China’s E-Commerce Battleground: What Investors Should Consider Carefully

Summary

  • In this article, we present a clear overview for investors to consider between the 3 key Chinese e-commerce players: Alibaba, JD.com and Pinduoduo.
  • We highlight the key differences in their business models and their impact on their respective profitabilities.
  • We also provide our projections into their future expected revenues, EBIT and FCF margins for the 3 companies.
  • Lastly, we present a simple valuation framework that we think all investors could use when considering these 3 companies at the same time.

Investment Thesis

Investors have often considered JD.com (NASDAQ:JD), Pinduoduo (NASDAQ:PDD) and Alibaba (NYSE:BABA) when making their decisions to invest in China’s e-commerce space. While we consider BABA as the undisputed leader in its market, we also highlight the key differences in their respective business models in their quest for e-commerce leadership. We then present a simple valuation framework that we think all investors can use, and highlight the risks that investors often ignore when considering the valuations in Chinese companies.

Alibaba Clearly Dominates GMV

Annual GMV for BABA, JD and PDD. Data source: Company filings

JD is China’s second-largest online marketplace based on gross merchandise value (GMV), well behind the market leader Alibaba, and ahead of fast-growing Pinduoduo. BABA clearly dominates the online marketplace in China by the sheer size of its transacted GMV ($7.49B yuan in CY2020) and there should be no doubt about its undisputed leadership.

While PDD is ranked third behind JD, investors should be able to observe that PDD has been catching up really quick, as the company grew its GMV by a CAGR of 88% from CY18 to CY20, while JD only managed to grow its GMV by a CAGR of 24.8% over the same period, clearly putting the company within PDD’s sights, and demonstrating the incredible growth trajectory of PDD. While BABA’s GMV CAGR of 14.4% is nothing much to shout about, we don’t think its undisputed GMV lead will be in question anytime soon moving forward.

Revenue Segments Clearly Show the Weight of their Business Models

BABA Revenue by segments. Data source: Company filings

While BABA and JD operates a widely diversified business model, BABA derives the large majority of its revenue from its third-party (3P) commerce business model (FY21: 75%). Even though in recent years, BABA has been diversifying its revenue into other areas, of which Alicloud is taking on an increasingly important role (FY21: 8%).

JD revenue segments. Data source: Company filings

On the other hand, JD derives the large majority of its revenue from its first-party (1P) business model, as product revenue accounted for 87.4% of FY20 revenue, and 86.3% of Q1’21 revenue, respectively.

PDD revenue by segments. Data source: Company filings

PDD, meanwhile, is a fully mobile commerce-driven company as it emphasized: “We have the privilege of being the only exclusively mobile commerce players of this scale in the world.” Therefore, even though many investors have often highlighted the better-diversified business models of JD and BABA, they should also clearly understand that we think commerce remains as the most important driving force for all three companies, a point that was also clearly articulated by JD: “JD Retail, as the core business of JD.com, will continue to strive for high and healthy growth in 2021 and serve as the cornerstone for JD.com’s overall development.”

Therefore, when looking at JD, PDD and BABA, we think investors should always first and foremost consider the underlying strength and potential of their commerce business model, before even venturing out to the other segments.

PDD has the Most Impressive Gross Margins

Peers LTM gross margins. Data source: S&P Capital IQ

While BABA doesn’t break out its gross margins between its segments (which makes it more complicated to analyze), we think it’s reasonable to assume that its 3P business model has largely been driving its gross margins, even though its gross margins have seen a discernible decline in recent years from 63.7% in 2016 to 41.3% in the latest quarter. We think this reflects the increasingly competitive nature of the Chinese e-commerce market.

On the other hand, JD’s 1P business model most certainly meant that they would always be operating with much lower gross margins, which is clearly reflected in the gap between PDD and BABA. Meanwhile PDD’s online marketing revenue has clearly been a highly profitable source of business, and we are also not surprised as ad revenue has always attracted high margins, allowing PDD to post strong gross margins in its most important segment. At the same time, BABA and JD had to rely on their respective profitable commerce business segments to subsidize the losses of its unprofitable segments.

