Pinduoduo: Cash & Innovation Machine In Hyper Growth Mode
Summary
- PDD a leading e-commerce platform in China that is still growing like a weed and generating a ton of cash doing it.
- The company enjoys many competitive advantages over competitors, driven by innovation.
- Following the recent growth sell-off, the stock is trading at an attractive valuation.
Pinduoduo (NASDAQ:PDD) is a force of nature that I needed to understand, and I am here to share with you what I have learned about this magnificent organization.
In only five years, the company went from nothing to the largest e-commerce platform in the world by annual active users. Driving this meteoric rise is a re-imaging and integration of social media and e-commerce, which should be an inspiration for all social and e-commerce companies globally.
The company is growing rapidly but isn't profitable. However, the company's business model allows it to generate an abundance of free cash flow, giving it an attractive free cash flow yield on a stock that might otherwise look expensive.
Q1
I usually don't spend much time on short-term considerations like quarterly earnings, but sometimes I make exceptions. In the case of PDD, which grew revenue 239% y/y, investor live in dog years (i.e. 1 quarter for PDD is like 7 quarters for "normal" companies).
This massive revenue growth is driven by a 31.2% increase in active buyers, reaching 823.8 million, and the rest largely driven by an increase in buying frequency of these buyers. The active buyer number puts PDD ahead of Alibaba's (BABA) 811 million active buyers. Notable strength came from its third-party platform and Duoduo Groceries (Maicai or 买菜) business.
Source: Company
Underlying PDD's growth is a massively growing Chinese consumer economy. According to the National Bureau of Statistics of China, China's GMV in the first four months of the year grew 27.6% y/y, reaching RMB 3.76 trillion.
In Q1, PDD emerged as the fastest growing platform among the top 20 apps in China on aggregate time spent. However, China's e-commerce market is extremely competitive with Alibaba (BABA), Meituan (OTCPK:MPNGF), and JD.com (JD) offering stiff competition. To win, PDD must invest aggressively, which is leading to increasing losses in the near term:
Source: Company
Business
PDD is the world's largest e-commerce platform by annual active buyer size, an incredible achievement by a company who only started commercial operations in 2015.
PDD operates as a 3rd-party platform and monetizes primarily through advertising. The primary attractions of the platform are value-for-money and a fun shopping experience, which focus on group purchase that drive volume discounts, combined with social media sharing and in-app games and entertainment that keep users engaged. Importantly, PDD's entertainment offering attracts users at a low cost.
Source: Company
Pitching itself as an online blend of Costco (COST) and Disney (DIS), or a combination of value-based shopping and light entertainment, PDD has spearheaded China’s adoption of social e-commerce.
PPD's competitively priced items is made possible by a unique strategy: factory direct selling, gaining purchasing leverage though social & team purchases across fewer SKUs, and very high inventory turns. Subsidies also play a role, but can be viewed as user acquisition cost.
The value of team purchase is that it aggregate demand that would otherwise be dispersed. Larger purchase orders lead to lower prices. As the platform for team purchases, PDD has access to proprietary data which can be used to build a highly differentiated AI infrastructure that powers its recommendations. With 1,900 dedicated engineers building this infrastructure, the company enjoys an enormous competitive advantage on this mode of shopping.
Factories also love PDD for its volume purchases and the data that it provides. Flipping factory direct selling around and you get PDD's consumer-to-manufacturer (C2M) model: using PDD's platform, manufacturers gain insight into demand and preferences, which allow them to more effectively manage inventory and deliver product innovation.
The company's innovation in the shopping experience drove viral adoption. The PDD user interface is SKU-centric and designed for mobile browsing and discovery. Each page is dynamically personalized, resembling a virtual bazaar whereby users can scroll and explore different products. The team purchase model was also re-invented to promote interactions between users:
Source: Company
In my view, adding gaming to the platform is an ingenious move that accomplishes several things: 1) it brings potential shoppers into the funnel early (i.e. young shoppers who might only have small sums to spend), 2) it leverages existing customers' social network to grow (i.e. invite friends and family) and 3) it keeps users engaged even when they are not in the mood for shopping (so when the shopping itch returns, you don't even need to switch apps).
