PDD Holdings – The Best Bet On Christmas Shopping (NASDAQ:PDD)

PDD Holdings (NASDAQ:PDD), the owner of Temu, is visibly trying to make its fourth quarter 2023 earnings the best in its history. Upping ad spend over the Christmas Season, it is investing heavily in growth. Temu ads were all over social media during the holidays, with massive sums of money being spent on Google (GOOG) and Meta (META) spots. Furthermore, the spending is set to continue, with PDD planning yet another Superbowl spot in 2024.

It’s for this reason that I expect PDD’s fourth quarter revenue to beat analyst estimates. Analysts are expecting $10.59 billion in revenue, which would be 83% growth from the year-ago quarter. Quite a bit of growth is already expected, but with Temu’s ad spending, there’s still significant potential for a beat. Last quarter, PDD did $9.4 billion in revenue, up 94% year-over-year. If the company does $10.59 billion in Q4 revenue, then, its sequential revenue growth rate will be a mere 12.2%. Given the known tendency for retailers to do more revenue in Q4 than any other quarter (due to Christmas shopping), the revenue growth that analysts expect appears to be based on very conservative assumptions. A beat would not be surprising.

On the other hand, the earnings situation is more complex. PDD is spending enormous sums of money advertising Temu, with the goal of making it a major player in global e-commerce. This spending produces the superior growth that PDD is known for, but on the other hand, it threatens the company’s margins as Temu becomes an ever-larger part of PDD’s business. Pinduoduo, the Chinese equivalent of Temu, has been profitable for over a year now. We know this because the last few earnings releases that PDD put out showed the company with positive earnings and cash flows, even though Temu is known to be losing money. It follows from this that if PDD keeps spending as much as it has been to grow Temu, then the whole company’s margins will suffer.

In fact, this is already happening. In the three most recent quarters, PDD delivered the revenue, operating income and net income figures shown below:

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As you can see, the third quarter net margin figure was the lowest out of all the most recent three quarters. EBIT peaked in Q2 but then declined from there. Broadly, we are seeing PDD Holdings’ margins decline. This trend will continue for as long as PDD keeps investing heavily in Temu’s growth, because the company is intentionally losing money in order to capture market share in the United States.

The Economics of Temu

The economics of Temu are complex, but basically, the company loses $30 per order (according to research by Wired) in order to give customers the lowest prices possible. It additionally pressures its suppliers to run losses, which prevents Temu’s loss per order from going higher still. As an example of how Temu loses money in order to gain market share, consider the company’s shipping policy. Standard shipping is free on ALL Temu orders, and express shipping can be obtained cheaply, yet Temu pays about $9 to $10 in shipping for an average order. The low prices this produces have resulted in Temu becoming extremely popular in an extremely short period of time, often topping U.S. app store rankings, but also extremely expensive to run.

It’s for this reason that I think PDD’s Q4 earnings could miss estimates, despite my simultaneous belief that revenue will handily beat estimates. PDD Holdings is spending so much money growing Temu that it’s becoming a large percentage of the overall company. At the same time, it’s Temu that provides most of PDD’s growth–the company’s growth had been decelerating prior to Temu’s launch. As Temu grows and loses money, PDD’s whole company margins decline. This could result in an underwhelming bottom line performance for Q4. Analysts expect PDD to do $1.52 and $1.43 in adjusted and GAAP EPS in Q4, respectively. In the year-ago quarter, the figures were $1.21 adjusted and $0.95 GAAP, which means analysts expect earnings growth between 25.6% and 50.5%. That’s a lot of growth expected given that Temu is losing money while becoming an ever-larger part of PDD’s overall business. We could therefore see some turbulence in PDD’s shares after earnings if EPS misses–I’d consider that the main short term risk as the probability of a revenue beat appears quite high.

Why is Temu Losing Money

Having shown that PDD Holdings is likely to report high revenue growth but underwhelming earnings growth for the fourth quarter, I now need to answer the all-important question:

Why is Temu losing so much money, and can it become profitable?

This is a very important question because the current situation implies that the company will eventually either stop growing or become unprofitable again. Right now, Temu is being subsidized by the highly profitable Pinduoduo, but if Temu gets bigger than Pinduoduo, then the whole company’s earnings swing negative.

So, why is Temu losing money?

The “big picture” reason is it’s trying to gain market share. Ecommerce is a competitive industry, with Chinese brands like AliExpress, Shein and Wish all trying to corner the market on cheap Chinese goods. Temu needs to beat all of these companies to maximize its earning power, so it focuses on keeping prices so low that competitors can’t afford to match them. When it works, this strategy can result in the “competitors” exiting the market, giving the company using the strategy more pricing power.

As for specifics:

A big part of why Temu is losing money is because of the cost of fulfillment. The average Temu order is $50, the average shipping cost per order is $9 to $10. Unless Temu vendors are earning enormous margins then that’s a $9-$10 loss borne by Temu right there. On top of that, there is the sum paid to the vendor, which reportedly is between 80% and 90% of the list price (in other words Temu collects 10% to 20%). With a $50 average order size, that’s another $5-$10 in losses right there. Finally, there’s marketing costs. Temu reportedly spent $1.4 billion advertising in the U.S. this year, and plans to spend $4.3 billion more next year. There’s no data on how much this adds up to on a per-order basis, but it’s possible to come up with an estimate. Temu did $1 billion in lifetime GMV by June 2023. The app launched in September 2022, so that’s $1.33 billion on an annualized basis. With the average order being $50, that’s 26.6 million orders per year. Divide $1.4 billion by that amount and we get $50 in advertising costs per order, on top of $9-$10 in shipping costs, and an undisclosed amount paid to vendors. This results in an estimated loss per order of $-50 ($10 in vendor’s fees minus $60 in costs). This is greater than the $30 figure cited in WIRED’s article, going by the mid-June estimate of GMV. GMV has grown considerably since June, though, so we likely end up with a loss per order estimate close to $30.

There are some fairly obvious ways for PDD to boost Temu’s margins. For example, it could cut back on the advertising, which would immediately increase the margin on every sale (though it would also slow down the growth in sales). The bigger Temu gets, the more PDD Holdings’ management has to think about things like this–at least if they want to keep having high margins. As for whether they will have success with it: well, it worked in China. But it costs $14 to ship a package from Guangzhou to the U.S., and PDD has already convinced its logistics partner to absorb much of that cost. Shipping within China is much cheaper. So, the road to profitability for Temu will be harder than the road was for Pinduoduo.

The Bottom Line

PDD Holdings is a profitable company, and a growing one. This Holiday Season’s shopping is likely to hand the company a big beat on revenue, which could send its stock soaring, maybe even take it to new highs. The downside is that the growth strategy will start eating into margins sooner or later. With Temu losing $30 per order, it would be hard for it not to.

When it was trading at levels between $70 and $95, I was eagerly buying up PDD shares. Today, the stock trades at 27.65 times earnings, seven times sales and 8.9 times book value. It certainly isn’t cheap compared to other well known Chinese ADRs, notably BABA and JD dot com (JD). PDD justifies this price premium with growth, but the growth strategy risks turning the company unprofitable. It’s a mixed picture. Nevertheless, with its high growth and margins, PDD has plenty of potential to beat expectations. On the whole I consider the stock a buy.