JD.com (JD) recently reported Q1 2019 earnings. As has become usual with the company, plenty of new developments have come about during this time, along with information on how it has managed to progress on its previous goals. This is why, despite my bullish thesis from a few months ago remaining intact, it is important to look at JD's most recent earnings and how these events should impact the company going forward.
A quick recap
In case anyone hasn't already seen JD's earnings statement, the numbers were as follows:
- Revenue of RMB121.08B (+20.9% Y/Y)
- Q1 Non-GAAP EPS of RMB2.23
- GAAP EPS of RMB4.96.
Both of these results beat expectations (revenue was expected to be just RMB120 billion), but the company's stellar EPS figures were the main highlight of the announcement. It was an impressive RMB2.23 a share (33 cents), significantly more than the RMB83 expected, and resulting in the highest quarterly profit in the company's history. This news resulted in the share price opening 9.9% higher on Friday morning, before giving back most of those gains by day's end due to negative sentiment surrounding the US-China trade war (finishing 2.4% up).
Overall, although I believe this is excellent news, investors should remind themselves not to focus themselves too much on earnings, since this is arguably the least important measurement of JD's success. In fact, as we will look at again shortly, management has effectively just committed to "give back" most of the profits to consumers during Q2 - something which, on the surface, looks like a relic of China's communist days!
The main takeaways from this quarter's earnings call
Investing, Investing, Investing
On reading the transcript from the earnings call, a few key points became immediately obvious. For starters, management is still focused on one thing over everything else when making capital allocations: Investing in JD’s future. Just as it has done since the company's founding, Richard Liu's goal is for JD to continue to grow and expand into lucrative markets, not sell out for profits over the short-term whilst the competition builds up around him. Because of this, investors shouldn't expect substantial profits anytime in the future, even now that much of the capital-intensive projects that the company has undertaken over the past few years (such as the construction of their logistics network) are completed. This will instead be allocated to four areas of the business: customer experience, new businesses (such as JD Finance and JD Health), technology (why R&D has recently increased rapidly), and the company's talent pool.
The last point here seems to have been taken for granted recently, with the recent 10% rumored layoffs suggesting the company is wishing to tighten up on staff expenditures, not increase them. If this was indeed the case, the recent boost in earnings would simply be a 3G Capital-style "cut the fat" type event - not a sustainable way of managing a growing business. Yet, contrary to this, the total headcount has actually slightly increased from 178,000 to 179,000 since last year. Not only does this show each individual staff member is becoming more productive (since revenues have increased far more over this time), but it also suggests that they are being moved up the value chain, with lower-skilled delivery jobs being automated whilst development ones are expanded. This is a very positive trend for the company, especially if it can manage to attract talent early on when it is still cheap (although the occasional poach from a competitor is still welcome, if necessary.)
Furthermore, what I said about its profits above is completely true. Richard Liu even felt it necessary to highlight this early on in the call, saying that profits were a "bit high" this quarter. Just like it did last year, the company plans to use the returns in Q1 to have additional discounts in Q2. Ultimately, this is a way to add new customers to the site, along with encouraging old ones to come back (the targeting of this being why overall user numbers haven't been increasing as much). This focus on the consumer may not make profits now but will certainly improve the company's long-term outlook, which will eventually prove to be far more beneficial to investors than an extra little cash now.
Margin growth is continuing to occur
Unlike Alibaba (BABA), JD has a very asset-heavy approach to e-commerce, giving it far more control over product delivery and the customer experience. The downside to that is far-lower margins, and due to the very competitive online retail landscape in China, this is especially tough:
As you can see, with the exception of 2016, net margins at the company have got steadily higher each year. They are now comfortably in the green, although still at less than 1%. On its own, this doesn't appear good; however, the fact that the company reinvests any gain into discounts the year later means this metric is likely to remain relatively low. This is why, to measure the company's success, it is far better to look at gross margins:
This graph doesn't even show the last quarter yet (which, at 15%, was by far the highest achieved), but the trend is obvious: margins are increasing continuously. In fact, this quarter marks the 20th in a row which has seen gross margin growth on a YOY basis, showing just how clear the long-term trajectory for JD is. Pending a global recession, I am confident that this will continue in the future as the company takes advantage of its increasing scale and utilization of its asset base. For example, its fulfillment expense ratio dropped from 7.2 to 6.7%, simply due to JD streamlining its operations.
