Pinduoduo: A fairy-tale story, but does the future really look bright?

Pinduoduo is the biggest e-commerce marketplace for agricultural products in China. Founded in 2015, it’s one of the fastest growing tech platforms, reaching more than 640 million active monthly users in 2020. Pinduoduo connects farmers and merchants directly with customers. Besides the agricultural produce, the product offering ranges from household items, personal care, apparel, sports and fitness items to even electronics.

Pinduoduo was established from the idea of Zheng Huang to build a social commerce venture. With his team from previous startups, they created a business model based on group buying, where customers can get a better price if they buy the same product together with their friends.

At first, they tested the model called Pinhaohuo, which was based on company buying goods from suppliers, then selling them to customers and providing the fulfilment. This model was replaced by simpler model called Pinduoduo, which is only a marketplace connecting the buyers and sellers.

Pinduoduo went public in July 2018 and raised $1.6 bn in the IPO, with shares priced at $19.

Management

Let’s look at the executive team of Pinduoduo. The change of the CEO last year raised some questions, and currently the CEO Lei Chen is the only C-level executive, which is rather unusual for a company with market cap over $200 billion.

Lei Chen is one of the founding members of Pinduoduo. He served as the Chief Technology Officer before being appointed as the new CEO in July 2020. Mr Chen has a background in computer science and work experience with Google, Yahoo Inc., and IBM in the United States.

Zheng Huang (also called Colin Huang) is the founder and the former CEO of Pinduoduo. His career started at Google as a software engineer and project manager and later on, he was a part of the team that established Google China. After his tenure at Google, he started several companies, such as electronics e-commerce site Ouku (later sold for $2.2M), Leqee, Lebbay or online game company Xinyoudi.

The CEO Lei Chen, as well as Zhenwei Zheng and Junyun Xiao were all previously part of the Huang’s ventures with the gaming company Xinyoudi.

Colin Huang stepping down as a CEO was a surprise for many, since the business was growing well. He remains the chairman and wants to focus more on long-term strategy, but this move raises some questions about his confidence about the future of the company. At the same time, he reduced his share ownership from 43% to 29%, although this still gives him sufficient control over the company.

Ownership structure

As already alluded to, Colin Huang holds the highest portion of shares, 29%. The other shareholders include tech-giant Tencent with 22% and Banyan Partners Fund with 14%.

Business model

The business model of Pinduoduo is quite simple. It provides a platform where consumers can shop for goods from different merchants. The success hinges on ability to attract both sides to join the platform.

The biggest advantage is remarkably low prices. The customers are always presented the two option when buying a product – the normal price, which is set by seller, and discounted price, which they can claim if they buy together with someone else as a group.

The discounts can be up to 90% off and the time to claim it is limited, but users can use WeChat to invite their friends, or also just join some strangers. The sellers in the end get their full price, so the discounts are covered by Pinduoduo.

Duo Duo Maicai

In August 2018, Pinduoduo launched a new grocery service Duo Duo Maicai. This is an extension of the existing services, integrated into the main app. The users can order fresh produce, meat, or other household items online, and then pick up the orders the following day at designated locations. This reduces the costs and logistical complexities with ‘last-mile’ deliveries, and thus allows to keep the prices down and allow for shorter delivery times.

Revenue sources

Pinduoduo generates revenues from two sources:

• Online marketing services – the sellers pay to be more visible on the platform, they bid for keywords and advertising placements. This represents about 90% of all revenues, despite Pinduoduo claiming that their model is highly personalized to individual customers
• Transaction services – merchants pay fees on their sales

Target group and consumer engagement

Unlike other e-commerce platforms like Alibaba or JD.com, Pinduoduo’s primary target group is consumers from lower-tier cities and rural areas in China. These customers are more price-conscious and are attracted by large discounts, while the quality is secondary.

Pinduoduo is heavily focusing on user engagement and experience, rather than monetization. The shopping experience is like a game – you can unlock the special prices, new users get one-off offers, there is time pressure, but in the end you get items for cheap.

Pinduoduo is providing personalized recommendations based on data about your previous purchases, your searches and also based on what your friends are buying.

The team purchase also contributes to user acquisition and lower acquisition costs. The consumers are incentivized to share with their friends, which then share further and that’s how the user base is growing.

Agriculture, merchants and consumer-to-manufacturer (C2M)

Pinduoduo built an online platform that connects more than 5 million merchants directly with consumers. The agriculture is one of the industries with lowest rates of digitalization and many farmers do not have sufficient skills for online business. That’s why Pinduoduo launched a program called Duo Duo University to help farmers learn how to sell on the platform, and also equip them with skills and better understanding of e-commerce, finance, business operations and online marketing.

