We maintain JD’s fair value estimate of $39 after the following changes. We revised year-over-year revenue growth in 2019, up by 230 basis points to 24%, reaching CNY 572 billion. This implies fourth-quarter growth of 23% versus the guidance range of 21% to 25%. Non-GAAP net income has been revised to CNY 9.5 billion in 2019 from CNY 8.9 billion, compared with the guidance range of CNY 9.8 to 10.5 billion. We now assume 20% revenue growth in 2020 to reach CNY 686 billion, while the net income margin will be 1.4% with a net income of CNY 9.5 billion in 2020, an increase from CNY 7.5 billion in 2019. Our ten-year revenue CAGR has been revised to 14% versus 13% previously. We forecast the operating margin will continue rising to 4.7% by 2028 and the net income margin will increase to 3.9% by 2028 versus 3.8% previously. We reduced our stage-two earnings before interest growth to 8% from 17% previously, while the stage-two investment rate has been brought up to 30% versus 24% before, to reflect the sector’s need to reinvest and bring it up to the industry average assumption. Since stage two only lasts for one year, the effect on the valuation is small. We believe there is approximately 20% upside to our JD.com fair value estimate.
Business Strategy and Outlook
JD.com has emerged as a leading disruptive force in China's retail industry by offering authentic products online at competitive prices with speedy and high-quality delivery service. JD’s mobile shopping market share has increased from 12.7% in first-quarter 2016 to 15.7% in second-quarter 2017, according to iResearch. JD adopted an asset-heavy model with self-owned inventory and self-built logistics, while Alibaba has an asset-light model.
JD is a long-term margin expansion story driven by increasing scale from JD direct sales and marketplace, partially offset by the push into JD logistics in the medium term. According to Deloitte, JD is the largest retailer in China. Among listed Chinese peers, JD’s net revenue in 2016 was USD 37 billion, 76% higher than for Suning, the second-largest listed retailer. JD does not disclose gross margin for the first-party business, but according to the earnings call for first-quarter 2017, JD’s gross margin in the first-party business still lagged the top-of-line retailers by over 10% on average. JD’s increasing scale in each category will allow it to garner bargaining power toward the suppliers and volume-based rebates. Since 2016, JD no longer fully reinvests its gains from improving scale. Instead, it offers the same promotion scale for customers while improving margins. Gross margin improved yearly from 5.5% in 2011 to 15.2% in 2016, and following the consolidation of JD Finance in second-quarter 2017, gross margin improved year over year from 13.7% in 2016 to 14.0% in 2017.
In the medium term, we expect to see the investment into JD logistics will hold back some of the margin gains. Starting April 2017, the logistics business became an independent business unit that will open its services to third parties. Management is squarely focused on gaining market share instead of profitability at this point, and to do so, it has invested heavily in supply chain management, integrated warehouse, and delivery services. As the logistics business gains scale and reaches higher capacity utilization, which we expect to happen after five years, we will see gross profit margin improvement.
We have revised JD.com's moat rating from narrow to none, as we no longer believe that the company enjoys a cost advantage moat source. JD.com still possesses a cost advantage over offline retailers, but we think the current competition comes primarily from other e-commerce players, such as Alibaba, Suning.com, and Vipshop.
JD.com's key competitive advantage is its fulfilment capacity. We believe it owns the largest self-built fulfilment networks. The company started to build its fulfilment infrastructure as early as 2007, and it both owns warehouses and employs its own last-mile delivery personnel. As a result, this large self-controlled fulfilment infrastructure has enabled JD.com to deliver merchandise to its customers in a timely, reliable manner. However, Alibaba, the biggest e-commerce player in China, has also invested in logistics over the past three years. China Smart Logistics, or Cainiao, established in May 2013, is Alibaba’s joint venture with five major express-delivery companies in China. It is also collaborating with 14 third-party delivery partners with more than 1,800 distribution centres. Unlike JD.com, Alibaba's logistics strategy is to build a scalable logistics platform, so it has focused on building logistics centres and Big Data infrastructure, and has collaborated with third parties on last-mile delivery. The monetisation will be from rental charges and Big Data service for courier firms. Hence, its logistics is less labour-intensive, but weakness stems from decreased control on delivery service quality and aftersales service. Alibaba has invested in several small delivery companies in the past several years, although it claimed not to invest in last-mile delivery. In May 2015, it acquired about a 10% stake in Shanghai YTO Express, one of the largest express service companies in China.
The intense competition in e-commerce also prevents us from assigning a narrow moat to JD.com; this might force it to invest more and could put pressure on its near-term profitability. In August 2015, Alibaba acquired a 19.99% stake in Suning, a leading offline electronic goods retailer. Suning has been actively expanding its online business to build an omnichannel model. In 2015, Suning.com, Suning's online shopping site, ranked third with 3.8% market share in terms of transaction volume for business-to-consumer e-commerce sites. Alibaba has been utilising Suning's fulfilment infrastructure to compete with JD.com, such as indoor installation and aftersales service, and Suning can leverage Alibaba's large online shopping user base. Moreover, other vertical sites have been aggressively expanding their online presence and fulfilment capacity. Vipshop, a leading online discount retailer for brands in China, has been growing rapidly with its flash sales business model. Its market share increased from 1.9% in first-quarter 2013 to 3.3% in 2015. Unlike Alibaba and JD.com, Vipshop focused its product categories in branded apparel, cosmetics, and footwear. With JD.com's aggressive expansion into nonelectronic goods, we view Vipshop as a strong competitor in this field, although its revenue is still only about 20% that of JD.com and its active user base is 12% that of JD.com.
