Securities in PDD portfolio (NASDAQ:PDD), the owner of Temu, is visibly trying to make its fourth quarter 2023 results the best in its history. By increasing its advertising spend during the Christmas period, the company is investing heavily in growth. Temu adverts were everywhere on social media during the holidays, with huge sums of money spent on Google (GOOG) And Meta (META) stain. Additionally, spending is expected to continue, with the PDD providing for yet another Superbowl location in 2024.
It’s for this reason that I expect PDD’s fourth-quarter revenue to beat analyst estimates. Analysts expect $10.59 billion in revenue, which would represent growth of 83% compared to last year’s quarter. Some growth is already expected, but with Temu’s ad spend, there is still significant potential for overrun. Last quarter, PDD had revenue of $9.4 billion, up 94% Year after year. If the company generates $10.59 billion in revenue in the fourth quarter, its sequential revenue growth rate will only be 12.2%. Given the known tendency for retailers to make more revenue in the fourth quarter than any other quarter (due to Christmas shopping), the revenue growth expected by analysts appears to be based on very conservative assumptions. A beat wouldn’t be surprising.
On the other hand, the income situation is more complex. PDD is spending huge amounts of money to advertise Temu, with the aim of making it a major player in global e-commerce. These expenses produce the superior growth that PDD is known for, but on the other hand, they threaten the company’s margins as Temu becomes an increasingly important part of PDD’s business. Pinduoduo, the Chinese equivalent of Temu, has been profitable for over a year. We know this because PDD’s latest earnings releases showed the company had positive profits and cash flow, even though Temu is known for losing money. It follows that if PDD continues to spend so much to develop Temu, the margins of the entire company will suffer.
In fact, this is already happening. Over the last three quarters, PDD has published the revenue, operating profit and net profit figures presented below:
2 billion dollars
The net margin
As you can see, the third quarter net margin was the lowest of the three most recent quarters. EBIT peaked in the second quarter, but then declined. Generally speaking, we see PDD Holdings’ margins declining. This trend will continue as long as PDD continues to invest heavily in Temu’s growth, as the company is intentionally lose money in order to capture market share in the United States.
The economy of Temu
The economics of Temu are complex, but basically the company loses $30 per order (according to a Wired study) in order to offer customers the lowest possible prices. It also puts pressure on its suppliers to make losses, which prevents Temu’s loss per order from increasing further. To illustrate how Temu loses money in order to gain market share, consider the company’s shipping policy. Standard shipping is free on ALL Temu orders, and express shipping can be had at a lower cost, but Temu pays about $9-10 in shipping for an average order. The low prices this produces have allowed Temu to become extremely popular in an extremely short period of time, often topping the US app store charts, but also extremely expensive to operate.
It’s for this reason that I think PDD’s fourth-quarter earnings could come in below estimates, despite my simultaneous belief that revenue will significantly beat estimates. PDD Holdings is spending so much money growing Temu that it now represents a significant percentage of the entire company. At the same time, it is Temu who is responsible for most of PDD’s growth – the company’s growth had been deceleration before the launch of Temu. As Temu grows and loses money, the margins of the entire PDD business decline. This could lead to disappointing financial results for the fourth quarter. Analysts expect PDD to achieve $1.52 and $1.43 in adjusted EPS and GAAP, respectively, in the fourth quarter. In last year’s quarter, the numbers were $1.21 adjusted and $0.95 GAAP, meaning analysts expect earnings growth of between 25.6% and 50, 5%. That’s expected strong growth given Temu is losing money while becoming an ever-larger part of PDD’s overall business. So we could see some turbulence in PDD stock post-earnings if EPS misses. I consider that the main short-term risk, such as the probability of an increase in income, seems quite high.
Why is Temu losing money
Having shown that PDD Holdings is likely to report strong revenue growth but disappointing earnings growth for the fourth quarter, I now need to answer the crucial question:
Why is Temu losing so much money and can it become profitable?
This is a very important question because the current situation implies that the company will eventually stop growing or become unprofitable again. Currently, Temu is subsidized by Pinduoduo, a very profitable company, but if Temu becomes larger than Pinduoduo, the profits of the entire company will be negative.
So why is Temu losing money?
The main reason is that it’s about trying to gain market share. E-commerce is a competitive industry, with Chinese brands like AliExpress, Shein and Wish all trying to corner the market for cheap Chinese goods. Temu must beat all of these companies to maximize its earning power, which is why it strives to keep prices so low that its competitors cannot afford to match them. When it works, this strategy can cause “competitors” to exit the market, giving the company using the strategy greater pricing power.
As for the details:
A big part of why Temu loses money is due to the cost of making it. Temu’s average order is $50, average shipping cost per order is $9-$10. Unless Temu’s suppliers are making huge margins, that’s a $9-$10 loss borne by Temu. Added to this is the amount paid to the seller, which would be between 80 and 90% of the list price (i.e. Temu harvest 10% to 20%). With an average order of $50, that’s another $5-10 in losses. Finally, there are marketing costs. Temu reportedly spent $1.4 billion on advertising in the United States this year and plans to spend $4.3 billion more next year. There is no data on how much this represents per order, but it is possible to make an estimate. Temu has achieved $1 billion in lifetime GMV by June 2023. The app launched in September 2022, representing $1.33 billion on an annualized basis. With an average order of $50, that’s 26.6 million orders per year. Divide $1.4 billion by that amount and you get $50 in advertising costs per order, plus $9 to $10 in shipping costs and an undisclosed amount paid to suppliers. This results in an estimated loss per order of -$50 ($10 supplier fees minus $60 costs). That’s more than the $30 figure cited in the WIRED article, based on the mid-June GMV estimate. However, GMV has increased significantly since June, so we will likely end up with an estimated loss per order of almost $30.
There are some pretty obvious ways for PDD to increase Temu’s margins. For example, it could reduce advertising, which would immediately increase the margin on each sale (but it would also slow sales growth). The bigger Temu gets, the more PDD Holdings management needs to think about things like this – at least if it wants to continue to have high margins. As for whether they will succeed: well, it worked in China. But it costs $14 to ship a package from Guangzhou to the United States, and PDD has already convinced its logistics partner to absorb much of that cost. Shipping to China is much cheaper. Thus, the path to profitability for Temu will be more difficult than that of Pinduoduo.
PDD Holdings is a profitable and growing company. Purchases this holiday season will likely give the company a big boost in revenue, which could send its shares skyrocketing, perhaps even taking them to new highs. The downside is that the growth strategy will sooner or later start to eat into margins. With Temu losing $30 per order, it would be hard for him not to.
When it was trading at levels between $70 and $95, I eagerly bought PDD stock. Today, the stock trades at 27.65 times earnings, seven times sales and 8.9 times book value. It’s certainly not cheap compared to other well-known Chinese ADRs, including BABA and JD dot com (J.D.). PDD justifies this price premium through growth, but the growth strategy risks making the company unprofitable. The picture is mixed. However, with its growth and high margins, PDD has considerable potential to exceed expectations. Overall, I rate the stock a Buy.