Pinduoduo provides merchants with insights about the customers and demand for products, which helps them tailor-make the products and also improve their inventory and supply chain efficiency. As the merchants are able to reduce their costs, they can provide low prices for customers.

Competitors in agricultural and fresh produce

Alibaba and JD.com both have business units in the grocery segment. They focus on the so-called hybrid model where physical and online shopping complements each other. They expand physical stores as well, recognizing that shopping is still an experience that people value.

JD Fresh

JD Fresh is the fresh food business unit of JD.com, which offers high-quality fruits, vegetables, seafood, meats, and frozen products sourced from more than 2000 partners. JD Fresh is able to provide fast delivery with their largest cold chain logistics network in China. JD is also expanding into offline stores with opening 7Fresh stores. Customers who are less than three kilometres can also order online and get delivery to their home within 30 minutes.

Freshippo

Alibaba launched a grocery retail chain Freshippo in 2016, also known as Hema in Chinese. More than 200 physical stores also serve as distribution centers for online orders, and delivery is available within 3 kilometers. Freshippo is providing high-quality food and interactive shopping experience with technology mainly in top-tier cities, but also expanding and adapting to different segments. For example, Freshippo Farmers’ Market is providing fresh produce for more price-sensitive consumers. In lower-tier cities with increasing consumer demand, Freshippo set up Mini stores. Freshippo is also investing beyond food, to strengthen the brand and customer loyalty. The first Freshippo Mall was opened in Shenzen in 2019 and provides retail, entertainment, dining, but also education and cleaning services.

Logistics is Pinduoduo’s weak point

Pinduoduo is not directly involved in delivering the goods, and they ship the goods via third-party providers, including via competitors in the e-commerce space, such as Alibaba’s Cainiao. The only initiative Pinduoduo implemented is an e-waybill system to make shipping information more transparent so that the users are updated when the goods are shipped, and the system also helps to detect fraudulent activities.

Fast delivery is one of the key dimensions that e-commerce companies compete on. If we look at the competitors in the e-commerce market, we can see that the logistics is a weakness of Pinduoduo and other players are miles ahead.

Alibaba founded the Cainiao Network, the logistics provider that ensures delivery within 24 hours to any region of the country. They have a strong network of warehouses across the country and partnerships with number of delivery providers.

JD.com has developed own capabilities under JD Logistics. They own 30 smart fulfilment centers, over 800 warehouses and have their own fleet of drivers. They manage to deliver over 90% of orders on the same day.

Both Cainiao and JD are innovating and investing in developing automated delivery robots and drones.

Key Performance Indicator – Gross Merchandise Volume (GMV)

GMV is one of the most important metrics in e-commerce. It measures the total value of all orders placed on the platform. Pinduoduo continues rapidly growing GMV. Based on the last report from Q3 2020, the total GMV for the last 12 month period was $223 billion, which shows the YoY increase of 74%. To compare, the GMV of Alibaba is about 4x as high, at about $1 trillion.

Key financial metrics

The revenues are growing at similarly high rates as GMV. In 2019, the revenues grew by 130% and the YoY growth for first 3 quarters of 2020 was 70%.

The highest expenses for Pinduoduo are by far sales and marketing expenses, which are as high as 80-100% of the total revenues. These expenses include the discounts provided as marketing to acquire and keep the users. As a result, the operating margins are negative.

The strategy to focus on user acquisition instead of profitability is understandable for new platform. Over time, the focus can shift to monetization by reducing discounts (sales and marketing expenses) or generating more revenues from sellers via fees or their marketing spend. But there is a risk that portion of users is active just because of high discounts and they find it fun to hunt good deals.

Active buyers and annual spend

The number of active buyers within the last 12 months has been rising steadily. In Q3 of 2020, there were 731 million active users, which is 36% growth YoY. Although, perhaps not immediately, this growth will be slowing down over time as there is a natural ceiling in terms of population of China. The current figure already shows that more than 50% of people in China are using Pinduoduo.

The average yearly spend per buyer is around $304, which is growth of 27% YoY. This corresponds to around $25 per month, which is not too much and there is certainly growth potential. Moreover, the average spend figure is likely driven by large purchases (e.g. electronics), so the median spend is likely to be even lower.

Valuation metrics

Pinduoduo is currently trading at $199.6 per share price and market cap of more than $232 bn, which makes it one of the highest values companies in China.

The table below lists metrics for other e-commerce players in China and US. As we already saw, Pinduoduo is operating with negative EBIT, so the valuation metrics based on earnings are all negative – P/E, EV/EBITDA, EV/EBIT.

