Some of you may have seen the 50-page JD short write-up that was recently posted on SumZero. The author essentially compares JD to Valeant and slaps on a $12 price target for his short thesis.

Coming up with such a sensasonal comparison, I was expecting to come across some high-quality analysis to back-up the attention-grabbing headline and hopefully learn some new insights from someone with an opposing view. Instead, what I got was a very biased and inaccurate report. A condensed version of the short seller’s paper can be found a here.

Below I will address all of the short seller’s major arguments.

Returns/cancellations may be as high as 20-25%. Net GMV removed after IPO.

Anyone who has put in some effort to study JD and the e-commerce industry knows that gross/reported GMV is before returns/cancellations (which the company clearly defines in its filings). That is practically how any discerning analyst models the business including the sell-side. I don’t know anyone who models gross GMV as being completely monetizable, or bases their valuation off of gross GMV alone. All Chinese e-commerce companies disclose only gross GMV which is common knowledge for those that have studied the industry, but somehow for the short seller this is a red flag for JD…

JD stopped disclosing net GMV after the IPO because all of its competitors including BABA only report gross GMV and reporting agencies/media were using JD’s net GMV figure to calculate their respective market share vs. Tmall which basically penalized them vs. the competition. But if you call up IR which doesn’t seem like the short-seller did, they would tell you what the net GMV and implied return/cancellation rates are. To the extent that gross GMV is useful as a financial metric, growth in gross GMV could be used as a rough proxy for measuring growth in net GMV or “net monetizable revenue” once one has come up with a reasonable return/cancellation rate.[1] Certainly this metric when properly adjusted is a key business driver for a company scaling in high-growth mode and by nature is very different from the questionable metrics used by internet companies during the dot-com boom as the author tries to draw a historical comparison to…

Historically returns/cancellations have been about 18-21% of GMV for the 1P and 3P business (IR will confirm this with you). Another way to confirm this is through public filings as JD reports both the gross GMV and net revenue figures (under the “online direct-sales” line) for the 1P business (the only difference between the company’s definition of net GMV and net revenue is the VAT which is 17%).

For example, in FY2015 JD reported gross GMV of RMB 255.6 billion and net revenue of 167.7 billion for the 1P business. The way to get the return/cancellation rate is to arrive at net GMV by adding back the VAT (167.7/0.83 = 202 billion). The difference between gross GMV and net is 53.6 billion (255.6 – 202) which implies a 20.9% return/cancellation rate. Where the short-seller miscalculated is instead of dividing the net sales by 0.83 (if the tax is 17% then what remains is 83%) to properly account for the effect of the VAT, he mistakenly grossed it up by 17% which understates net GMV and overstates the return/cancellation rate.

In any case, we can see that the return/cancellation rate has trended up over time. There are two primary reasons for this as management has clearly communicated: 1. The mix-shift away from electronics into more general merchandise, especially apparel, has increased the return rate (the return rate is still at industry-low levels around mid-to-high single digits whereas cancelled orders make up around 80% of the gross-to-net GMV gap); 2. More purchases are now done on mobile (mobile accounted for 30% of total orders in Q3 2014 vs. 72% by Q1 2016) where consumers tend to leave more orders uncompleted and where there is likely more impulse-type buying. Management is working to bring the completion rate on mobile down to a level more similar to desktop over time.

Accusing the company of a lack of disclosure where JD clearly defines gross GMV and net GMV in its filings and would readily supply information on net GMV over a simple phone call seems pretty ridiculous.

Brushing on 3P marketplace reported by media and recent JD comments: 10% GMV discount

Brushing is a common phenomenon on all marketplace e-commerce platforms including Taobao/Tmall, eBay and Amazon (I am reasonably knowledgeable about this as one of my best friends was a Powerseller on eBay, where brushing is extremely common). The idea is that to get better reviews and more importantly, a higher review count for their products, some 3P merchants would “brush” by buying their own products and write favorable reviews (and never delivering the product, for obvious reasons), in turn driving up the reputation of their stores and their rankings over keyword searches.

This problem in particular is prevalent over Taobao which does not charge a sales commission, and hence “brushing” is practically free for the merchant. On Taobao and to some extent on Tmall, this introduces an adverse selection problem on the platform as the bad actors crowd out the good actors who refuse to brush and artificially boost their ratings.

