Sometimes, you have to spend money to make money. That's certainly the mantra of Zheng Huang, the CEO of the Chinese e-commerce platform Pinduoduo (NASDAQ:PDD). The company's shares had a massive run this year -- that is, up until its third-quarter earnings report this week.

Pinduoduo went public back in July 2018 at $19 per share, with the promise of a unique e-commerce model. Initially targeting lower-tier Chinese cities and rural customers, it offered price-sensitive shopers large discounts on an array of goods by allowing them to team up online and buy in bulk. The social aspect of Pinduoduo was a unique feature of the e-commerce experience.

Thanks to the company's explosive growth this year, Pinduoduo's shares had doubled before the recent third-quarter earnings report. While those results weren't quite up to analyst expectations, the 23% sell-off afterward may have opened up an opportunity for those not yet in this exciting stock.

A young delivery man drops off a package and a customer signs for it.

Image source: Getty Images.

Huge growth, on both revenue and costs

At first, Pinduoduo's sell-off is surprising in light of its stellar revenue growth. Sales surged 123% year over year, on the back of 144% growth in gross merchandise volume. Monthly active users grew 85% to 429.6 million, and the annual spending per active buyer surged 75%.

These are fantastic growth numbers by any measure, which makes it curious that the stock sold off so much. The reason is that while revenue growth was impressive, it didn't quite live up to the lofty expectations set by Q2's blowout quarter. Q3's revenue figure of 7.5 billion yuan ($1.05 billion) fell just short of analyst expectations by about $30 million.

But what really appeared to get investors worried was Pinduoduo's huge surge in costs. Sales and marketing spending grew 114%, and research and development costs were up a whopping 240% year over year. Adjusted operating losses thus more than doubled, to 2.792 billion yuan ($390.6 million), and adjusted (non-GAAP) net losses were $0.20 per share, more than double analyst expectations for a loss of just $0.07.

Expenses or investments?

Pinduoduo's management stressed on the conference call with analysts that it is pleased to spend so much money. It doesn't view surging marketing and research costs as expenses, but rather investments in the long-term health of the young platform. If today's heavy spending brings on a customer who becomes highly engaged and "sticky," then management doesn't care if there is an immediate payoff in the same quarter. CEO Huang said:

Our investments in user engagement not only help us to attract new users, more importantly, it allows us to quickly build mindshare. Typically, it takes time for users to gain enough confidence from the initial purchase to develop a broader, sustainable shopping habit on an e-commerce platform. Our peers worldwide have gone through a similar process of educating their users and building their consumption habits to get to their current scale. The difference for us is that we don't have the same luxury of time. 

In other words, having started in just 2015, Pinduoduo is late to the game in the sense that it started its corporate life much later than e-commerce rivals Alibaba (NYSE:BABA) and JD.com (NASDAQ:JD). Therefore, the company must turn on the spigots to achieve scale quicker, so that competitors can't copy its model.

Deals, deals, deals

Since June 18, Pinduoduo has been in the midst of its 10 billion yuan subsidy program, which has been such a success that it has now been extended. This isn't Pinduoduo taking a 10 billion yuan cut in its take rate. Rather it's a partnership with its suppliers, using Pinduoduo's data to give out coupons for big discounts of, say, an extra 10% to 20% percent on big-ticket items such as Apple iPhones or Dyson vacuum cleaners.

The company has done a good job thus far of attracting lower-tier Chinese citizens to get bulk deals on general goods and merchandise, but the large subsidy program is geared toward bigger-ticket items -- even cars. For Singles Day on Nov. 11, Pinduoduo actually sold over 1,000 cars, mostly from emerging Chinese brands.

Huang believes the massive discounts and the introduction of higher-priced items are changing the way people see the company. "What this has done is to change people's perception of PDD," Huang said. "We don't just sell apples, but we also sell authentic Apple iPhones."  

An opportunity or danger sign?

Clearly, investors had been very optimistic on Pinduoduo over the summer, and thus got a bit of a reality check this quarter. Some may now think that the company will have to spend more than expected in order to gain share against the large incumbents.

Nevertheless, its revenue growth and user engagement are there. Triple-digit increases in revenue are downright impressive, and to see an increase of 75% in spending per user means that they are spending more on the platform and becoming more engaged. Scale matters in e-commerce, and Pinduoduo is doing the right thing by "overspending," if you could call it that, in order to gain a critical mass of customers, vendors, and data.

It actually makes most of its revenue from advertising and much less on just transaction fees, so having more eyeballs spending more time scrolling through Pinduoduo's pages and clicking on ads should benefit the company.

This is still a young, high-growth company that benefits from network effects, so the increased user count, revenue figures, and engagement are the most important metrics here. That's why fears over the company's spending -- which should really be thought of as investments in future growth -- may have opened up a nice opportunity for long-term investors looking to get into Pinduoduo's stock. Just keep in mind that, as with any high-growth stock, it could be a bumpy ride.