth quarter of 2017.
- Diluted net loss per ADS from continuing operations for the fourth quarter of 2018 was RMB 3.32 (US$0.48) compared to RMB 0.64 (US$0.09) for the fourth quarter of 2017.
- Annual active customer accounts increased to 305.3 million in the twelve months ended December 31, 2018, from 292.5 million in the twelve months ended December 31, 2017.
- Quarterly active customer accounts in the fourth quarter and third quarter of 2018 increased by 20% and 22% as compared to the same periods in 2017.
While revenues are growing north of 20% and active user accounts are growing north of 20%, the company has not done well over the course of 2018. Amongst the headwinds was a PR and corporate governance disaster when the CEO of the company Richard Liu was targeted with rape allegations. The only thing an investor can do is observe and let the justice system work this through. The China-US trade war dragged down with it many Chinese plays, especially high-beta plays like JD.com, while, in fact, JD.com seems fairly immune from the immediate effects of a no-deal.
On a more tangible note, the company has profitability issues (on a GAAP basis) and it seems to be front-loading investments that hurt its free cash flow.
However, as the smoke clears, investors will notice that the front-loaded investments were seeds planted today, to be harvested over the coming years. If you want to be ahead of the curve, it's probably better to take a look at the company now, rather than when the path to profitability is crystal clear.
|Full Year Results (2018)||Growth|
|Revenue||67.2 billion USD||27.5%|
|Diluted net loss per ADS||0,25 USD||x21|
|Free Cash Flow||-1.14 billion USD||(144%)|
This clearly shows, while revenues are growing, losses are increasing and free cash flows turn negative.
From the full year report:
Technology and content expenses increased by 82.6% to RMB12.1 billion (US$1.8 billion) in the full year of 2018 from RMB6.7 billion in the full year of 2017, as a result of the company's continued investment in top R&D talent and technology infrastructure.
JD's Chief Financial Officer Huang marked 2018 as an 'investment year' and its spun out logistics asset management company called 'JD Logistics' is expected to generate more profits over 2019: "the monetization could happen by next year so then it will impact our overall bottom-line forecast for this year," Huang said.
Picture 1: Cash flow and Working Capital from JD's Full Year Results
The cash flow picture seems to support this view, with capex nearly doubling from 11.3 billion RMB in 2017 rising to 21.35 billion RMB.
JD.com's growth shifts to different segments
JD.com isn't a hot start-up anymore, it's hard to keep up the growth rate. Traditionally, the bulk of its business was selling electronic goods. This is still the case and the skews the way most investors view the company.
Total revenues increased 27.5% in comparison to last year, but where the growth came from is quite interesting.
Picture 2: operating results per business
* New businesses of the company include logistics services provided to third parties, technology initiatives, and overseas business.
The new businesses segment grew by 244%. While still small, there are many initiatives launched to keep this up. Attempts to break through in the Western markets are helped by allies such as Walmart (WMT) or Google (NASDAQ:GOOG) (GOOGL), and the company has just formed a JV with COSCO to roll out an enormous logistical web to service globally. Walmart owns 12% of the company.
Picture 3: revenues per segment
The electronics and home appliance revenues grew at an 18.6% clip. Because of its size, it drags down the overall revenue growth number. However, a more interesting metric for a marketplace like company such as JD.com is GMV (gross merchandise value). Bloomberg reports that GMV rose above 500 billion RMB in December 2018. This rise will likely trickle down to more profits down the road.
- General merchandise revenues rose by 43%
- Service revenues rose 50.4%
The company is trying to spur growth in smaller, new businesses. At the same time, it attempts to focus more on profitability on its older more legacy-like business.
Earlier this year, the company said it would cut 10% of executives. Now there are rumours it would slash up to 8% of the total workforce. JD.com has 178.000 FTEs, so that amounts to more than 14.000 employees.
It seems the company has invested heavily in logistics, technology, and automation. Now, with everything in place, it attempts to shrink its costs by laying off workers and benefit from these investments.
Luckily, the company can learn from one of its lead investors Tencent (OTCPK:TCEHY), which owns a 20% stake. Tencent has also struggled to keep up with growth and is in the midst of reorganising the company.
Valuation criteria for JD.com
The trade war between the US and China has not helped sentiment for Chinese stocks, especially large online retailers with ambitions to sell more abroad, and high betas because of the 'growth stock label'.
JD.com and its natural rival Alibaba's (NYSE:BABA) share prices plummeted starting in the summer of 2018 until they found a bottom in December 2018. Still, over the course of 6 months, investors would have had nearly a 30% return.
The company didn't turn a profit in 2018 but had a net loss of 0.4 billion USD compared to a net loss of 0.8 billion USD a year earlier.
Finviz.com gives us a forward P/E of 32 for JD.com and one of 27.6 for Alibaba. Of course, we should look at the PEG ratio - price to earnings growth.
The PEG ratio is computed as follows:
- PEG = (P/E)/Annual EPS growth
A PEG ratio of 1 means a company is 'priced to perfection'. Lower means it's undervalued, higher means it's overvalued.
For JD's current price to make sense, it must grow earnings at 32% per year. Around 28% of this is supported by continued revenue growth, so this means the company needs to squeeze another 5% in cost reductions.
We believe three things will add to cost reductions and this earnings per share growth:
- Letting go of 10% of executives and 8% of total staff
- Investments in technology and logistics start paying off (as stated by the CFO)
- Economies of scale for existing businesses and improvement in 'new businesses' (resolution of trade war between US and China)
The above focuses on the real, underlying operations of the company, but we all know stocks don't move on fundamentals alone. If there would be a resolution of the trade war between the US and China, investors would put a higher multiple on Chinese stocks across the board. JD.com being a retail play, high beta internet company, with a global expansion plan, would likely benefit very much of this effect.
We have initiated a position almost 3 weeks ago and will likely accumulate over the coming weeks.
Disclosure: I am/we are long 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.