Brushing is a much smaller issue on JD for a number of reasons. Firstly, 56% of JD’s LTM GMV is 1P (self-operated) which by definition has zero brushing. Secondly, a very substantial % of GMV on the 3P platform is generated by flagship stores owned by the brands themselves who rarely engage in brushing. Thirdly, JD’s commission is much higher than Taobao/Tmall which makes brushing very costly for the sellers and lowers their ROIC on brushing relative to more legitimate marketing channels such as keyword bids and display ads. Finally, all of JD’s merchants are large brands or retailers that are over a certain size limit; JD is much more selective about its 3P merchants (far more initial due diligence and ongoing monitoring on marketplace merchants) and has a soft cap on the number of merchants allowed on its platform (JD only has around 100,000 3P stores vs. over 10 million on Taobao).

When a 3P merchant is caught brushing, JD generally kicks the seller off the website permanently whereas Alibaba follows a much more lenient “3-strike” rule (only removing the seller after catching him brushing/selling counterfeits three times). Unlike Alibaba which refuses to acknowledge brushing as a problem, JD has been heavily investing in anti-brushing technologies and has specifically called out their recent anti-brushing campaign as having a modest impact on GMV growth.

Furthermore, JD’s reported GMV has always excluded GMV generated by merchants with abnormally high return and cancellation rates, as well as any cancelled orders above 2,000 RMB to partially account for the effect of brushing. No other Chinese e-commerce company is as conservative with GMV reporting. Brushing is estimated to account for as much as 15 – 25% of Taobao’s GMV whereas most estimates put it at low to mid-single digits of 3P GMV for JD. Assuming 5% of JD’s 3P GMV is “brushed”, the impact on JD’s total GMV is less than 2.5%. Moreover, since 3P merchants mainly use brushing as a marketing tool, as JD’s technologies make it harder to brush, these sellers will increasingly have a stronger incentive to shift their marketing spending to keyword search advertising which would ultimately help offset any lost commission revenues related to brushed transactions.

As for the newspaper article which alleged that a JD employee helped sellers with brushing activities, JD has specifically responded that the employee was new to the company and was immediately terminated after the incident. The reality is no matter how much effort is exerted, you cannot completely prevent corrupt behavior at a company with over 110,000 employees.

Improper counting by orders placed and limited disclosure: 5% GMV discount

This argument is just plain bizarre. The author claims that GMV is inflated because 1. It includes shipping fees (well, nearly all of JD’s orders include free shipping to the customer and the shipping service is a key component of the online shopping value proposition; Alibaba also includes shipping revenue in its GMV and Amazon includes shipping in net revenue); 2. It includes GMV from equity investees – by that logic if Amazon owned 20% of one of its suppliers it should not count revenue derived from that supplier as actual revenue!?); 3. It includes internet finance revenue (will be discussed in point 9 below).

China-based auditor is unable to audit 100s of millions of orders: 5% GMV discount (We note that it is a gigantic task for JD’s auditor, PricewaterhouseCoopers Zhong Tian LLP to audit 100s of millions of orders placed which count towards GMV. As such given even the auditor cannot audit GMV, we would place an additional 5% discount/hair cut to the reported GMV figure.)

So the author has decided to give JD an arbitrary 5% GMV discount simply because it is impossible for the auditor to independently verify every single order on JD. I’m out of words here. Seriously, the same can be said about any large company engaged in large transaction volumes – Amazon, P&G, Wal-mart, JC Penney – you name it… Perhaps the author is trying to imply that management are disingenuous when disclosing key business drivers? In no part of the author’s paper did he touch upon any aspect of the founder’s background, character, or past dealings with major stakeholders – perhaps this not so surprising in such a biased paper as Liu could potentially be one of the most ethical corporate executives alive today.

JD is Enamored with GMV While Losses Grow Larger

JD’s core business is actually profitable, despite operating in a growth phase. The current reported losses are due to one-time impairments and current investments running through the PnL that are tied to fast-growing businesses such as JD Finance and JD Home/Daojia that are at present subscale. JD’s reported FCF profile also turned negative in 2015 in part due to the heavy investment in fulfillment center construction – this is mostly growth-related CapEx. But if you analyze JD’s FCF generation a few years back, you can clearly see that the core business is solidly profitable and this is in large part due to the Finance unit being started only in 2013, coupled with the company’s prior strategy of leasing warehouses to meet order capacity. If the author provided a sound argument that JD is investing in low-return projects, then criticism of the current heavy spending is warranted.

