The tech spin-outs
Of Chinese tech's propensity for conglomerates and their unfavoured sons
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JD Logistics was the second of JD.com's children to fly the coop, and it did so in style; on 28th May 2021, it listed on the HK stock exchange and raised $3.1bn from its IPO. JD Logistics's listing comes at the end of a long line of Chinese spin-outs, including Tencent Music, Youdao (NetEase’s education and cloud unit) and the infamously aborted Ant Financial listing.
I have long been puzzled by this generation of Chinese tech's children running around, some disparate business carrying their parental name while others are content to strike out independently. Why did these firms spin out and let their former business units flourish as standalone businesses while Western tech has trembled at the idea of separation? Are Chinese tech's spin-outs1 a sign of things yet to come for Western tech? Or are the carve-outs done with Chinese Characteristics and not applicable elsewhere?
The textbook reason for spin-outs is that this will increase shareholder value as the company is worth more as a standalone entity. This is known as the conglomerate discount. When a company spins out a division, there are clear benefits for both sides. Let’s use JD Logistics here to illustrate:
Being more legible to the public market: This is the case for both parent and child companies. Alibaba and JD.com are viewed as e-commerce platforms first and foremost, and their various business divisions in logistics, travel and enterprise software get painted with the same brush. Now we can say JD.com is an online retailer and JD Logistics is a logistics company, and the market can assign more relevant narratives to them respectively. This allows them to both raise money more effectively (See the piece on What Story are you living in? for more on this framework)
New neutral identity: With JD Logistics as a new brand, they can potentially work with other e-commerce players. They have agreements with Kuaishou and Sketchers among 190,000 external corporate customers as of December. Gaining some distance from their retailer parent can add credibility to their tech-first 3PL play in the Chinese logistics space.
Employees are more aligned to a central mission: With a more focused mission in a smaller standalone company, employees with stock options are better incentivised than previously.
Additional Chinese tech-specific factors include the Chinese tech propensity for conglomeration, unfavoured son syndrome, regulatory considerations, and a clearer IP wrapper structure.
The Chinese tech propensity for conglomerate
I believe Chinese tech companies typically tend towards conglomeration because of their emphasis on 'owning the user' mentality. This encourages them to 'own the funnel' by having a more comprehensive product range. They are also more likely to incubate divisions internally given blue ocean starting conditions, aka a lack of trusty outside vendors (see Ant's creation of Oceanbase), a need to create defensible moats in their Battle Royales and having access to cheaper capital than start-ups2. (See appendix for a primer on the origins of JD and why they created their own logistics network).
As a result, Chinese tech tends to have more diversified assets across different sectors. This means the various assets also tend to be undervalued by the market, and there are more candidates for spin-outs. Therefore more value can be generated by listing them as spinouts.
One significant difference between Chinese tech and its Western counterparts is that the former monetises businesses units without too many interdependencies. Unlike Google, which monetises with advertising across search, video and Gmail, companies like Bilibili and Tencent have several types of incomes which don’t require a foundational engine like Google Ads to keep generating revenue.
The unfavoured sons3
I have a theory about the spin-outs. They are often in the dead zone of products — too revenue generative to kill outright, too significant to be taken under a general manager’s wing, too cash hungry to keep ploughing resources into and too strategically insignificant to be prioritised. Much like how the landed gentry of yore used to send the younger sons to the army or clergy, and the eldest son inherited the title and the land - lesser businesses are sent along their merry way to seek their fame and fortune, but without the support of the parents. The more destitute the parent, the more children they sent out.
Some businesses provide solid if not spectacular returns and have their own needs that don't fit the family narratives. JD.com, with its very uninternet-like average gross margins of ~7.5% and less cash on hand relative to the other tech giants, is likely to prioritise high ROI investments. It’s ploughed resources into JD logistics over the years, but now that it’s finally grown, it’s up to the markets to do the rest of the work. That's especially true in sectors requiring high capital investments4.
Regulated industries
It's not just internal business politics that cause spin-outs — there's also the matter of national regulations and concerns to consider. The finance industry is considered a national interest category for China. In recent years, increased regulations and crackdowns have highlighted the government's resolve to keep firm controls over the sector. Healthcare is also subjected to more stringent regulatory oversight, and we see a similar dynamic with healthcare arms.
The recent reports that Tencent might put its finance division into a separate holding are not surprising. Every other Chinese tech giant has also spun off or started spinning out its finance division and abided by regulatory oversight — Alibaba to Ant Group, Baidu to Du Xiaoman Financial, JD to JD Digits(also JD Digits has now branded to JD Technology).
Given how nascent the financial system was when the Chinese tech players started, it made sense for them to be heavily involved and provide banking rails and credit where the existing banks could not. These finance divisions' spin-outs will be a growing trend as having a separate entity allows for clearer regulatory supervision. I anticipate that once Meituan's, Bytedance's, and Kuaishou's business divisions are also sufficiently big, a similar set of actions may follow.
The IP wrapper
Related to the above point for independence, another important trait that motivates some business units to strike it out on their own. Their proprietary IP, as well as having a cleaner legal structure, allow for further investments from other relevant entities. Tencent Music had a stock swap deal with Spotify and held agreements with other major labels. Baidu’s XiaoDu’s smart operating system is gearing up to be a spin-out as well. Allowing IP to be wrapped up and monetised effectively is cleaner with a separate entity.
The takeaway
So this was an exciting rabbit hole for Lillian to ponder, but does this have any relevance for the future of Chinese tech? I believe so. As we’ve talked about many times in this newsletter, I think that the gains of consumer tech have been diminishing in recent years, and companies will be looking for easy gains for their investors. Coupled with less stringent spin-out listings conditions, favourable market multiples, and a desire to get out of the government’s cross-hairs. It’s not a good time for a tech giant but a great time to start a tech family.
