Short-Term Uncertainty Raises Risks For Baozun

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About: Baozun Inc. (BZUN)
by: Investing Hobo
Summary

Key profitability metrics have trended down so far in 2019 from prior levels.

Trade tensions with China could escalate following a quiet period prior to China's National Day.

Longer term, Baozun investors should use any stock strength to hedge positions against potential short-term volatility.

At the headline level, Baozun's (BZUN) second-quarter earnings report looked very positive. Revenues grew at 47% annually to 1.7 billion RMB ($248 million USD) and non-GAAP EPS came in at $0.20. Despite revenues and EPS both slightly beating average Wall Street expectations, BZUN's stock dropped by over 12% following its earnings report. While forward guidance is in line with average analyst's expectations, several uncertainty factors should cause investors to be more cautious on BZUN in the short term.

Recent Downward Trend In Key Profitability Metrics

BZUN's post-earnings sell-off could have resulted in a number of reasons. It could have been technical due to a recent break below a key technical level at $50. It could have been 'buy on the rumor and sell on the news' since BZUN did rally 20% in the two weeks leading into its second-quarter earnings. What I haven't heard being brought up in post earnings articles covering Baozun is its recent downward trend in several key profitability metrics.

The following table shows either a deceleration in growth or downright contraction in three operating metrics that help drive Baozun's profitability.

FY 2017 FY 2018 Q2 2018 Q2 2019
Take Rate 11.47% 10.84% 10.74% 9.74%
Service Revenue Ratio 45.58% 53.33% 50.22% 50.18%
Non-GAAP Operating Margin 7.60% 8.00% 6.80% 6.10%

(Data taken from BZUN's Q2 earnings presentation.)

First, service revenue as a percentage of overall revenues has stalled around 50%. The trend prior to 2019 was a gradual increase in service revenue percentage which is positive because it's more profitable while at the same time less risky since it doesn't involve inventory risk. Q2 service revenue percentage declined both sequentially and from average 2018 levels.

Secondly the take rate, or the service revenues derived from gross merchandise volume [GMV], has declined further from 2018 levels. This marked the second consecutive year of take-rate declines and put first half 2019 levels below 10% for the first time as a public company. While the take rate might not directly affect profitability since margins could be different between product segments, a continued downward trend could suggest increasing pressure by Baozun's partners.

Lastly non-GAAP operating margins also continued to decline. This reaffirms cost reductions could not keep up with take-rate declines. It also disputes management's statement in its Q2 earnings conference call that a shift to non-GMV partners would have no effect on profits.

While Q1 results already showed these downward trends, the market rightfully gave Baozun a pass since the first quarter is typically the weakest quarter due to Lunar New Year effects. As a result, metrics displayed during the first quarter might just reflect an abnormality rather than a concerning trend. I believe it's for this reason BZUN sold off aggressively after Q2 results confirmed concerns the company might be operating at lower profitability metrics than originally predicted.

GMV Growth Slowdown

In addition to margin concerns, GMV growth has been slowing in recent quarters. While first-half 2019 GMV growth was still solid at 59%, it's down from CAGR of 63% in recent years. Obviously investors shouldn't be concerned by this minor slowdown since sales growth will always decline with increasing volumes.

However, the company's guidance for 40-45% GMV growth in Q3 and 45-50% GMV growth for 2019 implies further deceleration in the second half as the tables below shows.

H1 2019 FY 2019 (High EST) Q3 2019 (High EST) Q4 2019 (High EST)
GMV 17557 44139 9223 17359
Q1 2019 Q2 2019 Q3 2019 (High EST) Q4 2019 (High EST)
GMV Growth 58.43% 59.86% 45.00% 44.20%

(Data taken from BZUN's Q2 earnings using the high end of the company's guidance range to represent the base case scenario. GMV figures in millions of RMB.)

How much this GMV growth slowdown is due to the shift to non-GMV partners is uncertain, but with the combined recent downward trend in take rates and operating margin, current guidance raised more questions than management gave answers in their earnings conference call.

US/China Trade Risk

I mentioned in my previous Baozun article that trade tension with the US might be overstated given President Trump's history of backing down on threats regarding trade. I cited threats to Mexico then a complete reversal as one example. While President Trump has incrementally increased tariffs on imported Chinese goods, the increase had been measured and drawn out. In addition, actions against Huawei were in part retracted after the realization its supply chain affected so many US technology companies.

