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2 Risks to Know Before Investing in Pinduoduo

By Lawrence Nga – Oct 19, 2020 at 9:05AM

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The Chinese marketplace might seem like a safe bet on e-commerce growth, but investors should pay attention to these potential downsides.

Pinduoduo (PDD 8.47%), a leading e-commerce company in China, is one of the most successful IPOs in recent years. Since its market debut in 2018, its share price has more than quadrupled, thanks to the strong underlying business performance as well as the favorable investor sentiment for fast-growing technology companies. Still, Pinduoduo is facing numerous risks that may impact its long-term growth trajectory.

Solid track record

Founded in 2015 as a mobile-first social e-commerce platform, Pinduoduo grew its revenue at an impressive pace, hitting $4.3 billion in 2019 as gross merchandise value (GMV) -- the total value of products and services sold through the platform -- surged to $144.6 billion.

Many factors contributed to its success. Its mobile-first and social focus positioned the company well to serve Chinese consumers in the smartphone era. Moreover, its bulk-purchase model allows customers to form groups to buy their products at discounted prices while at the same time creating good value for sellers as they fulfill bigger customer orders. Also worth mentioning is the company's decision to incorporate online games to its platform to bring fun to the shopping experience. For example, customers can cultivate virtual farms to receive real fruits.

Three ladies shopping on their mobile phones

Image source: Getty Images.

Founder steps down as CEO

Despite the robust growth and market returns, investors should watch several key risks for this young company.

An important driver behind Pinduoduo's initial success was the leadership of founder and ex-CEO Zheng Huang. He began his career as a data scientist in Google, and following his stint with the tech giant, he went on to found an e-commerce platform, a game studio, and eventually started Pinduoduo in 2015. In many ways, Pinduoduo is a culmination of Huang's years of experience, both as a data scientist and as an entrepreneur in the e-commerce and gaming industries.

Huang had also been the promoter of Pinduoduo's core value -- "Ben Fen" -- which roughly translates as: "to adhere firmly to one's own duties and principles." Given how vital Huang has been to the company's success, his decision to step down from the CEO role in July is not something investors should take lightly. However, he will retain a major stake in the company and serve as Chairman of the Board.

And the new CEO, Lei Chen, seems to be a good fit for the role. Chen also trained as a data scientist and has previously worked at Google, Yahoo!, and IBM. He has been working closely with Huang since 2011, initially at the latter's gaming company and later at Pinduoduo. Also, Huang will continue to be involved with the Pinduoduo's strategic direction and organizational structure, even though he is stepping away from day-to-day management.

Continuing losses

Pinduoduo is still not a profitable business and is unlikely to become one in the near future. Its operating loss expanded from 286 million RMB ($41 million) to 8.5 billion RMB ($1.2 billion) between 2016 and 2019 as the platform continued to invest in sales and marketing and research and development to grow the business.

The Chinese e-commerce industry is highly competitive as major players like Alibaba and fight for customer mindshare. To fend off its bigger competitors, Pinduoduo will need to sustain its investments to grow its customer base. In other words, the company may remain unprofitable for some time.

On a positive note, Pinduoduo's strategy of spending heavily to grow market share is not a new one. Amazon is perhaps the textbook example of a business operating at a loss for most of its history and still coming out on top. Therefore, there is a good chance that Pinduoduo can benefit from operating leverage once it reaches critical mass, after which improved margins should help drive the company toward profitability.

In fact, operating margin improved significantly in the second quarter, gaining seven percentage points to negative 13.4%. However, Huang stressed during the latest earnings call:

Our Q2 results do demonstrate how leverageable our business model is and how we could deliver profitability in the short term. But we don't believe it is the right strategy to focus on short-term profit over a sustainable, long-term value. [...] We still need to continue our investment to grow user mindshare and engagement, as we mentioned several times in the prepared remarks. So we are not considering profitability this year.

Long-term opportunity

China's online shopping industry is poised to grow in the foreseeable future on the back of overall economic expansion and higher penetration for online shopping. As the second-largest e-commerce company in China with 683 million active buyers, Pinduoduo is well positioned to benefit from this tailwind.

But Pinduoduo stock trades at more than 18 times trailing 12-month revenue as of this writing, which offers shareholders little to no margin of safety. Combined with a major leadership change and steep losses going forward, investors should exercise caution if they choose to invest in the stock today.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Lawrence Nga has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alibaba Group Holding Ltd., Alphabet (A shares), Alphabet (C shares), Amazon, and and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. The Motley Fool has a disclosure policy.

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