Source: Company
Financials & Valuation
(Note: all financial forecasts are consensus numbers from FactSet, unless otherwise noted.)
PDD's growth is on insane mode. In 2019, the company grew 122% y/y. In 2020, it grew another 111% y/y, reaching over $9.1 billion in sales. This year, the company is expected to grow 95% against though comps, hitting $17.8 billion in sales.
The company, however, continues to lose money as it ramps up investments, as discussed earlier. In 2020, the company generated an operating loss of $1.4 billion. In 2021, operating income loss is expected to increase to $1.9 billion. Consensus forecast doesn't see an operating profit until 2023, when it is expected to generate $841 million.
However, the company generates a ton of cash, driven by its very attractive business model of collecting cash from buyers before paying merchants. For example, in 2020, the company's "Payable to merchants" line item contributed $3.7 billion to operating cash flow, which totaled $4.3 billion that year (the rest is driven by paying employees in equity which is officially non-cash, but in reality it is a cash item if the company buys back shares to avoid diluting shareholders -- that's a rant for another day). Furthermore, the company plants just 0.1 to 0.2% of its revenue on Capex -- that is light!
As a result, the company generated $3.8 billion in FCF in 2020, up 64% y/y despite heavy investments. In 2021, PDD is expected to generate $5.2 billion in FCF, up 37% y/y.
Lastly, the company's balance sheet is extremely strong:
Source: Company
For a hyper growth company that is generating a large amount of FCF, PDD doesn't strike me as expensive. The stock is trading at 4.7x forward EV/Sales, and offers a 2.05% FCF yield on forward FCF estimates.
I want to remind investors that this yield is way higher than the 10-year Treasury yield (at 1.56% at the time of the writing) and, unlike Treasuries, PDD's FCF is expected to grow. In addition, PDD does business in RMB, which has been strengthening over the past year vs. the USD.
I don't know about you, but I've been hedging my USD exposure as much as I can. As the saying goes on Wall Street (Bets), "Money Printer Go Brrr".
Risks
PDD is a relatively young company that has never made an accounting profit. (The company began commercial operations in 2015). Many investors will be sitting on the sidelines due to the lack of profitability, since it could imply that the business model is untested.
China's e-commerce market is extremely competitive with Alibaba, Meituan, and JD.com offering stiff competition. In addition, a stream of startups and new e-commerce channels are constantly emerging to change the competitive landscape. Investors in PDD should be vigilant to the rapid changes.
PDD's stock is highly dependent on rapid growth. PDD's aggressive investments may not generate the ROI or growth investors hope. Although the company is FCF positive, it depends on continued growth of the platform to drive more cash collection from buyers than outflows to merchants. If growth stalls, given current negative operating margins, FCF should turn negative.
The company is dependent on app stores to disseminate its mobile apps. This means the company is dependent on just two American companies: Apple (AAPL) and Alphabet (GOOG). This could become an issue down the line, however I believe Huawei's HarmonyOS offers an attractive alternative.
The company is dependent on Tencent (OTCPK:TCEHY). PDD generates traffic from WeChat and WeChat Pay. In addition, PDD depends on Tencent for payment processing, advertising and cloud technology.
Like all e-commerce platforms, including Amazon (AMZN), PDD incur liability for counterfeit, unauthorized, illegal, or infringing products sold or misleading information available on its platforms.
Takeaway
PDD a leading e-commerce platform in China that is still growing like a weed and generating a ton of cash doing it. The company enjoys many competitive advantages over competitors, driven by innovation. Following the recent growth sell off, the stock is trading at an attractive valuation.
This article was written by
Analyst’s Disclosure: I am/we are long BABA, TCEHY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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