Short idea – VIP Shop

VIP Shop – Short Thesis

VIP Shop is one of China’s largest online discount retailer. The company sells branded items through “flash sales” on its vip.com website. Flash sales means that a particular product is offered at a discounted price on the website for a limited period of time. The company claims to have 49 million registered users and 12 million buyers and is selling 8700 types of brands. VIP Shop is a legitimate company with seemingly trustworthy accounting and OK presence in China.

The share price has skyrocketed in recent years due to what is perceived as strong underlying growth rates:

Share price

THE SHORT CASE

  1. If you believe in search index volumes and website rankings, the company’s growth has more or less stopped,. Below is the search volume on Baidu for VIP Shop in Chinese (唯品会). The number of Baidu searches for the company name has trended downwards since 2Q14 and continued to decline since then. Google Trends paints a similar story with search volume falling of a cliff in 2H14.

Baidu searches

  1. Part of the reason for the recent decline in popularity of vip.com is bad publicity amid the revelation that much of VIP Shops’ products are in fact counterfeit. From July to November, the government is running a campaign they target online transaction platforms and group-buying websites to seek out and punish companies that enable its customers to buy counterfeit goods. Newspaper stories that VIP Shop’s branded products were counterfeit spread like wildfire on discussion boards. Baidu search queries for “VIP Shop counterfeit goods” increased slowly in 2014 and shot up sharply in August 2014.

Fake goods

Examples of comments on online discussion boards (my translation):

“Even if the products are not fake they are useless. I bought three pairs of clothing, but the stitching and size was off [not symmetric]. I wanted to return but had to pay the transport fee so I couldn’t bother”

“A lot of VIP Shops clothing has its brand name tags glued onto the clothes” [indicates that they are fake]

“Last year I did not notice any fakes, but this year I got 3 fake pieces of clothing from VIP Shop. No way it was 100% cotton… disgusting”

“VIP Shop has fakes. My friend bought a Supor Rice Cooker [a famous Chinese brand] and it broke down after just a few days. I took it to the repair man and found that the insides were completely different from the real version.”

Etc, etc…

  1. VIP Shop has essentially no competitive edge, and industry barriers are few to none. This is reflected in the large number of copycat group-buying or discount retailer websites that has sprung up in recent years. Typical sources of “economic moats” that protect companies from competition such as switching costs, network effects, strong brand etc are not really present:
    • Websites such as online discount retailers offer close to zero switching costs for the customer, and barriers to entry for new entrants is close to zero. The sales channel is not perceived to be attractive for brand owners anyway.
    • Since VIP Shop does not have a strong distribution network and no production by themselves, it is hard to imagine any substantial economies of scale.
    • Unlike Taobao, which offers a platform for merchants to sell their products and thus benefits from a virtuous circle of lower prices and more customers, VIP Shop has no benefits from such network effects.
    • Anecdotes suggest that not many people in China have not heard of VIP Shop. This could be due to the strong presence in lower tier cities rather than larger cities such as Shanghai or Beijing, but regardless stands in contrast to e-commerce giant Groupon for example, which is valued at a much lower market capitalization.

There are also questions marks about the sustainability of the business model, even disregarding competitive forces. High end retailers usually don’t want their products sold through discount channels, so how can VIP Shop ensure large enough supply of genuine products?

In the past, VIP Shop relied on cheap clothing bought from textile firms after the huge inventory peak in 2012. Inventories are still high, but at some point textile firms will have less of a need to sell deeply discounted inventory to flash sales e-commerce sites to improve their balance sheets. (http://www.chinadaily.com.cn/business/2013-11/01/content_17074708.htm)

Products such as handbags are sold on the VIP Shop website, but brands such as Coach have not given their permission for sales of their products. Technically, this suggests either parallel imports (not allowed on the mainland) or fake products. Whatever may be the case, it does not bode well for VIP Shop.

The number of complaints from customers about VIP Shop is much larger than other online e-commerce websites. According to the 2012 survey on online discount retailers, 42% of shoppers at VIP Shop complained about the product.

