To The Moon

Summary

• PDD has demonstrated impressive financial performance with rapid top-line growth and strong profitability metrics.

• The company has a strong financial position with a substantial net cash position and almost no leverage.

• Based on my valuation analysis, PDD stock is attractively valued.

Zhong Zhi

Investment thesis

Due to the high political and geopolitical risks inherent to Chinese companies, mostly all of the notable entities listed in the U.S. are trading with very attractive valuations. But it is important to select high-quality businesses trading at a discount. PDD Holdings $Pinduoduo Inc.(PDD)$ is one of them. The company demonstrated stellar revenue growth over the past five years, with impressive profitability metrics. The company owns an extensive Pinduoduo e-commerce ecosystem that serves more than 750 million monthly active users, which makes it well-positioned to absorb favorable secular shifts inherent to the e-commerce industry in China. All in all, I think that the massive upside potential outweighs the risks and assigns the stock a "Buy" rating.

Company information

PDD Holdings is a multinational commerce group that owns and operates a portfolio of businesses. PDD's primary asset is the Pinduoduo platform, which provides a comprehensive suite of diverse product categories.

The company's fiscal year ends on December 31. According to the latest annual SEC filing, about 79% of the total sales comprise online marketing services.

PDD's latest annual SEC filing

Financials

PDD demonstrates impressive financial performance with rapid top-line growth. The company's revenue increased almost tenfold over the past five years. As the business scaled up, profitability metrics followed accordingly. The company's operating profit and the free cash flow [FCF] margin ex-stock-based compensation [ex-SBC] are stellar. The company has invested substantial funds in innovation with annual R&D expenses above $1 billion in the last three years. I like the management's commitment to innovation, which will likely deliver long-term shareholder value.

Author's calculations

Strong financial performance with wide profitability margins in recent years allowed the company to build a robust financial position. PDD's balance sheet is a fortress with a substantial net cash position and almost no leverage. The covered ratio is skyrocketing, and liquidity metrics are also in excellent shape.

Seeking Alpha

The latest quarter's earnings were released on May 26, when the company smashed consensus estimates. Revenue demonstrated a staggering 50% YoY growth, and the adjusted EPS doubled. The gross margin was almost flat and above a stellar 70%. The operating margin more than doubled, though half of the expansion came from the shrinkage of the R&D to revenue ratio. The strength in profitability allowed the company to more than double its quarterly FCF to $1.2 billion. During the latest earnings call, the management reiterated its firm commitment to innovation.

Seeking Alpha

The upcoming quarter's earnings release is scheduled on August 25. Revenue growth momentum is expected to remain strong, with a 35% YoY growth. The adjusted EPS is expected to stay almost flat with a slight decline.

Seeking Alpha

The company operates in the e-commerce industry, expected to grow at 11.3% CAGR in China by 2028. E-commerce is not a hot topic like AI or EVs, but this industry still has a massive potential to grow. The expected industry growth in China is still in double digits, and it is a solid bullish sign for investors. PDD is well-positioned to benefit from secular tailwinds thanks to its massive scale and constantly evolving ecosystem. The company's strong profitability metrics allow it to accumulate cash to invest in growth, whether in-house or M&A.

Valuation

The stock rallied 3.5% year-to-date, significantly underperforming the U.S. stock market. On the other hand, PDD outperformed the iShares MSCI China ETF (MCHI), which declined 1.6% year-to-date. Seeking Alpha Quant assigns the stock a low "D" valuation grade because of high multiples compared to the sector median. But PDD is a growth company, and multiples do not always reflect fair valuation for such stocks.

Therefore, I want to proceed with my analysis with the discounted cash flow [DCF] approach. Due to substantial political and geopolitical risks, I use an elevated 15% WACC for all Chinese companies. I have revenue consensus estimates projecting a conservative 10% revenue CAGR. I used an average of the last five years for the FCF margin and expect it to expand by one percentage point yearly.

Author's calculations

As you see, the stock looks fairly valued with limited upside potential. But we should not ignore the company's vast net cash position, which would add $20 billion to the business's fair value. The stock has about 20% upside potential under a massively conservative WACC. Let me also simulate a scenario with a more moderate discount rate of 12%.

Author's calculations

Under a less conservative WACC, the stock looks massively undervalued. If geopolitical tension between China and the developed world eases, it might unlock a massive upside potential for high-quality Chinese companies. And PDD is a high-quality business.

Risks to consider

As mentioned in my "Valuation" section, the geopolitical risk is significant. The tension between the U.S. and China has escalated recently, and the war in Ukraine worsened the situation. Chinese companies may be forced to delist from U.S. stock exchanges, meaning there is a substantial risk for investors to get their investments frozen or listed in Asian stock exchanges.

Political and regulatory risks within China are also substantial. The country's legislation related to tech companies is rapidly evolving, and there is a high risk that the company might struggle to adapt timely to the changes in the legal environment. This can substantially disrupt the company's financial performance and the balance sheet.

The Chinese e-commerce industry is highly competitive. Competitors include giants like Alibaba $Alibaba(BABA)$ and JD.com $JD.com(JD)$. While JD is smaller than PDD, Alibaba is the leader with substantial resources and a diverse portfolio of businesses. PDD needs to innovate to not fall behind its constantly strong competitors. As an e-commerce platform, PDD also faces significant cybersecurity risks related to potential cyberattacks, users' data theft, or malware.

Bottom line

To sum up, PDD stock is a "Buy". The risk of investing in Chinese stocks is substantial, but we have a high-quality business traded at a substantial discount here. The management demonstrates exceptional execution and capital allocation, as seen in the latest financial statements. Secular shifts are also favorable for PDD, and its vast ecosystem makes it well-positioned to absorb tailwinds.

Source: Seeking Alpha