Chinese Internet stocks seem to be all the rage this year. JD.com (NASDAQ:JD) stock, for example, has risen more than 20% since the company's IPO in May. Let´s look at whether this rapidly growing Chinese e-commerce player is a smart purchase right now, or if it's better to stay away from the company for the time being.
The Amazon of China?
Investors usually try to associate Chinese companies with well-known U.S. players such as Amazon.com (NASDAQ:AMZN) and eBay (NASDAQ:EBAY). Although these comparisons can often be too simplistic, it's fair to say JD.com has a business model that offers some similarities with Amazon.
eBay in the business of matching buyers and sellers of different kinds of products, be it in consumer-to-consumer or business-to-consumer transactions. The company make most of its money in e-commerce via commissions on sales and advertising, which means that costs are relatively low and the business generates big profit margins.
eBay produced a healthy operating margin of 18.2% of revenue during the second quarter of 2014. After the coming separation of its marketplace and PayPal businesses, eBay management estimates the company will generate a segment margin of nearly 35% in its e-commerce operation.
On the other hand, Amazon and JD.com operate mostly as direct retailers, meaning they sell the products directly to customers. This means they need to take care of inventory risk, warehouses, and distribution, among other things. Profit margins tend to be much lower under this business model, and both Amazon and JD.com are losing money at the operating level.
There are important differences between Amazon and JD.com, though. Amazon has consolidated an undisputed leadership position in the U.S., benefiting from tremendous scale advantages in its main market. As the company grows in size, it gains purchasing power with suppliers and spreads its fixed costs over a growing amount of units, decreasing fixed costs per unit. The company becomes better and stronger as it grows.
JD.com, on the other hand, needs to compete against bigger companies with deeper pockets and higher profitability. As JD.com's business model is similar to that of Amazon, this has negative implications on profit margins. In addition, the company does not benefit from the same undisputed market leadership as Amazon.
Growing sales, stagnant profits
JD.com is generating extraordinary growth rates, both when it comes to operational metrics and sales. Gross merchandise value during the second quarter was up 107% from the same quarter of 2013, while active customer accounts nearly doubled from 19.6 million to 38.1 million. The company fulfilled 163.7 million orders in the second quarter, a 126% increase from 72.6 million in the same period of 2013.
This solid operational performance allowed JD.com to generate $4.6 billion in sales during the last quarter, up 64% year over year. Management expects revenue for the third quarter of 2014 to be in the range of RMB28 billion to RMB29 billion, or aproxmately $4.56 to $4.72 billion at current exchange rates,indicating a growth rate of between 55% and 61% from the third quarter in 2013.
While operational metrics and sales are clearly moving in the right direction at remarkable speed, profitability paints a very different picture for investors in JD.com stock. Operating margin declined from a negative 1.3% of revenue in the second quarter last yearto an operating loss of 2.8% of sales during the last quarter.
Cost of revenue represented 89% of sales during the second quarter, down from 91% of revenue in the same period last year. Although it's good to see JD.com generating some small improvement in this area, gross margins are still razor thin, and this does not leave much room for profitability after deducting expenses in areas such as fulfillment and marketing.
JD.com generates a large percentage of sales in the electronics and home appliance product categories, a remarkably competitive businesses with minuscule margins. The company has been expanding into other areas, and the percentage of gross merchandise value coming from general merchandise and other products increased from 34.6% in the second quarter of 2013 to 44.8% in the second quarter of 2014.
Successfully broadening its presence in different categories with higher margins could be a big positive in terms of overall profitability for JD.com. However, that is easier said than done when operating in a challenging and dinamic competitive environment.
JD.com is generating impressive sales growth, but profitability remains scarce. Expanding beyond sales of electronics and home appliances could be the most viable strategy to increase margins, but operational complexities and competitive pressure represent considerable challenges in this area. Until, or unless, JD.com proves that it has what it takes to combine rapid sales growth with increasing profit margins, investing in this stock remains a risky proposition.
Andrés Cardenal owns shares of Amazon.com. The Motley Fool recommends Amazon.com and eBay. The Motley Fool owns shares of Amazon.com and eBay. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.