Description

10-11x P/E (including cash) for a fast, profitable, secular grower capturing market share worldwide:

• The China business, which accounts for over 100% of profits today, continues to gain market share. Easing competitive tensions should lead to a reacceleration in GMV growth.
• Core China revenue is likely to grow by more than 35% this year, with net income expected to grow even faster.
• Temu's GMV continues to grow at triple digits year-over-year, according to various data sources, driven by geographic expansion and improving retention metrics. The business is likely to reach breakeven later this year and may provide significant tailwinds for profitability growth over the next few years. The business model is evolving from fully entrusted (fulfillment by PDD) to semi-managed (fulfillment by merchant), which should significantly expand the merchant count and product offering.
• Both businesses benefit from a model focused on offering the lowest prices to consumers, while other retailers optimize for a combination of price, selection, and convenience.
• The management team has executed well while keeping costs low. There is no mega tech bloat or social media influencer product managers here. The team built an e-commerce business from $0 to over $40 billion in GMV and achieved breakeven profitability within two years.

The China e-commerce industry’s competitive intensity will decline after Douyin and BABA realized they cannot compete on price

Startingin late 2023, there was growing concern about competition from BABA and Douyin. BABA’s GMV showed some acceleration for the first time in years, driven by increased subsidies, a stronger emphasis on price in its traffic algorithm, a shift of traffic from Tmall to the faster-growing Taobao, and an easy comparison base. Douyin also heavily subsidized its offerings and encouraged its livestreamers to promote more low-priced goods. Douyin adjusted its algorithms to focus on low price rather than GMV growth, including a new automatic price change function. Previously, the merchant portal suggested price adjustments, but the updated algorithm allowed real-time price reductions after comparing products across the entire Douyin e-commerce network. Additionally, Douyin incentivized merchants to break large orders into smaller average order value (AOV) purchases, hoping to drive more impulsive buying.

However, after disappointing GMV growth results during the 618 Shopping Festival and the first half of 2024, BABA and Douyin have decided to retreat from their "low price" strategies.

Douyin found that the livestreaming e-commerce model could not consistently offer the lowest prices to consumers. Influencers and service providers, such as MCN agencies, are integral to the livestreaming e-commerce model and require their own margins, making this channel structurally higher in cost. Moreover, products with strong conversion rates in livestreaming are often different from those on PDD. Despite Douyin’s aggressive efforts to lower prices, its price gap compared to standard products on PDD remains between 10-50%.

Douyin’s GMV growth was 60% in January and February, 40% in March, 40% in April, and less than 30% in July. This slowdown was attributed to the maturing livestreaming e-commerce model, AOV pressures from the low-price strategy, and lower conversion rates due to inefficient traffic allocation to broadcasts featuring lower-priced items.

BABA is facing a tough trade-off. Some background. Tmall has a high take rate, while Taobao has a low take rate. Taobao’s GMV is growing faster and offers more affordable, non-branded goods, benefiting from trade-down in a weak economy. BABA has attempted to accelerate GMV growth without significantly impacting its overall take rate by shifting slightly more traffic from Tmall to Taobao while increasing Taobao’s take rates. This strategy faces several challenges. Tmall merchants may be unhappy with the reduced traffic, and Tmall has 3-4 times the take rate on much higher order values. Any disruption in Tmall could severely affect BABA’s profitability. Additionally, our research survey indicates that merchants using both Taobao and PDD still experience lower return on ad spend (ROAS) on Taobao, despite its lower take rates. This is due to the complexities of BABA’s traffic allocation algorithm, which reduces conversion for low-priced items or deprioritizes traffic with high purchase intent for these items. Lastly, it’s unclear how much further Taobao can increase its take rate given these challenges. Taobao recently introduced its own Full Platform marketing tool, which boosted take rates this year, but merchants have reported worsening ROAS both absolutely and relatively, even though PDD has also increased its take rates through traffic allocation changes and new marketing tools. These factors likely contributed to BABA’s recent decision to de-emphasize low-priced order growth and refocus on overall GMV growth.

Despite aggressive efforts by competitors to prioritize low-priced items in the first half of 2024, PDD’s China GMV likely grew in the mid-20% range based on alternative data. This is remarkable given the ongoing challenges in the Chinese economy and retail spending. GMV growth is expected to re-accelerate as competitors retreat and PDD reinvests a portion of its incremental earnings into driving GMV growth.

China business GMV growth will be driven by expansion of branded products.

The majority of PDD’s China users come from Tier 3 and lower-tier cities and are extremely loyal to the platform. As their incomes continue to grow, they are expected to purchase more branded products, driving the next phase of GMV growth. Our research indicates that branded products are outgrowing non-branded products by a ratio of 4 to 1. PDD’s brand GMV is still relatively small compared to that of BABA and Douyin, suggesting a significant runway for growth. The stock is currently priced as if PDD’s GMV growth will stagnate. In reality, the platform is likely to achieve multiple years of high teens to low 20s percentage growth in GMV.

