2023-05-17 02:07:40 ET
Summary
- We believe PDD Holdings offers an attractive asymmetric risk-return proposition, with fair value closer to $107 per share in our view.
- Compared to other Chinese retail giants, it is expanding its operating margins while maintaining record top-line growth.
- In our view, geopolitical tensions have been exaggerated, and current trade relations are of utmost importance to both the Chinese and U.S. economy.
- While we believe PDD Holdings is vastly undervalued, we do not think investors should expect the Chinese economy to rebound anytime soon.
- Even on a technical level, we believe that PDD Holdings has entered the "bargain hunting" territory.
Investment Thesis
When investors think of China and its large cap technology names, they usually think of companies like Tencent ( OTCPK:TCEHY ), Alibaba ( BABA ) and JD.com ( JD ), as they are also the most covered here on Seeking Alpha. And while those players can certainly be valuable at current prices in our opinion, we think the overlooked & less covered PDD Holdings (PDD), previously Pinduoduo, has recently joined the club and entered bargain hunting territory.
With the reopening of the Chinese economy, recent positive Q1 results from JD.com and, in our opinion, exaggerated geopolitical concerns, PDD Holdings too seems about time for an upward correction. Even in a recessionary environment, we believe PDD Holdings can offer significant alpha while still providing protection against downside risk thanks to its excellent balance sheet position.
The Economics
First, for people who don't know PDD Holdings, the company is one of the largest companies in China, and essentially specializes in social shopping . Customers buy products and encourage others to buy the same product, so that bulk discounts can be applied.
The more people buy the product, the bigger the discount will be, effectively eliminating the middleman and giving both suppliers and customers more. Like eBay ( EBAY ), Alibaba with Taobao/Tmall and Amazon ( AMZN ), PDD Holdings receives much of its revenue from online marketing services where users pay to promote their merchandise. In 2022, PDD Holdings brought in RMB 130.56 billion or $18.93 billion in revenue, mainly from online marketing and transaction services.
Cost of revenue was only $4.56BN in 2022, meaning the company was left with $14.37BN in gross profit, or a gross margin of 75.9% for FY2022. Nevertheless, gross margins are moving in the right direction, reaching as much as 79.1% and 75.9% for Q3 and Q4, respectively.
Sales and marketing expenses in general are PDD's largest expenses, accounting for 41.62% of sales in FY2022. G&A accounted for another 3.04% of revenue in 2022, combined with 7.95% for R&D expenses. This brings operating profit to a staggering $4.41BN, or an operating margin of 23.3% for FY2022.
However, one of the overlooked aspects of PDD Holdings, in our opinion, is its balance sheet and interest-generating aspect. As of Q4 2022 , PDD Holdings has a net debt of a whopping -$19.21 billion, as they have $21.67 billion in cash and short-term investments, while they have virtually no debt. This balance sheet brought in $195.98M in interest and investment income alone in Q4 2022, or nearly $784M on an annualized basis.
This also means that when we calculate the enterprise value , we are only looking at $70.15BN if we strip out the cash, compared to the $89.40BN market cap. So if we look at pre-tax profit on a TTM basis, which was $5.26 billion, it is only trading at 13.34x EV/EBT.
Bargain Hunting Territory
With these things in mind, we will now explain why we believe PDD Holdings has entered "bargain hunting" territory from both a fundamental and technical analysis perspective.
From an operating income perspective, the company did not make a profit until 2H 2021. Looking at underlying free cash flow , PDD Holdings has always bottomed at around 10x EV/FCF in 2018, 2019 and 2022. However, there was an instance when the stock slipped to $23.21 for a few days, but shortly after returned to over $40, dipping as low as an EV/FCF of 4.39x.
That means we are at the very bottom of the historical range with our EV/FCF. Comparing this to other Chinese sector peers, we see that Alibaba and JD also typically hit their lows at 6x-8x EV/FCF, when US-China geopolitical tensions were at its worst.
