Description

This writeup is going to be short because it’s being written under the highest pressure imaginable. I’m not referring to the movements in the market. I’m referring to the fact that my wife went on a business trip and left me with our three children. I love making children but have mixed feelings about the fallout afterward. Currently I’m holed up in my office feverishly writing up this report as my children run patrols around the house attempting to locate me.

With that out of the way, I’m writing to recommend catching the falling knife and purchasing shares of Pinduoduo (“PDD”), which are worth at least $100 a share, 2.5x more than the current price.

The company

Pinduoduo is an e-commerce platform that’s sort of like Groupon, except it’s actually useful. Like Groupon, it allows consumers to receive lower prices by teaming up to make purchases. Unlike Groupon, whose model is self-limiting to the point of uselessness, PDD has come practically out of nowhere to have the largest number of users of any e-commerce platform in China. Compounding its reach, PDD has a contract in place with Tencent, which allows PDD’s users to send each other deals using Tencent’s social network. This leverages PDD’s own network and lowers PDD’s traffic acquisition costs versus the competition. The result has been incredible economics particularly for such an early stage firm. PDD’s selling and marketing expenses per annual active buyer is just CNY 56 versus CNY 65 for JD.com and CNY 68-123 for Alibaba.

PDD has in the past emphasized trying to make group purchasing a fun and social experience. As a result, the business model has been described as Costco + Disney, but we don’t see it that way. It’s more like a virtual Costco with a giant Walmart flatbed truck circling the virtual parking lot, picking up people in attempt to form a mob that instead of enforcing gender pronouns, will shrewdly band together to negotiate down the price of 2000 bathmats.

The business model is a “goods find people” model, which we aren’t generally fans of because it puts the cart before the horse—goods before the consumer’s desire for those goods. But Pinduoduo has found the sweet spot where this model actually adds a lot of value, and that’s in high-frequency goods like groceries, agricultural products, etc.

PDD has 17% market share and ultimately has a very good chance of winning 25% market share in China’s e-commerce landscape. It’s competing for a sizeable piece of the one of the most valuable oligopolies in the world. But even beyond this, PDD is appealing for two reasons. One, it’s actually one of the good guys. It truly does what Walmart and Costco do. It makes the average person wealthier by driving down the cost of their purchases. Meanwhile it doesn’t just do this by driving a hard bargain with the producer/manufacturer, thus simply robbing Peter to pay Paul. It offers true value-add, as it cuts out uneconomical layers of middlemen and gives the end consumer most of the savings.

Second, PDD is on the right side of the CCP’s common prosperity goals. This is a lifeblood interest of the CCP’s because its moral legitimacy hinges on continued elevation of the average person’s standard of living. PDD is somewhat unique among online platforms in that it uses its market power for the benefit of the little guy—instead of simply for itself. And this in turn makes it less of a target and more of the type of business the CCP actively needs.

In terms of economics, now that PDD has already achieved user scale, it has stated that it’s changing focus from sales and marketing expenditures to R&D. As we all know by now, online platforms have incredible economics—usually net margins of 20% or more. This is in part because in addition to enjoying scale and low marginal costs, these businesses can make incredible amounts of money advertising. And as PDD shifts from scaling to monetizing, its margins are already poised to reach 20% net within several years.

So we have a business growing 35% a year and with a very good chance of earning 20% net margins by 2024. However, it trades at just 2.5x sales and 8x 2024 earnings. Clearly PDD’s shares come with a big catch, and the catch is that Chinese tech stocks have been in freefall and the market has completely decoupled from fundamentals.

The situation

JP Morgan’s analyst, in downgrading 23 Chinese companies, summarized the current sentiment best. For the time being, he said, Chinese tech stocks are “uninvestable.”

The risks are almost too numerous to hold in your head at one time. There’s the regulatory risk from the Chinese authorities, whose actions were what started the avalanche that took out tech stocks in the first place. There’s the delisting risk for the ADRs from the SEC. There’s the risk of sanctions from the US because China is sort of supporting Russia vis a vis the war in Ukraine. There’s the pullback of spending on the part of the Chinese consumer. And finally there’s the omnipresent, slow-boiling tension between the US and China. I think all of these risks are really one risk, one that stems from the fact that the fact that China isn’t in any way, shape or form a free or open society. It’s an authoritarian place, and the last two years have all of a sudden reminded investors of that.

The person whose comments, I think, really hit the nail on the head were Beethoven’s in on the Alibaba thread. Comment #19. Beethoven pointed out that for a superpower, China routinely behaves in a way that’s morally wrong, if not morally disgusting. They brutally repressed scientists who tried to tell the truth about Covid. They destroy those they find inconvenient. They routinely cheat and lie. I agree 100% with those comments. But while I think they’re the truth, I don’t think they represent the entire truth.

For the last 2000 years, China has been a place that doesn’t conform to Western morality. The cold-bloodedness with which Chinese rulers have governed China shocks the Western conscience. Nothing the US or the world can do will change the place. It is what it is. In the past, some have tried to rule differently. But they always returned to the brutally top-down system of their predecessors.

It’s an ugly system. I’d never want it here, but that doesn’t mean that it doesn’t work over there. It also doesn’t mean that we can’t make money. Emerging markets often have heavy-handed, confiscatory regimes running them, yet when the price is right, these markets consistently produce incredible returns. A lot of money was made in South Korea back when it was a dictatorship run by a man who was little more than a gangster. Once again because the price was right. And right now in China the price is right. 

In view of this, it’s worth going back to first principles and asking ourselves what are the inevitable forces at play here. Number 1, China, for all its faults, will be substantially richer in 10 years than it is now. Number 2, the US and China actually have remarkably little to fight over. Every egghead at a think tank in Washington has an opinion about the US and China’s competing spheres of influence because such people are obsessed with abstractions that have little relevance to the average person. But these spheres of influence in actuality have remarkably little overlap. Taiwan, the South China Sea, the Middle East, Ukraine, these are not hills to die on. Meanwhile the US has essentially outsourced its entire manufacturing base to China. We depend on them. They’re what’s kept inflation here from doubling.

There is of course always the risk of a WWI situation—where countries go to war for essentially no reason at all and destroy an entire generation in the process. But thankfully wars like that rarely happen.

Ultimately China and the US are more likely to work out their differences than not. As evidence of this, just this morning, per Bloomberg, “China’s top financial policy body vowed to ensure stability in capital markets, support overseas stock listings, resolve risks around property developers and complete the crackdown on Big Tech ‘as soon as possible.’” Assuming they make good on this promise, investing in China makes sense because not only is the price right, but the clouds hanging over the Chinese tech market seem to be lifting.

Bringing it back to PDD, assuming the CCP doesn't confiscate your shares, which is unlikely, PDD's value is obvious. The company has already done the hardest part—gaining users—and it offers scale economics shared to a population desperate for them. A company with 17% market share in the soon-to-be largest market on earth deserves more than a $57 billion market cap.

Valuation

The company could realistically earn $7 billion in 2024. Putting a 25x multiple on that and discounting back to present day gives me a fair value of $100/SH, roughly in line with a lot of the sellside before concerns about China turned into total panic. That equates to 150% upside. There's a very good chance the company's worth substantially more, but $100/SH represents an undemanding base case. 

Catalyst

An end to the regulatory crackdown--in both the US and China