Our Updated Thoughts on PDD

Excellent Odds for Patient Investors who can Tolerate Volatility

Dear Readers:

On August 26, PDD Holdings (PDD), the parent company of Pinduoduro and Temu, reported its second quarter's earnings. Given the massive collapse of the stock, and given it's such a core position of our portfolio, I believe it would be fitting to report to you our thoughts on this position even before our third quarter's letter. 

What I did:

After listening to the absolutely "disastrous" conference call, this portfolio manager followed what Mr. David Einhorn once taught him -- "if you want to panic, panic first" -- and sold every single share of PDD when still in his bed at an average price of $112. The stock continued to decline as funds degrossed and leveraged positions got wiped out. Despite the tremendous value we saw in this stock, let's face it, it's a crowded trade. 

A lot of funds, including some famous ones that I deeply respect, had piled into this name. The above 13F screenshot summarizes funds' positions in this stock, and the position size (in %) of their US portfolios. 

As the stock declined, we gradually started to accumulate shares and reestablished a position at an average price of ~$98/share. 

Although we managed to avoid some capital loss through anticipating market sentiment, the damage is done, and we experienced a serious drawdown of our portfolio in the last several days. One of our highest conviction bets in March when the stock retreated to $110 and we started to accumulate shares turned out to be an unexpected "disaster" in our portfolio.

What happened:

We believe PDD wouldn't have fallen nearly as much if the management team had communicated in a slightly different manner. During the conference call, Lei Chen, the co-CEO of PDD, told investors that "profit will inevitably decline" in Chinese, while the English translation had "profitability" instead of "profit". In addition, the management team told the investors that buyback and dividend are not going to happen "in the next several years", while the English translation had it as "in the foreseeable future,” despite the fact that PDD has accumulated a net unrestricted cash position of $40 billion . In addition, the management team exhibited such a haughty attitude towards investors that some investors got completely pissed off. It is believed among some investors, us included, that Lei Chen's comment on "inevitable profit decline" was meant for government officials and journalists who dialed into their conference call, while the translation was directed towards investors. Anyone who participated in the education sector's bloodbath in 2021 would know how important it is for entrepreneurs to be politically correct during such public occasions. 

(Lei Chen on the left, and Jiazhen Zhao on the right, are co-CEOs of PDD).

What now?

Honestly, we are a lot less emotionally affected by the conference call than many of our peers. While we do not intend to ramp up our position size given the geopolitical uncertainties around the coming election and its impact on Temu, as well as the uncertainties with management's true intention and motivation behind a series of somewhat bizarre comments and our expectation of continued degrossing as many funds may experience client redemptions, we barely change our view that PDD is worth at least $200/share at the moment and could be worth substantially more as time drones on. 

Firstly, let's face it, it's one of the cheapest growth story I have ever seen. When I first started managing third party money in April 2022, I bought a ton of PDD in the high 30's. Even prior to that, I bottom fished and accumulated a 30% personal account position in PDD in the high 20's during the March 2022 meltdown. When I bought those shares, PDD had a market cap of $50 billion, a net cash position of $10 billion, and generated $10 billion of free cash flow (FCF) on a run-rate basis. In other words, net market cap to run-rate FCF was 4x, and GMV (gross merchandise volume) was growing at 50%+. Winding the clock to today, the stock is trading at $130 billion, it has a net cash position of $40 billion, and generates $20 billion FCF on a run-rate basis. In other words, net market cap to run-rate FCF is back to about 4.5x, insanely cheap, while advancement of the stock price was almost solely contributed by massive growth. I essentially think the market has given Temu negative value, and has given the main station (主站) of the business in China a massive discount even compared to its peers like Alibaba and JD.com, although, let's face it, PDD is the true market-share gainer among the three with the most efficient corporate army and best long-term capital allocation record. But the skeptics would say, "yeah it's optically cheap, but what if they squander the capital on their balance sheet and business fundamentals severely decline?" This leads to our second observation. 

Secondly, PDD has an impressive capital allocation history and rarely makes strategic mistakes. Admittedly, I was not a fan of the company in the early years of its public history and I did not fully grasp the ingenuity behind "ten billion subsidies"(百亿补贴). We all saw what they did with the subsidy and its meteoric rise as a most powerful e-commerce engine the world has ever seen. Same with Temu, with its GMV in 1H 2024 surpassing the entire GMV in 2023, and its earnings projected to reach breakeven as early as by the end of this year. Once and again, this lean and merciless corporate apparatus conquered the land it came upon, delivering absolutely stunning capital returns to its investors. As a matter of fact, since it went public in 2018, and despite the last six years have been atrocious for the Chinese economy and its equity market, PDD managed to compound at 20%+ on an annualized basis on massively improving return on capital employed (ROCE).

