JD.com (JD -1.15%), the largest direct retailer in China, lost more than 20% of its stock value this year as regulatory headwinds rattled Chinese tech stocks. However, JD still fared much better than its chief e-commerce competitors Alibaba (BABA -1.16%) and Pinduoduo (PDD -0.71%), which shed roughly 50% and 70% of their market values, respectively, this year.
JD was considered a safer bet on China's e-commerce market because it wasn't hit by a lengthy antitrust probe like Alibaba. It also didn't commit to spend all of its near-term profits on China's government-mandated "common prosperity" measures, as Pinduoduo pledged to do earlier this year.
Unfortunately, owning the best house in a bad neighborhood still couldn't shield JD's stock from the broader sell-off in China's tech sector. In addition, if we take a closer look at JD's business, it's easy to spot three bright red flags that might keep its stock in the penalty box next year.
1. Tencent's big divestment
Tencent (TCEHY -2.06%) has been JD's biggest investor since its IPO seven years ago. It still held a 17% stake in the company earlier this year.
Tencent integrates JD's online store into WeChat (also known as Weixin), which served 1.26 billion monthly active users in its latest quarter. WeChat is China's largest mobile messaging and Mini Programs platform for e-commerce services, deliveries, games, payments, and other services. Four years ago, JD and Tencent also co-invested in Vipshop (VIPS -0.91%) to integrate the smaller e-commerce company's flash sales into their own platforms.
Tencent and JD both view Alibaba as a common competitor. Tencent competes against Alibaba in the fintech, cloud platform, media, and gaming markets, while JD is Alibaba's largest rival in the e-commerce market. Therefore, pooling their resources together has been a mutually beneficial strategy.
But on Dec. 23, Tencent announced it would reduce its stake in JD to about 2.3% by distributing most of its shares to its own investors via a $16.4 billion dividend. Tencent's executive director and president Martin Lau will also leave JD's board. Tencent and JD will remain strategic partners, but this big divestment -- which was likely done to appease China's antitrust regulators -- will likely weaken the bonds between JD and its most important ally.
2. JD isn't immune to regulatory headwinds
JD hasn't been slammed by a massive antitrust probe yet, but it's been hit by a series of smaller fines over the past year. China's State Administration of Market Regulation (SAMR) has already fined JD numerous times in response to its "irregular" pricing strategies, "false" advertisements, and other undisclosed violations of antitrust laws.
Last month, JD, Alibaba, Baidu (BIDU -1.88%), and dozens of other companies were fined for previously unreported deals. The individual fines were small, at just 500,000 yuan ($78,497) each, but they indicate the SAMR will closely scrutinize all of JD's future investments and acquisitions.
But that's only half of the problem. In the U.S., the Securities and Exchange Commission (SEC) plans to delist shares of foreign companies that don't comply with tighter auditing standards for three consecutive years. Regulators in China and the U.S. are also scrutinizing the variable interest entity (VIE) structure, which enabled Chinese tech companies like JD to go public in the U.S. through holding companies in the Cayman Islands.
If JD refuses to comply with the new auditing standards or the VIE structure gets banned, its U.S. investors might need to trade their ADR shares for its Hong Kong-listed shares. All that regulatory pressure could limit JD's gains.
3. The "common prosperity" pressure could squeeze its margins
Earlier this year, China launched a "common prosperity" drive, which pressured companies to fund government-backed initiatives and redistribute their wealth.
Alibaba pledged to spend 100 billion yuan ($15.7 billion) on those causes over the next five years. Pinduoduo is allocating all of its quarterly profits toward a 10 billion yuan ($1.6 billion) goal of upgrading agricultural systems for lower-income and rural areas, which needs to be fulfilled before it uses any of its profits to expand its core business.
JD didn't set any concrete commitments like Alibaba and Pinduoduo, but it recently expanded its benefits for its drivers and established a trade union for all of its employees. These decisions could benefit its workers and prevent JD from being targeted by government regulators, but they'll also likely squeeze JD Retail's low-single-digit percentage operating margins.
These red flags will keep investors away
Analysts expect JD's revenue to rise 29% this year, which seems like a solid growth rate for a stock that trades at less than one times this year's sales. However, they also expect its higher investments and regulatory headwinds to reduce its net income by 2% this year -- which is a tepid growth rate for a stock that trades at 36 times forward earnings.
JD's earnings growth might stabilize next year, but the unpredictable headwinds will likely prevent investors from paying a premium for the stock. Therefore, I expect JD's stock to remain under a lot of pressure in 2022.