China business has more room to increase take rate through higher traffic monetization and new adtech tools.

Our research suggests that there is still room to increase the mix of monetized versus free traffic. Additionally, our survey of merchants who are heavy users of ad spend reveals an average net margin of 3-5%. This indicates potential for an additional 150-200 basis points of take rate that could flow to the platform.

To attract more ad spend from merchants, PDD recently introduced a new Goods Promotion scheme. This new scheme is an upgrade from the Full Platform Promotion tool introduced last year. It offers automated ad spend tools that help merchants achieve store-based ROI targets rather than individual SKU-based ROI. This should help maintain healthy ROAS despite higher effective take rates.

The market’s reaction to the Temu merchant protests is a gross overreaction

Another reason for the decline in PDD’s stock is news coverage of merchants protesting outside PDD’s offices. The protests were primarily in response to fines imposed on Temu. Given that 100% of profits currently come from the China business, some short-term or uninformed investors have adopted a sell-first, ask-questions-later attitude, despite the fact that Temu has not yet contributed to consolidated earnings. The fines were intended to improve product quality on the Temu platform. Now that Temu has reached a significant scale, the next drivers of GMV will be category expansion and product quality improvements, which will significantly enhance user retention and lifetime value (LTV). Additionally, there is geopolitical pressure for product quality improvements due to the risk of potential fines from regions like the EU for low-quality products. Although the fines are just one measure to improve the long-term health of the platform, their implementation was, in retrospect, poorly handled, leading to protests from a vocal minority of merchants.

What actually happened? Merchants protested a policy under which Temu froze the after-sales reserve funds of some merchants. The fines were based on merchant store scores, with certain categories of merchants being fined up to five times the penalty base rate. These fines impacted some merchants' working capital and their ability to pay employee wages. Merchants complained about the lack of specific details regarding the fines, with the platform providing only general reasons such as "the description of the products did not match what was received."

Our research indicates that only a very small portion of Temu’s GMV was affected by the fines. PDD has already made changes to the penalty system and refunded some of the unreasonable deductions to merchants. This incident does not negatively affect the overall user experience. Merchants will adapt by improving product quality or losing market share to those that do.

The platform's transition from low-priced, low-quality goods to low-priced, higher-quality goods is a natural evolution. A similar transition occurred in the China business, where PDD initially used addictive games and social hacks to attract users to extremely cheap but low-quality products. Over time, PDD adjusted various merchant policies to incentivize improvements in product quality, accurate product descriptions, and good after-sales support. Many merchants who could not meet these standards went out of business, while those who remained contributed to a dramatic improvement in overall product quality on the platform. A similar transition is expected to happen with Temu.

The advantage of a fast-moving culture is the company’s ability to quickly recognize and address problems. PDD was aware of some risks associated with the fully entrusted business model and has rapidly grown its semi-entrusted model to 20-25% of Temu’s US GMV in just two quarters. The company has acknowledged its mistakes in implementing the fines and has already taken corrective action.

Temu’s GMV and profitability growth has been truly insane. This is completely missed by peers based here in the US.

GMV has grown from $0 to a $40 billion run rate in just seven quarters. Profitability, which was -100% of revenue in September 2022, is now break-even overall and positive in early markets.

Temu has delivered significant consumer value due to its fully managed model, which eliminates inefficiencies in the distribution chain. Merchants ship their goods directly to Temu’s China warehouses, while Temu handles user acquisition, pricing, logistics, fulfillment, and customer service. Previously, merchants and manufacturers would need multiple layers of supply chain representatives and wholesale distribution before reaching the retail platform and the customer. Temu streamlines this process to merchant → Temu → customer. By reducing the number of intermediaries, Temu saves on net margins and overhead at each layer, passing these savings on to the consumer. Additionally, PDD has spent a decade working with manufacturers on the core PDD platform, gaining a deep understanding of millions of merchants and their cost structures, and effectively encouraging them to invest in advertising. In contrast, platforms like eBay, Amazon, and Wish are less involved in the actual supply chain.

The run-rate annual global GMV has likely surpassed $40 billion, with global GMV growing at over 30% quarter-over-quarter. Temu has de-emphasized the US market due to geopolitical concerns, with US monthly active users (MAUs) contributing approximately 20% compared to 30% from Europe. Even considering potential risks from US tariff and de minimis policies, there appears to be no existential risk to Temu as a whole.

Valuation

We value the business at $200 using a 15x multiple on 2024 earnings. Given e-commerce in China is a more mature industry, growth will be structurally lower vs the past but still high relative to other markets.

This yields at ~45-50% return from these levels.

Catalyst

Earnings