realalphaworks

[realalphaworks]

Leju Holdings: trending to the upside after reached the tipping point

Leju Holdings (NYSE: LEJU) is having a terrific start in 2020.

On the 7th and 8th of January, the stock of Leju, a leading e-commerce and online media platform for real estate and home furnishing industries in China, rose sharply for two consecutive days reaching a new 52 week high with a cumulative increase of 27.59%. Leju’s transaction volume also increased significantly reaching a new record high.

In contrast to the recent strength of the stock price, buying interest in Leju has been low. Leju's revenue began to decline significantly in the fourth quarter of 2016 and continued to do so into 2017 due to the effect of the home sales price limit set by the Chinese government at the end of 2016. Leju suffered substantial loss during that period and this suppressed Leju's stock price for a long period of time.

Why did the market sentiment suddenly turn?  Not only is the share price of Leju rising but the stock price of peers like Fang Holdings (NYSE:SFUN) and Fangdd Network Group (NASDAQ:DUO) are also showing signs of recovery. Does this mean that the industry's turning point has come?

Let’s first have a close look at changes in Leju’s investment thesis.

Hit hard by the home sales price limit

Sun Tzu said, “He who has a thorough knowledge of himself and the enemy is bound to win in battles.”

To find out why major institutions are now optimistic about Leju, the first step is to review the changes in Leju's revenue in recent years.

We compiled all the financial reports of Leju since 2014 and found that Leju's quarterly revenue dropped abruptly in the fourth quarter 2016, a year-on-year decrease of nearly 40%.  Leju's revenue did not pick back up throughout 2017 and 2018.

The 40% plummet is attributed to the launch of a price limit in the housing market in key cities across the country.

On 30th September 2016, Beijing took the lead in proposing new regulations enforcing land price controls and housing price limits. This was called the "930 New Deal". The "930 New Deal" was just the beginning of a national property market adjustment as more cities began to tighten the real estate market.

During that time, Leju’s business model was comprised of three parts, e-commerce, online advertising and online second-hand property listings.

The e-commerce business connects home buyers and developers with discount vouchers offering home buyers discounts and helping developers to promote their offerings; the more traditional  advertising business assists developers to carry out brand and project promotions; the second-hand property online listing business is built based on a platform that provides listing services for second-hand housing agents.

The e-commerce business accounted for the bulk of Leju’s revenue amounting to 70% - 80 % of total revenue. This business involves selling discount coupons to home buyers, where a RMB20,000 coupon can have a value of RMB50,000 when making a home purchase.

The voucher business allows customers to enjoy a good discount while providing developers with promotional help, customer lock-in, and market testing without making any cash payments thereby having minimal impact on the developers' financial statements.

Following the sudden change in real estate policy, the government started to restrict marketing activities of developers and imposed a price ceiling for new homes.

When the government released new building sales regulations, it directly capped the maximum price of the building to 80% -85% of the normal market price and this made it difficult for developers to give discounts. Their willingness to promote through discounting was thereby greatly reduced.

As Leju's e-commerce model was based on discounts, their e-commerce business therefore encountered a major setback and sales plummeted 45% year-on-year in the fourth quarter of 2016. Leju still needed to keep its team in place as a necessary expenses of the e-commerce business and this resulted in a huge loss in that quarter.

In summary, the plunge in Leju’s performance was due to the major external factor of the sudden change in China's housing market policy.

Transition in strategy

Leju had worked hard to recover from this setback throughout 2017 and 2018, and started implementing reforms in response to the tightening trend of the housing market.

In 2017, Leju launched its "1 + 1 + 7" strategy. The first "1" represents the “91” Leju membership service and discount platforms; the second "1" represents Leju’s e-commerce platform; and the "7" represents the seven marketing products based on big data, including Leju Smart Marketing, Leju Smart ad placement, Leju Search, Leju Brand Express, Leju Toutiaobao, Leju V Public, and Leju Live.

Leju launched a new real estate financial media platform, Leju Finance, at the end of 2017 providing brand promotion services for real estate companies. Leju Finance intended to open up the entire real estate space with innovative methods and users could find both of tenants and houses through Leju Finance.

In 2018, Leju launched a key account department that used annual contracts to deeply bind relationships with real estate companies.

In 2019, Leju achieved annual agreements with more than 80 developers, of which more than two-thirds are in the top 100 developers in China, and more than one-third of which are exclusive agreements. Leju's e-commerce business currently covers more than 200 cities across the country.

Leju further upgraded its strategy in 2019 to apply the three strategies in four areas. The four areas included new houses, second-hand rental houses, home furnishings, and property communities. The three strategies were new media, new advertising and new transactions.

In 2020, Leju's strategy will be upgrading once more to the "Smart 2020 - Industrial Interconnection and Technology". Focusing on the three major aspects of the real estate industry, i.e. media, advertising and transactions, Leju's chief executive officer, Geoffrey He with another three executives launched the Star Map, Nebula and Spark plans, the “Three Stars Plan” to supplement the “Smart 2020” Strategy.

For the Three Stars Plan, Leju hopes to maximize the value of content by using digital technology, to refine operations around the user decision-making cycle for house purchases, and to build a new ecosystem for digital real estate connected transactions.

