PDD Holdings: Temu And The Underbelly Of DTC Boom (NASDAQ:PDD)

We Are Thesis Retail markets are very dynamic, the ranks of the most popular retailers are constantly changing as new formats are being developed. The companies that strike a chord with their new formats can grow very fast and deliver extraordinary returns to shareholders. Low-cost Direct-To-Consumer retail has been the most successful format in the markets as of late. Retailers like Costco (COST), Ikea and Decathlon have grown rapidly. Now e-commerce retailers are taking over the low-cost DTC segment in a big way, and PDD (NASDAQ:PDD) is the most successful of them with Temu in the West and Pinduoduo back in China. Shoppers love their ultra-low-cost merchandise, and their sales are soaring rapidly. PDD not only offers considerable price savings, but it also excels at making sure its curated product catalogue includes mostly good quality products. PDD is reminiscent of Ikea and Costco as retailers that can offer unrivalled value for money. These types of retailers are worth a fortune! However, Temu is still selling at a loss and it is uncertain if the business can be scaled to a level where it becomes economically viable. It is easy to sell cheap when you are selling at a loss. PDD is also quite secretive and provides analysts with little to go by. It is not possible to dig down into reported numbers and verify them independently. We are excited about this business, just like the majority of analysts, but feel that we have to treat it with caution. In this article, we aim to provide a balanced insight into the good, the bad and the ugly of PDD. The good (I): direct-to-consumer is the hottest growth trend in retail Direct retail enables considerable savings for buyers by taking out the middlemen involved in the losing supply chains from Asia. The majority of generic low-value consumer discretionaries in supermarkets sell at multiples of Chinese factory gate prices. Direct-to-consumer retailers streamline the supply chain by bypassing the intermediaries and purchasing directly from manufacturers in bulk. Many of them also provide product specifications based on their customer data. Oro CommerceDTC retail platforms enable consumers in the West to purchase Chinese goods at a small markup to factory gate prices and save considerably. Several physical retailers already arbitrage this opportunity. Costco, Ikea, Decathlon and Lidl just to name a few are contracting directly with factories in China and placing orders in bulk to achieve manufacturing and supply chain efficiencies. These physical retailers are famed for value-for-money merchandise and have grown at a rapid pace. But there is a caveat in their strategies. To boost manufacturing and supply chain efficiencies, these retailers have to focus on a limited range of merchandise. So, for example, if you did not buy that speaker when it was on sale in Costco, you might never get a chance to buy it again. Once the production order is sold out, it’s gone. This is where the Chinese e-commerce DTC platforms step in. While also curating their portfolios of merchandise, they offer a considerably broader range than physical DTC retailers. They are also able to offer better prices than physical private-label retailers in the West due to lower logistics costs. The good (II): Chinese DTC platforms are gaining share due to logistics advantages Chinese DTC retailers do not have to maintain physical stores, warehouses or inventories in the West and they can pass on cost savings to buyers. They also benefit from tax advantages. Online DTC is a relatively new concept which has been pioneered by Shein, an online apparel merchant launched in 2012. Apparel is the category with the highest price difference between factory gate and American retail prices, so it is no surprise that it was chosen to develop the concept. Temu, and others, rely on incredibly logistically complex operations. The average order value of Temu has been around $30 but would include several items from different manufacturers. Temu ships around half a million parcels every day to the U.S. alone, and growing, which are pre-sorted and packaged in China. The company’s logistics partners sort millions of low-value Stock Keeping Units a day, that arrive from tens of thousands of manufacturers. Temu The high volume and low average SKU value make it incredibly difficult to manage this supply chain profitably and achieve a high level of fulfilment accuracy. We are fascinated by this capability. To achieve competitive delivery times, orders arranged by postcodes, are then flown into the U.S. and other markets in the West. These parcels have a low value to volume, therefore the airfreight costs must take a significant share of order value. These logistics operations require an enormous labour force as well as an extensive warehouse floorspace equipped with automated sorting equipment. Quite a substantial air freight capacity is also needed. The labour force as well as infrastructure tends to be considerably cheaper in China. This enables Temu to sell merchandise cheaper than U.S.