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China’s Second Biggest E-commerce Player: PinDuoDuo

Stocks

Written by:

Dr Wealth

Disclaimer: This is not an incitement to invest. Dr Wealth and its associates, partners, and contributors will not be liable for any losses you make in the course of investing. Do your homework.

Editor’s notes:
Investing in China can be a scary prospect. We want to make it less so. Particularly since most of the growth stock opportunities that can change your life will be coming from China within the next decade or so. You can approximate this article as a sort of investment thesis template for yourself in the future for investments you want to make.

What information did Matus here seek to find?
How did he look at an investment to size it up?

Much can be learned if you apply yourself. Enjoy.

Pinduoduo (PDD) is a relatively new upstart in the e-commerce scene in China. The company has caught a lot of news attention and comments recently, both positive and negative.

The aim of this article is to provide an accurate picture of Pinduoduo’s business, competition and future prospects.

Started in September 2015 Pinduoduo is an e-commerce platform that connects customers directly with manufacturers and farmers.

Initially, it brought fresh produce from China’s distant provinces directly into customer’s hands without intermediaries. This meant higher prices for farmers and better value for customers, benefiting both sides.

Today it is one of the largest suppliers of fresh produce in China and the company expanded its model into other consumables, apparel, cosmetics, furniture, household goods and electronics.

In only 4 short years, Pinduoduo has become the 2nd most popular e-commerce platform in China by DAUs and it was the second most downloaded app on Apple’s iOS Store on August 23rd according to analytics firm App Annie. Based on GMV, Pinduoduo was the 3rd most popular e-commerce app in China last year.

How does Pinduoduo Function?

Each item listed on the site has 2 prices – a market price and a group price.

You can buy it immediately for the market price, or you can share it with your friends and get a discount (team purchase). The more people that sign up to buy it, the larger the discount gets, sometimes as high as 70-90%. After you pay for the item, it gets delivered to each member of your group individually.

If you can’t find enough friends, don’t worry, you can browse a list of people who are looking to fill their groups and join them. Substantially all of the purchases on PDD platform in 2017 and 2018 were team purchases (Source: F-20 page 54).

The app includes other shopping incentives like short-term coupons (that last 2 hours) or gamification elements.

The founder Huang Zheng has described it as a combination of Costco and Disneyland and I think it’s pretty fitting.

Users can buy a large portfolio of items in bulk and have fun while doing it.

Pinduoduo rewards users who invite the most friends with cash red envelopes. It also has leaderboards of users who made the most money through these invitations. Some people have reported making almost 3,000 RMB by sharing with 290 people.

If you have hundreds of friends on WeChat, you can make solid money on the side. You can also join a lottery for 0.01 RMB and invite 5 more friends and get a chance to buy a chosen product for only 0.01 RMB.

These are only a few examples of many gamification elements that are present on Pinduoduo app.

Compared to traditional e-commerce platforms that offer a search-based shopping format, PDD focuses on a mobile feed that recommends products in a social and more dynamic nature, which provides a more interactive shopping experience.

In other words, users previously knew what they wanted to buy and merely searched for it, while on PDD they can discover new products and get many recommendations from friends – it sort of functions like Amazon in this case.

Despite the benefits of Pinduoduo’s platform, there are plenty of users who rate the app poorly.

According to the China E-Commerce Research centre, Pinduoduo received only a 1-star rating on the 2017 National User Satisfaction Survey of Major E-Commerce platforms, with 17.9% of users logging complaints.

There are many allegations of counterfeit or fake products on Pinduoduo, or users that receive items in lower quality than described.

Reasonably speaking, if you buy an umbrella for $2.5, you don’t expect it to last 10 years, but you don’t expect it to break down immediately either.

Given that the focus is mainly on low prices, there are likely plenty of merchants who supply low-quality goods.

However, the company has taken affirmative action, shutting down thousands of merchants and deleting millions of listings, as well as improving their reviewing and listing processes.

This problem is likely to persist for a while, but Pinduoduo is working actively to solve it.

Merchant Registration

Like other e-commerce sites in China, merchants must post deposits before they start selling on the platform. The size of the deposit depends on the merchant, his history and item categories. The company then uses AI systems to scan reviews from customers and product descriptions to filter out fraudulent or suspicious vendors and blocks their activity.

Pinduoduo doesn’t force its merchants to register exclusively on its platform, unlike other e-commerce competitors. The company had 3.6 million merchants at the end of 2018.

