To The Moon

Caught Up With Falling Chinese Stock Prices

Like most Chinese ADRs, JD.com (NASDAQ:JD) has been caught up by the negative sentiments surrounding Chinese companies and is down around 23% YTD. As an avid analyst of Chinesestocks, I have taken a quick analysis into JD to assess its investment potential. From my analysis, I found that while JD remains undervalued like many of its Chinese peers, I believe that there are major headwinds to the long term development of the company which will hinder growth rates, and will be elaborating on them in this article. Hence, I believe that there are better Chinese companies out there to purchase than JD.

JD is a Chinese e-commerce platform that started off by selling electronics and home appliances. Over time, the platform evolved to include a greater variety of general merchandise products from food and beverages to apparel to healthcare products and is now the 2ndlargest e-commerce company in China based on GMV. Beyond e-commerce, JD operates China’s largest logistics delivery network in China and has recently expanded into newer business segments: notably fintech and innovation through JD Technology and tele-health through JD Health.

Asset-Heavy Business Model

Right off the bat, the main differential factor between JD’s main e-commerce business and Alibaba’s (BABA) is their business model. JD operates an asset-heavy business model where it purchases inventory from its suppliers, stores it and delivers it to customers upon ordering. On the other hand, Alibaba operates an asset-light model and serves more as a marketplace to connect B2B or B2C. Coupled with its own logistics network, this allows JD to control the entire supply chain of its e-commerce business, hence giving them greater control over product quality and service quality/timing.

Revenue Segments

JD splits its revenue into four main segments: 1) electronics and home appliance revenue, 2) general merchandise revenue which both make upproduct revenue; 3) marketing revenue and 4) logistics and other services revenue which make upservice revenue.Product revenues are earned when JD sells the listed products while marketing revenue is earned by charging advertisements on JD’s platforms. Finally logistics revenue is obtained by providing courier/delivery services.

While JD has been diversifying its revenue sources, the huge majority (86%) of revenues still come directly from product sales onJD.com, and over 93% of revenues are derived from JD’s e-commerce platforms (including marketing) considering that the e-commerce platform is still the company’s largest user touchpoint. This shows that JD is still heavily reliant on their e-commerce business for revenue.

Industry Analysis

As the Chinese growth outlook has already been extensively covered by numerous analysts and writers (e.g. doubling of middle class, rapid urbanization hence consumption growth), I will just quickly touch on JD’s two main industries – China’s e-commerce and logistic industry.

China’s e-commerce market is soon reaching a mature stage of the industry life cycle as growth is expected tonarrowinto the low 10% from 2024 onwards. Hence, JD will need to significantly grow its market share or develop additional services should it wish to experience high growth rates in this business segment.

China's e-commerce growth

Industry Trend #2: Steady But Low Growth In The Logistics Industry

For the logistics industry, which JD Logistics operates in, a CAGR of 6% isforecastedfrom 2021 through 2026, representing steady but low growth. Additionally, with zero-COVID regulations causing supply chain disruptions in China, this growth could further be hampered.

China's logistics industry growth

In all, we can see that while JD has been experiencing rapid revenue growth in the past decade, the key industries that it is operating in are expected to see much lower growth in the upcoming years as the various industries enter a maturing stage. Hence, JD would need to possess strong competitive advantages and USPs to sustain its high growth rates, instead of solely riding on the secular growth of the industries it operates in.

Investment Thesis: HOLDThesis 1: Growth Through E-Commerce Is Unsustainable And JD Faces A Lack Of Other Long Term Growth Drivers

JD’s E-Commerce Platforms Have Rapidly Been Gaining Market Share But A Lack Of A Strong Differentiating Factor Will Hinder Growth In A Slowing Market

As mentioned in the industry analysis, the e-commerce industry in China is expected to slow in the coming years hence JD’s traditionally high e-commerce revenue growth rates of 20+% could be pressured. While JD has been successful in gaining market share over Alibaba in the past five years, quadrupling from 4% in2016to17%in 2021, this is unlikely to continue at such a rapid pace in the years to come.

First, JD will face increasing difficulty in poaching customers from Alibaba as JD does not have a strong USP over Alibaba. JD’s largest advantage historically is its direct control over the entire e-commerce supply chain due to its Amazon-like asset-heavy model. However, in recent years, Alibaba has alsostartedto pivot to a “hybrid” model. Alibaba has started to develop large warehouses to store products and expanded its Cainiao logistics system to give it greater autonomy and control on delivery timing and quality. Furthermore, Alibaba has also expanded its physical footprint through brick-and-mortar stores like Freshippo and Intime Retail, hence JD’s physical store footprint & supply chain control will no longer be a unique advantage moving forward.