Leju’s development strategy can be summed up as "Develop according to the routine, but not stick to the routine". “Develop according to the routine” is overweighting the weak cyclical advertising and media businesses thereby enhancing Leju’s brand influence in the industry and steadily increasing revenue for the company. “Not stick to the routine” is to implement using annual contracts to bind relationships with the real estate companies.

In the field of the new housing market, Leju's new transaction e-commerce business has a monopoly position in the market. Leju has played a very important role as a bridge between developers and potential buyers by providing a transparent and standardized platform for the two parties.

On one hand, it meets the marketing demand of developers and helps developers lock-in customers in advance; on the other hand, it provides buyers with a convenient home purchase experience.

From the perspective of the size of the market, the current market situation is very suitable for the development of Leju's e-commerce business model where more and more developers choose to cooperate with Leju to destock.

The e-commerce market is growing increasingly larger. As an absolute leader in the field, Leju will benefit the most from the e-commerce trend.

At the same time, in the process of constructing the new media strategy, Leju Finance and the new media operation for the to-business are pioneers in the real estate industry. In the field of real estate media, Leju Finance, established on December 12, 2017, is a leading financial information platform for China's real estate industry, covering real estate, home furnishings, real estate and commercial sectors. It provides real estate industry information and analysis with speed, angle, and depth , and is dedicated to being a discoverer, communicator and connector of a better life.

Leju Finance also provides assistance and premium value for the development of online advertising business. Platform-based media operations can achieve multi-channel media coverage (MCN). Through the creation, operation, and distribution of content, Leju helps developers use multimedia platform resources with effectiveness and efficiency. Not only does it reduce customer acquisition costs and improve the profitability of advertising but it also enhances the user conversion rate.

Leju’s digital transformation process, the cloud-eye and vision systems that are the result of many years of research and development, broadens Leju’s advertising strategy development prospects. Covering the target user group via new media multi-channels can provide developers with accurate tags for the user group, enabling developers to increase brand influence and transaction conversion rates. In addition, Leju has a powerful member database that attracts business customers. Leju has also conducted in-depth research and analysis on 2C users. There are reasons to believe that connecting 2C users will further help Leju's future development.

Reached the tipping point

The performance of Leju is gradually improving with its continuously upgrading business strategy.

From the huge loss in 2017 and small profit in 2018, the company finally achieved profitability in the first three quarters of 2019. Leju had a record loss of $105 million in 2017 and achieved a profit of $360,000 in 2018 as a result of the company's strategic change.

The company's main business has quarterly cycles. The first quarter of each year is generally the off-season, accounting for 15% to 20% of total annual revenue, and usually has a loss. The first quarter is therefore also the weakest quarter in Leju's financial performance. The cyclical effects on the second, third and fourth quarters are not significant with performance being significantly better than the first quarter. Second and third quarters were good and the fourth quarter is expected to be even better. Leju managed a turnaround in the first half of 2019 with an adjusted net profit attributable to shareholders of $1.76 million. In the third quarter, the profit trend continued with an adjusted net profit attributable to shareholders amounting to $15.89 million in the first three quarters. Keeping this rate of growth, we expect Leju's net profit will gradually return to the level before the regulation change at the end of 2016.

Leju got rid of its losses in the first nine months of 2019 particularly in respect to the latest third quarter where Leju's total revenue reached $185 million, of which e-commerce business revenue was $153 million, which represents a new revenue record for Leju's e-commerce business.

Although investors know that Leju's core business is related to the sale of new homes, there are not many people who have a deep understanding of this business. Most investors believe that the new home e-commerce business is positively related to the prosperity of the property market.

But this is not the case. If the property market is hot, then developers may not need to carry out marketing promotions. If the property market is depressed, developer's willingness to promote may not be strong. The best time for Leju’s e-commerce business is precisely when it’s unclear which direction the real estate market is going.

At the moment, the national real estate market price limit has been loosened. Property market sales are showing an uptrend in many second- and third-tier cities. Such a balanced market further amplifies the role of Leju's e-commerce business, and the willingness of real estate companies to cooperate with Leju has been further strengthened. Leju's e-commerce business has therefore reached a record high.

Not long ago, Ding Zuyu, CEO of E-House, released a forecast of China's property market in the next ten years. He believes that under the policy environment of "no housing speculation," the investment aspect of real estates will gradually weaken and the consumption aspect will increase in the next ten years. Housing enterprises will undergo an all-round upgrade in the face of an industry reshuffle. In the next ten years, real estate enterprises will still depend on financing capabilities. With limited profits in the market, it is even more important to control costs rather than expand financing capabilities.

Leading real estate companies such as Sunac China, China Evergrande and Country Garden have recently been vigorously seeking financing in capital markets, indicating that a real estate company financing arm race has begun. With the tightening of the overall financing of housing enterprises, the ability to sell houses quickly becomes a key indicator. As a transparent platform to promote the sales of new homes, Leju will obviously play an increasingly important role.

Leju’s share price is undervalued

Leju is one of the first real estate O2O platforms to go public in the United States, but it has been undervalued. From being suppressed by Fang Holdings (formerly SouFun.com) in 2014, and now being counterattacked by Fangdd Network Group, Leju has always been compared with the market and the wrong competitors, while Leju's advantage in the new house market has always been ignored by investors.

