A High Risk Bet Worth Taking

An Admission of Guilt

I admit, I finally did it. . .

I purchased shares in a Chinese company for the first time. Throwing aside the less-than-sterling track record of some of its U.S.-listed Chinese peers, I took the plunge and now own shares of Baozun (BZUN). 

Was it a mistake? Maybe. Will it be a life-altering 5-, 10-, 20-, or 30-bagger? Maybe. Will it tread water and neither gain nor lose much from my initial purchase? Maybe. Will its owners take it private the first chance they get when U.S. equity markets finally take a tumble? Maybe. Will China’s government regulate the VIE structure used by Chinese tech companies and leave U.S. investors holding the bag? Maybe.

But even owing to all those possibilities, there’s still plenty to like about Chinese brand e-commerce service provider Baozun. So, let’s take a closer look to find out the reasons for today’s guilty admission.

Shopify Clone? Or Cheap Chinese Knockoff?

Perhaps Shopify’s (SHOP) electrifying, levitating stock run from $20 to $111 in the last 20 months has left investors who missed the rally (or who want to join another one) in search of a cheap, Chinese knockoff.

Broadly similar to Shopify, Baozun helps its clients create online stores on Tmall and JD.com (JD), as well as their own independent official brand stores. The comparison is a valid one in general, although Baozun’s strategy is narrower in focus and the company doesn’t offer all of the same services as Shopify. But both are attractive business models with promising future growth prospects.

Among the most striking statistics from a comparison of the two companies include the following:

  • Baozun trades at about one-ninth the market capitalization of Shopify despite being profitable and booking higher annual revenues.
  • BZUN comes at a large price-to-sales discount of approximately 3.1 versus 34.8. The ratios I’ve calculated are based on 2016 revenues, which because of the high growth rate for each overstates them somewhat compared to the trailing twelve months, but gives a good approximation of the spread between the two companies. A premium for Shopify is likely justified due to its higher growth rate, but the current differential is massive.
  • If either company ever grew into a $20 billion market cap, that represents 48% upside for SHOP from its current $13.5 billion market cap, but 12x upside for BZUN from its $1.5 billion market cap. (Of course, it’s possible that one or both companies will never get there.)
  • Is Baozun the Chinese Shopify, or a cheap knockoff?  Review the table and the remainder of the article to decide for yourself. 
1 - SHOP Chart.JPG

The Value Proposition and Quality of Baozun

Before beginning, a shout out is warranted for another Seeking Alpha contributor, From Growth to Value. FGTV is one of a handful contributors I follow closely and his profile of Baozun is what initially brought the company to my attention. The linked article, Potential Multibaggers: Baozun, The Chinese Shopify, is a quality introduction to the company. I’ll cover a few of his points, but also highlight some of my own and go into some additional detail.

In the most basic sense, Baozun provides end-to-end e-commerce solutions for its brand partners, comprising the entire value chain of IT solutions, online store operations, digital marketing, customer service, warehousing, and fulfillment. The company offers its clients customized solutions depending on their specific needs and goals, and assigns them dedicated personnel. Further, the company also partners with leading logistics companies to achieve next-day delivery in 100 cities across China.

Perhaps most importantly is that Baozun helps its clients, mainly notable Western brands, navigate the intricacies of online commerce and digital marketing in China. The firm establishes and maintains social media accounts for its brand partners on Weibo (analogous to American peer Twitter (TWTR)) and WeChat, a powerful and widely-used messaging superapp. Baozun leverages its local expertise to create social media content, engage with consumers, and create positive word of mouth for the brands it serves. Without enlisting the services of a local expert, the task of successfully accomplishing this feat could be a tall challenge for a foreign company, considering the language and cultural barriers of doing business in a region much different than their home country.

An Investor’s Business Daily article provides some more color on this aspect of its business. Brendan Ahern, Chief Executive of KraneShare Advisors, a provider of China-focused ETFs, shared this perspective:

"As a Western brand entering China, you might say, 'We have such a big brand, we want to have our own online store.'  Baozun offers a plug-and-play solution. From click to delivery, they are going to help with that."

The article went on to describe Baozun’s understanding of how mobile has changed the way that Chinese consumers transact commerce, and how that knowledge can help them generate traffic for clients’ online stores through savvy social media presence and related marketing channels. It relates the following:

"At its core, Baozun helps Western brands understand how Chinese consumers shop online and helps them to deliver the features and functionality that those customers expect.  For example, it uses chat-focused customer service as a key brand-building channel in a country where the vast majority of pre-sale inquiries come through chat."

