Pinduoduo : The Next eCommerce King

Pinduoduo (NASDAQ:PDD) is one of China’s fastest-growing tech companies. Growing sales at 65% last quarter (26.48% in the trailing 12-month period), it has weathered China’s growth slowdown much better than other e-commerce giants have. Over the last 12 months, Alibaba (BABA) and JD.com (JD) have barely grown at all, so Pinduoduo’s performance has really stood out.

With all that being said, there are questions to ask about exactly how Pinduoduo is achieving its growth. It is known to be spending aggressively on Meta (META) ads to get Temu’s user count up, and it went so far as to buy notoriously expensive Superbowl ad space. Facebook ads can be very effective, and Superbowl ads can work too if they have the intended cultural impact. But it’s pretty clear that PDD is spending a lot of money to acquire customers in the U.S.

The question is:

Is it spending too much money?

It’s not uncommon to find growth companies overspending to acquire customers. When this happens we see revenue growth that might not be sustainable. For example, Netflix (NFLX) spent $2.53 billion to acquire 8.9 million new subscribers last quarter, for a cost of $258 per subscriber. For the company to break even on that investment, it will need the subscribers to stay in for more than two years on average! The point here isn’t to bash Netflix–I have no opinion on the stock–but merely to illustrate the fact that any company can juice its top-line growth with extreme marketing expenditure.

It’s logical enough to ask whether Pinduoduo is doing this. For one thing, people have heavily implied that it is. Zeyi Yang in the MIT Technology Review quotes a market researcher as saying that Temu has “little organic recognition,” and corroborates the researcher’s claim by saying that Temu inundates her with ads. Yang concludes her analysis of Temu by saying it’s likely to end up more like the niche AliExpress than the wildly popular SHEIN.

Additionally, it helps to scrutinize any growth story, to see whether the growth is of high quality, or simply being driven by unsustainable spending. If it’s the former, then you might have a buy on your hands; if it’s the latter, then you may want to think twice. In this article I will explore the question of Pinduoduo’s advertising spend, ultimately concluding that it’s fairly sustainable, and that the stock is a good value at today’s prices.

Earnings Still Rising Despite the Ad Ramp Up

The good news about PDD’s advertising spending is that it is not, so far, impeding growth. In its most recent quarter, Pinduoduo revealed:

• $4.99 billion in revenue, up 65%.

• $1.46 billion in operating profit, up 388%.

• $1.488 billion in net income, up 546%.

• $1.75 billion in adjusted net income, up 288%.

Expenses grew at the following rates:

• Sales and marketing ($1.975 billion) - up 40%.

• General administrative expenses ($127 million) - up 170%.

• Research and development expenses ($379 million) - up 11%.

As the screenshot shows, there was one expense category that increased dramatically in Q3 (general administrative expenses). However, that category was small enough as a percentage of revenue that it didn’t impede profit growth. The larger expense categories (marketing and R&D) grew slower than revenue did.

So far so good. We’ve got a fair bit of expense growth but it lags behind revenue growth, coming in at 38% overall. That’s good in principle, but what if the Chinese business is simply propping up a U.S. business (i.e. Temu) that is spending too much money to grow? This possibility needs to be investigated.

Temu’s financials are surprisingly difficult to tease out. The company’s earnings releases don’t break down results by segment, and the SEC filings don’t yield any information that’s not in the press releases. Therefore, we’ll have to use estimates in order to gauge what kind of revenue Temu is generating and how much marketing spend it’s consuming.

What we know is the following:

• Temu was founded in September 2022.

• The second quarter (the quarter before Temu was founded) saw 36% growth.

• Pinduoduo’s growth ramped up to 65% in the third quarter (50% in U.S. dollar terms).

• In the same quarter, China was heavily locked down, resulting in 3% growth for Alibaba and 11.4% growth for JD.

So Pinduoduo delivered accelerating growth, while its two main competitors showed slowing growth. It’s quite possible that Temu drove all of Pinduoduo’s growth in Q3. If it did, then the marketing spend was justifiable: the revenue increase was ahead of the increase in ad spend. Indeed, it was ahead of the growth in all costs combined!