PDD Holdings' TTM FCF per share is $5.49, meaning that at 6x and 8x P/FCF it would be worth $32.94 and $43.92, respectively. However, this does not take into account the huge amount of cash/short-term investments on PDD's balance sheet, which are currently worth $12.94 at book value per share. On a TTM EV/EBT basis, at 6x and 8x multiple, PDD stock would be trading at a market cap between $50.76BN and $61.28BN or $38.16 to $46.07 per share at 1.33BN shares outstanding.
At $38.16, we think the downside is about -42.19% from current levels, at which point we consider the stock to be even more than dirt cheap at 6x EV/EBT, for a company that is growing revenue by more than 37% YoY and operating income by about 22% YoY.
With these fundamentals in mind, we think PDD Holdings has also entered "bargain territory" from a technical perspective. First, it is important to note that PDD only became profitable on an operating basis as of 2H 2021, and is currently trading below these levels.
Currently, as mentioned earlier, PDD generates about $5.26BN in pre-tax profit on a TTM basis, compared to 2018 and 2019 when it lost quite a bit of money on an operating income basis. Since then, they have also expanded their balance sheet quite a bit, increasing the tangible book value per share from $2.12 to $12.93.
In other words, we consider the probability of a return to these 2018 and 2019 levels to be very low, as they have taken the EBT from over -$1BN to over $5.26BN and have dramatically strengthened their balance sheet. If the stock price were ever to fall to this resistance level of $30, almost half of the stock or $13 would be cash, making it a classic Benjamin Graham stock close to book value/liquidation value, thus drastically limiting downside risks.
Thus, we think the range between $30 and $70 at the Fibonacci retracement level represents the bottom of the trading range, with a potential hard bottom around $38.16 or 6x EV/EBT. At a more reasonable 8x EV/EBT, this would equate to $46.07 per share.
On the other hand, we don't think PDD Holdings should be trading near that bottom, as it is a company with a great balance sheet and operating earnings growing at over 22% year-over-year.
If we value PDD Holdings at a very reasonable 18x EV/EBT, we believe the fair value of the stock is around $90.37. We also think 18x EV/EBT is very conservative, given that the average PE ratio for the S&P 500 is currently 23.79x . And since earnings are growing 22% year over year, at a very reasonable price-to-earnings/growth ratio of 1 (22x EV/EBT), we believe the stock should be trading at $107.22.
In short, PDD has an asymmetric risk/reward profile, in our view, with a downside of $46.11 or -30.30% and an upside of $107.22 or 62.21% of the upside at fair value.
Geopolitical concerns aside, it is a mystery to us why PDD Holdings is not trading closer to fair value, because since 2020/2021, the company has enjoyed tremendous operating leverage, dramatically increasing operating margins while still growing revenues at an exceptional rate. Despite these vastly improved fundamentals, the stock has traded virtually sideways.
And this is true even compared to its competitors. PDD Holdings shined in comparison to its biggest competitors JD & Alibaba, as their operating margins increased dramatically even despite economic stress and lockdowns in 2020, 2021 and some parts of 2022.
To further quantify how cheap this company is relative to its U.S. counterparts, it currently pulls in about half the pre-tax revenue that its overseas U.S. retailer Amazon does now. Amazon may have had a tough few years, but needless to say, Amazon is valued at $1.17 billion and PDD Holdings at $88 billion.
Even on a free cash flow basis, PDD Holdings pulls in as much free cash flow as Amazon did in 2018, when Amazon was still valued at $1T. Needless to say, we believe PDD Holdings should be trading at much more than $88BN, as it is one of China's fastest growing companies, in the largest e-commerce market, with a market share of over 17.5%.
Even in terms of monthly active users (MAUs), the company lags just behind its larger counterpart Alibaba, which has a value of $230 billion compared to $88 billion for PDD Holdings, while having higher operating margins.
