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Why ROIC Sells Companies Like JD.Com Short

|About: Retail Opportunity Investments Corp. (ROIC), Includes: WACC

ROIC is a commonly-used metric in analyzing the financial performance of a company.

The metric, however, doesn't fairly reflect investments which require significant time before they generate returns.

ROIC paints too cynical a picture of growth prospects for companies with significant long-term, capital-intesive investments like

Return on invested capital (ROIC), as the name suggests, measures the rate of return that a company generates for every dollar of capital invested. A company’s ROIC is often one of the first values considered in a robust analysis of its performance. It should come as no surprise that the metric has become a common starting point for financial analysts, given its utility in assessing both a company’s performance against peers on a standardized basis as well as the effectiveness of internal decision making within the company.

It’s important, however, not to lose sight of the fact that ROIC is just that: a starting point in an analysis. Return on invested capital doesn’t fairly reflect those directional or organizational changes that have been implemented but that require time—and often large sums of capital—before they begin generating returns. After all, any significant organizational change is nothing if not a slow and tedious process.

Take, for example, A leading business to consumer (B2C) Chinese e-commerce platform, JD’s annualized ROIC for the quarter ending in September 2017 was 4.74% (GuruFocus). Alternatively, JD’s weighted average cost of capital (OTC:WACC), which those readers unfamiliar with the metric may simplistically think of as the cost that a company pays for capital invested in it, is nearly twice this value at 9.46% (GuruFocus).

The discrepancy here indicates that JD actually pays more for capital than it sees in returns on that capital, implying that the company destroys value as it grows. Does this mean that JD’s growth ambitions are unsustainable? Not necessarily. The apparent insufficiency of JD’s ROIC coupled with more detailed knowledge of its current growth strategies illustrate the limitations of ROIC as a metric as discussed in the second paragraph.

JD is admired by rivals for its intense utilization of smart warehouse technology, a primary driver of future growth for the company. Its efforts to automate its logistics processes and service customers more and more efficiently with robots, drones, and driverless cars have obviously required significant capital investment. It’s almost undeniable that these projects will produce impressive future returns for JD, but it seems unrealistic to expect that to occur immediately. That is, while significant capital has been invested and costs of these projects have been recognized, significant time is required to develop the technologies invested in and to learn and adopt best practices in their use.

Thus, while JD’s ROIC may give many investors reason for concern, it’s worthwhile to note that return on invested capital usually recognizes a project’s costs well before its returns, which paints an unrealistically clinical picture for companies like JD, whose growth strategies require sizable amounts of capital—and patience.

Disclosure: I am/we are long JD.