A striking feature of Baozun is the formidable client list it has developed, partnering with key Western brands including Nike (NKE), Starbucks (SBUX), Microsoft (MSFT), Victoria’s Secret (LB), Calvin Klein (PVH), Budweiser (BUD), Philips (PHG), Coach (COH), and many others. The article by From Growth to Value mentioned earlier highlighted a key point:

"The fact that these (and other) Western companies work with Baozun creates confidence. . .  I can’t imagine Nike or any of the others to partner with a company that they haven’t fully researched."

So, if you’re looking to validate whether Baozun offers a high quality and valuable service, you can rest assured in knowing that more than 100 top Western companies have already done much of the footwork for you. This is not to say that Baozun’s success is guaranteed, only to reinforce that it is a respected and highly-regarded force in an emerging industry within e-commerce.

More to that point is that the company has a strong endorsement not just from Western brands, but also the 800-pound gorilla of Chinese e-commerce: Alibaba (BABA). According to Baozun’s most recent annual SEC filing, Alibaba owns 16.5% of total ordinary shares and holds 9.5% of voting power as of March 31, 2017.

Baozun also has two directors related to Alibaba, Satoshi Okada and Qian Wu. And it is the only company that was rated as a six-star brand e-commerce service provider with Alibaba’s Tmall marketplace in both 2015 and 2016. This was the highest ranking awarded to a Tmall service provider, and is based on superior operational capabilities, brand development, and service ratings. These and other factors are key reasons why Baozun has gained an industry-leading 22% market share among brand e-commerce service providers.

And while company culture can be a difficult thing to assess in a foreign company, Chairman and CEO Vincent Wenbin Qiu highlights a significant increase in employee net promoter score and employee referrals in 2016, and cites these as evidence that the company is making progress in its goal of becoming a preferred employer for top talent in China. While the company may have a long way to go to achieve that goal, it’s valuable to know that it exhibits a stakeholder (employee) focus, which is an attribute that tends to manifest in future benefits for customers and shareholders as well.

So, after carefully examining the basic services and results of the company, how does Baozun package these services into a business model that it can effectively monetize to reward shareholders?

Baozun’s Business Model and Strategic Evolution

The first aspect to note from Baozun’s business model is that it seeks quality. As evidenced by the list of premier brand partners, the company is highly selective about the customers it works with, and isn’t one to focus on quantity over quality. Some key attributes it seeks before locking in a partnership, according to its annual report, are:

  • Established brands in profitable industries with growth potential.
  • The amount of projected gross merchandise value (GMV) and related service fees.
  • Projected profitability and proposed partnership duration.

Once it’s selected a brand partner, it delivers its services under one of three distinct business models:

1. Distribution – Under this model, Baozun selects and purchases goods from brand partners to sell directly to consumers. In the past few years the company has been actively moving away from the distribution model to avoid taking ownership of products, reduce inventory risk, and achieve higher-margin service fees.

2. Service Fee Model – Under this model, Baozun provides its full range of e-commerce solutions, including online store operation, digital marketing, and customer service, but doesn’t take possession of inventory.

3. Consignment Model – Under the consignment model, the company offers its full range of e-commerce solutions as with the service fee model, but also provides warehousing and fulfillment services, whereby brand partners stock goods in its warehouses and Baozun delivers them to customers. However, Baozun never takes title to inventory, doesn’t select merchandise, and doesn’t establish prices.

Baozun’s operating margins are superior under the service fee and consignment models, and it should continue to benefit by its gradual strategic shift from the distribution to the non-distribution models. This shift is a meaningful strategic maneuver, and is significant for a couple of key reasons.

First of all, although net revenues under the non-distribution model may be lower as a percentage of total GMV, margins are higher and inventory risk is eliminated. Second, strength of growth in what is gradually becoming Baozun’s core business is concealed by this strategic shift.

As can be seen in the tables below, the total growth rate in 2016 was 30.5%, but the higher-margin services portion of the business grew at 84.5%.

2 - Revenue Analysis.JPG

The trend continued in Q2 2017 with total revenue up 26.9% in RMB, made up of distribution revenues growth of 9.6% and services growing a robust 59.8%. In fact, from 2014 through 2017, services revenue growth has been well in excess of 50% each year.