However, we should be conservative here. Pinduoduo’s sales growth in the second quarter was 36%, which was higher than Alibaba and JD in the same period. That was all growth in the Chinese platform, because Temu wasn’t founded yet. So, we should assume that Pinduoduo is seeing growth in China, and that not all of Q3’s growth came from Temu.

Now, we need to determine how much of the Q3 revenue growth came from Temu.

The reported revenue growth in the quarter was 65%, but that shrinks to 50% if you calculate it with U.S. dollars (the calculation in the press release was done with RMB). If Pinduoduo’s third quarter growth included 36% growth in China (unchanged from Q2), then we’ve got 14% Q3 growth coming from the launch of Temu (14% on the base amount I mean, not 14% “of the growth”).

Reported Q3 2021 revenue was $3.337 billion, while reported Q3 2022 revenue was $4.991 billion. To grow $3.337 billion by 14%, you need to gain $467 million. That figure should approximate Temu’s contribution to PDD’s Q3 revenue. Pinduoduo’s increase in marketing costs in Q3 2022 was about $564 million. Therefore, if my assumptions hold, then Temu is already pretty close to breaking even. In fact, if $97 million of the $564 million increase in marketing spend came from Chinese operations, then Temu is already breaking even in gross profit terms!

It all looks good for Temu so far. However, I should stress that there are some heavy assumptions baked into the preceding sentences. Temu’s results are a complete mystery, so I had to estimate the level of organic growth and subtract that from total growth to get a Temu revenue estimate. If Pinduoduo’s organic growth accelerated last quarter, then the paragraph above could be inaccurate. However, when we consider the fact that China was locked down last quarter, there’s a strong case to be made that Temu probably did account for a decent sized chunk of Q3 revenue growth. That bodes well for PDD’s future, as Temu was only a month old at the end of the quarter!

Valuation

Having looked at Pinduoduo’s growth and expense picture, we can now move on to the valuation.

At today’s prices, PDD trades at:

• 26.25 times earnings.

• 7.3 times sales.

• 8 times book value.

• 22.49 times operating cash flow.

• 23.81 times free cash flow.

This might look expensive, but PDD’s multiples are honestly not even that steep compared to mature, slow-growing U.S. tech companies. For example, Microsoft (MSFT) trades at:

• 29.85 times earnings.

• 10 times sales.

• 11 times book value.

• 24 times operating cash flow.

• 33 times free cash flow.

Every single one of these multiples is higher than the comparable ones for PDD, yet PDD is growing the top-line 30 times faster than MSFT!

The overall mix of growth and value here is pretty attractive. If Pinduoduo keeps up its current growth rates and the stock price doesn’t change, then the stock will be dirt-cheap in a year or two. For example, if you take PDD’s $13.16 in revenue per share and grow it at 65% CAGR for two years, it grows to $35.82. At today’s stock price, that yields a price/sales ratio of just 2.6.

A Risk to Beware

So far, all of the fundamental factors I’ve looked at are flattering to Pinduoduo. It’s growing quickly, it’s profitable and it’s cheaper than even slow-growing U.S. tech stocks. It looks like an appealing package. However, there is a risk to keep in mind:

U.S./China tension

The United States and China don’t see eye to eye on many things right now. For example, the two nations disagree on the status of Taiwan. These and other issues have led U.S. officials to see China as a threat. Today, there’s draft legislation in the works to ban TikTok in America. It has already been banned from government owned devices in some states. So far, none of these measures have targeted e-commerce companies, but you never know what the future holds. There is some outside chance that Temu will find itself banned or heavily restricted.

On the whole, though, Pinduoduo looks like a solid bet. U.S./China tensions can sometimes be overstated, the two nations trade extensively with one another, and attempts to ban Chinese apps have failed in the past. As long as a worst case scenario in U.S./China relations doesn’t play out, Pinduoduo should do well.