Next, Alibaba has a much stronger network effect than JD and beats JD in almost all key metrics as follows:

JD vs Alibaba E-commerce Metrics

In terms of GMV, Alibaba is almost twice as large as JD and while JD is growing faster on a percentage basis, this is only because it becomes difficult for a larger company to sustain higher growth rates due to a higher previous year base. On an absolute basis, Alibaba still recorded stronger growth than JD, suggesting that JD’s superior growth is not as strong as it seems. As JD continues to grow, it will also start to see slowing growth rates like Alibaba.

For number of annual active consumers, Alibaba also has a much higher user base than JD and while some may argue that this gives JD a large room for growth, it will be difficult to pry away Alibaba’s consumers as Alibaba operates a wide ecosystem of products and services which JD is currently nowhere close to matching. This is reinforced by Alibaba’s 98%retentionrate and the fact that ARPU on Alibaba’s platforms quadrupled over the past five years. You can read more on Alibaba’s extensive network effects here:Alibaba: FY21 Results Reinforce Strong Buy

Hence, I believe that while JD will still continue to experience e-commerce growth, the explosive growth it once experienced will no longer be present moving forward due to industry and business fundamentals. Practically, I only see JD reaching 20-30% market share at maximum in the coming decade.

JD’s Other Business Segments Are Too Insignificant To Be Long Term Growth Drivers

With a slowing e-commerce business, JD is also unable to turn to its other business segments for long term sustainable growth as they are still too insignificant, contributing only 8% of total revenue.

Additionally, many of these businesses are not even in a strong industry position hence it will be difficult to capitalize secular growth trends of these up-and-coming industries in the long run. JD Logistics, arguably the second largest business segment operates in a highly fragmented logistics industry with only anestimated2.7% market share. While JD Logistics already has an established network of warehouses and delivery routes, so do itsothercompetitors like SF Express. In terms of smart logistics innovation, Cainiao is also a strong competitor which even has a stronger overseas presence.

For JD Technology which focuses on Cloud & AI, JD is still nowhere near a major player in either. JD is not even a top four cloud provider in China and perForrestor Wave, their cloud technology still severely lags behind Alibaba, Huawei and Tencent. Similarly in AI development, China’s top three developers are Tencent (OTCPK:TCEHY), Baidu (BIDU) and Alibaba while JD does not even make it into the top 30 companies/subsidiaries for AI patents according toNLO.

Top 30 Chinese Companies By Patents

JD Lacks Other Complementary Growth Opportunities As The Markets Are Already Saturated By Other Tech Giants

Considering that JD lacks viable growth drivers in its current businesses, a natural extension would be to grow in complementary areas such as international expansion for e-commerce which has been done by Amazon and Alibaba. The problem with this however, is that there is a lack of untouched markets in which JD can now expand in as e-commerce is already extremely developed in most nations.

For example, the South East Asian market is already dominated by Lazada and Sea Ltd (SE) owned Shopee; Japan is dominated by Rakuten; South Korea by Coupang (CPNG) and Europe/North American Markets by Amazon (AMZN). Hence, JD will have tremendous difficulties entering a new market unless it can provide a disruptive and strong USP which other platforms currently do not provide – and as established, JD does not possess this. Furthermore, given the asset-heavy nature of JD’s e-commerce business, it will be extremely economically u unviable to expand into a new geography as it would have to burn huge amounts of cash for inventory and logistics network building.

Therefore, I expect JD’s growth to slow down in the coming decades without a clear long term growth driver.

Thesis 2: Limited Margin Expansion Potential Due To The Nature Of JD’s Businesses

With slowing revenues, another way a company can increase shareholder value is through margin expansion. While JD’s margins have started to turn positive and are improving, I believe that there is a low limit for expansion given the asset-heavy nature of the business.

JD Will Not Be Able To Follow Amazon’s Footsteps In Terms Of Margin Expansion Potential

As investors like to liken JD as the Amazon of China, many investors believe that with scale, JD will be able to achieve strong margin expansion similar to Amazon. However, I believe that investors have overlooked the fact that Amazon’s margin expansion primarily came from AWS and not from its e-commerce segment.

By taking a look at Amazon’s North America e-commerce operating margins, we can see that even as it has reached a GMV of US$600 billion, it is only posing 3-4% in operating margins. Given that JD reported 2.1% operating margins in 4Q21, this means that in the long term, we could be looking at doubling of operating margins at best.