In 2014, Fang Holdings, which was in the limelight at that time, became one of the “The Best Stocks of China in 2014” by virtue of its monopoly position in the second-hand housing market and the listing income contributed by a large number of real estate agencies. The investor's investment logic at that time was based on the fact that second-hand transactions could be carried out frequently, while Leju, which was mainly engaged in new home transactions, was considered to have a lower prospects than that of real estate.

The market did not expect that real estate agencies would attack the platform model of Fang Holdings. After the real estate agencies built their own trading platforms, Fang Holdings' second-hand housing platform business lost the most.

After its main business was hit hard by the real estate agencies, Fang Holdings started to bet on its own real estate brokerage business. Fang Holdings strength has always been running platforms rather than being in the brokerage business and this move resulted in heavy losses.

The market currently gives them a similar valuation. However, based on other indicators, Leju's P/B ratio is 1.26 times and Fang Holdings’ P/B ratio is 0.52 times. It seems that Fang Holdings is undervalued, but this is mainly due to the fluctuation of Fang Holdings’ strategy. Leju adheres to the asset-light strategy.

On the asset side, Leju has almost no debt pressure on its books. In its third quarter financial report, the highest proportion of current liabilities is income tax payable, which means that Leju's assets are safer and can withstand extreme surroundings.

In terms of price to sales ratio, as of 16th January, Leju's TTM price to sales ratio is only 0.52 times, while Fang Holdings’ is as high as 1.25 times. Based on P/S valuation, Leju is more than 50% lower valued than Fang Holdings.

In fact, the investment logic of Fang Holdings’ main business is broken. As the business model transformation failed, it is normal for the stock price to plummet. However, Leju’s share price also took a hit due to investor bias, but Leju only has a small portion of the second-hand housing business.

This prejudice still exists. As a newly-listed real estate marketing company, Fangdd Network Group has a revenue of 948 million yuan in the latest quarter, which is not as good as Leju's revenue of approximately 1.273 billion, but its market value is three times of Leju’s.

At present, the overall valuation of Leju is relatively low, implying that it has a strong valuation advantage. During the period when the company's valuation was suppressed, the management of Leju showed strong resilience and continued to iterate the business of the enterprise in order to seek performance that could reduce the negative effects of the housing policy.

Leju's performance continuously improved in 2019 with the demand for Leju’s e-commerce business, its most important business segment, significantly expanding. The Chinese real estate market will be in an equilibrium state for a long time in the future, and this is the most suitable market for Leju's main business. In fact, the market has gradually corrected their perception towards the investment logic of Leju. Of course, the change of the overall logic is a slow process and will not happen overnight.

We believe that the significant increase in the transaction volume of Leju is a sign that some of the smart funds have already captured Leju's changing investment thesis in advance. The logic of these investors is simple. They don't even need to bet on the uncertainty of the future. They just need to wait for Leju's stock return to value to make a profit.

[realalphaworks]

360 Finance’s “capital light” model skyrocketed 10 times and the new trends in the fintech industry

On August 23, 360 Finance (NASDAQ: QFIN) released its unaudited second quarter 2019 earnings report.

In addition to doubled revenue and net income, the number that really caught my eyes is the loan generated by 360 Finance’s financial technology service segment, the so-called capital light model, which surged 10 times quarter on quarter. This indicates that China's financial technology industry, or fintech, has entered a period of rapid growth.

Coincidentally, on August 22, the People’s Bank of China (PBOC) released a heavyweight plan, the “Fintech Development Plan (2019-2021)”, which outlines the priorities and development targets for the fintech sector. It is the first time that China formally makes clear the role of the fintech industry as technology service provider, rather than a financial service provider.

With the enhanced technological capacity of fintech companies, the prominent value of their platforms, together with the supportive policy from the central bank, it creates a new opportunity for the accelerated development of the Chinese fintech sector. Meanwhile, there is a realistic problem for investors: how should we value fintech companies in this emerging industry?

I will discuss the valuation of 360 Finance as an example.

01

The new trends in the fintech industry from 360 Finance’s quarterly report

The second quarter earnings show that 360 Finance realized revenue of 2.227 billion RMB during the quarter, an increase of 128% from 979 million RMB from the same period last year. Non-GAAP net profit was 692 million yuan, an increase of 114% from 324 million year over year.

Behind the rapid growth of revenue is the growing loan origination volume.

Loan origination volume was RMB48,378 million during the quarter, an increase of 127% from RMB21,277 million in the same period of 2018.

When it comes to the factors behind the rapid growth of 360 Finance, we find that there are three that matter: first, it is the transition of 360 Finance to a capital light model; second, it is the efficiency improvement brought by AI-powered precision marketing; and third, it is the market leading risk management.

[1] Transition of income structure to a capital light model

In the second quarter, 360 financial technology service’s, the capital light model, contribution to transaction volume increased significantly, with a single quarter transaction amounting to 3.8 billion RMB, accounting to 8% of all loan generated, and astonishingly, an increase of more than 10 times over the previous quarter.