-based DTC retailers and gain market share. The good (III): Temu was enabled by advances in big data analytics Buyers in the West had direct access to Chinese factory gate merchandise at local prices for quite some time now through platforms like Alibaba (BABA). These operations were easier logistically as customers would have to order in bulk. This format did not achieve popularity as the quality of the goods was difficult to verify before purchase, and the minimum order value was large. Aliexpress and Wish were a second iteration of the direct sourcing from China concept. The platforms offered a broad range of merchandise directly from factories to retail consumers. However, to minimise logistics costs orders were mainly shipped by sea and took a long time to deliver. Product quality was also not vetted. These concepts did not catch on, even though the price point was attractive. Temu is the latest iteration of the direct-sourcing concept. They offer a curated product catalogue, as the products are customised based on platforms’ recommendations, and orders are delivered in about a week. Online DTC platforms require sophisticated customer data analytics, that benefitted from recent technological advances. Platforms have to break down consumer preferences and market trends and predict the type of products that are most likely to sell. They then pass on production specifications to manufacturers and order goods to be manufactured in bulk, to achieve manufacturing scale. Temu offers a considerably narrower range of products than AliExpress, but their range is matched closer to customer demands. The narrower range also allows for higher production orders per item, improving manufacturing and logistics efficiencies. Temu has also achieved faster delivery times by flying their orders instead of shipping them. The advantages on the product design and manufacturing side (in theory) should enable the platform to cross-subsidise some of the higher air freight costs and deliver attractively priced products. ForbesTemu is now offering excellent value for money, by selling generic goods of reasonable quality at much lower prices than other retailers. It is no surprise that they are growing rapidly and also developing a value-for-money reputation. The bad: it is easy to grow when selling at a loss PDD is a rather secretive business and they do not disclose the results of Temu. It is quite clear that the business is growing but nobody is sure how big or profitable it is. Most industry analysts seem to claim that Temu is still loss-making due to its aggressive marketing spending as well as logistics costs. JP Morgan has estimated that Temu is likely to spend $3 billion on marketing in 2024, while Goldman Sachs has estimated that Temu is losing $7 per order. Considering that the U.S. orders alone are nearing a million per day, Temu could be losing $2.5 billion per annum in the U.S. European operations are also likely loss-making. On top of this, Temu relies on considerable logistics operations to sort, package and ship its orders. All of these operations are externally owned while PDD contracts their services. Some logistics providers are giving Temu preferential rates while operating their businesses at a loss, hoping that someday the partnership will deliver profits. If logistics operations were owned by Temu directly, the losses would be even greater. PDD does not disclose much information about its logistics services providers, though it has come to our attention that recently IPO’ed Indonesian airfreight company J&T Express (OTCPK:JTGLF) is one of the most significant partners of Temu. The company is losing about $1.7 billion per year, hoping to entrench itself inside of Temu. As of late, air freight costs have also started to balloon as Temu and Shein’s order volumes are putting a strain on the industry’s capacity. The duo combined are reported to need 88 Boeing 777 freighters. Eventually, though the suppliers as well as Temu itself will want to make profits, meaning that the prices might become less competitive. Analysts indicate that Temu operates on the assumption that it can reach an average order size of $50 and have an average customer order 30 deliveries per annum. The higher-order value would enable achieving a positive gross margin after expensive air freight. While the high order frequency would help fund marketing and customer acquisition costs. As it stands today, Temu is not economically viable. We have bought from them and were satisfied with our experience, just like millions of others. However, it remains to be seen if it can actually make profits. The ugly: removal of the $800 de minimis provision could eliminate their cost advantage Temu’s main logistics operations are located back in China. These rely on low labour and infrastructure costs and could well be subsidised by the Chinese government hoping