Amazon E-commerce Revenue & Operating Income(Amazon 10-K)

Advertising & Logistics Have Higher Margin Potential But They Are Not Growing Fast Enough To Significantly Boost Overall Margins

Fortunately, JD does have business segments with higher margin potential. For example, advertising margins are extremely high as there is marginal cost to put up advertisements on JD’s platforms. Management has also stated previously that they believe scale will benefit advertising revenue and margins. On the other hand, logistics companieshavea 5-10% operating margin and I believe that given heavy automation, JD has the potential to be on the higher end of the spectrum.

However, both of these segments only make up 14.3% of revenues today and will be unable to significantly contribute to overall margins. Additionally, I notice that advertising revenue as a % of total revenue has remained almost constant over the past five years which is strange as given the rapid increase in users, I would have expected quick scaling of this revenue segment.

JD 5 Year Revenue Breakdown(JD 10-K)

Finally, I would like to emphasize that all these only represent margin potential and I believe that it would also be difficult for JD to fully realise these due to the strong competition which will be further elaborated in Thesis 3.

Thesis 3: Difficulties In Competing On Innovation Due To Low R&D Spend And Wide Spectrum Of “Young” Sectors

To realize growth and margin potentials (Thesis 1 and 2), JD would need to be an industry leader in order to experience strong growth in demand and minimal incremental costs. As a technology company, R&D is important to ensure that the company stays ahead. Given that JD is a laggard in key innovation technologies too, R&D is even more paramount for the company’s long-term fundamentals.

Lowest R&D Spend And Low Margins Makes It Extremely Difficult To Compete

The table below depicts JD’s R&D spend and other important metrics when compared to competitors which are operating in similar industries (both legacy & future developments).

R&D Spending Of Top Chinese Tech Companies

From the table, we can see that JD significantly trails other big tech rivals in both absolute R&D spending and as a percentage of revenue. This will make it extremely difficult for JD to innovate and stay on top in a fast-changing tech industry, especially considering that they are already lagging in cloud and AI. Taking a look at operating margins, it shows that other companies also have a larger leeway to increase R&D costs while staying profitable whereas this is almost impossible for JD. Should it want to commit to huge investments in innovation, JD would likely turn unprofitable which will not be welcomed by investors. Given that other big techs are in a much stronger position, I do not think that JD should be a top investment choice.

JD Has To Split Low R&D Cost Among The Most Business Segments Which Will Further Lower The Quality Of R&D

To make things worse, JD has to split its R&D spending over the most business segments. JD has to continually invest in e-commerce and logistics to fend of strong competition from Alibaba and gain market share, while it has to plow money to develop its health and logistics arms at the same time.

On the other hand, Alibaba’s main R&D focus is on new retail and cloud computing and the company is in a dominant market position for both. For Baidu, the focus is almost solely on autonomous driving and AI and likewise the company is the outright leader in this aspect. In Tencent’s case, most of the R&D is dedicated to cloud solutions and long term innovative technologies as it already has a strong competitive advantage in its core gaming business. Therefore, JD not only has one of the lowest R&D spend, but it also has to split it among the most categories, lowering the development budget for each of its businesses which are all already facing intense competition.

ValuationSum Of The Parts

Onto valuation, I conducted a SOTP for JD similar to my Alibaba and Baidu analysis. The following are some key assumptions:

• FY21 figures are used
• I have deducted intersegment eliminations equally from e-commerce and logistics as the annual report states that most of the overlaps are from these two segments
• E-commerce multiples are similar to that I used forAlibaba
• Logistics multiple is a sector average fromNYU
• JD Health valuation is from its IPO (hence it is higher than market value) while a 2022 privatevaluationfor JD Technology is used.

JD SOTP Valuation

With three different scenario, I obtain a valuation range of $81 to $111 before applying a margin of safety and these are all above today’s market price. Hence, based on valuation alone, JD is indeed undervalued with an average upside potential of around 81% based on a $53 share price.

Given that most Chinese tech companies are already undervalued, this does not come as a surprise. However, I believe that given JD’s weaker fundamentals to its competitors, investors could have better investments in companies like Alibaba and Baidu instead, where an average upside of 130% and 87% is calculated respectively in my previousarticle. Not only do they provide greater upside potential, these companies are also fundamentally stronger with more sustainable long term growth drivers. Hence, despite being undervalued, I will not recommend JD as a Chinese recovery play as there are better companies.

Conclusion

In all, while I agree that JD is a good company that is undervalued, I believe that there are numerous headwinds to its long-term growth – slowing e-commerce growth and the lack of viable long term growth drivers, coupled by weak margins and R&D spending to further innovate and overtake its rivals. As such, I will rate JD as a hold as the company will likely continue to grow in future but investors can likely find better returns from other Chinese tech companies.

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