Growth and Challenges of Pinduoduo, the Chinese eBay – Initiate with Hold [2/2]
This article is part II of our analysis on Pinduoduo– check out part I before you read.
What are the concerns of PDD moving forward?
In 20Q2, PDD managed to narrow its losses: the company reported a net loss of CNY 899 million, a YoY decrease. Its sales and marketing fees also fell to 75% of revenue from >100% in Q1. However, its GMV fell below analysts’ expectations of 80% – the latest financials indicating the implied GMV only grew roughly 48%.
Concerns about its GMV – GMV has always been an ambiguous term in e-commerce, as it does not take account of returned items. The resulting blur has been a concern for many analysts for the past several years. PDD's group purchasing model gave rise to some over-ordering activities from customers, which then resulted in items being returned. This GMV of PDD has been steadily growing for the past few quarters, but it dropped in Q2. "We always have reservations about what the GMV figure means," said Mark Webb of GMT Research. "But no matter how they calculate it, it's slowing."
PDD's ‘CNY 10b subsidy’ in Q1 brought in a lot of attention from the capital market. As the e-commerce market in lower-tier cities became saturated, PDD was hoping to use the 10b subsidies on expensive and luxury products such as Dyson and Maotai to break into major cities. But this effort was ineffective, as people still knew PDD for selling cheap items. In Q2, people were not buying expensive products on the platform, and they went back to purchasing necessities and cheap items. This phenomenon can be explained by the core of PDD's business model. Like many successful retail brands, PDD has found its success through establishing customer additivity – and, in this particular case, the additivity of buying on the cheap, including things they would not buy otherwise. This customer mindset that PDD relies upon could also be the reason why the 10b subsidy failed. PDD directed the subsidies to luxury items, as opposed to smaller items that it usually sold, and it could not give the same percentage of discount, which was the very satisfaction that kept customers on this platform.
Public Image – people often get to know PDD through its significant low price but low quality. Even though lack of quality is no longer the case for PDD nowadays, it is hard to remove the ‘cheap’ label. Under this label, it is very difficult for PDD's per-customer's purchasing price to match up with Taobao and JD, because consumers are still only shopping small and cheap items on this platform. For 2019, the average purchasing price of PDD customers was only CNY 1200, about ⅙ to 1/7 of Taobao. Now, the only way for PDD to grow its customer base is to penetrate the first and second-tier market, but so far, its brand image does not resonate with the preference from buyers in these markets. "They have a low-price image, a cheap stuff image, and also this image won't change, they don't have any way to change that because that's what has made them successful," said Steven Zhu of research firm Pacific Epoch. This quote is a great way to summarize how little room is for PDD to have its customers increase their spending.
Macro-Economic Cycle – When the economy is not doing so well, people become more sensitive towards prices and more willing to use PDD for purchase. It is proved by COVID 19 crisis period: people who used to perceive PDD as ‘low-end’ before no longer saw it the same way, and they started enjoying the discount offered in PDD. However, as China develops rapidly, it is possible that the general trend will turn to high price, high quality and well-branded products. Besides, PDD's current success heavily depends on its upstream - which are small suppliers and factories in China. Recent policies have been shifting to encourage tech driven instead of labor-driven economies. Will PDD still have an advantage in its current low-cost to access products? It is hard for anyone to accurately predict the future economy, but the risk and exposure PDD has to the economy will only increase in the future due to the sector it is in and the size it grows into.
Burning cash, but can it turn out sustainable? – Suppliers have reflected on PDD's low request for commission fees. Without paying for any advertisements, suppliers can still get the free traffic on PDD platform. For these several years, PDD never made any profit for these years with low revenue from advertising as well as its extremely low price for products. Quite the opposite, it has been burning cash on its advertisement which incurs a significant loss on its financials. For 20Q2, PDD’s loss was mainly driven by the drop in its marketing fees, but the management team has warned investors that this does not mean they will stick to the same marketing budget in the future. However, as we already can see from its GMV, at least its last CNY 10bn subsidy does not make a significant change as PDD expected. It is valid to concern if this constant burning of cash can really turn into a return in the future, as PDD's growth potential still faces a lot of obstacles to break.
What’s Next? - Our financial analysis and projections
Considering the positives and negatives discussed above, we initiate coverage on Pinduoduo with a Hold recommendation and December 2020 Price Target of USD 95.2 per share.
We drive our price target of USD 95.2 from a DCF methodology, assuming a WACC of 8.9%. Our price target implies a 7% upside – therefore, Initiate with a Hold rating. The revenue growth forecasts for 2020/21/2022 are 50%/40%/22% reflecting PDD's ramping up customer base in first and second tier cities and expanding into more product categories. We expect short-term gross profit margin will turn to positive due to the adaptable strategies PDD applied to increase monetization rate as well as compressing marketing fees to gain more efficient return. Still, the increasing branding quality and boosting efficiency in C2M may pose challenges here. We apply a 2.5% perpetual growth rate. Our bull case and bear case scenario valuations suggest a 33% upside and 26% downside, respectively.
In the long term, from EqualOcean’s perspective, there are two essential parts to identifying PDD’s future performance: 1) its ability to remove its low-price & low-quality public image to increase branding 2) implementing C2M and new branding incubation plan. For point one, PDD is in partnership with appliance giant GOME and hotel giant Huazhu starting this year. It is a sign that PDD is actively increasing its product categories to best meet clients’ needs. For the second point, PDD’s unique supply chain and high transaction volume give PDD the advantage of achieving its goal. However, both are still the biggest challenges awaiting PDD, as it approaches a change from its current status to recognizing a high margin or turning around its loss within this competitive e-commerce market.