According to 360 Finance’s IPO prospectus, the financial technology service is a service whereby 360 Finance provide technology support and expertise to funding partners for a fixed or floating fee based on loan origination volumes, without retaining credit risk exposure associated with the loans.

In fact, apart from 360 Finance, other Chinese fintech companies also showed their increased emphasis on their technology service segment growth.

For example, JD Finance achieved full-year profit in 2018, and their income structure has also changed where the portion of technology services revenue to total revenue tripled in 2018 year over year.

These examples have proved the effectiveness and high growth potential of the technology service model, and also in line with the new plan of the fintech industry issued by PBOC as mentioned above.

Technology service is the next growth hub for 360 finance. It is expected that the company's share of technology services revenue will gradually increase in the future.

360 Finance have made significant progress in enhancing technology and research capabilities this year as well as data mining and risk modelling. Technology-oriented employees now accounted for approximately 48% of total workforce which reflects just how critical the cutting-edge technologies are to our business. As of June 30, 2019, 360 Finance submitted 139 patent applications for proprietary financial technologies.

Also, in the second quarter of 2019, the number of 360 Finance’s institutional financial partners increased to 60 from 30 in the last quarter. Among the total amount of borrowing business, the financial institutions accounted for 85% of the total amount of funds, which was significantly higher than 79% in the first quarter. It is second to none among listed financial technology companies.

[2] Precision marketing solves pain points in traditional finance

We can see from the earnings report, 360 Finance’s accumulative registrations were 109 million in the second quarter, an increase of 96% over the same period last year of 55.6 million; the number of credit users was 19.23 million, an increase of 166% over the same period last year.

360 Finance achieved high growth in the number of customers because it has solved pain points in traditional finance.

In order to reduced reliance on manual marketing in traditional finance, 360 Finance came up with a unique DSP (Demand-Side Platform) system, which minimizes the use of labour in the marketing process and achieves precision marketing with AI technology.

The DSP system brings together inventory of various advertising exchanges, ads networks, supplier platforms and even media, which help agents manage one or more ad exchange market accounts with a single interface, improving the efficiency.

It is worth mentioning that the DSP system can target the audience to individuals rather than to a certain group as in traditional media. Even better, the big data calculus mechanism has the capacity to model the portrait of different groups, which helps find users with high ARPU (average revenue per user).

This solves the dilemma in traditional marketing where low click cost comes with high customer acquisition cost, or low customer cost comes with poor follow-up effect.

In addition to AI risk management and precision marketing, 360 Finance has also established an AI-powered system for underwriting and post-loan collections, which I will not go into details here.

[3] AI-powered risk management solves pain points in traditional finance

The earnings show that 360 Finance’s 90 day+ delinquency ratio was 1.02% for the quarter as of June 30, 2019. When it comes to risk management, 360 Finance has a comparative advantage over most of its peers.

Benefit from 360 Group's 1 billion devices and 515 million monthly users, more than 30 third-party data providers, financial partners, and user behavior data, 360 Finance has accumulated rich risk management capabilities and anti-fraud practices.

The AI-powered risk management independently developed by 360 Finance is named Argus. The name is taken from the giant eye of the Greek mythology, describing   strict scrutiny in one's actions to an invasive, distressing degree.

This risk management system is based on artificial intelligence technology, including machine learning, which can automatically make decisions throughout the loan transaction process. It is definitely an evolution of risk control performed by humans under the traditional financial model.

Its main functions include fraud detection, initial credit evaluation, continuous adjustment of credit assessment and credit collection strategies. The realization of each function is based on the use of big data collected from thousands of samples, and the personalized labels generated by a score system.

For a featured function “continuous adjustment of credit evaluation”, after the first transaction is completed for three months, the Argus engine will capture and analyze the user's financing behavior, click behavior, recommendation behavior, etc., and generate a behavior score called B Score. B Score will be re-evaluated at the time of user transaction as well as at the end of each month; afterwards it will be sent to a subsequent pricing engine for evaluation whether to adjust the user's credit limit and pricing.

The AI-powered technology has substantially enhanced the risk management capacity of the traditional financial institutions where it only takes 39 seconds to make a loan decision.

02

The dual logic of fintech company valuation

As an emerging industry, the fintech sector does not have a time-tested valuation methodology. However, under different valuation systems, the discrepancy between valuations could be huge.

Even the most commonly used P/S (Price-sales ratio) method in the industry has the problem of not being able to objectively reflect the business situation of a fintech company: where the ratio only examines the company’s revenue and can barely reflect the company's cost control ability. In the case of rising costs and declining profits, as long as the income remains the same, the valuation is unchanged.

In fact, for fintech firms, their profitability should be the key when it comes to valuation. At the same time, based on the premier value of their platforms, the valuation model should also include factors including business models and user scale.

From the business model perspective, the major categories of current fintech firms including financing firms, asset management firms, payment processors, technology service providers, and platforms.

For example, 360 Finance is a typical platform-type fintech company. 360 Finance has subdivided the scenarios for big data application, and developed a variety of scenarios by working with Di Da, Future Market, Pulse, E-bag Washing, and Haro bicycle, where it has empowered multiple industries.