The company also requires merchants to strictly abide by a 7-day return policy for non-perishable products. Customers can file return requests and if the request is denied by the merchant the issue is escalated to Pinduoduo directly.

How does Pinduoduo Make Money?

Initially, the company bought products directly from farmers and resold them to its users. This is a model used by their rival JD.com or Amazon but presents its own unique challenges and capital requirements. It was discontinued in early 2017 and now 100% of their revenue comes from online marketplace services, which are divided into 2 streams:

  • Online marketing services (89% of revenue in Q22019) – Merchants bid for keywords that match product listings on their platform, which is like Alibaba’s ad system. Alibaba derives 55% of its China commerce retail revenue from advertising.
  • Merchants on PDD can also pay for display ads and premium positioning in the app. Prices for these are determined based on an online bidding system, similar to Google’s. In fact, one can argue that PDD is not really e-commerce but rather a digital advertising company that monetizes its huge user base.
  • Transaction services (11% of revenue in Q22019) – commission fees generated from the transaction on the platform.
  • In the IPO prospectus, the company mentions that they charge up to 0.6% of the merchandise sold by merchants for payment processing fees and other transaction costs.
  • Given that this revenue was RMB 823 million ($120 million), the implied GMV is RMB 137.2 billion ($20 billion) which is not that far from the company’s published figures. Their 0.6% take rate is low relative to competitors and could be a source of potential revenue growth in the future.

As a result, the company purchases no inventory, avoiding this risk and high capital requirements, which should translate into attractive returns on capital in the future.

Pinduoduo Financials & Growth

PDD’s revenues have grown from RMB 505 million in 2016 to 13.1 billion by the end of 2018, representing a CAGR of 417%. In the first 6 months of 2019, revenues have reached RMB 11.8 billion ($1.7 billion), up 189% from the previous year. The operating loss in 2018 was caused in large part by stock-based compensation expenses of RMB 6.4 billion ($932 million) and large marketing expenses.

According to S&P Capital IQ, sell-side analysts expect PDD to hit 29.8 billion RMB ($4.2 billion) in revenue in the full year of 2019. That’s a growth rate of 127% which is lower than a year ago but still very impressive. For 2020 the consensus estimate is RMB 48.5 billion ($6.8 billion) which implies an expected revenue growth rate of 63%.

PDD had a high gross margin of 79% in the first six months of 2019, way above its competitors as detailed below (section Competitive landscape). They spent almost RMB 11 billion ($1.6 billion) on advertising in the first 6 months of 2019, or 93% of revenue, a staggering number. These are highly discretionary expenses and can be reduced at any point in time. In fact, marketing expenses in Q2 $890 million, causing an operating loss of $217 million. In other words, if Pinduoduo reduced its marketing spend by at least $217 million, it would already be break-even or profitable. The growth rate would naturally go down, which is something the company isn’t likely to do at this point.

The founder Huang Zheng has stated several times in his letters to investors that the aim is to grow intrinsic value for the long term and provide value to society as a whole, not to tinker with short term financials. As we will see later, Pinduoduo has powerful networks effects, as a large number of users brings more discounts from merchants which helps attract even more users to the platform.

The company has a significant net cash position of almost RMB 32 billion ($4.6 billion), which gives us an enterprise value of $29.6 billion. The large cash pile is used to finance their investments in marketing and advertising.

In addition, Pinduoduo has a negative working capital position, as it receives money from its users immediately, but pays it out to merchants several weeks later. In fact, Pinduoduo generated RMB 4.1 billion ($600 million) in operating cash flow during Q2, and RMB 2.6 billion ($379 million) in the first half of 2019. As a result, the company has no need for external financing at this moment to finance their rapid growth, although they might do additional secondary offerings in the future to bolster their balance sheet.

The last twelve-month GMV (Gross merchandise volume) has grown rapidly in recent years, from 38.4 billion RMB in June 2017 to RMB 709.1 billion ($100 billion) in 2019 in only 2 years, which is pretty incredible and represents a CAGR of 331%. While the growth rate in recent year (171%) has slowed down from the past, it’s still in the triple digits which is amazing given their large size.

During the same period, the number of monthly active users has grown 11-fold to 366 million (up 88% YoY).

Monthly active users refer to those people, who opened PDD’s app during the month, and it doesn’t include those who accessed it through WeChat or other social media.

