PDD Holdings: I Am Optimistic About Q3 Earnings Release

Investment thesis

My initial bullish thesis about PDD Holdings (NASDAQ:PDD) stock aged extremely well as the stock rallied by more than 40% since early August, compared to a less than 1% increase for the S&P500 over the same period. Such a massive rally is unsurprising given the company’s stellar Q2 performance with above 50% YoY revenue growth and best-in-class profitability. I am optimistic about the company’s upcoming quarter’s earnings release because there were recent positive signals for PDD in the macro environment. The company’s balance sheet is a fortress, making it well-positioned to continue investing in marketing and innovation. Lastly, my valuation analysis suggests the stock is about 35% undervalued. That said, I reiterate my “Buy” rating for PDD.

Recent developments and earnings preview

The latest quarterly earnings were released on August 29, when the company smashed consensus estimates by a wide margin. Revenue grew YoY by a staggering 58%. The revenue growth in the local currency, RMB, was even more impressive at 66% YoY. Despite nothing but impressive revenue growth, profitability metrics shrank notably on a YoY basis. The cost of revenues significantly outpaced the top-line growth due to increased fulfillment fees and payment processing fees. The gross margin declined YoY from 74% to 64%, and that was the main adverse factor for the operating margin, which narrowed YoY from 27.7% to 24.3%. However, PDD’s key profitability metrics still far outperform the sector median.

Strong financial performance in Q2 allowed PDD to generate almost $2.9 billion in levered free cash flow [FCF], almost a 100% YoY increase. The strong FCF generated further improved the company’s fortress balance sheet. PDD is in a massive $22 billion net cash position with almost no leverage. Liquidity metrics are also in excellent shape. From the financial position perspective, PDD is firmly positioned to continue investing in growth and innovation.

Let me focus on the upcoming quarter’s earnings preview as the Q3 results release is approaching. The earnings release is scheduled for November 23, according to investing.com. Quarterly revenue is expected by consensus at $7.4 billion, which means a massive 50.5% YoY growth. Despite the expected massive revenue growth, some struggles with the bottom-line expansion are projected by consensus as the adjusted EPS is forecasted to shrink from $1.20 to $1.16 on a YoY basis. I attribute this to the increasing fulfillment fees and payment processing fees, which were the main reason for profitability shrinkage in Q2. While this might be a warning sign for investors, I think this adverse effect is temporary. The company demonstrated a strong ability to deliver operating leverage as the business scaled up over the long term. As revenue is expected by consensus to almost double in the next couple of years compared to FY 2022, I believe the top-line growth will offset these temporary challenges for the gross margin.

A lot of pessimism around Chinese companies this year was due to soft macroeconomic data in the first half of the year, as a more robust rebound was expected after seizing the country’s zero-COVID policy. However, the Chinese government decided to address the issue from the fiscal side by boosting spending, which is good news for the country’s economy. As a result, the IMF raised China’s GPD growth forecast to 5.4% for 2023. Increased fiscal spending means more jobs, ultimately leading to a boost in consumer spending as well. That is good news for PDD, and the positive effect is likely to be absorbed in the next multiple quarters. That said, I think that this factor might lead to an optimistic outlook from the company’s management during the upcoming earnings call.

Apart from the expected positive outlook from the management, I expect Q3 results to be solid as well. I am optimistic because China’s economy grew more than expected in Q3, and strong consumer spending was one of the key growth drivers. As the company’s by far most significant revenue stream is its e-commerce platform, Pinduoduo, the stronger than expected consumer spending data suggests that PDD is likely to deliver above consensus revenue figures as well. The recent Q3 earnings beat from JD.com (JD), one of PDD’s closest rivals, also adds optimism to me.

It is also crucial to underline that consensus estimates look not that hard to beat compared to the recent strong dynamic. The expected $7.4 billion revenue in Q3 is higher sequentially by only 3.3%, which does not align with some of the details unveiled during the latest earnings call. The management did not give explicit guidance for Q3, but I think that we should read between the lines. According to the management, new promotional activities found positive consumer responses, which indicates the robust ability to select effective engagement strategies. The management also reiterated its commitment to invest in the development of PDD’s ecosystem, which will attract the best merchants and expand the network. This is also likely to have an immediate positive effect on PDD’s upcoming quarterly earnings.

Last but not least, when analyzing the upcoming quarter’s earnings, it is also crucial to take into account the company’s earnings history. As we can see above, the company has a stellar history of EPS surprises, usually outperforming consensus estimates by a wide margin. The only quarter when the company missed EPS estimates was Q4 of 2022, but this was mainly due to the uncertainty and delays in abandoning the zero-COVID policy by the Chinese government. The uncertainty regarding COVID-related restrictions, which lasted from 2021 to 2022, also affected several quarters when the company missed quarterly revenue estimates. But now, in 2023, the zero-COVID policy is in the rearview window, and there is more certainty around the ability of the company to meet its revenue plans. As a result, in Q1 and Q2, PDD delivered massive revenue outperformance compared to consensus estimates. And that is another big reason why I think PDD will top Q3 consensus earnings estimates.

Valuation update

The stock rallied by 42% year-to-date, significantly outperforming the broader U.S. market. PDD outperformed the iShares MSCI China ETF (MCHI) by an even much wider margin since its inception in 2023. PDD’s valuation ratios are substantially higher than the sector median, but that does not surprise me, considering the company’s massive growth momentum and stellar profitability. That said, high valuation ratios do not necessarily mean overvaluation. We need to look at the discounted cash flow [DCF] simulation for a better understanding of the valuation attractiveness.

Given the vast uncertainty in the geopolitical relationships between the U.S. and China, I use a higher 13% WACC for discounting than I did initially. I have revenue consensus estimates projecting a 10% CAGR for the next decade, which looks very conservative to me. I use a 13.5% FCF margin for my base year, which is the last decade’s average. Given the stellar 28% TTM FCF margin, I expect the metric to expand by 150 basis points every year.

According to my DCF simulation, the business’s fair value is approximately $207 billion, which indicates a 35% upside potential from the current market cap. That said, my target price for PDD stock is around $160 per share.

Risks update

Investing in Chinese stocks listed in the U.S. carries significant legal risks that potential investors should be aware of. In recent years, the escalating geopolitical tensions between the U.S. and China led to discussions about the potential delisting of Chinese stocks from American stock exchanges. Despite the probability of such a scenario decreasing in late 2022 when the U.S. accessed audit data, I think this risk is crucial to be aware of. The geopolitical environment is evolving rapidly, and relationships between China and the U.S. are still far from being called “friendly”. While the probability of delisting is low, the potential adverse financial impact for investors might be huge.

Furthermore, there have been well-documented cases of financial statement manipulations by certain Chinese companies in recent years. The Luckin Coffee case stands out, given the scale of the accounting fraud. Such cases raise questions about the reliability of financial reporting from Chinese public companies.

Bottom line

To conclude, I reiterate my “Buy” rating for PDD. The company continues to deliver stellar revenue growth, and its profitability metrics are unmatched despite temporary weakness in gross margin in Q2. My analysis suggests that the company will likely deliver strong Q3 earnings with a positive outlook for Q4 and FY2024. Moreover, my DCF simulation suggests that the stock is about 35% undervalued, making PDD a compelling investment opportunity.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.