To be fair, we could adopt the the Sum-of-the-Parts valuation model (SOTP) together with its valuation premium. The specific models are as follows:

(1) Sum-of-the-Parts valuation

Payment segment: market value / transaction size, reference interval of 0.05-0.2X; price-earnings ratio of 25X-30X

Financing business: market value / loan scale, reference interval of 0.2X-0.4X

Asset management business: market value / AUM (asset management scale), reference interval of 0.02X-0.18X

(2) Valuation premium

Customer premium: customer-scenario-product-profit

Technology premium: technology - product - profit

Collaborative premium: customer-cross product-profit

Using Sum-of-the-Parts valuation method, 360 Finance generated a total of 48.378 billion RMB in the second quarter. With reference to the market value/loan generation scale of 0.2X-0.4X, the market value is between $1.4 billion to $2.7 billion.

Under the framework of this valuation, with reference to 360 Finance's current market value of $1.4 billion, it is at the lower end of the valuation range.

Using the second valuation method, for the customer premium, 360 Finance has access to the 1 billion mobile devices of 360 Group and the 515 million active monthly users.

This scale is equivalent to the number of Alibaba mobile MAU, to which Ant Financial has access.

In terms of technology premium, Ant Financial and 360 Finance both introduced artificial intelligence as a major technology tool, which enables the provision of AI-powered risk management, customer service, underwriting and post-loan management and collections.

In terms of collaborative premium, similar to Ant Financial's most profitable products Hua Bei (spend it) and Jie Bei (borrow it), the core product of 360 Finance is 360 Jietiao, which is a institutional provided loan rather than a P2P loan. The fund mainly come from large financial institutions such as ICBC and China Everbright Bank, where the funds are guaranteed.

As of June 30, 2019, 360 Finance accumulated borrowers reached 12.54 million, an increase of 167% over the same period last year of 4.69 million. From the numbers we can tell that 12.54 million borrowers has a lot of room to grow given a pool of 109 million registered users.

So it is easy to conclude that from the three aspects of customer, technology and collaborative premium, 360 Finance and Ant Financial have a similar business logic.

This also means that despite of the differences in business segments and user values, 360 Finance is still unable to achieve the valuation of tens of billions level of Ant Financial; but from the valuation premium perspective, it has the potential to become the next billion dollars valuation unicorn.

To conclude, 360 Finance, currently only valued around $1.4 billion, has not been tapped by the market for its valuation premium. This creates a good opportunity for savvy investors.

[realalphaworks]

Luckin Coffee: How Do We Evaluate its Q2 Earnings?

On 14th August, Luckin Coffee (NASDAQ: LK) released its first earnings after IPO. The second quarter 2019 financial result shows that its expansion continues to accelerate. Revenue increased 648.2% year over year to 909.1 million yuan, while Luckin ended up with a net loss of 680 million yuan for the quarter. 

It is a glass half full scenario for investors. The pessimists argue that the loss has expanded, while the optimists believe that the income growth rate is far greater than the pace of loss expansion, and it is only a matter of time for Luckin to become profitable.

By examining the numbers carefully, we find that Luckin’s rapid growth is driven by store expansion, product price increase, rising transaction value per user, and cost control in the second quarter, rather than simply “burning money”.

Furthermore, we find that Luckin’s business model is transforming from a delivery model to a pick-up model, which further narrows its store operating loss and single-cup loss. We are positive about Luckin's long-term growth and profitability.

[1] Total number of stores increased by 374.8% year-over-year

Luckin's net loss in the second quarter was an inevitable result of rapid store expansion.

As of the second quarter of 2019, the number of Luckin coffee stores reached 2,963, increased 374.8% from 624 stores from the same period last year.

The 374.8% expansion rate of stores, comparing to just over 100% increase in net loss, indicates that Luckin's cost control has significantly improved.

As shown in the figure below, on a single cup basis, operating costs, depreciation cost, logistics and storage cost all decreased year-over-year.

[2] Store operating loss decreased by 31.7% year-over-year

The store operating loss decreased by 31.7% to 55.8 million yuan this quarter, as a result of Luckin’s strategic transformation from a delivery business model to a pick-up model.

In the second quarter, the number of pick-up stores and relax stores both increased. The number of pick-up stores increased from 2,163 in the first quarter to 2,741, and the number of relax stores increased from 109 to 123 during the same period.

By the end of the second quarter, the percentage of pick-up stores reached 92.5% of the total store count, which further increased compared to 91.3% in the first quarter.

Corresponding to the structural change in store types, the proportion of delivery orders dropped to 19.8% from 62.2% compared to the same period last year.

The numbers show that Luckin is turning away from the delivery model to the in-store pick-up model.

The transition to a pick-up model means that Luckin Coffee will not have to bear huge delivery costs and obtaining higher efficiency, which will reduce its operating costs. The data shows that 56% of Luckin's sales expenses are from logistics and distribution in the second quater. In the first quarter, this number even reached 94.61 million yuan.

[3] User size has increased 6 times year-over-year

In the second quarter of 2019, the number of transactions was 22.8 million, compared to 2.9 million in the same period last year, an increase of 686%. Luckin added 5.6 million new transactions in the second quarter.

Obviously, the number of users still maintains the momentum of a high growth rate.