to keep local factories busy. If Temu was forced to onshore its logistics operations to the U.S. it would lose much of its cost advantage. De minimis refers to the minimum value of the goods below which no duties are collected as the low value of such items makes it counterproductive to apply normal customs procedures. This value in the U.S. is currently $800. The EU is now planning to impose duties even on low-value items. While the scrutiny in the U.S. is also increasing. Higher taxes would make the items less competitive, potential delays are a larger risk though. As millions of additional parcels start arriving from China daily, it becomes increasingly difficult to monitor the contents of these parcels. This arrangement creates significant risks. Longer and more expensive customs clearance procedures could remove some of the cost advantages of Temu or even force the retailer to move some of their operations to the U.S. and incur considerably larger costs. Shipping pallet loads directly from China and sorting them into individual orders would be akin to what Amazon (AMZN) is doing now. PDD is not likely to have a significant cost edge in this game. Valuation and Financials During FY2023 PDD has generated $8.5 billion of earnings, growing at an impressive 82%. PDD trades at 22X prior financial year earnings. The company is now expected to grow earnings by another 83% over this year and deliver ~$12 of EPS. The earnings were revised considerably higher after strong earnings performance over the last 2 quarters. Seeking AlphaAlthough no segments are broken down, it is safe to assume that Chinese Pinduoduo accounts for all the company’s profits while the international Temu is still loss-making. The near doubling of the company’s earnings must originate from China. Since Chinese GMV estimates for 2023 range between $400 and $500 billion, Pinduoduo already has a significant market share domestically. Increasing sales volumes by another $400 billion in a single year would be very challenging. We can therefore deduct that Pinduoduo is expected to increase take rates in transaction services and increase the fees of online marketing services. Fee increases in the fiercely competitive Chinese online retail market might not be easy. In Q1 of 2024, PDD reported that revenues from transaction services increased to RMB44.4 billion, up 327% from the same quarter last year. Such a steep rise must be associated mainly with the growth of Temu volumes. Operating profit in Q1 was RMB28.6 billion versus RMB8.5 billion in the same quarter last year, with operating margin increasing to 33% from about 22% last year. Assuming that the main volume growth came from loss-making Temu, the 56% increase in Online Marketing revenues must have been the main margin growth driver. PDD is continuing to perform well in China due to the continuing strength of its cost-competitive merchandise as consumer confidence fails to recover. However other platforms, like Taobao and Tmall are also growing. PDD must be growing revenues by raising platform fees considerably as volume growth would be seen in competitors’ numbers. Alibaba has been reducing fees in China lately. Higher Pinduoduo fees would indicate that the company’s competitive advantage is narrowing. We doubt that they will be able to raise fees a lot more. PDD currently trades at 3X forward sales multiple, in line with American peers such as Etsy or eBay, it is considerably more expensive than Alibaba however. TIKR TerminalWe are somewhat sceptical of the ability of the business to double its earnings once again this year. The company is already of significant scale in China and growing further at rapid rates might become ever more challenging. The growth of Temu is also putting pressure on the company’s profits. Key Takeaways PDD is a leading Chinese online direct-to-consumer merchant, gaining market share in the fastest-growing retail segment. The company draws buyers to its platforms by offering low prices, good quality products and engaging shopping experiences. Temu, PDD’s international DTC platform, has been growing rapidly. Temu’s expansion is particularly aggressive, with the company and its partners subsidising the marketing and logistics expenses of the business. Pinduoduo has also been increasing platform fees in China, which resulted in considerable earnings growth last year. However, the Chinese market is quite competitive and it will not be easy to continue raising the fees, nor it will be easy to double sales volumes. We therefore see the current full-year earnings guidance of $12 per share as rather optimistic. The long-term growth potential seems to be significant, however the economic viability of Temu has not been proven yet. Regulatory risks also linger. We will Hold out from buying the stock now, but we intend to keep up with this fast growing direct-to-consumer retailer. 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.

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