Unlike its nemesis Alibaba which has probably been one of the worst capital allocator of modern Chinese financial history, PDD has consistently been one of the shrewdest capital allocators, and has a unique focus on intrinsic value, mentioning this concept more than any other major US listed Chinese ADRs that I know of. In the company’s first-quarter 2024 conference call, "intrinsic value" was mentioned thrice under the following context:

"Our business does not follow a linear path and our earnings will almost certainly fluctuate. Therefore, we suggest our shareholders not to measure our overall performance with results from a few quarters. Our financial performance may beat or miss market expectations at times, but as long we keep focusing on long-term value creation, ultimately, this short-term fluctuation will convert to our growing intrinsic value. " (Lei Chen)

"We always focus on the long-term growth of the company's intrinsic value and will not smooth out short term financial data". (Jun Liu)

"Currently, we are still in a growth phase. If we see value-creation opportunities in the future, we will invest aggressively. These investments may bring fluctuations to short term profitability, but will help us grow intrinsic value in the long-run. This is our view on profitability. " (Jun Liu)

As a matter of fact, nothing the management said, except its tone, fundamentally differed from what we always know about this company. But the skeptics would continue, "yeah that might be right as well, but what does any of that have to do with you, small shareholders, if your interests and the company’s interests are not aligned?" This leads to our third observation. 

Thirdly, I do not believe PDD will screw over the small shareholders like us. When it went public, it could have done its IPO at $22/share, but Zheng (Colin) Huang, then the CEO of the company and now one of the richest business tycoons in China, suggested it still stick with $19/share, believing the management team and the company's investors should make money together.  Some worry about accounting frauds, which in my view is quite laughable -- as a short-seller myself, I have seen enough frauds to say that typically a real fraudster will not talk to you like this management team did if it ever wants to defraud you -- it'd be the stupidest way to commit frauds, ever. In addition, although PDD has not yet returned capital back to us shareholders, keep in mind the company has become profitable on a GAAP basis for only 3 years! Yes, the company’s cash hoard of $40 billion may sound like a lot of money, but there are many reasons why this may not be much at all under the current context. 1). PDD, like any other private businesses trading public, needs the capital to cope with short term liabilities. In China, for a credit system a lot less developed and strongly biased towards SOEs (state-owned enterprises), entrepreneurs frequently treat all liabilities as financial obligations; 2). The cash pile serves the function of scaring off its competitors -- anyone who knows the story of "hundred delivery companies' war-fare" and Xing Wang (王兴) revealing the cash position publicly for Meituan at the peak of contention would understand the significance of preserving cash; 3). In the worst case scenario, Temu may get fined by Europe or US and it's prudent to have the capital to deal with such mishaps; 4). Importantly, I personally believe dividend and buyback are just one way to reward shareholders, and dividend in particular is just not tax efficient in the US. Berkshire Hathaway has not bought back stock until last decade, but it created value for shareholders through organic growth and smart capital allocation -- PDD excels at both as well. Some would point to Alibaba and JD's incrementally more shareholder friendly policies and praise their recent equity price stability. Oh come on, do I need to remind such individuals that JD went public in 2014 and is up 31% over the last decade, delivering a 2.7%/year return that barely wins against inflation, while BABA went public in 2014 as well, while doing nothing but destroying 13.7% of any dollar invested in the company at its IPO in 10 years?? We need to be honest with ourselves -- has PDD ever done anything that harms small shareholders? I will follow the presumption of innocence and assume PDD will keep compounding intrinsic value as it has repetitively articulated publicly, until evidence proves otherwise. 

Frankly speaking, if I was not managing third party money and did not need to control volatility, I might have as much as 30% of my account invested in PDD at this point. Fortunately, our investors have a long-term time horizon. There will continue to be volatility in our portfolio and even this pick may turn out to ultimately be a mistake, but we react based on the information we have and try to be as emotionally stable and rational as we can, and that's why we did not come out on the first day of the collapse and waited for several days to think things through. After thinking things through, we believe PDD at the current price, is the fattest pitch we can find in 2024 so far.

Wish us luck!