Pinduoduo (NASDAQ:PDD) recently reported its third quarter earnings, and investors seemed impressed by the Chinese e-commerce company's numbers. Its revenue grew 697% annually and 24% sequentially to 3.37 billion RMB ($491 million), beating estimates by $52 million.

Its trailing 12 month GMV (gross merchandise volume) rose 386% annually to 344.8 billion RMB ($50.2 billion). During that period, its active buyers rose 144% to 385.5 million, while its annual spending per active buyer grew 99% to 894.4 RMB ($130.20). Its monthly active users (MAUs) rose 226% annually to 231.7 million during the quarter.

Dollar signs "float" out of a smartphone.

Image source: Getty Images.

Those figures look phenomenal compared to bigger e-commerce companies like Alibaba (NYSE:BABA) and JD (NASDAQ:JD). But if we dig a little deeper, we'll find four simple reasons to avoid Pinduoduo.

1. Widening losses

Instead of selling brand name products like Alibaba's Tmall and JD Mall, Pinduoduo mainly sells cheaper generic products to lower income shoppers in lower-tier cities. These shoppers score bigger discounts when they convince their friends, family members, and co-workers to make the same purchase. Pinduoduo nurtures this "social shopping" experience by letting shoppers share links via social media platforms like WeChat.

This model attracts a lot of shoppers, but the average order size per buyer is small, and its profit margins are non-existent. Pinduoduo is already selling its products at paper-thin gross margins, and the costs of operating and promoting its e-commerce platform are crushing its bottom line growth. That's why its operating expenses surged 722% annually to 3.87 billion RMB ($563 million) during the quarter.

During the quarter, Pinduoduo reported a GAAP operating loss of 1.27 billion RMB ($185 million), compared to a loss of 234 million RMB a year earlier. Its GAAP net loss widened from 221 million RMB to a whopping 1.1 billion RMB ($160 million).

Its non-GAAP net loss, which excludes stock-based compensation expenses, also widened from 218 million RMB to 619 million RMB ($90 million). Its non-GAAP net loss of $0.08 per ADS beat expectations by $0.16, but Pinduoduo's losses will keep widening as its revenues rise.

A shopping cart icon on a smartphone.

Image source: Getty Images.

2. Tough competition

Pinduoduo controls just 5% of China's e-commerce market according to eMarketer. That puts it in a distant third place behind Alibaba and JD, which control 58% and 16% of the market, respectively.

Pinduoduo has a first mover's advantage in its niche market of socialized bulk purchases, but Alibaba and JD can also launch similar platforms. Alibaba's Taobao, for example, launched its discount shopping app Taobao Tejia earlier this year to lure shoppers away from Pinduoduo.

Pinduoduo's growth is also decelerating. Its triple-digit year-over-year growth figures look incredible, but its quarter-over-quarter growth looks less explosive:

Segment

Q2 2018

Q3 2018

Revenue*

95.7%

24.5%

Monthly active users

17.3%

18.8%

Active buyers (trailing 12 months)

16.5%

12.2%

Annual spending per active buyer*

13.2%

17.3%

GMV (trailing 12 months)*

31.9%

31.6%

Quarter-over-quarter growth. Source: Pinduoduo quarterly reports. *RMB terms.

Those growth rates are still solid, but Pinduoduo's year-over-year growth will look less impressive next year, as its growth in revenues and users could peak soon.

3. A questionable business model

In early August Chinese regulators launched a probe into Pinduoduo's business over allegations of counterfeit goods, IP infringements, and sales of potentially dangerous products. Pinduoduo removed millions of product listings in response to the probe, but the damage was done as investors filed class action lawsuits against the company.

Those legal troubles emboldened short sellers like Blue Orca, which claims that Pinduoduo inflated its GMV total for five quarters through its March quarter and inflated its 2017 revenues by 40%. Blue Orca claims that much of Pinduoduo's "phantom" GMV and revenue growth came from unfulfilled or failed bulk purchase orders, a claim the company denies.

4. A rich valuation

Lastly, Pinduoduo's stock is expensive at 15 times this year's sales and 7 times next year's sales. Alibaba trades at just 5 times next year's sales, and JD trades at less than 0.4 times next year's sales. Alibaba and JD were also both profitable in their most recent quarters.

Pinduoduo has no clear path toward profitability, which will become more apparent once its dizzying year-over-year revenue growth rates cool off. When that happens, investors will be glad that they didn't buy Pinduoduo's stock at these levels.

Leo Sun owns shares of JD.com. The Motley Fool owns shares of and recommends JD.com. The Motley Fool has a disclosure policy.