Coupang: South Korea Growth to Slow (NYSE:CPNG)

Summary

Coupang (NYSE:CPNG) is a champion of South Korea’s e-commerce market and is often called the Amazon ( AMZN ) of Korea. The company owns its logistics network, offers next-day delivery for loyalty scheme members and has a growing third party market.

Almost all Korean households are already active Coupang shoppers and most are Rocket WOW members. Future growth in active customers is limited going forward, however, sales per customer should continue to grow, albeit at a slower pace than before. Korea already has the highest e-commerce penetration in the world.

Coupang is a good quality business and will maintain a strong position in Korea. The main controversy when evaluating Coupang comes from their future growth prospects. The company has invested to grow in tangential business areas such as food delivery and retail in Taiwan and most recently bought a British luxury fashion retailer.

These growth initiatives are still in short supply and operate in quite challenging markets. Whether the company can generate attractive returns from these is debatable.

We like the Korean commodity trading business, but are not intrigued by new growth or valuation initiatives.

Merchant or a platform?

When evaluating an e-commerce retailer, it is important to determine whether it is a merchant or a platform. Merchants earn revenue based on gross merchandise value and often generate single-digit profit margins, platforms, on the other hand, charge a net fee per GMV and often generate 20-30% profit margins.

Coupang generates 87% of its revenue from its own inventory sales. Assuming the trade is able to generate an operating margin of 5%, while 3P has a potential of 20%, the retail operations should be able to generate operating profits of approximately $1.5 billion.

Last year, Coupang’s Product Commerce division generated EBITDA of $1.5 billion, in line with our expectations, for a gross margin of 6.3%. The third-party business is growing faster than the trading operation; therefore, we can expect the operating margin of the business to increase over time.

Assuming the trends of the last three years continue, by 2026 the trade division’s margin could increase to around 6.8-7%.

We have seen many overly optimistic margin assumptions when evaluating Coupang. It’s important to note that 1P retail is still the company’s bread and butter, and it often takes years to scale third-party business, just like we’ve seen with Amazon or JD. Coupang’s produce trading division is unlikely to reach double-digit margins anytime soon, even though profitability is likely to continue to increase over time.

In the second quarter of 2024, Coupang reported an increase in trading operating margins to around 7.3% from 5.6% last year. This level of profitability is now above our previous expectations, although the accounting change appears to have contributed to the acceleration.

Retail business is quite seasonal and the performance of a single quarter should not be extrapolated; however, we will continue to monitor the performance of the business to reassess the likely return potential.

Active customer growth is decelerating

South Korea has a population of about 52 million and there are about 24 million households in the country. Single-person households account for ~40% of the total.

Coupang now has approximately 21 million active customers in the country, of which 14 million are Rocket WOW subscription members.

Coupang so far serves almost all households in Korea, young and old, it is most likely that their growth in the domestic market will slow down in the future.

As Coupang illustrates, each new cohort of users took a few years to get used to the new service and scale up their purchases, after which growth would settle down to an average pace.

As the majority of households appear to already be shopping on Coupang, new customer cohorts will contribute less and less to sales growth, and overall growth rates per customer are therefore likely to settle slightly above overall market growth rates of electronic commerce.

Coupang will gain share in the maturing Korean e-commerce market

The e-commerce market itself is already quite mature in Korea, with online accounting for 35% of total retail sales, some of the highest in the world. Most recently, online retail has been the main driver of the e-commerce industry.

Assuming that most of the items that could have been sold online are already sold by Coupang, the lack of major new categories may lead to slower growth rates in spend per customer going forward.

However, it would be reasonable to assume that Coupang will continue to gain market share due to the quality of its services and the value for money proposition of its membership package.

The Korean e-commerce market is quite fragmented, with market leader Coupang accounting for only 22% market share. We believe that with the growing adoption of the loyalty scheme, Coupang could continue to increase spend per customer.

Korea’s e-commerce market growth is expected to drop to single digits, so Coupang could continue to grow merchandise revenue into the teens.