Plenty of candidates are ripe for this move. Bytedance’s business model of being a super app factory also it’s suited to having spin-outs IPO while remaining private. Other candidates include NetEase’s music division, BYD’s semi-conductor unit, JD Technology and Meituan’s Qingzhu in the distant future.
All in all, I would expect spin-outs to be a mainstay for Chinese tech giants in the future, especially as they focus on profitability while managing sustainable growth paths. I’d keep my eyes on the unfavoured sons in these tech households for the next listing opportunities.
Product walkthrough this month will be on Pinduoduo’s app, there’ll also be an update on Community Group Buying for Premium Subscribers. We’ll also be taking votes for the deep-dive this month in the Circle Community.
Appendix
This appeared originally as a tweet thread and is also housed in the Chinese Characteristics Circle Community (Premium members only) along with my other tweet threads for ease of access:
Let's talk about the history of JD.com and its complicated founder Richard Liu - a man who grew up in poverty and arrived in Beijing with 76 eggs.
Today JD.com is worth $110bn and has three successful spinouts to its name. Growing up in a small village in Jiangsu, Liu had no stable electricity or running water. Meat was a treat served on special occasions, and his grandmother would bribe the butchers with peanuts for a fattier cut each year.
In middle school, he took his entire savings of 50 RMB and went to Nanjing through Xuzhou. He saw the Jinling Mansion Hotel, a 37-story building, the tallest he had ever seen in Nanjing.
He realised there was an entire world outside of Suqian, and he wanted to see it.
Studying came naturally to Liu, and he was accepted into the prestigious Remin University in Beijing. His family were too poor to come up with the money for the train tickets, but the entire village chipped in. Those that didn't have money gave him eggs.
Very Hamilton-esque.
So the story goes, Liu arrived in Beijing with 76 eggs and 500 RMB sewed into his undergarments and vowed never to ask for money from his family again.
But as a sociology major, he realised quickly his future wasn't destined for cash unless something changed soon. Liu started learning programming in 1993 and then earned money on the side with his new skills. He put his savings to use in his final year by opening a restaurant with his girlfriend (and later first wife).
Business life was about to deliver its first blows.
Even though Liu paid above market wages, the chef and waitress stole from the restaurant and forged receipts. The restaurant quickly shut and left Liu in debt and the notion that you can't delegate out the operational responsibilities in business.
Post university, Liu set up a small stall in Zhongguancun, an electronic bazaar. There he peddled hard disks but quickly realised that consumers wanted specialist high-end goods rather than the cheap electronic commodities that flooded the bazaar.
360buy (as it was known at the time) operated on a no-haggling but quality guarantee, and by 2003 it had opened 12 shops around China. Business was good, and Liu was intent on becoming the best electronics retailer in China.
But then, SARS hit China, and everything changed.
Forced to close his 12 shops down but facing mounting inventory challenges, Liu dusted off his programming books and started posting and selling online. Sales trickled in, and 360buy managed to survive. Post-SARS, Liu kept the online channels and made a discovery.
Online sales with almost no overhead had surpassed the sale of most of his offline stores. Liu made the decision and then pivoted to an online model, shutting down his sites one by one while writing the code for the new website himself.
The website steadily grew and focused on 3C products (computer, communication, and consumer electronics). In 2007, it raised $10m from Capital Today (after being turned down by every VC firm), rebranded to JD.com and announced that it would own its fulfilment.
This was unthinkable at the time; even Amazon, so the saying went, didn't have its own logistics structure. Who was JD.com to start such a capital intensive venture?
However, Liu knew that owning your operations was a moat at the end of the day. It delivered a superior customer experience because your employees cared; it allowed faster turnaround because you owned the structure. Because you were selling electronics, couriers wouldn't steal your packages as often.
JD has positioned itself with consumers as a platform for authentic electronic goods and supplemented it with speedy delivery. Its tagline, "Authentic Products, Delivered Today", is a dig at Taobao.
Their customers reside in tier 1-2 cities and are primarily male.
Along the way, JD.com has a series of spinouts in JD Digits/Technology (whose IPO plans have been shelved) and JD health. More is also on the way; JD property and JD Cloud are additional pieces. The reasons for this are in another thread.
JD.com's strength remains in electronic goods and top tier Chinese cities as its consumer base trade convenience for price. It's held steady in market share against Taobao and PDD across the years, but the 1P fulfilment structure margins are razor-thin.
Relative to the marketplace model of Taobao and PDD. http://JD.com is a digitalised retailer that owns its inventory and uses logistics as a moat. Similar to Amazon, they are their first and best customer before opening these platforms to third parties.
What seemed like a money burning move in 2007 now seems prescient in 2020 as each e-commerce platform is all building its fulfilment channel. But how many can reach the scale of JD and how JD can keep growing with such competition is another question.
Liu is not a simple rags-to-riches story. His history with its many ups has also been since checkered with dismissed sexual assault charges and outcry over his endorsement of 996 work culture.
But the ups and downs of his story are familiar; it’s another China tech story.
I’m not very precise during this article as I’m conflating Spin-offs and Carve-outs, there are legal differences, but I’m using the term spin-offs to apply to both
For a great series on this thinking, I recommend Cedric Chin’s Chinese Business Man Paradox.
This should really be unfavoured children to be gender neutral, but sons are more aligned with my historical metaphor.
Even lightweight consumer Chinese investment businesses are still more capital-intensive given the endless subsidy wars that occur