Chinese regulators are reportedly probing e-commerce giant JD.com's (NASDAQ:JD) finance arm over allegations that it breached security laws, according to Bloomberg. The charges include underwriting unapproved securities with its Bai Na service, and possibly misleading and defrauding customers with promotions.
Shares of JD didn't sell off after the report, but it raises concerns that regulators could force the company to alter parts of its business. Let's take a closer look at JD's business and how the allegations could impact the company's growth.
What does JD.com do?
JD, formerly known as 360buy, is the second largest B2C (business-to-commerce) website in China after Alibaba's Tmall. The company's major backers include internet giant Tencent (OTC:TCEHY), which owns 15% of the company, and retail giant Wal-Mart (NYSE:WMT), which controls 11%. JD's e-commerce platform is integrated into Tencent's WeChat, the most popular messaging app in China, and it fulfills deliveries from Wal-Mart stores across China.
JD generates most of its revenues from its core marketplace business. During the third quarter, its GMV (gross merchandise volume) rose 43% annually to 158.8 billion yuan ($23.8 billion). Annual active customer accounts rose 57% to 198.7 million.
That robust growth lifted its total revenues by 38% to 60.7 billion yuan ($9.1 billion), but that represented a slowdown from 42% growth in the previous quarter and 52% growth in the prior year quarter. JD's bottom line remains in the red, and it's only posted one quarter of profitability over the past four quarters.
What does JD Finance do?
In 2013, JD launched JD Finance, which offers financial services and products to consumers and small businesses in China. The unit formed a wide range of partnerships with companies like ZestFinance, which provides credit risk evaluation for Chinese companies, and UnionPay, the country's national banking card association.
In 2014, JD Finance launched Baitiao, the first internet-based credit product in China. JD claims that Baitiao usage surged 800% annually during Singles Day (Nov. 11) -- the biggest online shopping day of the year -- in 2015. Its ecosystem also includes JD Zhongchuang, which finances promising start-ups, and the country's biggest crowdfunding platform. It recently announced plans to expand into the insurance and online brokerage markets as well.
JD Finance's growth has attracted a lot of big investors. Last year, the unit raised $1 billion from investors and was valued at 46.65 billion yuan ($6.8 billion). JD doesn't disclose how much revenue JD Finance generates, but the company has admitted that it isn't profitable yet. Looking ahead, JD plans to spin off JD Finance as an entity entirely owned by Chinese investors, which would let it enter new financial markets (like securities) which entities with foreign investors are banned from.
JD plans to acquire a minority stake in the new company, which would give it 40% of the unit's pre-tax profits -- assuming that it achieves profitability. That move would also remove JD Finance's more volatile cash flows from JD's balance sheet. This strategy closely mirrors Alibaba's spin off of Ant Financial Services Group, a domestic Chinese firm which remains closely tied to its former parent company.
That's why the regulators are closing in
JD Finance must clear a lot of regulatory hurdles before the spin off is approved. That's probably why regulators are now putting its financial products under the microscope. Allegations of misconduct at JD aren't new -- a leaked internal memo from last October highlighted ten cases of internal corruption, with the staff accepting bribes, gifts, and banquets from suppliers prior to Singles Day.
JD isn't the only tech company in the crosshairs of Chinese regulators. Prior to this year's Singles Day, regulators issued warnings to JD, Alibaba, Tencent, Baidu (NASDAQ:BIDU), and Amazon's Chinese division regarding counterfeit products, false advertising, and falsified sales figures.
That warning was likely related to Baidu's previous issues with misleading ads, Alibaba's ongoing issues with counterfeit products at Taobao and Tmall, and the SEC's current probe into Alibaba's accounting methods and the accuracy of its sales figures. Those issues tarnished the reputations of both companies, and it looks like it's JD's turn to be scrutinized.
Should JD investors be worried?
Facing a regulatory probe is never good news, but I think the investigation into JD Finance shouldn't be compared to the investigations at Alibaba and Baidu -- which targeted issues within their core businesses.
JD Finance is a secondary business for JD, and any penalties levied against the unit should have a limited impact on its core marketplace business. But if the investigation kills the spin-off of JD Finance, it could weaken JD's competitive position against Tmall and weigh down its bottom line growth.
If you already own JD.com shares, there's no reason to panic and sell. But it also isn't a great time to start a new position -- JD's slowing sales growth, lack of profitability, and regulatory pressures could all limit its upside potential for the foreseeable future.