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Morningstar | JD's Margin Expansion Story Intact; Expanding Into Lower-Tier Cities in 2019

No-moat JD reported several pieces of good news in its fourth-quarter results that point to continuous margin expansion, namely increasing economies of scale at JD Mall, continuous ramp-up at third-party logistics, and stronger growth of higher-margin categories and marketplace business. Management expects non-GAAP net margin to increase to 1.3%-1.8%, or 0.8%-1.2% excluding the development profit from the property management business in 2019, from 0.7% in 2018, which is a positive. Net revenue growth in the fourth quarter was 22%, near the high end of guidance of 23% and better than our expectations of 19%. Year-over-year net revenue growth guidance for the first quarter of 2019 is 18%-22%. We maintain our fair value estimate at $36 per share.

Non-GAAP net income margin was 0.7% in 2018 versus 1.4% in 2017, dragged down by the third-party logistics business. However, we saw an expansion in non-GAAP operating margin of JD Mall to 1.6% year over year from 1.4% in 2017, helped by growing scale in the first-party business and a mix shift to higher-margin 1P categories (general merchandise). Revenue from higher-margin general merchandise categories grew 38% during the quarter, driven by skincare and cosmetics categories; this compares with 20% growth in net product revenue. Non-GAAP operating margin of new businesses in 2018 was flattish year over year at negative 35%. Management said the new JD Logistics third-party business achieved significant gross margin improvement during the fourth quarter due to growing scale and optimization of its operation. The pricing of JD Logistics has moved back to a normalized level after the initial discounts to sign up major customers. Therefore, we expect the non-GAAP operating loss margin of new businesses in 2019 will reduce. Furthermore, higher-margin marketplace gross merchandise volume grew 40% year over year, which compares with only 28% growth in overall GMV.

To increase its customer base, JD is tapping into lower-tier cities and has developed group-buying business. Annual active customer accounts were 305 million in 2018, a year-over-year increase of only 4%. Quarterly active customer accounts increased only 6%. This shows a sign of saturation in JD’s middle-class target customers. Group-buying business has led to the rapid growth of e-commerce competitor Pinduoduo, which effectively taps into the lower-tier markets. We think group-buying business can also tap into female customers. Group buying business will also be launched in the apparel category, which has suffered from Alibaba’s competitive tactics. Management has seen good spending by these group-buying customers. Management will also develop a supply chain for lower-priced products this year.

Management has identified areas requiring efficiency improvement. For example, JD will improve its understanding of merchants and tag them with various characteristics. When there is a promotion, JD can give more relevant resources to merchants that match the goal of the promotion.

JD will dispose of some of its logistics facilities with a gross value of CNY 10.9 billion to JD Logistics Properties Core Fund, which was co-established with GIC, Singapore’s sovereign wealth fund, to recycle its capital. The disposition will be largely completed in 2019. JD will manage and lease these facilities and will receive management fees. We expect to see improvement in the group’s cash flow following the transaction. The estimated internal rate of return from the transaction will be in excess of 17%, and it would have led to at least CNY 1.5 billion in additional profit in 2018 on an annualized pro forma basis.