[4] Average monthly transacting customers (MAU) increased by 35%

In the second quarter 2019, Luckin Coffee’s MAU was 6.2 million, and the average monthly sales volume was 27.6 million pieces. On average, each active user consumed 4.45 items per month. Compared to the average user consumption of 3.3 items per month in the same period last year, representing a c. 35% increase year-over-year.

Luckin's monthly average merchandise sales volume in the second quarter increased by 589.7% year-over-year, higher than the MAU growth rate of 410.6%. This shows that user quality has significantly improved.

[5] Single-cup coffee revenue increased 16.6% year-over-year

In the second quarter, revenue from the freshly-brewed drinks segment was 660 million yuan, and a total of 210.56 million cups of coffee were sold, representing an average income of 10.4 yuan per cup of coffee. In the same period last year, Luckin made an average of 8.9 yuan per cup of coffee.

Year-over-year, Luckin's single-cup coffee revenue in the second quarter increased by 16.6%.

[6] Subsidies decreased by 45% year-over-year

From the very beginning, Luckin has been questioned by its substantial compensation to customers. In this quarter, we find that Luckin's subsidy is shrinking sharply.

In the second quarter, Luckin's free product promotion fee decreased by 45% year-over-year to a historical low of 6.5 yuan/person.

According to the conference call, the retention rate of Luckin Coffee users remains constant as the first quarter this year.

The above analysis shows that the subsidy of Luckin has dropped sharply, while the number and quality of users remains rapid growth. This fast growth is based on a range of factors, including store expansion, product price increase, per capita consumption increase, and cost control enhancement, rather than simply “burning money”.

Institutional investors are long on Luckin Coffee

Even before Luckin Coffee released the first quarter result, a number of institutional investors overseas had already voted for the prospect of the Chinese coffee market by raising their stakes.

On 6th August, Point72 disclosed to the SEC that it had invested US$390 million to increase its holdings of more than 2.12 million shares of Luckin ADS at an average price of US$22.9 per common share (Note: ADS means American Depositary Shares; each ADS equals to 8 shares of ordinary Luckin shares), which is 17.02 million shares of common stock.

After the transaction, Point72's holdings of Luckin reached 5.08%, becoming its fourth largest institutional investor. What is more striking is that Point 72 just cleared its Starbucks (NASDAQ: SBUX) holding in the first quarter this year.

For Point72, many investors may still be unfamiliar; but for the American drama "Billions" that has been popular since 2016, the prototype of Bobby Axelrod, the protagonist of "Billion", is the founder of Point72, Steven A. Cohen, who is known as the "king of the hedge fund."

According to the SEC filing, not only Point72, many other institutional investors also increased their stakes in Luckin Coffee.

According to Bloomberg terminal data, Luckin's largest investor is currently the Capital Group, which holds 15.57% of Luckin's outstanding shares. This institution is one of the oldest and largest investment management institutions in the world, with an AUM of more than $1.4 trillion in 2018.

Following the Capital Group, there is also a long list of internationally renowned institutional investors: Qatar Sovereign Wealth Fund, Darsana Capital Partners LP, which is also the cornerstone investor of the Chinese Groupon “Meituan” , Janus Henderson Fund, managed by the "Old Bond King" Bill Gross, Fidelity Fund, Franklin Resources, BlackRock, Singapore Sovereign Wealth Fund, and Deutsche Bank etc.

Overseas institutional investors are optimistic with Luckin Coffee for obvious reasons. Apart from Luckin’s strong fundamentals, they understand the business model of Luckin Coffee, particularly with a comparison with Starbucks. More importantly, they see a rapidly growing  Chinese coffee market and a very low consumption rate.

China's coffee consumption growth rate is 10 times of the global average rate. According to the US Department of Agriculture, China's raw coffee consumption had an average annual compound growth rate of 24.27% in the 15 years of 2003-2018, while the global coffee consumption growth rate was only 2.58%.

Final Thoughts and Conclusion

The fundamentals of Luckin Coffee continue to improve. The single-store sales of freshly brewed drinks increased by 22.8% in the first quarter this year compared to the same period of last year, and it was achieved with much less customer compensation. At the same time, the store operating cost has been reduced, and the stores are gradually moving towards the break-even line driven by a transition to the pick-up model.

What is even more valuable is that Luckin Coffee's growth is organic with a strong focus on the Chinese domestic market, and expanding to non-US overseas markets. For example, on July 22, Luckin Coffee signed a strategic cooperation framework agreement with Americana Group, the largest food manufacturing and sales company in the Middle East, to launch a new coffee retail business in the Greater Middle East and India. This means the performance of Luckin Coffee is unlikely to be affected by the trade war.

[realalphaworks]

Pinduoduo: tripped up by its own success

By Mr. Ge and Mr. Fei

Targeting the lower tier city population, Pinduoduo (NASDAQ: PDD) quickly grew into an e-commerce unicorn, but the same strategy has also locked up its growth potential and future GMV. Despite the share price of PDD is 30% lower from the high point of the year, a c. $25 billion valuation does not seem to be an attractive investment opportunity.