However, with the recent escalation on August 1st compounded by punitive increases on existing tariffs three weeks later, the situation may have crossed the point of no return from China's perspective. In my opinion, based on my review of news based in China, Chinese President Xi no longer believes any deal can be reached with the current US administration.

October 1st is China's National Day and is very important for its leaders. For this reason I believe China will unlikely take any action that could cause additional erratic responses from the US side. China has tried to dial down tensions by calling for a pause in the new tariffs and by not taking additional retaliatory actions after the recent cumulative 5% hike on current tariffs. More importantly China agreed to meet in the US next month to restart trade negotiations. This move effectively ensures a status quo in the current trade situation until October, thus setting a quiet period heading into China's upcoming National Day.

What happens after could be entirely different and in my opinion the odds of China retaliating are very high. Observers including many in the current US administration have incorrectly estimated China's ability to both endure pain internally and retaliate at equal levels to the US. Yes, it's true China imports much lower volumes from the US and cannot match tariff retaliation in this regard. However, there is a disproportionate number of the US companies doing business in China relative to Chinese companies doing business in the US.

According to S&P Global, 4.3% of the $11.25 trillion in 2018 S&P 500 total revenues were derived from China. That's $484 billion in China revenues from the top 500 companies in the US. That's more than the $419 billion trade deficit with China in 2018. What is important to note is that most finished goods are not exported to China from the US, but produced in China for Chinese consumption. For this reason the actual trade deficit with China is much smaller and China's ability to retaliate heavily underestimated.

If China believes the structural relationship with the US has fundamentally changed, it will eventually turn its economy inward to become more self-reliant. I won't go in depth here, but it's very easy to imagine which US products and brands could easily be replaced by Chinese counterparts. Of course, the most obvious action is to use boycotts on US products as China has done in the past against other countries for political reasons. China could also levy value added taxes on certain 'foreign entities' it deems a national security risk, at rates mimicking US tariff rates on Chinese products. This could make it very difficult if not impossible for US companies operating in China to do business.

While I did not believe China would use this nuclear option in the past, it seems increasingly more likely now given how much trade tensions have escalated. The impact on S&P 500 earnings would be more dramatic than the lost revenues since many US companies have operational risk in China. If China believes President Trump would do anything to keep the US markets and economy stable, China's pressure on US corporate earnings could cause the US to rethink their perceived trade advantage and agree on terms more amicable to China.

In my opinion, China will not back down and if the US doesn't either, both sides will be in for a world of pain. China has already taken numerous domestic stimulus steps in preparation, including lowering reserve rate requirements. What China wants is clear, a reversion to the status quo prior to US tariffs. What it has offered is a gradual increase in purchases to narrow the trade deficit. If this is not acceptable to either political party in the US, relations between the two countries may permanently change.

How this nuclear option affects Baozun is clear – the company has fairly high exposure to US brands and thus in the short term would see material revenue declines. While in the longer term the company can realign its business with other countries as well as domestically, any additional increase in trade tensions with the US would likely be very negative for the company.

Final Thoughts

Fundamentally, there are concerns for Baozun as described above involving declining profitability metrics. Are current operating levels a red flag yet? No, but the decline from levels last year have already caused analysts to lower EPS estimates for 2020 and beyond. Baozun still has a great business model but earnings may need to be readjusted to take into account recent trends.

While it's difficult to factor in the political situation between the US and China, investors should be aware of the risks described in the previous section. Again it's not a death sentence for the company but if those events play out, it will take some time for the company, and China for that matter, to realign their business relationships to exclude the US.

Lastly on a technical level, BZUN's failure to break out above $55 followed by a breakdown below $50 is not encouraging for bulls. $50 is now resistance and unless the stock breaks back above $50 convincingly, it's at best stuck in the recent $40-50 range. Negative divergences for MACD and PMO also lower odds of a successful breakout to the upside.

bzun daily chart (Daily chart with key $50 level drawn.)

For these reasons, investors should proceed with caution regarding BZUN in the short term. The 'quiet' period prior to China's National Day on October 1st could cause stocks to melt up on trade optimism but I would use any strength to hedge such selling out of the money calls, buying protective puts, or a combination of the two which is what I am personally doing to at least partially hedge my longer term BZUN position. Hopefully worse-case scenarios don't materialize but that's not a chance I'm willing to take in the current state of the markets.

Disclosure: I am/we are long BZUN. 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.