Special Report: Slings and Arrows of Bad Publicity Fail to Dislodge ZTO Express

One of China's elite express delivery companies, ZTO Express, was charged in a class action suit with failure to exercise due diligence. Nevertheless, business is booming for the Shanghai-based company.

Author: Ed Newton   

A class action lawsuit filed earlier this year against ZTO Express (Cayman) Inc. (NYSE: ZTO), claiming that its 2016 IPO inflated profit margins by hiding low-margin business in a "network partner" category, has failed to undermine the company's dominance in China's express delivery segment. 

The most recent earnings report for ZTO, one of the largest express delivery services in China's burgeoning parcel delivery markets, showed revenue growing at solid double-digit pace with anticipated earnings rising even more rapidly.  

The company announced a week ago that its income for the third quarter ended Sept. 30 soared 31.1 percent to RMB 717.2 ($107.8 million) compared with a year ago. Revenue jumped to RMB 3.14 billion ($472.4 million), an increase of 33.6 percent, from the same three-month period last year. The positive results continued the company's trend upward, following a second-quarter rise of 43.5 percent in year-over-year results.

While the stock price for the Shanghai-based company has ranged from about $11 per share to more than $17 on the NYSE over the past year, shares took a hit in the weeks after the class action suit was announced in July, falling from about $16 to just above $13. But it has since recovered, trading close to $17 per share and closing Friday at $16.47. The stock price has suffered some dips since ZTO went public in October last year out of concern for periodically weak earnings-per-share growth and allegations of improprieties in ZTO's IPO. But the overall trend has been steadily upward.

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The company's growing delivery network have served to keep it viable, even when the news was bad. The network reportedly covers 96 percent of China's cities and counties, offering proof of the conventional wisdom that, particularly in the express delivery business, if you can deliver the goods, you'll never lack customers.

"ZTO is both a key enabler and a direct beneficiary of China's fast-growing e-commerce market," the company asserts. The market, fed by increasing disposable income from China's fast-growing middle-class, is 1.5 times as great as the U.S. market. 

The company now has 79 sorting hubs and fleet of more than 4,400 trucks, as well as a partner network "to provide pickup and last-mile delivery services." The company's parcel volume during the quarter increased by more than 39 percent, to 1.54 biliion. At the same time, ZTO was strengthening the centralized control of its assets. 

"The network partner model is developed to reach and serve the Chinese e-commerce industry's fragmented and geographically dispersed merchant and consumer base and seasonal demand," a company representative says. 

ZTO's primary clients are major e-commerce sites like Alibaba and JD.com. Most of ZTO's revenue comes from parcel volume and fees it charges partners for merchandise going through its network. The company is, like Alibaba, incorporated in the Cayman Islands, bypassing a Chinese law that forbids foreign ownership of strategic assets. 

Thus, investors in the company own stakes in a "variable-interest entity" rather than in the company itself. Instead, investors own shares in an entity that's entitled to profits earned by ZTO.

Allegations of inflated profits 

But it was ZTO's touted network of partners that raised questions from international investors. 

According to the complaint against ZTO, the company's prospectus issued in connection with the IPO contained "materially false and misleading information." ZTO was said to have "improperly inflated its stated profit margins by keeping low-margin segments of its business out of its financial statements." 

ZTO and the underwriters of its stock market listing "improperly inflated its stated profit margins by keeping certain low-margin segments of its business out of its financial statements," the complaint charged. "The Company failed to disclose that it used a system of ‘network partner' to handle lower-margin pickup and delivery services while maintaining ownership of core hub operations." 

The company allegedly kept "network partners" off its own books to exaggerate profits. The lawsuit was filed in Alabama state court by the city of Birmingham's pension fund. Morgan Stanley and Goldman Sachs Group, which let the marketing effort for the IPO, were named in the suit. The pension fund plaintiff charged that the IPO marketers had failed to act with adequate due diligence. 

The IPO was the largest U.S. listing last year and the largest Chinese listed by a Chinese company since Alibaba Group Holding's $25 billion IPO in 2014. The day the lawsuit was announced, ZTO's stock closed 20 percent below its IPO price of $19.50. 

A ZTO spokeswoman told Reuters that day, "We believe the claims are without merit and intend to defend ourselves vigorously." 

Despite the bad publicity, ZTO has remained a desirable investment in the view of stock analysts. The most recent consensus among 15 analysts polled by CNN Money rated the company a Buy, a rating which has held steady for a year.

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