Perhaps the author didn’t catch this, but JD added two new internal KPIs for 2016 (that will affect employee compensation) – and both are focused on increasing profitability – Cash Flow Days and Operating Profit. The author has also omitted the steady gross margin expansion JD has shown year after year driven by rapidly growing 3P contribution profits.

I believe the right way to think about the GMV metric is to use it as a relevant benchmark for comparing the profitability and margin structure of the target business to other offline and online retailers at similar scale. GMV is a relevant metric for hybrid or pure-play marketplace retailers since a marketplace business (commission-based revenue model) has a very different margin structure to a direct-sales/1P business. Depending on the average product/gross margin of the 1P business, and the average commission/take-rate of the 3P business, comparing the profitability of a hybrid online retailer to a pure-play direct-sales retailer by assigning a steady-state or long-term margin on GMV could be a useful tool for analysis. Conventional analysis such as assigning a margin as a % of revenue for both 1P and 3P units is also possible, but less useful for straight comparisons between different retail models. Remember that GMV should always be adjusted for returns/cancellations, and any VAT taxes. No competent analyst I know of uses gross GMV for straight comparison/modelling purposes.

What the author seems to be missing is the massive operating leverage that will become evident from owning your own fulfillment assets as order volumes continue to grow as well as the sizable gross margin expansion from 3P GMV growth and increasing scale in the 1P business. The author seems to be skeptical that JD’s 1P gross margins will eventually expand despite his own admission that GMV will likely grow at least in the 30%+ range (faster than any direct competitor). I view this risk as very low given JD’s track record in execution and the fact that they are already the largest direct-sales retailer and are growing all categories at a volume rate multiples of that of their largest rivals Suning and Gome. The author also does not take into account the considerable likely incremental cost-savings in the future from more automated warehouses and the use of delivery drones.

Ultimately, it is the margins (gross and operating) and FCF, in particular, that matters most to JD’s long-term intrinsic value (something the author has yet to have an opinion on) and JD management understand this as well (apparently the author doesn’t think so) and have their own opinion of what type of margins JD could achieve long-term if you speak with them. Overall, it appears that it is the author who is myopically focused on GMV and short-term reported losses over having an informed view of what the economics of JD’s business could look like longer-term.

Paipai acquisition boosted JD’s GMV by RMB 33.6bn ($5.3bn). GMV was counted, but RMB 2.8bn impairment created for shareholders. Questionable capital allocation for GMV?

The $5.3 billion the author quoted is cumulative GMV over two years (seems like he made the number artificially larger to exaggerate his claim). Ever since the Tencent – JD strategic partnership transaction closed, JD has always disclosed core GMV on an ex-Paipai basis (Paipai is a C2C platform originally owned by Tencent). JD shuttered Paipai last year because as a C2C platform similar to Taobao, Paipai is fraught with counterfeit products and given the sheer number of small merchants on the platform, it is practically impossible for JD to enforce a counterfeit-free platform. In sum, JD’s decision to kill Paipai was motivated more by reputation management over short-term economic considerations.

More importantly, the author omitted the biggest component of the Tencent deal which gave JD an exclusive position on Tencent’s flagship mobile apps WeChat and QQ (35% of all time spent on the internet in China is spent on Wechat). WeChat and QQ now account for 20 – 25% of JD’s customer traffic and have helped JD significantly accelerate its growth profile. To completely disregard this contribution while isolating a minor part of the deal to discredit management’s capital allocation track record is one example that highlights the author’s overly biased position.

JD counts in its GMV orders placed in JDs websites but operated by equity investees like Bitauto and Tuniu where traffic generated through JD platform…The question is why should JD be counting in its GMV when this is an equity investee?

It doesn’t appear that the author has ever used JD’s website. GMV generated through both Bitauto and Tuniu actually take place on JD’s platform under its travel and auto verticals so Bitauto and Tuniu are effectively 3P sellers on JD just like any other 3P merchant. Both account for a negligible amount of JD’s GMV currently.

These investments (Tuniu, Bitauto and Yonghui) have been a dud and burned real cash…

This argument is analogous to saying that because a stock in your portfolio has fallen below your cost basis that it must be a permanent impairment of capital… please spare me.

