One of the more fascinating stories in business of late has been the rise of Pinduoduo. Founded barely four years ago, Pinduoduo is now taking over 25% of the growth in online retail in China, and is now one of Alibaba’s leading challengers. This is as surprising as if a company set up in the US and competed head-to-head with Amazon a few years later.
Chinese e-commerce is highly competitive but growing fast, with growth running at over 20% pa, during a period of negative PMI and outright contraction in cyclical retail sectors like autos.
A company taking 20% of a fast growing industry soon becomes 20% of that industry. In this case, that would be a company of considerable value.
For reference, Alibaba is taking over 50% of the sector’s growth, and trades on a market cap of ~$450 billion, while Pinduoduo, taking ~20% of growth, trades on $23b. There is clearly an enormous opportunity here.
So how did Pinduoduo come from nowhere to second in one of the most competitive sectors on the plant?
In short, they riffed on two well-explored themes: social media & group buying.
While you can purchase items at a set list price on the app, shoppers are encouraged to form groups, with the price visibly dropping with every additional member. Users are encouraged to share hot deals with their friends on Tencent's WeChat app.
This viral process allows Pinduoduo to aggregate huge amounts of demand, accumulating over 300 million users in a few years, and selling items as cheaply as $1.50 for an umbrella, or $150 for a PC. The app is particularly popular in price conscious demographics like new mothers in 3rd and 4th tier cities.
Tencent owns an 18.5% stake, and allowed the firm to flourish on its WeChat network. This may end up being Tencent's most successful attack on its rival Alibaba's home turf. There are over a billion Chinese on WeChat, but only about half that on Alibaba's leading apps, so the ecommerce opportunity remains wide open.
Pinduoduo's approach is very different from previous models of group-buying, such as Groupon, which sells coupons for a fraction of the cost and keeps the lot as revenue. Merchants gamble that they will earn more from the one-off increase in traffic than it cost to issue the coupons.
In contrast, Pinduoduo enables specific factories and farms to sell single products direct to consumers, and cut out layers and layers of middle men. This is well-suited for perishable goods like fresh fruit and vegetables, where supply is lumpy. Farmers can sell entire crops when they're harvested. Pinduoduo is a long-term solution for these kinds of suppliers.
The economics offer a triple win: Pinduoduo takes about 2.6% of the purchase price, up from about 2.2% a few months ago. Other than that, the savings from cutting out middlemen are split between the producers and customers.
In the past two quarters Pinduoduo significantly beat on revenue. In January the firm posted revenues 8% higher than expected, and in April, 13% higher. The company is substantially larger than forecast, and has materially more scale than at the beginning of the year. Naturally, this has come with higher than expected marketing and growth related expenses.
Why are we comfortable with this?
We're big believers in assessing hidden value. A classic example is Netflix, a firm that posts prodigious revenue growth and has vastly outperformed expectations by underpricing their product and investing their entire revenue, and then some, in creating excess entertainment value for subscribers.
Netflix could lift prices at any time, and all the extra revenue would flow straight through to the bottom line. There's no way to look at Netflix’s historic figures and see the latent value hidden in the user base. Few in the UK will notice their monthly subscription cost increased from £7.99 to £8.99 in March this year.
Algorithms miss this kind of value too, as there’s no easy way to take reported figures and calculate the likelihood a company can raise prices, though perhaps the growth rate of net subscribers is a good indicator that the firm could lift prices without a net loss of subscribers.
Software-as-a-service firms offer another example. When a new user signs up, they have basically zero impact on a company's income statement, balance sheet, or cash flow. Yet that user may pay $15 a month for a decade, and in cases where switching is tedious/expensive, like accounting software, be willing to pay higher and higher prices for much longer.
Investing money today to capture hundreds of millions of customers for the indefinite future is an entirely rational strategy, though this shows up in historic financials as increasing losses.
The key is to determine the profit opportunities from those that offer only revenue. So where does Pinduoduo stand here?
Alibaba’s core e-commerce group consistently earns operating margins about 40%. This is in stark contrast to Amazon, who earns low single digits in the US and negative margins elsewhere around the world.
These companies are often seen as comparable, and in many ways they are, such as the scale of their user base, their dominance in online retail, and their investment in areas like cloud computing. But Alibaba is really an advertising business, selling extraordinarily valuable advertising real estate: users typing in particular keywords are highly qualified buyers.
Amazon has only recently started experimenting with this properly, and the moment they choose to do so, can generate significant new revenues, that will be largely profit.
Pinduoduo's revenue model is closer to Alibaba's. With no inventory to hold, they can sell advertising real estate at little to no marginal cost to themselves. In fact, analysts estimate that Pinduoduo, with >130% growth, is trading on a 2020 after-tax earnings multiple of only 14x.
We think the fundamental outcome is going to be very different, with revenue vastly ahead of estimates, but profits far lower. The long term rewards of maintaining this >20% grip on market growth vastly outweighs short term considerations.
Fortunately, the firm is capitalised correctly, with $4b of net cash (EV of $19b), to play this kind of long term game. Our timing here hasn't been impeccable - the firm is over 50% away from it April high and about 15% away from our average purchase price. The story is similar with our other Chinese investment, iQiyi.
Mixing social and e-commerce has always offered an immense opportunity to anyone who gets it right. You may remember Facebook's poorly judged attempt to encourage us to broadcast our latest purchases.
Pinduoduo has clearly landed on one of the first successful models, incorporating social networks and gamification directly into the purchasing process.
It's hard not to wonder if there would be a way to match this kind of success outside of China. Where would you start? Would millenials share a deal for avocados at 25c each? Or do you follow Pinduoduo's example and offer nappies in bulk to new parents? Perhaps the answer is to target price-concious buyers of high value objects like watches and homewares.
Precisely what it would take for a social, group-buying e-commerce model to work in the West is left as an exercise for the reader.
Best wishes Michael