Crucially, gross margin improvements will eventually filter down to the net margins, even if it may not currently seem like that is the case. Once the property monetization I discussed last quarter goes ahead, this should start to accelerate, and before long the trend in net margins should also be positive. The decline in 2018 was also only due to one-off investments/accounting, the extent of which won't occur again in the future.
JD Healthcare and hidden value waiting to be unlocked
One of the most exciting items to come out of these earnings was the selling of $1 billion of JD Healthcare to various venture capital and strategic groups in China. The 14.5% of the company sold for this price means that the whole business is worth just shy of $7 billion - not bad for a company only worth $42 billion in total. This means that this section of the company, previously rarely discussed on any conference calls, accounts for over 10% of JD's current market cap.
Although little detailed information exists on its operations, JD has the status as the largest online pharmacy in China, along with having a rapidly growing online service platform. This should allow it to become far more valuable over time, as healthcare expenditure in China takes up an increasingly high amount of the country's GDP (with plenty of room to grow, judging by the current 18% in the USA).
With that in mind, some may wonder why JD has sold any of the business off. After all, the company has enough cash flow to finance any expansion efforts itself instead of bringing on a partner. Yet, I believe the reasoning for this event is not so much for the money, but instead, to highlight just how valuable the remaining 85% of the company is. This is since, as my sum-of-the-parts valuation from a few months shows, a great amount of hidden value exists within JD, collectively meaning the market is assigning very little value to the company's core operations.
Because of this, any effort to give JD's side ventures more transparency should be welcomed by investors, due to it resulting in far less discounting by the market once it is obvious just what the "takeover" value would be for the specific sections. More often than not, the smaller stake that the company now has will actually be valued at more than the entire business was valued at beforehand, as is shown by the very little most investors even know about its existence in the first place (thereby valuing it at nothing).
Lastly, news came out about the JD-Tencent (OTCPK:TCEHY) partnership, with JD.com CFO Sidney Huang saying:
"We are delighted to expand our strategic partnership agreement with Tencent covering a broad spectrum of strategic and business collaboration initiatives."
Even though this announcement was very bland, later on in the call an analyst took management up on the specifics of what will be changing with the new partnership. Along with continuing to use Tencent's WeChat as a "gateway," both for customer acquisition as well as general selling (the former being something planned to be used extensively due to the number of new customers it brings in), it is also going to be able to take advantage of its membership of Tencent Video and iQIYI music. Moreover, Tencent will be further used as a place for JD to advertise, something that hasn't been fully as monetized as it could be.
Most importantly, this reaffirming of its partnership with Tencent is good, simply due to JD being fairly reliant on Tencent in quite a few areas. The backing of such a heavyweight protects the company against any drastic moves by competitors such as Alibaba, along with ensuring Tencent doesn't start to compete with the company itself. Any extra co-operation is only a bonus, which this suggests may occur sooner rather than later.
Overall JD's Q1 earnings were very positive, both in terms of results and guidance for the upcoming quarters. It is clear the company is continuing in its efforts to create value for shareholders by optimizing operations, improving cash flow and highlighting the different assets that exist across the company. With this in mind, the company should be able to continue its rise upwards over the coming quarter and look to begin its ascent back to previous highs over the next year. Because of this, investors who aren't already overweight JD could look to buy on any dips that occur in the stock price due to trade war news, whilst overall sentiment surrounding Chinese stocks is kept artificially low.
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Disclosure: I am/we are long 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.