Fair Value and Profit Drivers
Our fair value estimate for JD.com is $39 per ADR. We derive our valuation by discounting three-stage cash flow against a weighted average cost of capital of 9.8% and a Chinese yuan/U.S. dollar exchange rate of 7.05.
The 14% CAGR in revenue in the coming 10 years will be driven by a 14% CAGR in online direct sales and a 27% CAGR in services and others. By the end of the decade, we expect online direct sales and services, and the "others" segment to normalize to 6%.
We expect online direct sales gross margin to increase in the coming decade due to the JD’s direct sales business’ increasing bargaining power against suppliers, and the rising contribution of the higher-margin general merchandise. This will be partially offset by increasing contribution of the currently unprofitable third-party logistics business. Continuous improvement in utilization of logistics will increase gross profit margin to reach 18.1% by 2028 from 14.3% in 2018.
In the next decade, we forecast gradual non-GAAP operating margin expansion from 0.4% in 2018 to reach 4.7% in 2028. We assume fulfillment to sales ratio to reduce to 6.2% in 2028 due to better unit economics. Marketing to sales ratio is expected to maintain at 4% from 2019 to 2028 as we think competition in e-commerce sector will always be intense and JD will always have to keep its brand awareness. As the key teams in the research and development are already in place, we expect research and development to sales ratio to peak at 3.3% in the third quarter of 2018, and we expect such ratio to gradually reduce to 2.5% by 2028.
Risk and Uncertainty
We assign a high uncertainty rating to JD.com's fair value estimate, as the company still faces stiff competition from both Alibaba and other vertical e-commerce sites.
Despite JD.com's rapid business expansion, Alibaba remains the dominant player, commanding roughly 80% market share during the past two years. Tmall, Alibaba's business-to-consumer, or B2C, marketplace, has increased its market share from 53.3% in 2011 to 60.4% in 2014, versus JD.com's increase from 17.2% in 2011 to 19.5% in 2014, according to iResearch. Moreover, the other vertical e-commerce players, especially Vipshop, have been aggressively expanding their online presence and fulfilment capacity. Vipshop, a leading online discount retailer for brands in China, has been growing rapidly with its singular business model (that of flash sales). Its market share increased from 1.9% in first-quarter 2013 to 3.8% in first-quarter 2015, surpassing Suning Yigou, and it is now ranked third in the B2C e-commerce market. Unlike Alibaba and JD.com, Vipshop focused its product categories in branded apparel, cosmetics and footwear. Since JD.com has been aggressively expanding into nonelectronic goods, we consider Vipshop a strong competitor in this field, although its revenue is still only about 20% that of JD.com and its active user base is 12% that of JD.com. In addition, some cross-border e-commerce sites have emerged in the tailwind of soaring demand for overseas products. The fierce competition might force JD.com to invest more than we are expecting, which could put pressure on its near-term profitability.
We view the quality of JD.com's management as strong with a Standard stewardship rating.
Richard Qiangdong Liu founded JD.com in 2004, and has been the chairman and CEO since inception. He has more than 15 years of experience in the retail and e-commerce industries, and has proven himself a visionary and a capable business leader.
Given his strong track record, we think Liu gives the Street confidence in JD’s long-term potential but also poses a key-man risk. Liu was arrested in Minneapolis, Minnesota, in America on a rape accusation in September 2018. No criminal charges were pressed against Liu due to insufficient evidence, however, a successful conviction could have sent him to prison for up to 30 years. Liu has considerable influence over board matters. According to JD’s 2017 annual report, “under our current memorandum and articles of association, our board of directors will not be able to form a quorum without Mr. Richard Qiangdong Liu for so long as Mr. Liu remains a director.” This means that the board cannot make decisions in absence of Liu.
There was also some indication of poor corporate governance in the past. Based on JD.com's dual-class voting structure, holders of Class A ordinary shares are entitled to one vote per share in respect of matters requiring the votes of shareholders. In contrast, Liu, the holder of Class B ordinary shares, is entitled to 20 votes per share, subject to certain exceptions. This gives Liu full control of corporate matters requiring shareholder approval (79.5% of the voting power), despite his equity stake of only 15.5%. A one-off share-based bonus of $591 million paid to Liu as the company prepared for its U.S. IPO in 2014 raised concerns for us, and shows what this shareholding structure can lead to.
Like many other Chinese Internet companies listed in overseas markets, JD operates under a variable interest entity (VIE) structure designed to let companies bypass Chinese legal restrictions on foreign ownership in certain sectors. JD's foreign investors will essentially hold shares of JD's VIE domiciled in the Cayman Islands. We don't expect any legal challenges to VIE structures by the Chinese government in the future and believe that JD will consider a China depository receipt listing in the future. However, if the legitimacy of JD's related VIE is found to violate applicable law or regulation, Chinese regulatory authorities might take action against the VIE, including revoking the business and operating licenses of JD's subsidiaries or the VIE, or discontinuing, restricting, or restructuring JD's operations. Since the Chinese Ministry of Commerce has the jurisdiction to regulate VIEs, we believe overseas investors would have limited legal rights.
Given that JD Finance and JD.com are both controlled by Liu, we see potential conflict of interests. For instance, JD.com could continue using JD Finance’s services due to Liu's preferences and not business considerations.
JD.com is China's second-largest e-commerce company after Alibaba in terms of transaction volume, offering a wide selection of authentic products at competitive prices, with speedy and reliable delivery. The company has built its own nationwide fulfilment infrastructure and last-mile delivery network, staffed by its own employees, which supports both its online direct sales and its online marketplace businesses. JD.com launched its online marketplace business in 2010.