A shifting investment thesis

First, let’s take a look at the key to the success of PDD, which includes four factors:

a. On the demand side, the demand for low price goods in the lower tier cities was ignored by Alibaba (NYSE: BABA) and JD.com (NASDAQ: JD);

b. On the supply side, Alibaba’s Taobao pushed out low-end businesses, causing a considerable portion of the 8 million merchants on its platform looking for other platforms to survive;

c. Tencent’s (OTCPK: TCEHY) WeChat provided the possibility of efficiently matching the massive supply and demand;

d. The distributed AI algorithm developed by PDD worked magically with the “group buy” model.

The founder and CEO of PDD, Zheng Huang, successfully mixed consumer insights, business model with the right technology. The ultimate goal is to create “COSTCO plus Disney” shopping experience, while the bottom line is low price.

However, the growth potential of PDD’s GMV is also capped by factors which made it successful, including the low income consumer base and the “group buy” business model; meanwhile the featured customer-to-manufacturer model is unlikely to become a new growth driver any time soon.

Annual GMV is unlikely to exceed RMB 1.5 trillion

GMV is the most important indicator for e-commerce companies. We find that PDD’s future GMV growth is limited by consumers’ per capital income, number of consumers and the product categories.

A typical portrait of a PDD customer is one from a lower tier city, where a sell side report provides a clear description from the dimensions of age, geographical distribution and gender.

Compared to BABA and JD, PDD has more female users, elder users, and lower tier city users.

According to CNNIC's (China Internet Network Information Center) data, 40% of China's 800 million mobile payment users have a monthly income of less than 2,000 yuan, which is about 300 million users. This is roughly in line with the National Bureau of Statistics' income survey data.

By the end of 2018, PDD’s annual active buyers reached 420 million. It is reasonable to assume that the median monthly income of these 400 million people does not exceed 2,000 yuan.

Another approach to assess the income level of PDD’s users is per capita GMV. In 2018, PDD’s per capita GMV was 1100 yuan. If the goods on its platform is 30%-40% cheaper than competing products, consumer may save around 500 yuan per year.

A 500 yuan saving may be attractive to consumers with an annual income of 20,000 yuan; however, the higher the income, the lower the sensitivity of consumers to this level of discount.

Moreover, when consumers get affordable prices, the extra price he/she pays is the possibility of waiting and chances of buying inferior goods, which means that the current 400 million user base is close to a ceiling.

Now, we can estimate PDD’s GMV.

PDD has 400 million consumers with an average monthly income of 2,000 yuan, which sums up a total annual income about RMB 9 trillion. According to the data from the National Development and Reform Commission in 2017, half of China's household consumption expenditures are in catering, housing, communication, medical care, culture, education and entertainment. These are areas that cannot be effectively reached by PDD.

After deducting this part, PDD’s target market size is around RMB 4.5 trillion. If the market’s online penetration rate reaches 50% in the medium and long term (much higher than the overall consumer online penetration rate is because of the elimination of service consumption expenditure), and if PDD takes 60% of the market share, PDD’s core customers can create approximately 1100 billion GMV per year.

Adding the contribution of non-core customers, the ceiling on PDD’s annual GMV is about RMB 1.5 trillion.

This is roughly in line with the GMV calculated by the major investment banks based on the forecast of the customer unit price, shopping frequency, and the number of active sellers.

However, this is a rather optimistic estimate, because PDD’s group buy model is not applicable to every product category as it has obvious limitations, and this excludes management execution risk.

PDD’s product category fully reflects the characteristics of its business model and the specific e-commerce environment where PDD thrived: agricultural products, fast-moving, clothing, home and small appliances have contributed most of the GMV.

As for the features of PDD’s products and its business model, they include:

First, the demand for the product is relatively high frequency. High-frequency goods are more likely to form a group and shorten the delivery time.

Second, the price is low as low price attracts new customers and generates selling points.

Third, the group buy model creates more circulation points where it generates more value for consumers and businesses.

Fourth, the supply side capacity has a large room for improvement.

A glimpse at PDD’s plan on GMV

Although Zheng Huang has never revealed his goal on PDD’s long-term GMV, the company's fourth quarter marketing expenses and management's outlook gives us a glimpse at the company's plan.

PDD’s marketing expenditure for year 2018 is about 11 billion yuan, although  Zheng Huang noted that this should be regarded as a long-term investment in capitalization, but for the capital market, investments need to generate returns.

Compared to China's Internet companies, using proportion of marketing expenses to revenue as a benchmark, Tencent and BABA have the lowest number, about 1:6, while the industry average is 1:5, and the lowest only 1:3. We believe Zheng Huang has done the math.

Assuming PDD’s marketing output ratio is much higher than the industry average of 1:5, and the monetization rate is 3.5% in the medium and long term, the marketing investment of 11 billion yuan can generate about 1.5 billion GMV, which is close to the above calculation.

Monetization rate and PDD’s profit estimation

As for the other key indicator: the monetization rate, PDD is unlikely to surpass BABA, judging from the user group, product categories, category gross margin, space for transaction efficiency improvement and industry competitive position.

The 1.5 trillion GMV and 3.5% monetization rate have largely depicted PDD’s fundamentals for the next 2-3 years. And the high adjustability and uncertainty of marketing expenses determine the short-term fluctuations of stock prices.

