VIE structure listed in New York

Recently listed ZTO Express is a parcel company that provides door-to-door delivery of goods purchased online in Mainland China. The NYSE listco is a Cayman Island incorporated holding company that provides economic access to (but not legal ownership of) the main operating businesses in China via a consolidated variable interest entity (VIE). These VIE structures bear their own risks but that is not where our main concerns lie…

Unusually profitable

Parcel delivery volumes have soared in Mainland China, rising at an average rate of 77% in 2008-15, benefitting from the rapid growth in online sales. However, this is an extremely competitive business. Delivery rates are about one-tenth the levels in Europe and the US. Such intense pricing pressure is partly explained by the fragmented market, with the top five operators having a combined share of just 60%. Furthermore, Alibaba is, in effect, each operator’s largest customer. Sales on its various platforms account for about three-quarters of ZTO’s volumes, and Alibaba is able to direct vendors to a preferred parcel delivery company. Despite operating in such a tough environment, with little pricing power, ZTO is unusually profitable. Its 2016 operating profit margin was 28%, around double that of the major international operators, such as Fedex, UPS and DP-DHL. In addition, its return on production assets, which includes fixed assets, land and inventory, of 70% is extraordinarily high. So, what explains this world-beating performance?

Low-cost claims don’t stack-up…

One possible explanation for ZTO’s supernormal returns is that it operates an extremely low-cost model with high levels of automation. Moreover, as one of the largest express companies in China, it enjoys significant economies of scale. However, on closer examination, these claims don’t seem to stack up. The top four operators all have similar market shares; all operate broadly the same model and there is plenty of evidence that peers are also automated. Yet, ZTO’s margins and returns are significantly higher.

…instead, returns probably engineered to maximise IPO pricing

A more likely explanation is that this is another highly engineered Chinese IPO. ZTO has no track record, having been cobbled together over the last 3 years using acquisition accounting. Huge chunks of the business are off-balance sheet. Network-wide parcel pick-up and delivery is largely performed by 9,100 separately owned “network partners”. ZTO only performs sorting and linehaul transport, although a third of its long-haul trucks are in an unconsolidated related party company (Tonglu Tongze), majority owned by management. The relationships between ZTO Express, Tonglu Tongze and its network partners are unclear, which suggests profits may have been temporarily concentrated in the listed entity to help with the IPO. ZTO has also been cutting corners. Its IPO prospectus reveals a worrying list of regulatory short-comings, such as lack of appropriate permits, falsifying staff numbers to procure licences, land title defects, failure to comply with labour laws and internal control breaches. Hardly the stuff of a world-class business.

4Q16 miss shows story starting to unravel

Indeed, the recent 4Q16 result suggest ZTO’s story is already starting to unravel. The company missed the consensus profit forecast by 4% when we would have expected it to beat consensus so close to the IPO. Furthermore, margins appear to have been supported by unusually high profits from accessory sales (which tripled y-o-y) and unusually low levels of underlying SG&A expenses. Meanwhile, operating cash flow remained flat despite a 58% y-o-y rise in adjusted EBITDA, and the company failed to generate any free cash inflows due to a sharp pick-up in capex.

Lower growth and higher costs forecast

It’s unlikely to get any better. Revenue guidance was tepid with management expecting a rapid deceleration of revenue growth in 1Q17, far below consensus forecasts for the whole of 2017. Furthermore, capex guidance has jumped; management now expect spending of RMB4.5bn in 2017, almost double consensus forecast of RMB2.4bn. This is a problem. Management had led the market to expect inflated returns from ZTO Express and its inability to deliver even the first set of results calls into question over-optimistic consensus forecasts for 2017 and 2018.