Revenue and EBIT Analysis

PDD LTM revenue and YoY revenue growth. Data source: S&P Capital IQ

PDD LTM EBIT margin and LTM SG&A margin. Data source: S&P Capital IQ

While PDD has yet to post EBIT profitability, we have seen the company improve its operating leverage significantly, through its largest expense segment: SG&A. Most importantly, this took place as the company posted highly impressive YoY revenue growth rates (LTM: 133.7%). We think this clearly demonstrates the company’s growing economies of scale, in which PDD also highlighted:

But if you look at this quarter versus the same quarter last year, the year before, sales and marketing intensity as a percentage of revenue, excluding the 1P, is coming down, right? We are seeing efficiency from a sales and marketing perspective for us to continue to improve. And this is being done so in a way that’s also inclusive of the Duo Duo Grocery as we think about these businesses quite holistically.

JD YoY revenue growth, LTM SG&A margin, LTM EBIT margin. Data source: S&P Capital IQ

On the other hand, for JD, while we had noticed a pretty remarkable improvement in its LTM SG&A margins (from 6% in Feb 17 to 4.6% in Q1’21), the fact that it was quite a small segment to begin with has also limited its impact to the bottom line, which we could clearly observe as its LTM EBIT margins only improved from 0.1% in Apr 17 to 1.2% in the latest quarter.

While we know the nature of a 1P business model is less focused on EBIT margins, and more focused on the scaling up its revenue, JD’s GMV when compared to BABA’s, has not convinced us that the company has been able to grow rapidly to achieve the scale necessary to justify its low margin business model as the company is simply a distant second to BABA in terms of GMV. In addition, the fast growing PDD has also clearly been catching up with JD, and we think may even overtake JD’s GMV moving ahead.

PDD and BABA Clearly Lead Active Users Metrics

Peers annual active users [AAU]. Source: China Internet Watch

In addition, we could clearly observe PDD’s meteoric rise through the lens of its AAU, which had even eclipsed BABA in Q1’21, and further opened up its lead against JD. While JD and BABA have also launched their own social commerce programs to deal with PDD’s competitive threat, we think PDD’s growth momentum has already reached a critical mass that has clearly allowed the company to benefit tremendously from network economics and should support its growth even further ahead.

BABA and PDD MAU. Source: China Internet Watch

E-commerce sales by platforms.

We could also clearly observe the increasingly important role that PDD and the other social commerce platforms are playing within the e-commerce pie, as social e-commerce accounted for 34.37% of the total e-commerce transactions. PDD’s rise has certainly been seen through its underlying drivers as represented by its AAU, MAU, and its GMV. We think PDD poses a significant threat to JD as JD hasn’t been able to effectively address the rapid underlying growth posted by PDD.

Leading WeChat e-commerce mini programs MAU. Data source: QuestMobile

DAU of e-commerce apps. Data source: Jiguang

Even though PDD may have led the share of social commerce with its 16.47% e-commerce market share, the other social commerce programs still accounted for about 17.9% of the e-commerce market share.

In addition, when we study in detail on the WeChat Groups and Mini Programs (both are important segments of the social commerce pie), we noticed that PDD and JD have been the two leaders here, with the obvious exception of BABA, which has yet to make progress in its collaboration with WeChat. Therefore, while we couldn’t fault JD for trying, it still need to do more to counter the growth of PDD.

On the other hand, while BABA has not been able to break into WeChat’s mini programs, the company’s huge popularity alone has allowed it to sufficiently dominate China’s e-commerce space for years and with the scale of its GMV, we expect to see the company continue maintaining its lead over PDD even as its younger competitor has made incredible progress in DAU and MAU.

Forward Revenue, EBIT and FCF Projections

Peers projected YoY revenue growth. Data source: S&P Capital IQ

Peers projected EBIT margin. Data source: S&P Capital IQ

While we expect all 3 of them to continue growing fast moving forward, we have factored in somewhat of a slowdown in growth even though PDD is still expected to post YoY revenue growth north of 25% moving forward (see charts above), while BABA and JD are both expected to grow slower.