The marketing expenditure will be stable when the management believes that the customer growth has reached the limit. This is exactly why Zheng Huang said that the company will maintain a higher marketing investment for some time. However, the timeline is unlikely to be later than the first half of next year.

So we know, PDD’s 2020-2021 annual profit is around 10 billion yuan.

C2M business model is not the new growth driver

As for PDD’s featured Customer-to-Manufacturer model (C2M), it is unlikely to become PDD’s main valuation driver in 2-3 years. The C2M system develops slowly, and PDD will also encounter the challenges that BABA and Netease (NASDAQ: NTES) have been through.

Zheng Huang clearly understands the challenges, and he has taken a realistic approach to strategic planning. He indicated in the fourth quarter conference call that 100-1000 suppliers will be developed in 2019-2020.

Moreover, the product categories that C2M can be applied earliest require consumers to pay a premium for differentiated and personalized goods, which is in contradiction with PDD’s targeted low-income and elder consumer group.

For now, the most ordered customized paper products on the platform are still bulk commodities, and the degree of difference is extremely low, which is far from a standard differentiation level of C2M.

Overall, we find that PDD is not an attractive investment anymore. Its GMV growth is limited by its target consumer group, monetization rate not surpassing Alibaba and C2M model is not becoming a new growth centre soon.

[realalphaworks]

Secrets behind Huawei’s Hongmeng OS: anchored in Nokia, beating Android

On July 31, Huawei announced its business results for the first half of 2019: revenue increased by 23.2% year-on-year to CNY401.3 billion, which shows Huawei's amazing vitality.

During the press conference, the question asked the most was on Huawei's in-house operating system “Hongmeng”, but the answer from Liang Hua, the rotating chairman, was unclear.

Here, based on information collected in the past few months, we will show you what we know about Hongmeng OS.

The telecommunication industry started to learn about Huawei's Hongmeng OS in late 2015. From our source, Hongmeng OS is called "LiteOS" inside of Huawei, and it was originally Huawei's light version OS for IOT (Internet of Things) devices.

Some people in the industry believe that the original research and development team of Hongmeng OS is from Nokia. This view seems to be plausible from public information:

In 2011, after abandoning its own smart phone Symbian platform, Nokia announced that it will transfer the software development team of the Symbian platform to Accenture, a consulting company. By the end of the year, 3,000 Symbian developers from Nokia joined Accenture to continue developing the platform. Accenture is Huawei's strategic partner, and the two have been working closely together for many years.

However, even if Hongmeng OS was born of Nokia's Symbian, the subsequent research and development is based on Huawei's own needs and embarked on its own technical route.

Hongmeng OS is currently being researched and developed by Huawei's Central Software Institute. The kernel should be based on Linux.

 Many industry professionals we interviewed believe that Hongmeng OS is not widely used in mobile phones currently.

The reason is that Huawei has not planned and is not fully prepared to develop a mobile operating system. Considering that Huawei has always been an enterprise service provider, its mobile phone business has only gradually emerged in recent years. Although it has always been wary of Google's system, for Huawei, the challenge of developing a new operating system and created a new ecosystem is enormous.

In addition, unless it is the last resort, Hongmeng OS will almost certainly be resisted by the Huawei’s sales team. Even if it is now blocked by the "Android + GMS" ecology, the internal staff still expects the ban will be lifted via negotiations.

However, judging from the attitude of Huawei's top management, Hongmeng OS will play an increasingly important role in the Huawei system.

We believe that the probability that Hongmeng OS will reach or exceed the Android system in the future is high, from the perspective of technological know-how.

From the perspective of evolution path, the Hongmeng OS may repeat the path of  Kirin chip:

When Huawei first launched Kirin chip, it also suffered from chip fever and poor performance.

Later, Huawei applied the Kirin chip to products such as set-top boxes and network cards, and gradually expanded the scope of its application, which finally achieved success.

We reckon that Hongmeng OS may repeat the original strategy of Kirin chip, first focus on TV, tablet, intelligent hardware and other IOT (Internet of Things) scenarios, gradually cultivate user habits, expand participants of Hongmeng OS ecosystem, and finally have a virtuous circle.

In addition, we believe that the future Hongmeng OS may adopt the design concept of “weakening the app store” to reduce the dependence on the system ecosystem software in the initial stage. For example, the way to push an app based on user needs. The so-called "smart service".

Despite of this, the expansion of Hongmeng OS's overseas market will also face challenge from users who rely on Google Maps, Gmail, YouTube and other applications.

In the domestic markets, the success of Hongmeng OS is largely depending on Tencent.

While WeChat has almost become an operating system itself, Zhang Xiaolong, the founder of Wechat, has not yet spoken out his further plan.

Previously, Huawei's Honor Magic phones applied the "applications lead to applications" concept, where the system suggests Huawei applications, products or movies based on leads from the user’s WeChat chat records. This violated Wechat’s privacy philosophy and the two had a difficult relationship.

As Wechat is a must-have app for Chinese users, it’s nod is critical for Huawei’s development in the domestic markets.

To conclude, Hongmeng OS may not be widely used in mobile phones for now, but it is becoming increasingly important in the Huawei system. Based on Huawei’s technological know-how, Hongmeng OS has a great chance to surpass the Android system.