PDD at 2x EV/EBIT

Himalaya Capital's Li Lu made this stock his 3rd largest position

source: Globe and Mail

To be clear, I arrived at an EV/EBIT of 2x by also including their short & long-term investments into their Net Cash. PDD holds a huge part of its asset base in both short & long-term time deposits and government bonds, and I included these into its Net Cash position when calculating its EV. Having said that, it’s true that after deducting the value of these cash-like investment assets from its market cap, PDD trades at a mouth-watering 2x EV/EBIT.

PDD should be familiar to most readers, being the 3rd largest e-commerce app in China. Most analysts will try to impress you concerning its “group-buy” feature that gamifies the e-commerce experience and gathers customers together to enable its Customer-to-Manufacturer (C2M) feature, which generates economies of scale and eliminates the middleman from the retail value chain. While we will explore this below, the investment thesis for PDD doesn’t rely on its business outperforming significantly. The investment thesis is simple — PDD is almost a net-net, and it simply holds too much cash for investors to ignore. At the current Enterprise Value of the company, the stock is practically screaming at investors as they are getting close to a 50% EBIT yield after cash.

Having said that, it remains instrumental to understand this still-growing business and the risks to the cash flow that exists, since PDD doesn’t return the cash to investors in the form of share buybacks and dividends. Why does PDD hold so much cash? Where does the business ultimately land? And why are investors not paying more attention to the stock when it is so clearly undervalued?

Business Model

Pinduoduo is China’s 3rd largest e-commerce app, after Alibaba and JD.com. Unlike most e-commerce sites in China which focus on Tier 1 and Tier 2 cities, PDD focuses on mostly Tier 3 and below cities where the rural communities live. This gives it a niche that the other e-commerce giants like Alibaba and Meituan have tried and failed to penetrate.

Pinduoduo also has a separate app called Temu which focuses on international markets. We shall explore below how PDD uses much of the same customer strategies that made it successful in China inside the Temu app to court the international customer. Currently, Temu’s geographical expansion includes the likes of North America, Western Europe and Southeast Asia.

Western e-commerce consumers who are familiar with Amazon will find a lot different in Pinduoduo’s approach to courting customers. Firstly, much of Chinese e-commerce strategy revolves around “gamification”, which turns the e-commerce experience into a game that rewards consumers with discounts on products. Pinduoduo also participates in this sort of customer strategy, where it ropes in friends and family members to participate in “group buys”, which rewards customer groups who buy in bulk purchases.

This creates a few strategic competitive advantages as compared to traditional e-commerce sales, which tend to involve individual purchases spread out over a large number of suppliers. Firstly, it creates economies of scale by allowing manufacturers to keep utilization rates at their assembly lines high, as they can predict with high accuracy how many products need to be manufactured. This allows them to spread the fixed costs of their operations over many more products, thus allowing them to pass the savings onto customers. Secondly, manufacturers who can now expect high purchase volumes from these “group buys” can subsequently skip the middlemen distributors who typically form 2 to 3 layers of the value chain and get their products straight to customers. This Customer-to-Manufacturer (C2M) approach significantly drives down unit costs and therefore prices, making it a win-win approach for both PDD’s customers and manufacturers.

Thirdly, both manufacturers and PDD can avoid holding costly inventory through these “group buy” approaches, since it creates ready-made demand for products straight out of the assembly line. Indeed, PDD famously has zero inventory days, which is unheard of in the Retail industry and even bucks the trend amongst e-commerce giants where 3rd party Fulfillment services are the norm. Holding such little inventory makes PDD a suitable channel to fulfill e-commerce grocery sales, which tend to be perishables and therefore have a low shelf life. PDD’s grocery arm, DuoDuo Grocery, is a huge business in China with operations spanning the entire countryside delivering products such as chicken, corn, cabbage and carrots to households all across China.

PDD also gamifies the consumer experience in other ways. For instance, they don’t have a shopping cart, and prompt customers to make impulse purchases by encouraging them to make purchases one item at a time (in bulk volumes). Pinduoduo’s app is also not designed like a traditional e-commerce app such as Amazon or Alibaba, which prioritize storefronts and displays products siloed within them. Instead, the app combines all stores into a giant “warehouse” that prioritizes time-sensitive discounts and turns the retail experience into somewhat of a video game, rewarding “players” with discounts on products independently of which seller it comes from. This once again triggers the dopamine-inducing sales mindset in the customer and encourages them to impulsively hit the Buy button on their app in order to rack up group buy volumes.

As PDD generates such high volumes, it makes sense for the company to sell its own white-labeled products. PDD famously has a much lower Average Order Value than competitors like Meituan or Alibaba, as most of the products it churns are daily necessities like food items, tissues, kitchen utensils and the like; it eschews higher priced items like electronics or clothing in favor of SKUs which can be massively mass-produced. These items can subsequently be white-labeled under the PDD brand, which turns the company into a retail giant larger than the likes of Walmart China or Costco China. It also has a significantly lower SKU count at about 1,500, compared to the latter which holds inventory for over 10,000 SKUs. This keeps operations lean and focuses sales around a limited number of best-selling items as opposed to providing the widest assortment of inventory.

As you may have observed, PDD’s operations create a flywheel which generates economies of scales across all business segments. It firstly encourages group buys through the gamification of its app design, drawing in friends & family to participate in impulse purchases of single-item transactions. This design encourages volume sales which keeps utilization rates at manufacturers high, thus allowing them to pass on fixed cost savings in the form of lower prices to customers. PDD subsequently leans on such large volumes to form its own white-label brand around a relatively small selection of SKUs, thus pinching margins from the value chain and allowing them the heft to compete against other e-commerce giants. It also helps that it focuses on a customer niche of Tier 3 or below cities, where the bigger e-commerce companies have a lower footing in and where PDD can muscle its way around.

Temu, which is Pinduoduo’s international arm, operates on a very similar concept of encouraging impulse purchases on products manufactured by its partner suppliers in China. The higher logistics costs of transporting items overseas means that it has a slightly higher AOV, but the underlying principle is the same — keep the flywheel spinning by encouraging volume purchases that can be grouped together across the world thus generating economies of scale across the value chain. The app frequently has discounts to encourage such impulse purchases geared to hit a Minimum Order Quantity that allows suppliers to produce such SKUs economically and affordably.

Aside from their structural C2M advantages, the algorithm for achieving retail success overseas is the same as anywhere else. Do a big splash of marketing to gain users in order to drive Big Data-driven marketing analysis, invest marketing dollars further, do promotions and advertising where appropriate, and seek a balance between gaining market share and keeping retail dollars. The flip side of the double-edged sword of being in a commoditized industry is that there’s low barriers to entry and it’s a game of survival of the fattest, which benefits PDD given how much excess cash it has on its balance sheet. While nobody is claiming that Temu will overtake Amazon anytime soon, it helps that there’s a reliable formula for Temu to rely on in order to gain mindshare and take American and European retail spend, which in no way restricts itself from operating purely in China.

As such, PDD and Temu’s huge war chest is a structural advantage in terms of marketing dollars. Given that they effectively have an unlimited marketing budget, what matters is a return on A&P activity which can be measured by S&M expense as % of revenues. The rest is to simply to rely on organic traffic being driven by having a robust & competitive inventory stack, which PDD already has plenty of experience offering in China and can simply replicate for the rest of the world under Temu.