We’ve Raised JD’s Fair Value Estimate

“The decision to restructure JD’s offline retailing network and connect it with a dedicated group purchase platform would stand the firm in good stead from a longer-term perspective. Business lines targeting the lower-tier cities, like its convenience store franchise, are now realigned. This synergy shall give the firm a new growth point,” Tam says.

She has raised her fair value estimate of JD by 37% to US$ 100 per ADS or HK$ 390 per share. After the recent market correction, JD is trading at a roughly 30% discount to its fair value.

Penetrating rural areas

The concept of community group purchase starts with online platforms that pull multiple orders in one neighborhood. A buyer places an order for groceries, for example, on a mobile app, and later picks up their order in their local mom-and-pop store.

As Tam explains, “This retailing model has become highly active especially in the Mainland China’s remote areas.” Located in the lower-tier provinces, these neighborhoods are generally defined as ‘sinking markets’, and are scattered across the country. These small cities are typically overlooked thus far by large firms like JD, and remain unreachable in the national logistics system. 

This is changing now, as e-commerce giants like such as meal-delivery platform Meituan (3690) and low-tier e-commerce platform Pinduoduo (PDD) target the growing numbers of internet users in rural regions. They expect the user numbers to take off from a low base, possibly driving huge growth in purchase volume and in dollar amount. To attract offline stores to participate, the e-commerce players offer vendors a rebate.

 “Platforms like Meituan and Pinduoduo are truly the early movers in this field. Concerns have arisen about how they incentivize community vendors. Giving out heavy subsidies may not be a sustainable solution over an extended period, especially when peers with deep pockets start to enter the space,” says Tam, referring to resourceful Alibaba (9988, BABA) and JD, which rank top two in terms of e-commerce business scale. “Such a subsidy war can be very unpredictable depending on the competitors’ moves and can substantially reduce the near-term margin.”

JD’s Strategy Will Pay Off

She thinks JD’s strategy is more prudent. According to Tam, JD counts on early operation metrics to decide where to put resources. “JD avoids being too aggressive. Rather than trying to establish presence everywhere, it is prioritizing the cities where it has higher confidence in or better-than-peers business performance data.”

Long-term growth also has to hinge on something more solid, rather than ‘burning cash’. The group purchase mechanism is basically driven by actual orders, so efficiency is enhanced in ways like reduced wastage and minimized storage space. “A reliable logistics web will be key. JD has extensive experience in supply chain and logistics, which will give it an unrivaled advantage,” adds Tam, citing the spin-off JD Logistics.

According to Tam, the medium-term plan for JD will stress the build-out of this already strong network. The goal is to gain market share instead of propping up profitability. 

“To do so, JD has invested heavily in supply chain management, integrated warehouse, and delivery services to penetrate less developed areas. As the logistics business gains scale and reaches higher capacity utilization, we will see gross profit margin improvement.” The near-term impact is that capital investment could put pressure on its profitability.

Keep an Eye on Alibaba

Broadly in the Chinese online market, JD is set to be one of the winners, in particular from the antitrust probe of Alibaba.

Last month, Alibaba was fined by the regulator on anti-competitive behaviors with a record penalty. To comply with the new rules, Alibaba has rewritten vendor exclusivity deeds and merchant retention measures. “Merchants won’t be forced to choose one between Alibaba and competing platforms under the anti-monopoly rules with many of them returning to sell on JD’s platforms.”

Alibaba sits on more than 60% of the e-commerce market share in China, compared to Amazon (AMZN)’s 38% market share in the US. It thus presents a reasonably large room for JD and other players to capture the losing share by Alibaba.

Investors should be aware that the e-commerce market has passed the explosive growth stage and is now facing a stage of competition. JD would be forced to invest more to secure its leading place.

Tam sees the chance of JD overtaking Alibaba in the foreseeable future as slim. This is because “Alibaba already has about 2.5 times JD's customer base and Ant Financial (Alibaba Group’s financial arm) has the largest third-party payment system, Alipay, in China.”

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