On 27 Oct 2016, ZTO Express, a Fedex equivalent of China, held the biggest IPO of 2016 in the US so far, raising $1.4 billion at $14bn valuation. Its stock, however, fell from $19.5 to $16.6 on its first trading day, a decline of 15%. It has subsequetly fallen another 13% to $14.48 as of 14 Nov 2016. An investor might wonder: could the stock have fallen enough to make it an attractive investment opportunity? Or is it still an overvalued company?
While the company has some impressive numbers, there aren’t much information available about the company to an average investor, as with most IPOs. To help people think about whether they should invest in the stock, we have weaved through its prospectus and have come up with four questions that any investor should figure out before making a decision.
ZTO Express operates in an extremely competitive market. Unlike in the US where top 2 players control 70-80% of the market share, the Chinese market is split among 6 main players who control less than 70% of the market. As parcel delivery is a relatively commodity service, these companies cannot differentiate on many factors besides pricing.
Such dynamic has put a constant pressure on their pricing power. For instance, see this section from ZTO’s filing:
“We operate in a highly competitive and fragmented industry. We compete primarily with leading domestic express delivery companies including SF Express, STO Express, YTO Express, Yunda Express as well as EMS. We compete with them based on a number of factors... In particular, we have historically experienced declines in the delivery service market prices and may face downward pricing pressure again."
In 2015, their revenue per parcel delivered decline by -4% from RMB2.15 to RMB2.07. Even during the first 6 months of 2016, there were a number of acquisitions that obfuscates the underlying fundamental trend. For example, ZTO’s average pricing might have gone up just because they acquired another company with higher average price even while both ZTO and the acquired company suffers declining price. While the financials reveal a 6% increase in revenue per parcel during this time period, some analysts are suspecting that actual pricing may have declined.
This would be a key concept to understand before investing in ZTO’s stock. Will pricing stabilize or will it continue to decline? Given the intense competition in the market, it seems likely that it will continue its downward trend. It would be crucial to understand how quickly and to what extent it could decline. Some sell-side analysts seem to be forecasting a decline of average price from RMB2.14 in 2016 to RMB2.06 by 2018.
|Sell-Side Est (in RMB mn unless otherwise indicated)||2014||2015||2016E||2017E||2018E|
|ASP per Parcel (RMB)||2.15||2.07||2.14||2.1||2.06|
Cost Control & Gross Margin
Second most important to understand is how quickly ZTO can reduce its costs to protect its gross margin. Even with decreasing average price, ZTO could grow profit if its costs can decrease faster than revenue per parcel. See below excerpt from ZTO’s prospectus:
“If we and our network partners cannot effectively control our costs to remain competitive, our market share and revenue may decline. Additionally, if we have to subsidize our network partners to increase our network partners' competitiveness, our gross margin may decline.”
ZTO is already spending only RMB1.4-1.5 per parcel that they deliver. How much could they decrease this figure through automation? How will the different rates of change in price and cost influence the profitability of ZTO Express?
|Sell-Sides Est (IN RMB mn unlies otherwise indicated)||2014||2015||2016E||2017E||2018E|
|Cost per Parcel (RMB)||1.53||1.36||1.41||1.33||1.28|
|Cost of Revenue||2,771||4,010||6,350||8,743||11,063|
Influence of E-Commerce Companies
ZTO Express is right in the middle of an e-commerce battle that’s going on in China. JD.com, an online retailer that owns and operates its own delivery network including warehouses and, first & last mile delivery, has been waging war against the e-commerce giant Alibaba. It’s somewhat like Amazon vs Ebay in the US, but with very crucial differences. While Amazon is the big player in the US, Alibaba is still multiple times bigger than JD. ZTO Express work very closely with Alibaba, and Alibaba accounts for 75% of ZTO’s business by volume.
Given this unique situation, an investor should have a good idea of 1) how JD.com’s business will impact ZTO Express’s operation and 2) how Alibaba may or may not help ZTO fend off JD’s attacks. Let’s delve into each one by one.
On one hand, ZTO has a large scale advantage against JD. Just in first 6 months of 2016, ZTO delivered 1.9 billion packages. In comparison, JD “only” delivered 716 million orders during the same time period. Such a difference in scale could mean that ZTO’s delivery service can be offered to users at much lower price than JD’s.
On the other hand, however, ZTO makes a 34% gross margin on its deliveries and handles only the long-haul transportation. Crucial parts of picking up orders from merchants & delivering them to customers (known as first & last mile) are outsourced to local partners, who also have to make their own margins. In contrast, JD handles all of this in-house, with less middlemen to inflate the overall cost associated with getting a package to the end buyer. Because JD handles the difficult first and last mile, it costs JD RMB13 to deliver a package on average while ZTO charges only about RMB2 per delivery. What would be important to measure, then, is what it costs to deliver a package throughout ZTO's entire value chain including its outsourced partners. If JD indeed has a much more efficient delivery network than ZTO’s despite the scale disadvantage, it could be a tremendous concern for ZTO’s future.
|Cost per Delivery||Description|
|ZTO||RMB2||Long-Haul Only. Cost of Local Partners?|
|JD||RMB13||First Mile, Long-Haul, Last Mile|
Furthermore, Alibaba's interests should be well understood. Because it accounts for 75% of ZTO's business, Alibaba practically can control ZTO's destiny. Alibaba wants to provide best customer experience at lowest price possible to its online shoppers, which means lower delivery prices and higher customer service. An investor should understand that such a factor could negatively influence ZTO's long term profits.
Valuation & Margin of Safety
Last but not least, an interested investor should enquire if he is comfortable with the risk he’s taking by buying the stock given its valuation. Currently, ZTO Express is valued at around $12bn with 24x 2017 PE multiple based on sell-side estimates. Although ZTO has grown its business quickly over time, such a price is not an obvious signal for cheapness. Given what you know about the company (hopefully taking into account issues we raised above), does such a price provide a deep enough discount to the stock’s fair value? What are some other companies that are trading at similar multiples, and are they more or less attractive than ZTO? An investor should build a comfortable level of confidence that the stock is trading at a substantial enough bargain before investing in it.