ZTO Express Delivers Exceptional Profits for Investors

The company was the most profitable in China’s ultra-competitive parcel delivery industry during the third quarter

Key Takeaways:

• ZTO Express’ revenue grew much faster than its operating costs in the third quarter, allowing it to post 65% profit growth and industry-leading margins
• The company’s newly boosted stock buyback and application for an upgrade to primary listing status in Hong Kong could help to lift its shares

By Ken Lo

China’s already ultra-competitive express delivery industry got a jolt early last year when newcomer J&T Express turned up the heat by igniting a major price war to announce its arrival. But the maverick was quickly reined in by regulators, who set the industry back on a more sustainable road that is now showing up in healthier financials for most players.

ZTO Express (Cayman) Inc. (ZTO.US; 2057.HK) has led the charge back to health, leveraging growing orders and prices, as well as effective cost control, to become the sector’s most profitable company. That prowess was evident in the company’s latest results issued last week, which showed its net profit margin reached 21.2% in this year’s third quarter, head and shoulders above the 2.8% and 7.2% for peers S.F. Holding (002352.SZ) and YTO Express (6123.HK; 600233.SH), respectively.

The results show ZTO’s revenue grew by 21% year-on-year to 8.95 billion yuan ($1.25 billion) during the quarter, even as its operation costs rose by a more modest 11.6%. That helped to fuel a 55.9% surge in its gross profit to 2.44 billion yuan, and an even stronger 65.1% rise in its net profit to nearly 1.9 billion yuan. The company said that orders in the first half of the fourth quarter held steady as e-commerce sellers rolled out promotions, despite some subsequent turmoil. That turmoil was reflected in this year’s “Single’s Day” shopping extravaganza on Nov. 11, which saw most e-commerce companies fail to disclose specific sales data, leading many to speculate that most or all posted no growth or even business declines on China’s biggest shopping day of the year.

As conditions remain tough in China’s slowing economy, ZTO said it believes the broader parcel delivery market could be due for some reshuffling. It forecast the sector will become increasingly polarized, as the better-run players widen the gap with their less efficient peers. The could put the accelerator on consolidation, allowing the strongest players to gain share while the laggards stagnate or get forced out.

Survival of the fittest

ZTO predicted the expected consolidation could be imminent, and expressed faith in its own prospects as it posted strong margins across the board. Its gross margin improved from 20.5% in the first quarter to 27.3% in the third. At the same time, its operating net cash inflow improved to 2.82 billion yuan in the latest quarter from 1.79 billion yuan a year earlier.

The company estimated its fourth-quarter capital expenses would register 2.1 billion yuan, mostly for land acquisition, construction of sorting facilities and automation. Following its issue of $870 million worth of five-year convertible notes in August, it had 14.6 billion yuan in cash and cash equivalents in its reserves by the end of September. With that kind of money and its strong balance sheet, the company looks like a potential acquirer of some of its weaker peers if and when the consolidation comes.

ZTO’s Hong Kong-listed shares rose by a cumulative 6.8% in the two days after it published its results. Daiwa Securities pointed out the company registered strong profit performance in the third quarter, and added its gross margin was ahead of expectations, prompting it to raise its target price for the stock from HK$280 to HK$285 with a “buy” rating. The new target price implies upside of over 60% when compared with the closing price of HK$177.50 last Friday.

S.F. Holding is still China’s top parcel delivery company, posting third-quarter revenue and net profit of 69.08 billion yuan and 1.96 billion yuan, respectively. It uses a model where the headquarters directly owns and operates all of its branches to ensure consistent quality throughout its network. But such a model also has its downsides, especially in terms of higher costs for more personnel and facilities. That difference makes it more difficult for companies like S.F. to keep costs down, squeezing its margins.

By comparison, ZTO uses a blended operating model that sees some of its branches run by franchisees, especially the complex and labor-intensive business of last-mile delivery. Such a model can result in lower efficiency through some order-mismatching. But its broadly lower costs and greater flexibility can also deliver better profit performance.

Pandemic cuts both ways

Having less employees on the payroll, especially at the lower end, has also proved beneficial to ZTO as the government pressures companies to provide better wages. Last July, seven of China’s central government departments jointly published an opinion on protecting the rights of couriers, prompting many express companies to give their workers raise. Such pressures will grow as China continues to pursue “common prosperity” as a national strategy, putting more pressure on direct operators like S.F. Holding while having less impact on hybrid operators like ZTO Express.

While different business models are having different impacts, the Covid-19 pandemic has had a unified effect on the industry, both in good ways and bad. On the good side, it has stimulated online buying. But on the bad, it has also disrupted logistics through control measures that frequently result in road closures and loss of drivers when they are forced to stay home. Last year when such control measures were relatively relaxed, the number of packages the company handled jumped by 30% to a record high of 108.3 billion. But stiffer controls this year have had a chilling effect.

ZTO handled 6.4 billion packages in the third quarter, up by 11.7% year-on-year, boosting its market share by 1.3 percentage points to 22.1%. Management said that despite weaker-than-expected overall growth in the industry, the average price for the company’s core delivery business rose by 9.9% during the quarter, and it was confident of picking up at least another percentage point in market share this year.

The company’s board authorized a $1.5 billion share buyback scheme in mid-November, boosting its earlier plan from an original $1 billion, to shore up its share price. In another step to support the stock, the company earlier this month also announced plans to upgrade its Hong Kong listing to “primary” from “secondary” status, which could eventually make its shares available to Chinese mainland-based investors.

ZTO’s shares currently trade at an estimated price-to-earnings (P/E) ratio of just 16 times, close to YTO Express’ 16.7 times. Both are well behind industry leader, S.F. Holding’s 27 times. But ZTO’s stronger margins over YTO Express point to greater profit potential, which may help to boost its shares further in the future.

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