This compares to 755 million MAUs achieved by Alibaba in their recent quarter (JD.com doesn’t reveal its MAUs). GMV from Tier 1 and Tier 2 cities has gone from 33% in September 2018, to 37% in January to 48% in June.

So the company is no longer just serving Tier 3 and Tier 4 cities with cheap products as many have claimed before.
Annual spending per active buyer in Q2 has grown 92% from 763 RMB to 1468 RMB (207 USD).

The company defines an active buyer a user who placed an order to purchase an item through the app, social media or other access points, regardless of whether that order was actually paid and fulfilled. Same goes for GMV, as it refers to the total value of all orders for products and services placed on the Pinduoduo mobile platform, regardless of whether the products and services are actually sold, delivered or returned.

What this means is that both GMV and the number of buyers are likely overstated, as they include buyers and orders that never materialized.

While it represents a red flag, it is actually common practice among many internet companies in China to inflate their user and activity numbers to generate media attention. We just have to take it with a grain of salt.

Based on Pinduoduo’s take rate from transactions of 0.6%, the implied GMV is RMB 137.2 billion, as detailed in sections below.

The company also disclosed that in 2018 alone they processed 11 billion orders on its mobile platform, while in the first half of the year they had 7 billion orders which represent a 25% market share based on 27.8 billion parcel deliveries in China (Source: Investor conference call).

Pinduoduo New Logistics Venture

Until now, the company has relied on Alibaba’s Cainiao network to ship its goods, which meant that Alibaba had access to tens of millions of PDD’s orders and its customer shopping habits. In March the company launched a rival to Alibaba’s logistics network Cainiao, and now almost all of its 40 million daily orders are processed in this system.

This was a huge problem. Giving your competitors access to your client base’s shipping orders and shopping habits is generally a bad idea all around, so this is a definite plus.

Pinduoduo is pursuing an asset-light business model same like Alibaba. So instead of buying trucks and building their own warehouses (as JD.com has done), it is looking to partner with independent 3rd party logistics providers, fulfilment centres and retail shops which will allow building a large network without spending too much money (CAPEX).

Image result for cainiao

They already launched their own e-waybill system, which is an electronic document that describes a package, its origins and destination. It was originally introduced by Alibaba in 2013, and now Pinduoduo is looking to establish a rival network to provide more choices for consumers and transport companies. So far the whole system is for free but could be another source of revenue in the future.

Cainiao was valued at $20 billion in the past when Alibaba bought majority control in 2017. If Pinduoduo manages to establish a network of similar scale, it could be a significant source of value in future years.

Who Is Huang Zheng?

Image result for pdd founder

Pinduoduo was founded by Huang Zheng (Colin), a son of factory workers who showed exceptional mathematical talent since an early age. He was admitted to Hangzhou Foreign Languages School, which was one of the elite high schools in China during the 1990s that had foreign teachers and overseas exchange programs.

Thanks to that he was able to get to Zhejiang University and later graduated from University of Wisconsin, getting a job in 2004 in Google as a software engineer. He was among the team that established Google China but later left and later founded an e-commerce site Ouku.com focused on electronics, which proved to be just one of his early business ventures.

Duan Yongping, the famous Chinese investor and founder of BBK Electronics and smartphone brands Oppo and Vivo is an early investor in the firm and personal friend and mentor of Huang Zheng. Other investors in Pinduoduo include Tencent with a 17% stake, Gaorong Capital with 8.4% and Sequoia China with a 7.2% stake. Hang Zheng holds 45% of shares, however, his voting stake is 89%, giving him essential control of the firm.

For anyone interested in more information about Huang Zheng, here are two interviews with him:

  1. Son of Chinese Factory Workers Built This $1.5 Billion Startup
  2. Interview with Pinduoduo EN #Sky9 Capital

Who’s the Competition?

The dominant players in China’s e-commerce industry have for years been Alibaba and JD.com. In fact, many investors assumed that it was already saturated, and any upcoming players would have a very hard time catching up to these two juggernauts. The arrival of Pinduoduo changed the industry, and it appears it already surpassed the no. player JD.com.

Alibaba remains the undisputed champion with 755 million monthly average users (MAUs). JD doesn’t disclose this number, it rather publishes the number of annual active customer accounts, which are users that made at least one purchase during the year. This number reached 321 million in the latest quarter, up 3.5% from a year ago. Pinduoduo, on the other hand, discloses annual active buyers (483 million in Q22019) but that includes users that might not have purchased anything.

