Long-Term Margin Forecast Remains Intact for JD Health

We maintain our fair value estimate of HKD 64 for JD Health 06618 after the company reported second-half revenue of CNY 26.5 billion, which was better than the top range of guidance of CNY 23.9 billion, but operating margins declined by 70 basis points to a loss of 0.4% due to a combination of unfavorable product mix and greater subsidies given out for promotions during the coronavirus pandemic. Revenue was better than expected due to outperformance in sales in the fourth quarter, which accounted for one third of annual sales as lockdowns in November and December 2022 prompted consumers to order drugs and health products online. However, gross margin declined to 20.7% from 21.8% due to the decline of over-the-counter drugs as the Chinese government limited the amount, and restricted promotional sales, of OTC drugs during the pandemic. Operating expenses also increased 20% year over year as JD Health held many promotions to raise the profile of its company, and fulfilment costs rose due to more orders. However, the platform grew a healthy 25% year on year to 153 million annual users in 2022.

Despite the decline in operating margin during second-half 2022, we believe JD Health’s long-term margin expansion thesis remains intact as management expects OTC drugs sales to recover and that fulfilment expenses should become a lower part of revenue due to economies of scale. JD Health reiterated its long-term guidance of 8%-10% net margin (excluding share-based compensation costs). Net margin expansion will be driven by higher gross margin as well, and we expect long-term steady-state gross margin to be about 25%-26% due to a more favorable product mix as we expect OTC drugs, with higher gross margins, to grow faster than prescription drugs sales in the long term. We do not believe the margin declines signals any structural changes to the business and view shares as attractive should there be a pullback in price, given the firm’s expected growth and margin expansion opportunity.