PDD Holdings: A Good GARP Stock Made Even Better By Stable Margins (NASDAQ:PDD)

PDD stock is a good GARP opportunity

PDD Holdings Inc. (NASDAQ:PDD) just delivered a strong quarter. According to its recent 2023 Q4 press release, its profits beat expectations on both lines. Its EPS (on a non-GAAP basis) dialed in at $2.40 per ADS, beating market expectations by a wide margin of $0.75. Its revenue totaled $12.52B, also beating market expectations of $1.68B.

What really surprised me was the cost-control measures and stable margin amid Temu’s rapid expansion. As seen in the chart below, its total operating expenses have risen by quite a bit lately. It was below $2.4B during 2021~2022 and now sits around $4.3 billion on a quarterly basis. However, the margin (see the bottom panel) has been remarkably stable at around 23.6% in recent quarters, despite the Temu expansion and inflation pressure.

Meanwhile, quite counterintuitively in my view, its stock prices have suffered a sizable correction since the earnings report. As shown in the chart below, the price of PDD recently peaked at around $150 per ADS in early 2024 before the earnings report, but since has dipped to the current level of $130 after that. Such a price decline, when combined with its earnings growth potential, has made the stock a good GARP opportunity (growth at a reasonable price), as detailed next.

PDD stock: growth outlook

The chart below describes consensus EPS estimates for PDD stock in the next 3 years and the implications of such EPS growth on its implied P/E ratios. As seen, consensus EPS estimates for PDD point to robust growth. Its 2024 FY EPS is projected to grow about 31% YOY to $8.46. Thus, the implied P/E ratio is only about 15x for FY 2024. Looking further out, PDD’s EPS is expected to continue growing at a 20%+ annual rate to $13.7 in FY 2026. By then, its implied P/E would only be in the single digits.

Next, I will argue that such a growth curve is very likely thanks to its rapid expansion, stable margins, and robust profitability.

PDD stock: growth catalysts and return projections

PDD stands out in China’s e-commerce landscape due to a few key differentiation factors that can support the above EPS growth projection. The top one on my list is its C2M model (Consumer-to-Manufacturer). Unlike giants like Alibaba Group Holding Limited (BABA) and JD.com, Inc. (JD), which focus on a traditional marketplace model, PDD facilitates a more direct connection between consumers and manufacturers. This can lead to lower prices for consumers as there are fewer middlemen involved. The second one is its successful integration of social commerce & gamification with shopping experiences. PDD leverages social features to drive engagement. Friends can team up to get even steeper discounts through group buying features, creating a more social shopping experience. They also incorporate gamification elements to make shopping more interactive.

Thanks to these features, its mobile shopping app has been attracting a large user base and an incredibly high penetration rate. According to data from Statistica,

As of the first quarter of 2023, the Chinese mobile shopping app Pendulous had approximately 623 million monthly active users, up from 622 million in the previous quarter. That quarter, Pinduoduo reached a mobile penetration rate of around 62.8 percent.

Furthermore, at its current valuation multiples, I see excellent return potential even at much lower growth rates. As a conservative scenario, I will project its growth rates based on its return on capital employed. The method is detailed in my other articles, and I will just quote the results here:

The method involves the return on capital employed (“ROCE”) and the reinvestment rate (“RR”). The ROCE for PDD is around 47% as seen in the chart below. Its RR is about 15% on average in recent years. With these inputs, PDD’s organic growth rate would be ~7.1% (47% ROCE x 15% RR = 7.1%). Note this number is the real growth rate without inflation. To obtain a notional growth rate, one would need to add an inflation escalator. Assuming an average inflation of 2.5% would bring the terminal growth rate to 9.6%.

It is indeed far below consensus projections in the 20%+ range. However, a simple discounted free cash flow model would show that even such a conservative projection can lead to outsized return potential. To make the estimate even more conservative (and also more realistic in my view), I will use a two-stage discount model, with a growth rate of 9.6% in the first stage and a lower rate in the second stage to capture the terminal growth rate. As detailed in my earlier article:

There are a total of 3 key parameters in this 2-stage model: the discount rate, the growth rate in stage 1, and the terminal growth rate. For the discount rate, I relied on the so-called WACC, the weighted average cost of the capital model. The discount rate for PDD is about 9.5% on average in recent years following this model.

For the growth rate in the second stage, I will assume an RR of 5%, which is the average RR for large mature tech firms. With this RR, PDD’s organic growth rate would be ~2.35% (47% ROCE x 5% RR = 2.35%). Again, adding an inflation escalator of 2.5% would bring the nominal growth rate to 4.85%.

With all these parameters, the table below summarizes the results. Note I projected its FWD free cash flow to be $10.45 per ADS. These projections were based on a projected cash flow of RMB111.4 billion, CAPEX of RMB323 million, and an exchange rate of $0.14 to 1 RMB. As seen, under the more conservative growth rates, the fair price turns out to be about $353 per ADS, far above its current market price.

Other risks and final thoughts

PDD faces all the common risks generic to other Chinese e-commerce stocks. These risks include an overall economic slowdown, regulation changes (the Chinese government’s recent tightening on e-commerce firms serves as a good example), competition, et al. Here I want to point out two risks that are more relevant to PDD. The top thing to my mind is its lack of fulfillment centers and distribution networks. Unlike Alibaba and JD.com with their own fulfillment centers and distribution networks, PDD relies on third-party logistics providers. There are certainly advantages to this asset-light model. However, I am more concerned about the downside – this lack of direct control could impact delivery speeds, quality of service, and also cost.

All told, I see far more upside potential compared to downside potential and rate PDD Holdings Inc. stock as a BUY under current conditions. To recap, the gist of my bull thesis is a promising GARP opportunity. The opportunity is made even better with its effective cost-control measures, an area that many growth companies suffer amid rapid expansion.

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.