Complaints

  1. The large amount of competitors that have sprung up testify that barriers to entry in the industry are sparse. Alexa website ranking puts VIP Shop at spot #126 in China and it is dominating in its niche. Flash sales operators like VIP Shop used to take 20-25% commission from vendors (a major source of their profits) but this commission has since dropped to 5% following pressure from Vancl and others.
  1. E-commerce sites in China evade sales taxes by not providing official invoices. This has been raised by shopping mall owners and bricks-and-mortar retailer as an unfair advantage of online retailers and the government considers it a loss of major tax revenue. The government is planning to roll out a nationwide e-invoice system in 2015 that will force online merchants to pay sales tax, which would then lead to higher prices (http://www.marketwatch.com/story/as-alibaba-ipo-looms-china-mulls-taxing-alibaba-users-2014-08-07)
  1. Certain claims by management seem too good to be true, or potentially false.
  • VIP Shop claims that 93% of its shoppers are repeat customers. But how can 93% of its shoppers be repeat customers than almost half of its customer complain about the service and the return rate is 15-20%?
  • Gross margins improved drastically from 9% to well over 20%, but management has failed to provide a good explanation other than “pricing power”. A plausible explanation is that the company increased the share of fake SKUs among total merchandise volume
  • The company claims monthly unique visitors of 25 million, yet data analytics website similarweb.com shows a number of just 4.5 million. This number is also not growing at any considerable pace.
  • VIP Shop has earlier claimed that it has no bricks-and-mortar stores. In an interview with the CEO earlier this year, he confessed however that the company did in fact have offline stores. It seems that VIP Shop regularly uses these offline shops to sell inventory that it cannot get rid of online.
  1. Valuation multiples are ridiculously high. The stock has become the object of speculation and somewhat of a favourite growth stock among institutional investors. For those that still entertain the idea that VIP Shop’s share price has been driven by revenue growth rather than any speculative excess, please look at the EV/Sales chart over the past few years:

Bloomberg

Not only has TTM sales increased at a rapid pace, but the EV/Sales figure has also shot up in a parabolic curve from EV/S of 0.5x to 4.5x currently. If VIP Shop achieves the same EBITDA margin as worldwide Group Buying website Group On has at 6.5%, VIP Shop would trade at 69x EBITDA. The shares are pricing a very long runway of growth.

PB

VIP Shops P/B at 32x is by far the highest of any major listed e-commerce company, and one must wonder: if the business is so easily replicable, why pay 32x book instead of starting a direct competitor at 1x book? It is either the world’s best money machine, or simply an overpriced stock. A telling sign is that VIP Shop’s Enterprise Value is 28 times larger than US competitor Overstock.com and 3 times larger than global group buying giant Groupon. The absolute number of US$12 billion in market cap is a large one indeed. The Chinese population is larger than the US, Groupon’s home market, but then again customer’s purchasing power is much less and the competition in the Chinese e-commerce industry is fierce.

Screen Shot 2014-09-21 at 09.17.45

In the more developed US market, the four largest “flash sales” retailers Zulily, Gilt, Rue La La and Haute Look have combined sales of roughly US$4 billion. Assuming a “reasonable” maturity EV/EBITDA of 10x and EBITDA margin of 6.5%, VIP Shop would have to have a 100% market share in a total market size of US$19 billion at that date. Given that China’s economy is still smaller than the US one, the numbers look implausible.

  1. Insiders are selling: other than a secondary placing in early 2014 of 1.3 million shares from insiders, Sequoia has also gradually been reducing its shareholding.
  1. The VIE structure of foreign listings of Chinese IT companies makes it hard to understand what the contractual rights of ADS unit holders actually are. Technically ADS holders have a right to the profits of the Chinese entity, but it is not yet clear whether Chinese courts would uphold these contracts. It is also unclear how ADS holders will be rewarded as all VIP Shop revenues are domestic and payment of dividend would require both withholding tax and a way to circumvent China’s closed capital account. VIP Shop does not pay any dividend and, judging from other Chinese VIE’s, it may never do so. It is not clear whether ADSs of Chinese VIEs should command premium valuations when both cash flow and voting rights are highly uncertain.

SUMMARY

VIP Shop is a reasonably successful e-commerce website with seemingly trustworthy accounting. Ultimately however it has a flawed business model where the company more or less deceives it customers by selling fake goods. If Baidu search queries is anything to go by, customer numbers have probably peaked already. This has been coupled with a speculative frenzy in the stock, driven by a promotional management, and where the stock has become the market darling among institutional investors. The valuation is now 32x book and close to 5x EV/EBIT, despite being in a low-margin, no barriers-to-entry business. Consensus expects revenues to grow 70%+ per year over the next 3 years with margins being constant. I challenge this view and believe that VIP Shop has already hit its peak due to problems with counterfeit goods, which was probably why the company managed to keep prices low and profitability high in the first place. I expect near-term issues from negative news reports amid a government crackdown on counterfeit goods. Even longer-term, I see few ways to justify its HK$12 billion valuation, even in a wildly bullish scenario of large market growth and additional market share gains.

Sell short at current price of US$209 using funds of 5% of total funds in the portfolio.

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