Both Tuniu and Bitauto are publicly traded on the NASDAQ and JD’s write-down of value in both was driven by the fact that their market capitalizations have fallen substantially over the past year (JD acquired a stake in both during 2015). For context, Tuniu is the third largest Online Travel Agency in China (think Priceline) and has recently established an alliance with industry leader Ctrip (forming effectively a monopoly); Bitauto is one of the top two advertising platforms in the internet auto vertical. Both are rapidly growing players in industries with massive TAMs. To say that the investments have been a waste of money simply because of short-term volatility appears quite unfair to say the least.

JD has not realized any capital losses on these investments and it is also obvious that Chinese-related securities as a whole have not been performing well over the past year. Both stocks have gotten crushed over the past year (each down by more than 50%+) and I am not saying that over time JD’s investment in either Tuniu or Bitauto might not turn out to be a disaster but I definitely think it is premature to jump to a conclusion that they are without properly assessing management’s decision. One has to consider that management is very focused on long-term value creation and that is also reflected in their capital allocation decisions. Now if the author provided some sound fundamental analysis to support his claim that Tuniu and Bitauto were a waste of shareholder cash instead of relying on Mr. Market as his informer of intrinsic value then I’m all ears. In any case whether these equity investees become very valuable or not, they are not key value drivers to either the long or short thesis.

JD’s consumer finance business GMV as % of GMV has been rising (with limited disclosure). JD has no track record in growing, operating and managing risks in internet finance.

First of all, what JD refers to as consumer finance GMV is not the revenue of the JD Finance business but rather the portion of GMV that’s tied to JD’s consumer financing offerings (for example, it’s the GMV recorded when you buy, a fridge on a consumer loan from JD Finance). JD has separated JD Finance into a standalone unit that will be self-financed in 2016. This unit was valued at $7.2bn post-money in January (which the author conveniently omitted in his analysis) by top-tier investors and will likely be IPO’d sometime within the next few years. It is true that JD’s experience managing internet finance businesses is rather short but the same can be said to just about any internet finance company on the planet. The whole point is they will try to get better at it and create value by leveraging JD’s massive distribution platforms. To reiterate in my original JD paper posted several weeks ago, JD Finance’s management team is prioritizing risk management over speculative lending growth.

As GMV grows, are investors underestimating the risks in JD Finance business? Internet Finance is a space with intense competition with larger, more profitable players!

Internet finance is a multi-trillion dollar opportunity in China. It appears the author believes this is a liability (note that the business is now siloed away from the core business in the worst case scenario that it never achieves minimum efficient scale) solely on the rationale that 1. This is a new area for JD and 2. This area is competitive and yet extremely well-informed people at Sequoia think this business is worth at least $7bn.

Admittedly there is competition in the Chinese internet finance space, especially on the online payments side given the larger size of AliPay for third-party payments. But as I mentioned in my paper, the market opportunity is large enough that at this early stage multiple players can create a considerable amount of value given their online distribution advantages and richer data sets over the state-owned banks.

Has the author provided any rationale that this business is not worth at least $7bn today? No, in fact he did not touch upon the nature of the fundraising round in January. Bigger picture, JD’s core business alone could be worth at least $200bn over the next 5 – 7 years, which frankly would make the internet finance division’s value look like peanuts today.

JD’s Management Has Limited Tenure For a 12 Year Old Company Which is Rarely a Promising Sign For a Company Yet to Make Money

The author really just answered his own questions here. JD is a very young company and as a result has short-tenured executives. It is also important to keep in mind that when JD was founded it was very much a one man show where Richard pretty much took on most of the executive responsibilities as the company did not have the money nor reputation to hire professional managers. JD upgraded its C-suite in the early 2010s after receiving investments from Hillhouse and Tiger Global and that allowed Richard to delegate more responsibilities to professional managers.

Who is Jiaming Sun Owning 55% of the VIE, more than Richard Liu, JD’s Founder? A Mystery

It wouldn’t be such a mystery if the author had done any research in actual Chinese. Sun Jiaming is one of JD’s earliest employees and as recently as a year ago was the SVP of General Merchandise at JD. He recently left the company for personal reasons but like Liu he had to enter into a series of contractual agreements to ensure that JD would retain effective control over the VIEs should he stop being a JD employee.

JD is a Hedge Fund Darling and Has Nearly Unanimous Buy Ratings by Analysts. Is It A Crowded Trade Like Valeant?

Yes there are some very smart people who own JD in size who hold a better opinion of the company than the author. By the author’s logic is any name heavily owned by hedge funds doomed to fail as an investment?