In the second quarter of 2024, Coupang reported strong underlying revenue growth of 24%. However, it is expected to decelerate by the mid-teens and later to single digits.

The potential threat from Chinese platforms

Retail is a very dynamic market, and it is possible that new formats will completely drive the growth of the e-commerce market, and continuing to increase market share will not be so easy.

Lately, Chinese dropshipping platforms AliExpress (BABA) and Temu (PDD) have started to gain market share in South Korea, increasing sales by 130% in the past 6 months.

The popularity of the latter two platforms has also been exacerbated by the economic problems that many Korean households have been facing recently. Chinese factory-to-consumer retailers offer value that is often hard to match for local merchants; however, delivery times are much longer.

With time, however, the Chinese seem willing to invest and improve the quality of their services. Alibaba recently announced plans to invest $1.1 billion in the market to improve its logistics capabilities.

It is possible that over time it will become more difficult for Coupang to continue to gain market share.

Coupang is trading at around 22 times forward three-year commodity trading earnings

Coupang’s commodity trading business is currently undergoing a rapid growth phase, as evidenced by its recent strong revenue growth. The business’s margin is also increasing as the third-party business outgrows merchant services.

Assuming 15% growth in trading revenue over the next 3 years and an operating margin of 7%, we would arrive at a 3-year EBITDA estimate of ~$2.6 billion. After depreciation, interest and taxes, we would arrive at approximately $1.8 billion in revenue for the trading division.

Coupang’s current market cap is ~$40 billion, so we infer that the business is trading at ~22X three-year forward earnings. Given the strong growth and fairly dominant position in the Korean market, we’d say this valuation multiple seems reasonable, neither low nor high.

Until now, I have completely ignored the offer development division of the business. This part of the business is still loss-making, but if management could make these businesses work, Coupang’s value could be further enhanced.

Arguable Value of Developing Offers

The Developing Offering division’s sales were mainly generated from online ordering and delivery services to restaurants in Korea and retail operations in Taiwan, but increased significantly with the acquisition of Farfetch.

Online fashion retail is a very difficult market to compete in and Coupang acquired the business out of bankruptcy.

Farfetch operates in a slightly more promising segment of luxury e-tail, as a higher contribution per order helps offset logistics costs more efficiently. On the other hand, driving traffic to your luxury online store can be quite expensive.

It’s not yet clear exactly what Coupang’s plan is for the fashion retailer. The business is quite far from the core Korean business operation and the synergies will not be significant. It would appear that it will be operated as an operationally independent entity

Due to the inclusion of Farfetch, Coupang’s profitability as a whole has dropped considerably. If management doesn’t find a way to turn this business around, the entire group will likely start trading at a discount to the commodity trading division to reflect the cash flow from the developing deals.

During the latest earnings call, management claimed that:

On Farfetch, , our goal is to generate near positive adjusted EBITDA on a run rate basis by the end of the calendar year. We execute to plan and are on track to achieve these goals for the year so far. Although we are still in the early stages of our journey.

As it stands today, it would not be reasonable to assign a positive value to the Offer Development division. If management fails to turn Farfetch around, Coupang could even revalue at a lower valuation multiple to reflect the division’s losses.

The bottom line

Coupang is a dominant e-commerce retailer in South Korea, serving almost all households in their home market. The company has benefited from the rapid growth of e-commerce in a market where online retail penetration is one of the highest in the world.

Growth in Korea is likely to slow down in the future, however, Coupang could continue to grow as it gains market share due to the logistical advantages and value provided by the membership scheme.

Coupang has also expanded into tangential industries such as food delivery and online fashion, however, these are still in short supply and it is not certain when profits can be expected.

Farfetch in particular has been a rather odd acquisition and we’ll be watching closely to see what their plan is for the British luxury fashion retailer.

As it stands today, Coupang appears to be trading at a fair value given the slowdown in Korean market growth and the uncertainty surrounding the developing Deals. We’ll stay on the sidelines for now, but we’ll continue to watch this high-quality business.

Editor’s Note: This article discusses one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.