According to Bloomberg News and Jiguang, Pinduoduo surpassed JD.com in daily active users more than a year ago in early 2018. Daily users might not directly translate into buyers, but it appears that PDD has outgrown JD in terms of its user base.

When it comes to commissions, Alibaba charges 0.5%-5% for Tmall, 0% for Taobao and 5-8% for Alibaba.com platforms. JD.com commission fees are 2-5%, which is still way above the rates that PDD charges (0.6%). As a result, there is substantial room for a possible increase in the future.

It appears that the company wants to reduce prices as much as possible, to drive merchants and customers onto the platform, which makes sense in the long run.

JD.com generated RMB 271 billion in revenue in the first six months of 2019, with an operating profit of RMB 5.2 billion. Profitability at JD remains lower than Alibaba’s, due to the low margins of their direct selling business. BABA generated an operating profit of RMB 33.1 billion on revenues of RMB 208 billion, which includes not only e-commerce but also their cloud computing business and other ventures. PDD remains a small player compared to them, but it’s quickly catching up with revenues of RMB 12 billion but operating losses totalling RMB 3.6 billion.

Another difference that catches the eye is gross margins. JD margins are at 15%, low due to their direct selling approach. Alibaba’s margins are better because it’s an asset-light platform business, but PDD stands at 78%, which is actually closer to Google (GOOGL) and Facebook (FB), because 89% of their revenue comes essentially from digital advertising. High margins leave a lot of room for marketing and R&D expenses, which is exactly what PDD Is doing.

PDD faces competition not only from established giants, but also from new entrants into the space. In total 13 other companies have raised RMB 2 billion ($282 million) to compete in the group buying arena, including Meituan Dianping’s co-founder who launched platform SongShuPinPin. Meituan itself launched a group buying mini program on WeChat in October covering a wide range of goods including fresh fruit. As expected in China, if there is a concept that works you can expect plenty of competition in the field pretty quickly.

I believe the new entrants will have a very hard time competing with PDD due to powerful network effects already in place. Metcalfe’s law states that: “The effect of a telecommunications network is proportional to the square of the number of connected users of the system (n2).” It means that if someone has a network of 1,000 people and the other a network of 10,000, the number of enabled conversations isn’t 10 times higher, it’s 10^2 or 100 times higher. As a result, the larger network is roughly 100 times more valuable than the smaller one.

In addition, Pinduoduo has created a positive self-reinforcing cycle, in which the higher amount of users drives better discounts from manufacturers which brings more people onto the platform which means even more discounts and so it continues. That’s why the company spends so much on advertising, to attract as many users as possible to achieve critical mass and make the market impossible to penetrate for competitors. The same loop works for Amazon or for Costco and Pinduoduo illustrates it in the following picture:

According to data from GGV Capital (July 2018), Pinduoduo relies heavily on traffic from WeChat, unlike other e-commerce platforms. Only 38% of PDD’s users came through the app, compare to 57% for Vipshop, 73% for JD.com and 100% for Alibaba’s Taobao.

Tencent holds 17% of PDD’s stock based on its latest annual report, so it shouldn’t be a problem in the near term. In addition, the average order value in 2018 based on GGV Capital data was $6 at PDD, $30 at Alibaba and $60 at JD, which leaves plenty of room for PDD to grow. The company mentioned on their latest conference call that average order value climbed above RMB 50 in Q2 2019.

Figure 8 Source: GGV Capital

Pinduoduo Valuation

The company doesn’t generate an accounting profit yet, so it’s very hard to come up with margin estimates or a DCF model. Using simple P/S ratios, we can compare how it trades relative to competitors Alibaba (BABA), JD.com (JD) and Meituan Dianping.

Figure 9 Source: Morningstar, Yahoo Finance, Ycharts, Company filings, S&P Capital IQ

PDD stock is the most expensive based on this metric, however, it is also the fastest-growing. Pinduoduo grew 169% in the last quarter, Meituan 51%, Alibaba 42% and JD 22%. PDD is the fastest growing of them all plus has more than double their gross margins (except for BABA). PDD stock is not priced cheaply relative to its competitors, however, it’s cheap compared to its future potential. Their platform has very strong network effects, makes most of its money from high margin digital advertising, which could translate into 20%+ operating margins in the future.