The transition also presents a margin expansion story with gross margin (which for this purpose I define as total net revenues less cost of products and fulfillment expenses) growing from 10.5% in 2013 to 30.0% through Q2 2017. 

3 - Gross Margin.JPG

Baozun could deliver significantly improved financial results if its Maikefeng marketplace begins to show improvement. Maikefeng was launched in 2014 to improve operational efficiency and help brand partners clear inventory at discounted prices. The segment weighed heavily on net earnings of the company, offsetting much higher operating income generated by the brand e-commerce segment:

4 - Operating Income.JPG

By continuing its shift to an asset-light, service fee model and gaining economies of scale in its Maikefeng marketplace to approach breakeven or better, management is already using multiple levers to improve profitability as it continues its outsized revenue growth in key strategic areas.

So, Baozun has evolved its strategy into a business model that works well, has high margins, and is scalable. Now the question is whether it can create shareholder value by driving future growth to leverage its evolving business model.

Management and Industry Growth Levers

There are four key levers which give Baozun a substantial runway for growth from both a top-down and bottom-up perspective. Two of these levers are directly controlled by management, the others are industry driven. They are:

  1. Chinese e-commerce growth (industry related)
  2. Growing internet penetration in China (industry related)
  3. Growth in number of brand partners (company specific)
  4. Growth in GMV of existing brand partners (company specific)

Let’s take a look at each one of these in sequence:

Growth Lever #1 – Chinese E-Commerce Growth

Chinese e-commerce is experiencing massive industry tailwinds with 40% to 50% and higher growth rates year to date in 2017 for top companies like JD and Alibaba. This is following a year in which Chinese online commerce grew 26% in total to $749 billion in 2016. More of the same is forecasted for the future, with the market expected to reach approximately $1.1 trillion by 2018. And China has embraced e-commerce far more readily than in many other countries, with approximately 10% of GDP spent on e-commerce compared to approximately 2.5% in the U.S.

Growth Lever #2 – Chinese Internet Penetration

The fast growth and large percentage of income spent on e-commerce seems likely to combine with growing internet penetration to keep online commerce booming in the country. In 2016, an estimated 721 million Chinese citizens had internet access, a penetration rate of 52.5% compared to 88.5% in the U.S. As China grows and the internet becomes more widespread, it stands to reason that these forces will sustain the high rate of e-commerce growth.

Growth Lever #3 – Increase in Brand Partners

A growing number of brand partners is another way in which Baozun can continue its momentum. The total has nearly doubled from 71 in 2013 to 140 as of Q2 2017.

5 - Brand Partners.JPG

However, the rate of growth has gradually declined each year–to an annualized ~10% in 2017–meaning that Baozun will need to reaccelerate expansion in this metric or otherwise look to growth in average GMV per brand partner to keep the growth engine revving.

Growth Lever #4 – Brand Partner GMV Growth

Perhaps an even great growth prospect, and one over which management exercises most control, is the average GMV per brand partner. Since the service model typically includes variable fees based on volume of merchandise sold, growing GMV will drive higher revenues. In 2016, despite only 30.5% revenue growth, GMV increased approximately 67%, and management aims for greater than 50% growth again in 2017.

In summary, Baozun is a high-quality service provider with lots of growth potential. But there are some red flags and possible future risks which prospective shareholders should consider before making an investment decision, and before determining an appropriate size for the position.

Backbreaking Volatility

One of the first considerations is historical volatility. If you’re looking for a sleep well at night stock, BZUN may not be the one for you. Since May 1, 2017, the stock has had 22 single day movements in excess of 5%, either up or down. That makes up 25% of the total trading days during that timeframe. The stretch includes 15 days of 5% gains or greater and 7 days of 5% losses or greater. The largest one-day gain has been 14.7% on May 16th, and the largest one-day loss has been -24.2% on August 22nd.

In addition, there have been 34 days of 3% or larger movements, 39% of the total. And with growing tensions in the Korean Peninsula and threats from President Trump regarding military action against North Korea and a possible suspension of all trade with China, it’s fair to expect this kind of volatility to continue in the foreseeable future. That could cause Baozun stock to become meaningfully cheaper in the near future, depending on the market's reaction to recent events. The tables below document the volatility from May 1, 2017 through September 1, 2017.

