ZTO Express: Volume growth expected to accelerate in H2 (NYSE:ZTO)

I last wrote about ZTO Express in an article published in June of this year. At the time, I was concerned about ZTO losing market share and the ongoing price war in the Chinese express delivery industry. Unfortunately, this trend continued in the second quarter of 2024, which is confirmed by ZTO earnings resultswhich were released on August 20th after the bell.

Facing another quarterly loss in market share, ZTO management is determined to fight back. At the same time, management is also committed to maintaining a stable level of profitability. I think ZTO Express will likely catch up in the second half of 2024. With the stock still trading well below my estimated fair value, I maintain my long-term “Buy” rating for ZTO Express.

The most important information about the results for Q2

According to ZTO’s press results for Q2 the most important events of the quarter include:

• Revenues increased 10.1% year over year.
• Gross profit increased by 9.6% year-on-year.
• Adjusted net income increased 10.9% year over year. Adjusted diluted EPS increased 10.1% year over year.
• Shipment volume increased by 10.1% year-on-year.
• ZTO’s market share decreased by 2% to 19.6% year-on-year.

In the second quarter of 2024, the growth rate of China’s express delivery market was very strong, as more and more consumers chose to shop online and major e-commerce platforms spent large amounts of money to subsidize consumers. ZTO President Meisong Lai revealed during the financial results conference call that the shipment volumes for China’s express delivery industry “increased by 21.3%, exceeding expectations. However, the share of low-priced shipments continued to grow, and price competition intensified even more.”

As I pointed out in my previous article, as the market share leader, ZTO chose to sacrifice market share over profitability during one of the most intense price wars in the Chinese express delivery industry. In summary, in the first quarter of 2024, ZTO’s parcel volume growth rate of 13.9% was already significantly lower than the industry’s growth rate of 25%. In the second quarter, ZTO continued to significantly lag the industry, as ZTO’s parcel volume grew only 10.1% compared to the industry’s growth rate of 21.3%. ZTO’s market share fell below 20% again after falling below 20% for the first time since 2020.

During the earnings conference call, when Goldman Sachs analyst Ronald Keung asked him about the market share loss, Mr. Lai explained that “Price competition intensified, and part of the unprofitable volume increased. Therefore, ZTO Express voluntarily gave up some unprofitable parcels. Although ZTO’s market share in terms of parcel volume decreased, its market share in terms of profit increased even more.”

Based on the management commentary, it seems that ZTO management simply can no longer cope with the loss of market share. For example, ZTO CFO Huiping Yan clearly stated that “volume is not unimportant because it enables the use of scale.” This is a clear change of tone regarding strategic priorities. Previously, ZTO placed profits above volume. Starting in Q3, ZTO is shifting its priority back to volume and market share gains. ZTO management is leading “volume growth of 15% to 18% in 2024”indicating a growth rate of at least 18% in the second half of 2024. This growth rate is significantly higher than the 10% growth rate in the second quarter. The ZTO Management Board is “We are very confident that we will achieve this 18% growth target given current trends and business conditions.”

I think ZTO Express can achieve the 18% growth rate in two ways. The first is to follow the aggressive pricing strategy of its competitors and even outbid them. However, doing so will hurt ZTO’s profitability unless ZTO drastically reduces its unit cost. The second option is to increase ZTO’s market share outside the e-commerce market. This means that ZTO will have to take market share from SF Express and JD Logistics in the business and retail parcel market. Since the average selling price is much higher for the business and retail segments, but the unit cost is almost the same, ZTO does not need to lower the price too much. If ZTO chooses the second option, the company will have to spend more on sales and marketing to attract mid-range and high-end customers to switch. Of course, it is not easy. Let’s see which option ZTO chooses in Q3 and Q4.

Financial projections and valuation

I have updated my financial outlook for ZTO to reflect the latest quarterly results and management guidance. I have increased my growth rate for the China express delivery market through 2024, while lowering my estimate for ZTO’s market share. I have slightly lowered my estimate for ZTO’s margin, as ZTO may need to aggressively lower its price to regain market share.

In terms of valuation, I continue to apply a P/E multiple of 15, which implies a discount of over 40% to the sector median to account for China-related risks and near-term margin pressures.

Based on my financial forecasts and valuation estimates, ZTO is still undervalued.

Discussion about risk

I have discussed ZTO’s long-term risks in my previous articles. Based on the Q2 results, I add a short-term risk, which is a potential decline in gross and net margins. As I stated in the above section, ZTO has only two options to increase its market share in Q3 and Q4. If ZTO decides to follow the lead of its competitors and aggressively price its products and services, its gross and net margins will have to decline unless ZTO achieves significant cost reductions. Although ZTO has a history of best-in-class operational efficiency, I would not rule out the possibility of a significant margin decline in the short term.

Application

ZTO’s Q2 2024 results are largely in line with my expectations. I have mixed feelings about management’s decision to shift ZTO’s priority back to volume growth. I believe that pursuing volume growth during a period of intense competition could be a double-edged sword, depending on ZTO’s execution. ZTO has a history of excellent execution in the past. Therefore, I am mildly optimistic that ZTO can increase its market share in H2 2024 without materially losing profitability. At the current price, ZTO has almost 50% upside potential relative to my 2025 fair value estimate. Therefore, I maintain my Buy rating on ZTO.