E-commerce market and retail sales in China

E-commerce sales in China reached $684 billion in the first half of 2019, up 17.8% year-over-year. This is down from previous growth of 32.4% in the first six months of 2018, caused by slowing GDP growth in China and the trade war with the United States. E-commerce sales represented 25% of total retail sales in the country during this period, with Eastern China commanding a share of 83.2%. Goods for pets, fresh food and cosmetics are the most popular categories for buyers in larger cities, while home appliances, clothing and car accessories are preferred in rural markets.

Figure 10 Source: Emarketer

Based on data from EMarketer, Alibaba is still expected to dominate the field with 56% share, JD.com is second with 16.7% and Pinduoduo comes third with 7.3% of China’s e-commerce sales. Not only is the market still huge, but it’s also growing by double digits, so there is significant room for Pinduoduo to expand.

Risks

  • Pinduoduo has been blamed several times for selling fake, low quality or counterfeit goods (scmp.com). Although they have responded by blocking thousands of merchants and delisting millions of products, the risks remain. On one hand, when Alibaba and JD.com cracked down on fake and counterfeit goods merchants, they might have found a home on PDD’s platform. On the other hand, if you sell millions of products for very low prices, you are going to encounter plenty of instances of poor quality or fake products. Given that Pinduoduo is a young company, they didn’t have the necessary processes to deal with this.
  • In November 2018, the short-seller Blue Orca Capital published a report stating that Pinduoduo has likely inflated its GMV and revenue figures and understated its staff costs and underreporting net losses. Soren Andahl from Blue Orca also said that PDD’s business is a fad, that they sell the cheapest products to the poorest Chinese and will not survive. Their main points centre around a discrepancy between the company’s SEC and SAIC (China’s State Administration of Industry and Commerce) filings, as well as their way of reporting GMV. Also, Blue Orca mentioned that PDD was using shadow entities to hide personnel hiring and the respective costs. While the differences between filings are a red flag, they are a very common occurrence in Chinese listing and not necessarily indications of fraud. Here is a detailed article from GeoInvesting, the people behind the documentary “China Hustle”. In fact, 48% of PDD revenue came from Tier 1 & Tier 2 cities, so it’s no longer about selling cheap products to rural China. The company didn’t provide much commentary regarding the report on their next quarterly call and elected not to say much about it (Nikkei.com).
  • A large part of Pinduoduo’s traffic comes from WeChat and other social networks. This is a result of people sharing products and deals and the company has no control over these access points. For example, Tencent has blocked Alibaba from its platforms, which could also happen at some point to PDD, even though Tencent is a shareholder.
  • Pinduoduo was founded only in 2015 and grew extremely fast to serve hundreds of millions of users. Their infrastructure must be very complex and causes occasional bugs to happen, which can cost the company millions. In addition, there might not be processes and functions that are present at larger and more established companies, which are however necessary to operate at such scale. It’s very different to sell products to 10 million people, then to 100 million.
  • The group-buying model always was and will be competitive. New entrants are coming into space, while older and established players are also playing with the idea.

Summary

Pinduoduo has rapidly climbed to the 2nd spot in China’s e-commerce market.

While it’s still far behind JD.com in terms of GMV, it’s catching up quickly. Their margins are far superior to both JD and Alibaba, and the platform likely hasn’t reached full monetization potential. Average order values are still very low, with significant room for growth.

Furthermore, 89% of its revenue is derived from search and advertising, directly from GMV, so it makes sense to focus on marketing and attract as many users to the platform as possible.

The company is viewed as a cheapskate currently, which might deter some consumers, merchants and even advertisers from participating on the platform.

As mentioned in their latest release, 48% of GMV already came from Tier 1 and Tier 2 cities, so this perception will likely change as time goes by. Their new logistics venture represents optional value, as the company claims its e-waybill system is already second-largest in China behind Alibaba.

Pinduoduo’s business model is largely misunderstood in the West, it’s simply viewed as another e-commerce company. Its stock is also underfollowed, as it has only 10K followers on Seeking Alpha compared to JD’s 84K and BABA’s 343K. China’s e-commerce market is huge and still growing, but the real question remains whether the business model can be expanded abroad to other countries and regions.

I believe that Pinduoduo has a very high chance of becoming a lasting force in China’s e-commerce industry, and its stock presents a very compelling investment opportunity.

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