It’s simply not enough to be “contrarian” to do well with an investment – you also have to be right. Simply calling JD a hedge fund hotel and comparing it to Valeant without providing any sound fundamental analysis to back-up the claim basically kills any credibility the author had in my mind.

Looking at JD’s shareholder base and the extensive sell-side coverage, I would view the story as pretty well-known by major institutional investors (so it is definitely not an “under-the-radar” type of mis-pricing): JD is typically pitched as a vehicle to gain exposure to the growing Chinese internet and consumption theme. However, I am not convinced that the long thesis is well understood by the majority of potential shareholders who sit in an office in New York and lack a variant perception. As for my numbers they are materially higher than Street consensus over the next several years and I am highly skeptical that the market is accurately pricing in the long-term earnings power of the business. If the current stock price represents the market consensus then I think a sound case can be made that consensus is way too conservative on a longer-term time frame.

I would also note that there are those that actually conduct their own independent due diligence in order to develop a well-informed view of their holdings (and pencil out the numbers accordingly) vs. those that conduct limited due diligence and simply piggyback off of their buddy’s ideas at other funds. Price-agnostic buying of “outsider” companies based solely on getting exposure to a robust narrative such as TDG, CSU, or any Liberty-related story, for example, is almost a guaranteed path to generating mediocre returns.

It is also important to consider the quality of the funds holding the stock vs. simply labelling the stock as a hedge fund hotel that is ready to crash. Different funds have different time horizons, investor bases (quality matters) and average cost bases that could affect the short-term liquidity of shares. In JD for example, despite the numerous Tiger Cubs in the stock I basically treat their exposure as one de facto position since they like to share the same ideas with each other (hedge fund circle jerk is real). Hillhouse of course is well-known for taking concentrated positions with a very long-term time horizon.

Frankly when it comes down to it whoever owns the stock is irrelevant for the long-term fundamental investor in my view – except in the rare case that a large shareholder is actually adding value to management by leveraging its exceptional proprietary research to create additional value. Over the short-term it could affect the stock’s liquidity and cause higher than average volatility since shorter-term funds can crowd in and out of the stock – I view these liquidity events as more of a potential opportunity for the longer-term investor – but it could very well be a real risk for the shorter-term investor/trader.

Finally the stock is hitting fresh 52-week lows and is near its IPO price which took place more than 2 years ago; sentiment at the moment appears quite poor – calling it a crowded trade like Valeant at this point seems like a stretch at best… I am not even going to get into how JD is different from VRX since the author obviously made no worthwhile effort in his own case despite his claim.

“Services and other” revenue has deferred revenue included and limited disclosure

The author seems to take issue with the fact that 4% of JD’s deferred revenue account (a whopping $80 million) is related to Bitauto and Tuniu. “At APS, we note that there are accounting ways counted here like deferred revenue from 2015 resulting from “resource” arrangements with Bitauto and Tuniu, equity stakes where JD is deeply underwater. Burning cash but booking accounting revenue?”

Really not sure what the author here is suggesting really. There is a clear business relationship between JD and Bitauto and Tuniu both of which are NASDAQ-listed industry leaders. To not book revenue would be illogical when a service is provided or expected to be provided.

JD’s Non-GAAP gross margins need to be adjusted to reality

The author is correct in stating that JD’s 1P gross margin has been flat in the last four years. However, this has been the result of an intentionally low-pricing policy as part of management’s plan to quickly gain scale (management has stated quite explicitly at meetings that they have been deliberately holding gross margin flat and reinvesting scale benefits back into pricing), similar to what Amazon has been doing for the past twenty years. One interesting data point is that despite being the largest retailer in China, JD’s gross margin is over 10 points below its offline peers such as Suning and Gome which has helped them to win substantial share in the price war. 2016 is the first year JD is letting 1P gross margin expand (already increased 80 bps in Q1 this year) and management’s plan calls for 1P gross margin to increase from around 6.5-7% currently to 13-14% in the next few years. In my own estimates I am assuming 1P gross margins to expand closer to 12% by 2020.

