SUMMARY

With a market capitalization of less than $50 billion, JD.com has plenty of room to grow
Partnerships are important as it helps the company to gain scale outside of China.
The company continues to gain efficiency as it builds its infrastructure such as warehousing and delivery capabilities.
Two trends that will propel JD.com forward: China’s rising income and adoption of Internet in their everyday lives.

(A) Introduction

China has only scratched the surface of the iceberg when it comes to the use of the Internet. Much of the rural places remain undeveloped as compared to the first and second tier cities around them. According to various reports from McKinsey, the Chinese e-commerce landscape is still developing at a rapid pace and investors are paying attention. While most people would be familiar with names like Alibaba, Tencent and Baidu, many have never heard of this little company that is disrupting the e-commerce world.

Founded by Richard Liu Qiangdong in July 1998, JD.com (NASDAQ: JD) is a Chinese e-commerce company headquartered in Beijing and it is currently one of the two largest online retailers in the country by transaction and volume.

JD.com Stock Soared 62.8% in 2017 !

China’s No. 2 e-commerce retailer notched great gains last year and appears to have plenty of growth opportunities ahead.With new partnerships and plenty of greenfield opportunities ahead of it, JD.com is poised to one of the most explosive growth in a market where investors are struggling to find decent bargains.

(B) Assessing Online Retailers’ Business Model

Before we take a deep dive into the business, it is critical to understand how the e-commerce space operates.

It is common for Alibaba to be compared to Amazon.com and we understand why. After all, both of them sell goods online but more than that, we are swayed by the similarities in their market values. Their business models, however, show that the comparison is misguided. When online retailers are being assessed, there are three questions to ask in order to better understand the business model.

a) Firstly, does the company own the online platform? For any company that does not, it is a huge red flag.

b) Secondly, does the the company own the products or goods it sells on the website? Herein lies the difference between Amazon.com and Alibaba.

Amazon.com’s business model requires it to purchase inventory and sell it to shoppers whereas Alibaba’s model is similar to a platform. It does not purchase any inventory but allows merchants to list their products on its website as a means to reach out to online customers.

What about JD.com you ask? It should be compared with Amazon.com as both businesses stock up products to be sold to consumers. As for Alibaba, think of it as similar to eBay, an online auction site. Since none of these companies own their inventory, they are essentially different from other retailers.

c) Lastly, we need to consider the ownership of delivery of the goods. Here is where Alibaba and Amazon.com and JD.com differs as well. Alibaba has been plowing in tons of cash into building its delivery service while Amazon.com chooses to outsource its delivery arm. JD.com, on the other hand, has chosen to vertically integrate its delivery service to be a part of its platform and we will see later why this is such an important factor for it to prosper in the US market.

So there you have it – an e-commerce site has to own 2 of 3 things in order to remain successful. It has to own its platform; whether it has control over its products or delivery arm is the difference between most companies.

From here, let’s dive into JD.com to see what makes it an attractive investment proposition.

(C) Business Performance

I think most of us should be familiar with the kind of business that JD.com has. How then will it differentiate itself to consumers and more importantly for us, to investors?

If you’ve been shopping online on Chinese e-commerce sites, you will know that China is notorious for counterfeit goods being passed on as the real deal and sold online to unsuspecting customers. For customers who have been ripped off that way before, it leaves them feeling resentful against the website, regardless of whether or not the company has control over its inventory. This isn’t good news if the company has a terrible reputation amongst online shoppers over the long-term.

Since Alibaba does not take control over its inventory, it has limited control over the goods that is moving through its systems. As a result, the Office of the U.S. Trade Representative added Alibaba’s Taobao marketplace under its watch list which classifies it in the same category as other digital black markets. On the other hand, JD.com has built a vertically integrated marketplace that allows it to guarantee the authenticity of the goods that it sells. This will not only allow it to build a brand which consumers will feel at ease with when shopping on its site but also sustain trade and diplomatic relations with the US.

What’s more is that JD.com manages its delivery service which offers same-day and next-day services in China. With close to 70,000 delivery workers, it has been able to focus on customer service in a way that is tough to beat.

The business has also been performing well financially.

Revenue for the latest quarter increased by almost 40% as compared to the year-ago quarter, coming in at $12.67 billion while earnings per share surpassed expectations to land at $0.23. Revenue for the company has been exploding (in a good way) as sales for the current quarter alone has outstripped sales for the entire of 2013. Since then, it went on to increase by almost four-fold and investors can expect that it will not slow down anytime soon. During the same period, gross margin has improved from 11.6% to 15.3%.

Cash flow for the business has also recently turned positive. Cash flow from operation increased from $588 million to $1.2 billion in over the last four years while free cash flow stands at $622 million by the end of 2016.

On the valuation side, JD.com is selling for an extremely low price-to-sales multiple. Despite a slight increase over the last year, it is still far lower than that of Amazon.com and Alibaba. If the pricing multiple increase, JD.com will bring about sizzling returns for investors.

(D) Risk

Being in a cut-throat industry is no fun and investors can expect to run into serious firepower from competitors. JD.com must continue to invest heavily in its infrastructure if it plans to stay ahead of the competition. At the moment, the company seem to be holding its ground just fine.

Also, if JD.com experiences a margin compression, it could face difficulty in reaching profitability. The longer it remains unprofitable, the bigger the expectation for larger, positive net income in the future. If JD.com does not deliver, the stock price may just come tumbling down.

Lastly, we ought to remember that shares of JD.com that trades on the NASDAQ only allow investors to participate in the economic benefit but does not offer ownership (read voting rights) of the parent company which is based in China. If the management team were to make decisions that would put investors at a huge disadvantage, shareholders would not be able to vote against it or exercise their rights.

Conclusion

There are three major tailwinds that will enable the company to soar. Firstly, it is the rapid market growth in the Chinese and international markets. Secondly, it is the economics of scale it will achieve as the first tailwind plays out. And alst but not least, many Chinese citizens still lack access to the internet and hence, do not participate in the e-commerce market. Once more of China gets online, JD.com’s addressable market will further increase, causing the positive growth cycle to continue.

JD.com is not yet profitable, although it churned out a little more than $3 billion in free cash flow over the past 12 months (almost $2.5 billion in FY17 Q2 alone!). But because of its leverage, I believe annual revenue growth will continue to expand by double figures over the next five years which will mean that earnings before interest, tax, depreciation and amortization (EBITDA) will likely turn positive during the same time frame. Soaring net profits and free cash flows will make today’s price look like a bargain. Right now, with a market cap hovering around $60 billion, JD.com is only worth just 12% of Alibaba’s market value.

Marcus Ho
Research Analyst, Mind Kinesis Value Investing Academy

Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.

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