The debt-to-equity ratio of Pinduoduo is at 31%, which is at not problematic. Looking at the composition of balance sheet, about 36% of assets is restricted cash, which roughly corresponds to what has to be payable to merchants.

When we look at the EV/Sales ratio, Pinduoduo is trading at 35.3, which is by far the most from all the competitors. Taking the median ratio of selected companies, which is 2.3, the implied share price for Pinduoduo is $16.5.

The similar picture is shown by Price/Book ratio, where Pinduoduo is trading at 60.3 ratio, while Alibaba at 8.3, JD.com at 8.5. Taking again the median ratio of 8.2, the implied share price for Pinduoduo is valued at $27.2.

Now, these ratios are trailing and by no means the valuation method is perfect. At this point it is difficult to estimate the pattern for EBIT and when Pinduoduo can turn to positive earnings, in which case we could use other valuation methods, including DCF. But looking at the high ratios we can see that investors have extremely high expectations about the future growth. These may remain unfulfilled as Pinduoduo is seemingly lacking the capabilities to expand their revenue models further with logistics or moving into physical retail – or at least it’s safe to say that competitors are better positioned in the e-commerce area.

Peter Lynch stock category

The legendary investor Peter Lynch categorizes stocks based on their characteristics into six categories: asset plays, slow growers, stalwarts, fast growers, cyclical and turnarounds.

Pinduoduo can be characterized as fast grower. The revenues are growing at extremely high rates, which is the result of growing customer base and spending.

Although fast growers carry considerable risk, they are in fact Peter Lynch’s favourites and he believes that these companies can provide highest returns for investors. However, the high growth is not sustainable forever and investors should watch out for signals of growth slowing down.

Risk 1: Competition from other e-commerce players

The business model of Pinduoduo is rather simple and hinges on providing heavy discounts to consumers. This model can be unsustainable from the long-term perspective and can also be replicated by competitors such as Alibaba or JD.com, which also have deeper pockets, strong logistics network and capabilities (in terms of technology), and customers experience. Pinduoduo’s target group is different than of other e-commerce giants, but Alibaba and JD.com are already expanding their grocery services beyond top-tier cities.

Risk 2: Quality of goods

Pinduoduo is competing on prices and targeting price-sensitive customers who do not care too much about quality. The goods sold on Pinduoduo are often times of low quality, including many counterfeit products. This can be a problem for Pinduoduo to grow into biggest cities where customers have more money to spend, but they also care about quality. One negative experience and you can lose them for lifetime. With many counterfeit products sold, Pinduoduo can also be subject to allegations and lawsuits.

Risk 3: Reputation

Pinduoduo has a list of negative events over time, which raise the questions about the integrity and business practices.

Before the IPO in 2018, the investment firm Blue Orca Capital accused Pinduoduo of overstating revenues to boost the price, with actual revenues being 36% less than reported 1.2 billion yuan.^[1] They also accused Pinduoduo of inflating the GMV by accounting for orders that were initiated but not completed, when users didn’t manage to fill the team spots. The estimates shows that actual GMV was somewhere around 34%-47% less than reported.

The company was also accused of unauthorized selling of Apple products. Pinduoduo is not authorized online reseller (while JD, Tmall and Suning are), but was selling iPhone products for 500 to 1000 yuan less than the market price during the Double 11 sales season.^[2]

The platform also had some loopholes when group of users managed to steal discounts worth tens of millions of yuans. ^[3]

The most recent news are even more sad, as early in January 2021, a 22-year old employee died from overwork and couple of days later another employee committed suicide.^[4]

^[1] blueorcacapital.com

^[2] http://www.ecns.cn/news/cns-wire/2019-04-09/detail-ifzhaszu6982038.shtml

^[3] https://asia.nikkei.com/Business/Companies/China-s-Pinduoduo-reports-theft-of-online-discount-vouchers-to-police

^[4] https://www.techinasia.com/another-pinduoduo-employee-death-renews-concerns-chinese-tech-cos-996-work-culture

The growth story of Pinduoduo over the last 5 years has been unprecedented, but there are many question marks about the team, strategy to grow and start generating profits.

At this point, we see Pinduoduo as overpriced. Based on our valuation, the target stock price is in the range between $20 and $40. Because of the strong interest of investors and many unknowns about strategy, we do not recommend shorting the stock in the short-term, as the momentum can continue for a while. But we recommend watching out for any new signs about the business in the next earning call with Q4 results (estimated date March 10, 2021) or any competitor moves into lower-tier segments. We will, of course, watch out too!