Outbound/last-mile shipping costs are not captured in COGS – this is also correct, but the author is completely wrong on everything else when it comes to JD’s cost structure compared to Amazon. First of all, JD lumps its shipping expenses into the fulfillment costs line under Opex because JD’s fulfillment operations are integrated with its proprietary last-mile delivery. Amazon’s fulfillment cost is also recorded as an Opex line item but outbound shipping is lumped into COGS because Amazon outsources the majority of its last-mile delivery to UPS/USPS/FedEx. The short-seller’s analysis which adds all of JD’s fulfillment costs back to COGS is misleading and not comparable to Amazon. To make JD’s results apples-to-apples to Amazon we need to add back only the last-mile delivery portion of fulfillment. More importantly, Amazon also has a substantial 3P operation (50% of Amazon’s orders are 3P compared to 44% for JD) which similar to JD is 100% gross margin and overstates Amazon’s 1P gross margin in the consolidated revenue line. Finally, prime membership fees and AWS revenue at Amazon are both very high gross margin revenue streams (offset by much higher Opex ratios than retail) that skew the numbers.

JD’s use of weighted average inventory – the author’s assertion that electronics prices are falling 10 – 15% a year is purely fictional. According to the National Stats Bureau of China deflation in prices of electronics and appliances has only averaged about 1.3% for the past three years. Also the author seems to be forgetting that JD is a direct retailer with substantial scale, not a supplier that may have to eat deflationary pricing. More importantly, JD’s inventory turnover is very fast at about once every 35 days so COGS for the first 11 months of the year would be the same regardless of whether JD uses weighted average or FIFO. The impact of the inventory accounting choice is very small.

JD’s inventory has grown faster than 1P direct sales in 4 out of the last 6 years and in the last 2 years. Rarely a promising sign given huge $3bn of inventory as of Dec 2015

Even according to the author’s table inventory turnover has been very much flat for the last five years (2009 is irrelevant given the company was super tiny at the time):

Also it’s important to note how fast the inventory turnover is – if you calculate inventory turnover correctly (by using average inventory for the denominator rather than ending inventory like the author did), JD’s inventory turnover comes out to be over 10x or once every 35 days.

JD relies on Non-GAAP accounting metrics but several of the expenses should be viewed as real expenses and given real cash was burned on investments

The author is correct in stating that stock-based comp should not be added back as it is a real expense. However, practically ALL best-in-class high-tech companies do it so JD’s practice is not out of line with industry standards. Furthermore, stock-based comp at JD makes up a much smaller % of its market cap than most Silicon Valley tech companies, suggesting that JD dilutes shareholders less on an annual basis. Note that on my own numbers I fully expense stock-based comp as a real expense when assessing profitability. In reality whether you adjust for SBC or not, the equity here is demonstrably undervalued.

JD consolidated operating cash before internet finance working capital is scant and GMV conversion to operating cash is limited even before internet finance business started

JD actually has generated positive maintenance free cash flow every year in the last four years when CFO is adjusted for the internet finance business which is a negative drag to JD’s working capital position. But more importantly, JD is currently in a high-growth phase and accordingly has been heavily investing in growth-related capex over the past couple of years (tied to expanding fulfillment capacity via fulfillment center buildouts, equipment, etc) like any fast-growing online retailer well-positioned in the most attractive e-commerce market globally would be.

It is true that JD has reported little accounting profits despite raising a substantial amount of capital over its rather short 12-year history as a company. But I think it is first-level thinking to take reported financials as a proper measure of the economics of the business or assume that the business will be in a perpetual state of cash burn – without being thoughtful about how the economics of the business will look like in the future. My own view is that JD has steadily increased its earnings power over time, management has consistently focused on maximizing value over the long-term (and this means raising enough capital historically to pursue this goal), and the time and capital it took to build a moat around the business today illustrates the substantial barriers to entry in becoming a tier-1 e-commerce platform.

Allow me to demonstrate in greater detail why I believe the author’s thinking is flawed here. Aside from wrongly adjusting the Gross GMV figure, the author failed to properly adjust JD’s reported EBIT and FCF to normalized levels in order to account for the substantial growth-related investments. A more sophisticated type of analysis would include a deep dive into the unit economics of JD’s business on a customer and/or order-level basis in order to assess whether any incremental invested spending/capital is generating a sufficient incremental rate of return. Now one can have a legitimate debate about the magnitude of the rate of change over time for these metrics, yet the author has failed to even mention them. At this point in time, all the key drivers are solidly moving in the right direction (and have been improving historically) and JD’s unit economics have already hit a positive inflection point (customer-level IRRs are likely already in the triple-digit range driven mainly by the growth of 3P contribution profits, a steadily declining fulfilment cost per order/customer, and a larger customer base). For the long-term investor, it is a thing of beauty to be invested in a company that has a long runway to invest substantial amounts of capital at high incremental returns.