Risks - Chinese Macroeconomics
And so the question remains as to why PDD Holdings, along with other Chinese companies, are still trading well below intrinsic value, in our opinion. While some point to the obvious geopolitical tensions, we believe there are more macroeconomic than geopolitical aspects involved in this story.
First, in terms of geopolitics, tensions indeed seem to be running high after the U.S. banned certain chip exports to China and shot down a suspected Chinese spy balloon earlier this year. However, we point out that we believe relations between the United States and China are vital to both sides. The trade deficit with China increased from about $10 billion in 1990 to about $382.92 billion in 2022. The United States imports more than half a trillion worth of goods by 2022, and China is a vital part of the United States and its supply chains.
China is the largest trading partner of the United States, and we believe that sanctions and stricter regulations on both sides would be harmful.
Especially in this climate, where we believe China has been the deflationary force of the past 20 years as it has exponentially expanded exports to the United States.
Speaking of deflation, it also comes as a blow to economists who have predicted a Chinese reopening boom. We take the opposite view, given recent data. The growth rate of Yuan loans outstanding , which was expected to grow tremendously, is currently only 11.8%.
That seems like a lot at first glance, but in reality is almost the lowest figure in the past 2 decades. China's economy may be reopening , but loan growth itself has not yet returned to its previous levels and is currently even below 2020 levels.
In the United States, the Federal Reserve is also focusing on inflation, while in China the PBOC may be concerned about the complete opposite. Inflation in China is moving in the wrong direction, and is currently even heading into negative territory. Perhaps the Chinese reopening boom is not what economists had predicted.
China's PPI figures are also gearing up for a horrible scenario: they plunged 3.6% in April, heading for the worst year since 2000, 2009, 2015 and 2020.
With PDD Holdings, we also need to consider the conversion from RMB to USD, as the income and profits generated abroad in China are denominated in USD for investors in the US. China's currency has also weakened and currently stands at 1USD:7RMB. We believe that this drastic weakening of the RMB may also lead to further deflationary forces for the U.S., with the U.S. arguably ending up in the same scenario as China is now, namely deflation .
In short, while we believe that geopolitical tensions are at the root of why Chinese stocks are much cheaper than their U.S. counterparts, we also believe that this false thesis of a reopening boom , concocted by many, is the reason that U.S. investors are cautious about Chinese stocks.
We would not count on a boom in the Chinese economy anytime soon, but still believe that PDD Holdings trades drastically below intrinsic value in the event of even little growth. As for geopolitical tensions, we think Taiwan is not a hill to die on for both China and the United States, as both sides are critically dependent on each other as trading partners, and that tension will ease as we saw after 2018.
We believe that without China, the United States would face severe inflation and immense manufacturing problems. Without China's deflationary forces, we would not even want to predict where the U.S. CPI would be today. On the other hand, China's growth depends on its ever-growing trade with the US.
As for regulation in China itself, we believe PDD Holdings is in an excellent position as it aligns itself with the government's interests. PDD Holdings lowers both costs by providing more value to consumers and manufacturers/ producers by eliminating unproductive labor. Compared to JD, Alibaba and Tencent, which may have more in the eyes of regulators to counter monopolistic tendencies.
The Bottom Line
We believe PDD Holdings is vastly undervalued and is currently trading below its intrinsic value, which we believe is around $107. Improving operating margins, tremendous top-line & bottom-line growth combined with an exceptional balance sheet make the company an excellent Buy.
Seeking Alpha's Quant Rating also rates PDD Holdings as Buy, with a score of 4.14 out of 5. We also agree with this evaluation, and might even classify it as a "Strong Buy" if it ever comes close to our worst-case scenario price target of $46.11. Moreover, we are waiting for more macroeconomic data to support a recovery in the Chinese economy, as we believe these are the main reason for the underperformance of Chinese stocks, along with geopolitical tensions that we believe will ease in the future.
For further details see:
PDD Holdings Has Entered Bargain Hunting Territory