Tech

Tim Culpan is a technology columnist for Bloomberg Gadfly. He previously covered technology for Bloomberg News.

To understand the thinking behind JD.com Inc.'s spinoff of its financing arm, just go back six months to a statement from one of the world's biggest credit-ratings providers:

"Fitch Ratings says that China's largest direct sales online retailer by revenue, JD.com Inc. (JD) does not have an investment-grade credit profile due to its low profits and weak cash generation. In addition, Fitch believes that JD's internet financing business is an integral part of its retail operations and thus, the company needs to be analysed on a consolidated basis."

(The italics are mine.)

In other words, Fitch looks to be saying: If you want an investment-grade rating, you need to deconsolidate your finance business. While Fitch hasn't provided one, Moody's Investors Service and S&P Global Ratings did, giving JD.com only their very lowest tier of investment grade -- not exactly a resounding endorsement.

JD.com sees another reason for a spinoff. In a statement Tuesday night, the company said it wants to make JD Finance, which lends money to JD.com's shoppers, a fully Chinese-owned entity so that it can avoid restrictions on foreigners investing in the country's finance industry. Oh, and the massive valuation premium for China-listed companies over those in the U.S. is another good reason.

Growth Cost
While quarterly revenue has doubled, JD.com remains unprofitable
Source: Bloomberg

There are parallels to what Alibaba Group Holding Ltd. is doing with its Zhejiang Ant Small & Micro Financial Services Group, including their chairmen taking considerable voting rights in the spun-off entities.

There are also differences. While Alibaba functions mainly as a marketplace for third-party buyers and sellers, JD.com is a full-service retailer. The company does its own merchandising, holds and manages inventory, and provides fulfillment logistics (including plans to fly delivery drones).

A major upside of the JD.com model is its ability to control and improve the customer experience, including monitoring and blocking fake goods. The downside is that it's expensive and requires cash to build.

Cash Story
JD.com's spike in cash from operations coincided with a big jump in investing outflow
Source: Bloomberg

JD.com had negative cash flow from operations last year. There was a huge spike in the past two quarters as it made acquisitions and funneled acquired inventory into operating flows, coupled with a large increase in negative cash flow from investments.

To keep building chairman Richard Liu's planned empire, more cash will be needed. The $3.7 billion that JD.com had on the books at the end of September isn't disastrous, but it's barely budged from the same quarter two years prior, despite quarterly revenue having doubled in the same period. That doesn't give a lot of room for further acquisitions.

As We Were
Cash and near-cash has barely changed over the past two years, despite quarterly revenue doubling
Source: Bloomberg

Moody's pointed out in April that JD.com's rating not only includes the risk and costs of acquisitions and building out its logistics business, but potential contingent liabilities associated with JD Finance. Those risks were mitigated, it said, by the fact that the company is funded by equity and its loan book was relatively small at the end of last year.

"It is important that there is sufficient transparency around JD Finance's activities over time," Moody's wrote. "A rapidly growing loan book, with low transparency, could pressure JD.com's rating."  S&P went a step further, saying "we deconsolidate the financial contribution from JD's captive finance operations when assessing the company's financial risk metrics."

So while a sale of JD Finance, whether through an IPO or privately, would provide a nice one-time cash injection (any continuing inflows would require the finance business to start making a profit), the real benefit of a spinoff would be to rid JD.com of that albatross and allow it to hit the debt markets again.

Gadfly's Christopher Langner contributed to this column.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Tim Culpan in Taipei at tculpan1@bloomberg.net

To contact the editor responsible for this story:
Paul Sillitoe at psillitoe@bloomberg.net