JD has a number of related party transactions that are large and merit closer attention. What is Staging Finance entity given it is responsible for RMB 1bn of related party transactions?

All of the so-called “related party transactions” took place with companies that are equity investors/ investees of JD (Tuniu, Bitauto, Tencent, Staging Finance). Nothing strange here.

Some Insiders Have Been Net Sellers In Last 12 Months. Share Buyback Not Yet Conducted. Instead, JD Has Raised $2bn In the Last 5 Months

The claim that insiders have been selling stock is simply bogus. Fortune Rising is an employee Incentive Pool where shares are periodically sold for employee awards. Richard Liu has not sold a share since the IPO and owns close to 20% of the company. The buyback hasn’t been conducted but I expect them to be buying back shares very soon, especially with the stock trading at these levels.

It also appears that the author taken the recent financings out of context by suggesting that JD has conducted $2bn of straight dilutive equity raises when in reality $1bn was a series A funding round raised for the JD Finance unit at a $7.2bn post-money valuation (worth a whopping quarter of the current JD market-cap today) and another $1bn was a recent bond issuance at very attractive terms – likely done to increase the company’s firepower to repurchase undervalued shares. The author seems to believe that JD is doomed in a perpetual state of capital raising when in reality the balance sheet is very strong, the core business is already FCF positive and its margins are on the verge of a major inflection point. Perhaps most importantly, JD Finance will now also be independently financed. Overall, I believe the risk is to the upside with respect to a greater chance that JD will be buying back their own stock at these levels vs. diluting the equity; count this as another potential near-term catalyst to my own thesis.

Other additional points

The author’s subsequent analysis regarding 1. JD’s slowing GMV (which is natural given the law of large numbers and it’s impossible to maintain 80% growth for a $70 billion retailer??), 2. Intense competition from Alibaba/Suning (JD is growing at 3-4x the speed of Suning’s overall business which is struggling to clip a double-digit growth rate and is taking market share from both Taobao and Tmall), 3) However, some investors had valued the stock once at peak market cap of $50bn due to its GMV and revenue growth. It’s nice to know that the author is competent at reading stock price histories. Seriously… is it not a surprise that a Chinese “high-growth internet stock” could have a volatile share price print over any period of time?

JD.com vs. Amazon.com

So I think I have a right to a damn opinion here since I’ve studied both companies quite extensively. Overall, I agree with the author that a comparison between JD and Amazon is irrelevant given where each retailer is in its respective growth cycle and their different business mixes. Amazon is different from JD in many ways, particularly in its business mix (AWS + online video streaming + Prime + other moonshoots vs. JD’s end-to-end fulfilment network + JD Finance + O2O), but similar in many ways also, namely the corporate culture, extreme emphasis on the customer experience and long-term focus on creating shareholder value.

The author seems to be suggesting that the market consensus is long JD to get exposure to the “Amazon 2.0” theme in China which admittedly could reflect the thinking of some of the longs in the stock today. Where I disagree is that 1) JD is an extremely well-managed business, (like many of the large Chinese internet companies are) – likely better managed than Amazon – look at what they did to Amazon in China for example 2) JD is a much more attractive investment compared to Amazon today.

Consider that Amazon is currently trading around 1.5x 2016 GMV (or slightly less than 1 times if you assume AWS is worth $150 billion), and that JD is trading at less than 0.4x 2016 net GMV (less than 0.3x when JD Finance is excluded), it’s obvious to me that JD is being valued at a massive discount relative to Amazon despite growing GMV at more than twice the rate that Amazon is and operating an extremely attractive market for e-tailing.

Also the author’s negative view of JD’s massive employee growth and his analysis of the cost structure is simply misplaced. Other than Baidu’s growing self-owned O2O unit Baidu and Tencent operate a much more asset-light business model than JD and hence do not have a large growing blue-collar labor force and are not comparable benchmarks. So JD’s employee base has grown a lot over the years – cool – has it ever come across to the author that JD’s fulfilled order volume has grown from ~194mm in 2012 to ~1,263mm units in 2015 – a more than 6x increase and much faster than total Chinese parcel volume growth? I guess the author assumes that parcels deliver themselves magically in China. Has the author mentioned at all in any part of his write-up about JD’s growing competitive advantage in logistics by operating its self-owned fulfilment network? The author seems to be missing the whole essence of JD’s business model which is a combination of managing an online platform and end-to-end fulfillment network which is quite a powerful model in the right market and if managed by the right people. It is also interesting to note that Amazon has started to in-source parts of the logistics process as their order volumes continue to grow. (For the record I have great respect for the leadership in both companies and believe that over time both companies will become increasingly more valuable).