Given the significant improvement in operating leverage that we observed earlier for PDD, we think PDD is only a couple of years away from turning EBIT profitable. Moreover, we think the company is likely to continue gaining operating leverage, even though its revenue growth is expected to slow, and eventually outperform both BABA and JD by the end of FY25 if it is able to continue executing its mobile commerce focused growth drivers well.

While we have also factored in a significant improvement in JD’s EBIT margins, we think that the company would still likely continue to operate with razor-thin margins until we have seen more meaningful contributions from its other higher value-added segments. On the other hand, we think BABA would still continue to hum along nicely, but we don’t think its business model would be as profitable as PDD’s ad-driven business model in the next few years, as Alicloud should still be expected to scale, but not contribute meaningfully to EBIT margins.

Peers projected unlevered FCF margin. Data source: S&P Capital IQ

We also expect PDD’s strong EBIT profitability to flow over to its FCF profitability and expect PDD’s FCF margin to significantly improve, in line with its EBIT margins, and eventually outperform BABA by the end of FY24. At the same time, we continue to expect JD’s FCF margins to remain in the low-single digits as we do not see any potential strong growth drivers to change our assumptions at this point in time.

Key Risks to our Assumptions

Peers EV / Revenue. Data source: S&P Capital IQ

We don’t particularly like to use PE as a reference here as we do not think the comparison is fair to JD since JD operates with low EBIT margins, which is similar to what we observed in Amazon (NASDAQ:AMZN) before they had AWS. An investor who uses PE to value AMZN then would surely have never gotten on board with the stock. While an imperfect measure at best, we think using the EV / Fwd Rev framework may present a better overview of the stocks’ current valuation.

JD NTM (TEV / Rev) 3Y mean.

PDD NTM (TEV / Rev) 3Y mean.

BABA NTM (EV / Rev) 3Y mean.

If we refer to the charts above, we could clearly see that JD has always been cheap. The stock’s 3Y revenue multiple mean is 0.65x, as compared to its EV / FY+1 Rev of 0.6x. We understand that while investors may think that the stock is also cheap based on SOTP, DCF or other valuation metrics, but its 3Y mean has said otherwise. Even its 5Y revenue multiple mean of 0.74x is hardly inspiring.

PDD (7.7x) and BABA (3.4x) on the other hand have EV / FY+1 Rev multiples that are trading well below their respective 3Y means of 9x and 6.12x, respectively. Therefore, we could certainly argue that PDD and BABA may represent a better value than JD right now.

Key Risks to our Assumptions

While we don’t think that the above 3 companies are expensive right now, investors need to be aware of the regulatory risks that have been dominating this sector for a while now, and have gotten increasingly frequent, and unpredictable, with the latest blow being dealt to DiDi Global (NYSE:DIDI) only very recently.

While investors may still take such opportunities to add exposure, we also wish to highlight that while we don’t think they are expensive from a valuation standpoint, such regulatory risk that affects Chinese tech companies are inherently very difficult to model. As a result, the valuation methods that we use to look at US companies may not work as well in Chinese companies, and we would like to highlight the difficulty of using US companies in our benchmark comp sets as a result.

In addition, while none of the above companies are listed in China’s A-shares market, which is dominated by the whim and fancy of retail investors, negative investors sentiments could still dominate the Chinese tech stocks and would continue to drag down their performances, while their US peers continue to march higher. Hence, we would like investors to be fully aware of these risks when deciding to add or increase exposure to Chinese stocks, even though their valuations look attractive right now.

Wrapping It All Up

While BABA is expected to continue its undisputed leadership in China’s e-commerce space, we expect PDD to continue its meteoric rise and eventually overtake JD in terms of annual GMV if it could continue its incredible growth rates. We think PDD’s high gross margins is the company’s key leverage in its competition against both BABA and JD. While JD has one of the best fulfillment networks in the market, we think the company is still not growing fast enough to justify its razor-thin margins business model.

Author: JR Research, Seeking Alpha