6 - BZUN Volatility.JPG

Other Risks to Consider

The risks to an investment in Baozun are many. Here are a few key ones to consider.

The company is subject to substantial revenue concentration. Its top ten brand partners accounted for 74% of its revenue in 2016. A loss of one or more of these key clients could set the company’s growth trajectory back by a year (or more), not to mention any possible damage that could result to the company’s image if its brand portfolio weakens.

Another consideration is that foreign ownership of Chinese technology firms is restricted. To raise funding on foreign capital markets, Chinese tech companies create VIEs to circumvent Chinese law. According to a 2012 Forbes article, the Chinese government is aware of the practice but is considered to be unlikely to take restrictive action against existing companies with this structure due to massive foreign financial interests in them. This is a common practice for all similar Chinese firms, and one that has been in place and well known for years. For instance, Baidu (BIDU), Alibaba, Tencent (TCEHY), and others are subject to the same risk.

Also, Chinese companies in general have not developed a reputation for a strong shareholder orientation. As an example, in an earlier Seeking Alpha article, contributor Oneil Trader, who identified this opportunity long before the stock broke out, pointed out several instances where Chinese managements have taken their companies private well below their offering prices during periods of temporary market weakness, then relisted the shares in China. In a separate and different example, Morningstar points out how Alibaba transferred ownership of Alipay to a new company controlled by its CEO Jack Ma, without approval of major shareholders Yahoo (AABA) and Softbank. (It should be noted that a settlement was later reached with these shareholders and that this occurred before Alibaba was publicly traded in the U.S.)

Some also suggest there is a risk that JD or Alibaba could introduce a similar service to compete with Baozun, but a counter-argument is that the market size is small enough that it isn’t worth the time of these two e-commerce titans. Instead, Alibaba and JD will benefit by partnering with Baozun which, if successful, will benefit its larger partners by growing the transaction volume and GMV of Western brands on their marketplaces. And Baozun is an expert at what it does, as rated by Alibaba, so it’s uncertain whether the company could even approach the same capability if it were to enter this market. This means that Alibaba and JD would have more to gain by letting Baozun do what it does best, and partnering with it rather than competing against it.

Another potential risk to current shareholders is future dilution which could offset some of the earnings growth the company expects to achieve. And lastly, there is the ever-present geopolitical risk with U.S.-North Korea tensions, and China in the middle. Each individual can make what they will of this situation and how it might impact an investment in Chinese e-commerce.

Portfolio Allocation

In summary, Baozun is a promising enterprise with immense growth potential but complemented by equally pervasive risks. The attractive feature of the stock is the opportunity to own shares of a very small but fast-growing company and the possibility to participate in a long period of robust growth and share gains leading to investment returns equaling multiples of the original investment value, should things develop as hoped.

Obviously, the maximum loss is 100%, which is a risk worth taking, but not one to which I’m personally comfortable devoting a sizable position. Instead, my holding of Baozun occupies a place in my Action Portfolio, which is a system of side bets comprised of stocks with high potential but also higher risks and for which my conviction is not as great as my prime investments.

If the stock does exceptionally well, it will power large gains relative to the size of my investment. If it does poorly, my maximum loss is capped and won’t do significant damage to my overall portfolio. The ratio of potential payoff to potential loss, in my view, could be as high as 5:1 or 10:1 under the most optimistic scenario, which makes BZUN a high-risk bet worth taking in my opinion. That’s the strategy I’m adopting with BZUN stock, and that’s the approach that I feel the circumstances merit.

In the comments section below, I’ll look forward to seeing your opinion about the company, details of your own approach to investing in the stock, suggestions of other growth stocks worth researching, or any other valuable feedback or analysis you wish to add. Good luck and, as always: Be Virtuous!

Disclosure: Jason Rowland owns shares of BZUN and all stocks in both The Prime Portfolio and The Action Portfolio.

Disclaimer: I am not a registered investment advisor. I receive no compensation from any of the companies of which I own shares and of which I write about. The strategies discussed are designed to suit my own investment objectives, not those of any other individual. They are for illustrative and educational purposes, and they are not guaranteed to be effective. It is possible that not all material information will be discussed about each security highlighted on the site.

All investments involve risks. All information on The Virtuous Cycle website is general analysis and my own interpretations of available information. It is neither financial nor investment advice, nor is it a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals must do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making their own investment decisions.