Shares of Vipshop (NYSE:VIPS) recently rallied after the Chinese e-commerce company reported its third quarter results. Its revenue rose 16% annually to 17.8 billion RMB ($2.6 billion), beating estimates by $60 million.

Its non-GAAP net income fell 11% to 501 million RMB ($73 million), or $0.11 per ADS, which beat expectations by two cents. On a GAAP basis, its net income declined 32% to 229 million RMB ($33 million), or $0.05 per ADS.

A young woma shops online while drinking tea.

Image source: Getty Images.

The results weren't that impressive, but it marked the first time Vipshop cleared both top and bottom line expectations in three quarters. The stock was also probably due for a bounce after plunging from $19 to about $5 this year. But is this rally sustainable?

A niche underdog in a crowded market

Vipshop specializes in flash sales of apparel, accessories, and other products. It controls just 2% of China's e-commerce market according to eMarketer, which puts it in fifth place behind Alibaba (NYSE:BABA), JD (NASDAQ:JD), Pinduoduo, and Suning -- in that order.

Vipshop's two biggest backers are JD and Tencent (NASDAQOTH:TCEHY), which co-invested $863 million in Vipshop last year. That's the main reason Vipshop surged from $12 to $19 earlier this year.

Earlier this year Vipshop launched hundreds of "mini programs" on Tencent's WeChat, the top messaging app in China, and bundled its Prime-like "Super VIP" membership packages with Tencent Video's subscriptions. JD also integrated Vipshop's products into its own marketplace.

Vipshop stated that 22% of its new customers came from Tencent and JD's platforms during the third quarter, compared to 24% in the second quarter. Vipshop is also trying to expand beyond e-commerce with a new fintech subsidiary, but that's a crowded market that might increase the company's credit risk.

A woman pays with her smartphone.

Image source: Getty Images.

Unimpressive growth and contracting margins

Vipshop's total number of active customers rose 11% annually to 26.5 million during the quarter, but also fell 11% sequentially. Vipshop is trying to offset that slowdown by expanding its Super VIP program, but its sequential growth also decelerated over the past year:

 

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Super VIP customers

< 1 million

1.5 million

1.9 million

2.3 million

Source: Vipshop quarterly earnings.

Meanwhile, the growth of Vipshop's average revenue per customer (ARPU) continues to decelerate, even as its growth in orders holds steady:

 

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Total orders

27%

25%

31%

29%

ARPU

22%

25%

12%

5%

YOY growth. Source: Vipshop quarterly earnings.

Vipshop's decelerating ARPU growth and sequential decline in active customers indicate that its order growth is being supported by higher sales of cheaper products. Vipshop is also relying on aggressive promotions to attract customers. That's why its gross and operating margins both contracted significantly during the third quarter:

 

Q3 2017

Q3 2018

Gross margin

22.9%

20.4%

Operating margin*

4.6%

3.1%

Source: Vipshop quarterly earnings.

Even though Vipshop beat expectations with its top and bottom line growth during the third quarter, its growth rates actually look dismal relative to its growth in previous quarters:

 

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Revenue

27%

25%

18%

16%

Non-GAAP net income

(9%)

(9%)

(14%)

(11%)

YOY growth. Source: Vipshop quarterly earnings.

Vipshop expects its revenues to rise just 8% to 13% annually during the fourth quarter. For the full year, analysts expect its revenue to rise 18%, but for its earnings to drop 22%.

Stick with the market leaders instead

The bulls might claim that Vipshop looks dirt cheap at 0.3 times this year's sales and 10 times this year's earnings; that its ecosystem is sticky, with 96% of orders being placed by repeat customers during the third quarter; and that it might be acquired by a larger e-commerce player.

Unfortunately, Vipshop simply won't rally in a market where leaders like Tencent and Alibaba are already struggling. Chinese tech stocks have fallen out of favor due to trade tensions, a depreciating RMB, and concerns about the growth of the country's economy. Therefore, it might be wise to nibble on the market leaders, but it doesn't make sense to invest in fading underdogs like Vipshop.

Leo Sun owns shares of JD.com and Tencent Holdings. The Motley Fool owns shares of and recommends JD.com and Tencent Holdings. The Motley Fool has a disclosure policy.