So the author seems to jump to a simplistic conclusion that operating an asset-heavy business is an inferior model to an asset-light one such as Alibaba and appears to be basing his conclusion on the current financial profiles of both companies. This is almost like saying that Walmart is an inferior business to eBay simply because it is a more asset-heavy business and thus has a higher cost structure, yet we all know how this big-box retailer came to dominate retailing in America. I have detailed extensively in my own paper why I think JD will be a long-term winner in China and will not go over it here again.

Final Thoughts:

What I always try to do is to have a superior understanding of the opposing argument better than the other side in order to deserve the credibility to voice an opinion. Although it is obvious that the author has spent a considerable amount of time on this short thesis (50 pages…), when it comes down to it he provides zero justification for his arbitrary $12 target price (FWIW at that price the stock trades at less than 2.5x and 3.5x EBIT and FCF on my 2018 #’s and less than 1x for both metrics by 2020).

If I were to construct a robust bear thesis on JD I would try to prove that it is a massive fraud since it’s the only scenario in my mind where the equity is worth near 0. However, the author has provided no “smoking gun”, nor has he approached with his analysis from this angle – the author claims that he has conducted channel checks, but where is the evidence of empty warehouses or fake suppliers or merchants? Frauds are also typically highly promotional companies that are overvalued on fake reported numbers alone which I argue that JD is neither.

Instead, the author primarily relies on speculative near-term catalysts (that are unlikely to materialize in my view) for his thesis over sound fundamental analysis (doesn’t seem like there is any margin of safety at all in his trade). With nearly $3bn of net cash sitting on the balance sheet, an improving margin profile over the next few years, and the JD finance unit being independently siloed – I see a future equity dilution as a low probability. Over time, the company’s earning power will become increasingly evident to the market – this is a long-term thesis that requires time to play out after all (if the stock was obviously undervalued to the casual market observer, I would be less confident that it was wildly mis-priced).

The only thing in the report that the author brought up as a legitimate concern to me is the CFO Sidney’s background at Longtop Financial Technologies – Longtop turned out to be a major accounting scandal that was exposed in 2011. Sidney worked briefly at Longtop when the company was still private as the CFO from July 2005 until March 2006 (around 8 – 9 months). From my understanding Longtop was engaged in fraudulent accounting since 2004 until it went bust. I believe Sidney was unknowingly a victim of fraud at Longtop (keep in mind he was there years before the company went public and he was not named in the lawsuits that ensued after Longtop’s collapse in 2011). The subsequent company he joined thereafter was acquired by Blackstone. I will definitely circle back to this issue at a later date and appreciate the author for highlighting this. For now, Sidneys’ position as JD’s CFO implies that Liu has basically endorsed him. My own impression of Sidney is that he is very straight-forward in his communication, is very thoughtful about the business and does not overly promote the business like what the author has implied throughout his report. Richard Liu himself is not promotional at all but it seems like the author has a different opinion. If he author can provide a sound argument that Liu is unethical and thus the equity is uninvestable then that would be a much more robust short thesis.

Other than that the author’s work here was extremely biased (the analysis was even misleading in my view), omitted major facts pertinent to his argument and failed to explore any element of the bull case (there was no acknowledgement at all of the real possibility that JD could be a multi-bagger investment over the next several years). The paper overall was very short on any real fundamental analysis, with little thought about the future economics of the business, and lacked any rigorous analysis on JD’s key business drivers. I’m also sure that Mr. Munger would be absolutely delighted if he found out that his picture was included in this paper…

In sum shorting JD stock presents an atrocious risk/reward profile since the equity can double or triple overnight and remain demonstrably undervalued (that’s what I would call a large margin of safety).

[1] This is a bit of a side note but to clarify in my paper I defined 1P net GMV as 1P Gross GMV net of returns/cancellations and the VAT, and 3P GMV as 3P Gross GMV net of only returns/cancellations (since JD takes a commission out of the entire 3P-related transaction where the VAT is not stripped out of that calculation). Originally I took a more conservative route and stripped out the VAT from the 3P-related transaction when calculating 3P net GMV.