Mine initial bullish thesis about PDD Holdings (NASDAQ:PDD) stock aged remarkably well as the stock rose more than 40% since the start of August, compared to a gain of less than 1% for the S&P500 over the same period. Such a massive rally is not surprising given the company’s stellar performance in the second quarter with over 50% year-over-year revenue growth and best-in-class profitability. I am optimistic about the company’s next quarter earnings release because there have been positive signals for PDD in the macro environment recently. The company’s balance sheet is a strength, making it well positioned to continue investing in marketing and innovation. Finally, my valuation analysis suggests that the stock is about 35% undervalued. That said, I reiterate my Buy rating on PDD.
Latest developments and earnings preview
The latest quarterly earnings were released on August 29, when the company shattered consensus estimates by a wide margin. Revenues increased annually by 58%. Revenue growth in the local currency, RMB, was even more impressive at 66% year-on-year. Despite impressive revenue growth, profitability metrics shrank significantly on a year-over-year basis. Cost of revenue significantly outpaced top-line growth due to increased fulfillment fees and payment processing fees. Gross margin fell on the year from 74% to 64%, and this was the main negative factor for operating margin, which narrowed the year from 27.7% to 24.3%. However, the key to the PDD profitability measurements still exceed the sector average.
Strong financial performance in the second quarter allowed PDD to generate almost $2.9 billion in free cash flow. [FCF], almost 100% annual growth. The strong FCF generated further improved the company’s balance sheet. PDD is in a massive net position of $22 billion with almost no leverage. Liquidity metrics are also in excellent shape. From a financial position perspective, PDD is strongly positioned to continue investing in growth and innovation.
Let me focus on the next quarter’s earnings preview as the release of third quarter results approaches. The earnings release is scheduled for November 23, according to invested.com. Quarterly revenue is expected by consensus at $7.4 billion, which means a massive 50.5% year-over-year growth. Despite the expected massive revenue growth, some struggles with bottom line expansion are forecast by the consensus as adjusted EPS is forecast to shrink from $1.20 to $1.16 on a year-over-year basis. I attribute this to increased fulfillment fees and payment processing fees, which were the main reason for the decline in profitability in the second quarter. While this may be a warning sign for investors, I think this negative effect is temporary. The company demonstrated a strong ability to provide operating leverage as the business grew over the long term. With consensus revenue expected to nearly double in the next two years compared to FY 2022, I believe top-line growth will offset these temporary gross margin challenges.
Much pessimism around Chinese companies this year was due to soft macroeconomic data in the first half of the year. more powerful comeback expected after the country’s zero-covid policy took hold. However, the Chinese government decided to address the issue from the fiscal side increasing costs, which is good news for the country’s economy. As a result, set up the IMF China’s GDP growth forecast at 5.4% for 2023. Increased fiscal spending means more jobs, eventually leading to a boost in consumer spending as well. This is good news for PDD and the positive effect is likely to be absorbed in the next multiple quarters. That said, I think this factor could lead to an optimistic outlook from the company’s management during the upcoming earnings call.
In addition to the expected positive outlook from management, I expect the third quarter results to be solid as well. I am optimistic because China’s economy grew more than expected in the third quarter and strong consumer spending was one of the the main drivers of growth. Since the company’s most important 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 numbers as well. The last Third quarter earnings beat from JD.com (JD), one of PDD’s closest rivals, adds to my optimism.
It’s also important to underline that consensus estimates don’t look that hard to beat compared to recent strong momentum. The expected revenue of $7.4 billion in the third quarter is higher sequentially by only 3.3%, which is inconsistent with some of the details revealed during last earnings call. Management hasn’t given clear guidance for the third quarter, but I think we have to read between the lines. According to the management, the new promotional activities found positive consumer responses, which shows the strong ability to choose effective engagement strategies. The management also reiterated its commitment to invest in the development of the PDD ecosystem, which will attract the best dealers and expand the network. This is also likely to have an immediate positive effect on PDD’s future quarterly earnings.
Last but not least, when analyzing the next quarter’s earnings, it is also important to consider the company’s earnings history. As we can see above, the company has a stellar track record of EPS surprises, usually beating consensus estimates by a wide margin. The only quarter when the company missed EPS estimates was the fourth quarter of 2022, but that was largely due to uncertainty and delays in abandoning the zero-covid policy by the Chinese government. Uncertainty regarding the COVID-related restrictions, which ran 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 back window and there is more certainty about the company’s ability to meet its revenue plans. As a result, in the first and second quarters, PDD delivered a massive earnings performance compared to consensus estimates. And that’s another big reason why I think PDD will top third quarter consensus earnings estimates.
Shares are up 42% year-to-date, significantly outperforming the broader US market. PDD outperformed the iShares MSCI China ETF (MCHI) by an even wider margin since its inception in 2023. DDAs evaluation reports are significantly higher than the sector average, but that doesn’t surprise me, given the company’s massive growth momentum and stellar profitability. That said, high valuation ratios don’t necessarily mean overvaluation. We need to look at discounted cash flow [DCF] simulation for a better understanding of the attractiveness of the assessment.
Given the high uncertainty in the geopolitical relationship between the US and China, I use a higher 13% WACC for discounting than initially. I have income consensus estimates projecting a 10% CAGR for the next decade, which seems very conservative to me. I use a 13.5% FCF margin for my base year, which is the average over the last decade. Given the stellar 28% TTM FCF margin, I expect the metric to expand by 150 basis points annually.
According to my DCF simulation, the fair value of the business is approximately $207 billion, indicating a 35% upside potential from the current market cap. That said, my target price for PDD stock is around $160 per share.
Investing in US-listed Chinese stocks carries significant legal risks of which potential investors should be aware. In recent years, escalating geopolitical tensions between the US and China have led to discussions about the possible delisting of Chinese stocks from US stock exchanges. Despite the likelihood of such a scenario diminishing the end of 2022 when the US has access to audit data, I think this risk is essential to be aware of. The geopolitical environment is rapidly evolving, and relations between China and the US are still far from being “friendly”. While the probability of delisting is low, the potential negative financial impact to investors could be large.
Additionally, there have been well-documented cases of financial statement manipulation by some Chinese companies in recent years. of Luckin Coffee Box striking, given the scale of the accounting fraud. Such cases raise questions about the reliability of financial reporting by Chinese public companies.
To conclude, I reiterate my Buy rating for PDD. The company continues to deliver stellar revenue growth and its profitability metrics are unmatched despite the temporary weakness in gross margin in the second quarter. My analysis suggests the company is likely to deliver strong Q3 earnings with a positive outlook for Q4 and 2024. Furthermore, my DCF simulation suggests the stock is about 35% undervalued, making PDD a compelling investment opportunity.
Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. stock exchange. Please be aware of the risks associated with these stocks.