On May 27, 2022, Pinduoduo (PDD: NASDAQ) held its Q1 2022 earnings call, showing impressive financial results and climbing more than 15% during the trading day. It’s been the fourth quarter that PDD keeps generating profits since it turned losses into gains in Q2 2021. This article will show key points of the leading Chinese E-commerce firm and may restore public confidence in Chinese Concept stocks.
Steady profit stage is coming
In this quarter, PDD’s revenue reached CNY 23.8 billion, up 7% from the previous year, driven by an increase in revenues from online marketing services and revenue from transaction services, offset by the decrease in revenue from 1P trials. Revenues from online marketing services reached CNY 18.2 billion, up 29% year over year, while transaction services revenue this quarter was CNY 5.6 billion, surging 91% from the same period of 2021, which is dazzling. In terms of cost, its cost of sales decreased to CNY 7.2 billion this quarter, down 16% versus the same quarter of 2021. Owing to this, its non-GAAP operating profit reached CNY 3.7 billion versus the operating loss of CNY 3.2 billion in the same quarter of 2021. We believe, considering the current market capitalization of PDD, it is inevitable to see slower growth. Yet it may not be a bad thing as more sustainable project spending and more agriculture initiatives are the main reasons behind the process in the past three quarters.
One noteworthy thing is that in Q1 PDD’s marketing expenses were CNY 11.2 billion, further reducing its proportion of the total revenue to 47% (from 54% last year, much lower than 112% at the peak). PDD, while reducing its marketing expenditure, substantially increased its R&D expenses and reached a historical high, up 20% from the previous year to CNY 2.7 billion, as it recruited more specialist talents. We think this is a good sign that PDD is reshaping its annoying marketing strategy since its establishment and paying more attention to making profits through technological innovation.
Why turn to agriculture?
As we mentioned in our former articles, since CEO Chen Lei has been the main decision-maker of PDD, it seems that the strategy of this e-commerce company has changed greatly, from focusing on marketing to focusing on agricultural science and technology investments. In fact, after one year that he has been in the role, the strategic transformation has achieved initial results. Since the first profit in Q2 last year, PDD has achieved profits for four consecutive quarters and entered a stable profit stage. This, we think, is owing to PDD’s long-term firm investment in agriculture, which believes that technology and talents are the keys to promoting agricultural and rural modernization. The growing profit is a reward for seizing agriculture-related opportunities in small-town and rural markets.
Since 2020, due to the continuous impact of the epidemic and the uncertainty brought about by geopolitics, Chinese e-commerce companies have all turned to fierce differentiated competition. The strategy of PDD is heavily weighted toward agriculture technology. On the one hand, the focus of China’s agriculture, rural areas, and farmers’ policies is shifting from poverty alleviation (which is realized in 2021) to rural revitalization. On the other hand, the focuses of e-commerce giants have been moving from the incremental model to an existing model, which means that re-purchase capacity will become one of the main drivers in future operations. Agricultural products, as a kind of high-frequency consumption, contribute a large number of sales to PDD. However, agricultural scientific research is a long process of investment, and it may take 10 years or more to make breakthroughs and switch into mass production. Investing in agricultural science and technology is essentially sacrificing short-term profits and pursuing long-term sustainable development.
However, we believe that this market, though extremely difficult, has great potential. Currently, at the international trade level, China’s high value-added agricultural products still depend on imports. According to the data from the Ministry of agriculture, China’s agricultural imports are basically twice the exports. This trade deficit is not because China’s agriculture cannot be self-sufficient, but because the lack of high value-added agricultural products. For example, high value-added agricultural products such as edible oilseeds, cereals, wheat, corn and soybeans are the categories with a large import balance. At the policy level, the national agricultural and rural informatization development plan for the ‘14th Five-Year Plan’ requires that the national online retail sales of agricultural products should reach CNY 800 billion by 2025, which is highly in line with PDD’s strategies layout. As far as we are all aware, policy trends are a key consideration when investing in emerging markets with unique political environments. Especially for Internet companies since the 20th century, Ant Group’s tentative IPO is a negative example. A very important fact is that due to the political particularity, the small-town and rural market is one of the markets that China pays close attention to. A piece of great evidence is that, earlier in 2021, Pinduoduo was among three technology companies commended for their contributions to C
hina’s poverty alleviation efforts.
Uncovered potentials and efforts behind the profit
Since Q1 last year, PDD has stopped disclosing single quarter GMV, and the growth rate of annual active buyers and average monthly activity has gradually dropped back to single digits. We believe it is a good strategy as, with the increasing scale of the platform and the disappearance of the demographic dividend of the Internet, it is difficult for PDD to continue to maintain high-speed GMV growth. In other words, the valuation premium brought by rapid growth is unsustainable. PDD changed its strategy at an appropriate time and achieved initial success.
As mentioned earlier, PDD Commission revenue in Q1 nearly doubled, which we found is mainly driven by the commission revenue from more product sales. At present, it is undeniable that the logistics processes of agricultural products still need to be improved, and the distribution of resources is still very uneven across regions. This is where PDD saw the opportunity, by improving this problem and benefitting from it. At the same time, in terms of agricultural infrastructure, PDD adopts route planning technology and network solutions. The company has initially created an efficient agricultural product logistics system, directly connecting over 1,000 agricultural production areas, and encouraging more than 16 million farmers to participate in the digital economy.
Moreover, PDD launched a CNY 10 billion agricultural initiative in August 2021 to support agricultural modernization and rural vitalization. As of March 31, 2022, nearly 40,000 high-quality agricultural products have been launched on this channel. Moreover, PDD launched or assisted several influential events including the international smart agriculture competition 2020, the Global Agriinno Challenge 2021, and the first China Agricultural Robot innovation competition, trying to break the traditional restrictions and promote the development of smart agriculture. In addition, PDD has also further increased its investment in infrastructure such as agricultural product transportation, logistics and warehousing in the past few quarters. All we believe are factors that promote PDD to achieve high growth of this segment in recent quarters.
Long term bullish, risks draw attention
Though suffering from regulation constraints, a downturn market and tightening Sino-U.S. relations, it is still worth giving a guideline for PDD, as many investors are restoring their confidence of Chinese Concepts Stocks. We used EV/revenue and P/B ratio to value the company. Considering that the company has been able to turn losses into profits and its competitors have much lower ratios, we decided to use the adjusted historical average method. From the chart, it is obvious that the ratio is at a low level, which we think is mainly caused by the regulation changes in China recently. Based on its current financial performance and its current trading environment, momentum and competitive landscape, we calculated that 7.5x EV/revenue and 8.7x P/BV is an appropriate valuation for PDD in 12 months, which corresponds to a target price of USD $91.48.
We are still firmly bullish on PDD, at least from the perspective of it as a value investment. One day in the future, we may finally notice the opportunities and values and changes to China’s agricultural industry benefiting the whole Chinese society, brought by PDD’s agricultural digitalization strategy. However, under such a strategy, as it is difficult to generate sustained high growth and high initial investment, PDD will be more vulnerable to market fluctuations and international trade frictions in the short term, and the price may not be satisfactory. Medium and short-term investors need to pay more attention to this. Moreover, investors should also keep an eye on the SEC regulation changes of the company, which we think could be the largest threat to this investment.