PDD Holdings' Post Earnings Plunge: A Buy Opportunity (Rating Upgrade)

Summary

• Wednesday, PDD Holdings Inc. put out its Q4 earnings, beating EPS estimates by a whopping 45%.
• Revenue grew 123% and earnings grew 146%.
• Nevertheless, the stock dropped 7.2% after the release came out.
• Some people may have found the numbers "suspiciously good," but I see little reason to doubt them after looking at accounts receivable/sales and related quality metrics.
• PDD Holdings Inc. stock's bizarre post-earnings reaction is a buying opportunity.

Wednesday, PDD Holdings Inc. (NASDAQ:PDD) released its fourth quarter earnings and easily surpassed what analysts were expecting. Revenue came in at $12.35 billion, up 123%, a beat by $1.5 billion. Earnings per share (“EPS”) came in at $2.41, up 146% and a beat by $0.75. In case you didn’t catch that last bit: earnings were a full 46% ahead of what analysts had been expecting!

Normally, you’d expect a stock to deliver a pretty big rally on such a wide beat, but PDD’s trading was actually pretty tepid after earnings. The stock only gained 3.6% the day earnings came out. The following day, the stock actually plunged a full 7.2%, erasing all the post-earnings gains and then some.

That’s not to say that the release was all sunshine lollipops and rainbows. Some aspects of it were disappointing, for example, the lack of segment data on TEMU. Also–this is more conjecture–the numbers may have been so good that investors grew suspicious of them. TEMU is known to be unprofitable, and its growth should theoretically eat into PDD’s margins–if it is more rapid than the growth in the profitable China segment. Prior to the Q4 release coming out, margins were expected to decline to 20%. So, it’s possible that some investors were wary of PDD’s “suspiciously good” numbers.

That being what it is, I see little reason to doubt the numbers that PDD put out. The company is audited by a Hong Kong affiliate of Ernst and Young, the #3 accounting firm in the world. A company like that is unlikely to risk its reputation by giving clean audit opinions when, in fact, its client’s books are full of red flags. The company’s just-released earnings are so far unaudited, but the audit report for 2022 is available in that year’s annual report. That year, Ernst and Young Hua Ming reported that PDD had effective internal controls, as well as sound statements of income, cash flows, equity and balance sheets. So, the auditor thinks that PDD’s 2022 financials were legitimate.

When I last wrote about PDD Holdings, I rated the stock a "Buy" on the grounds that it was both growing quickly and relatively inexpensive. Today the company’s earnings are more than 100% higher than they were then, while the stock has irrationally sold off on good news. In this article I explain why I’m upgrading my rating on PDD Holdings to Strong Buy.

The Earnings Numbers - Are They Reliable?

As mentioned previously, PDD’s fourth quarter earnings were unambiguously strong. The release showed 123% growth in revenue, 146% growth in earnings, and EPS 45% ahead of estimates. Why, then, did the stock sell off?

One possible reason is people simply doubting the numbers the company put out. There’s such a thing as suspiciously good earnings. PDD’s margins increased in the fourth quarter, yet the company’s biggest growth driver, TEMU, is known to be unprofitable. Is the company engaging in creative accounting here?

To answer that question, we need to look at the company’s financial statements to see if we can find any red flags.

If you look at Seeking Alpha Quant’s PDD balance sheet and income statement, you can see that the accounts receivable to sales ratio has been trending mostly downward. A high AR/sales ratio is a hallmark sign of a company with unsustainable revenue. The long-term trend in PDD’s AR/sales is downward (i.e., good), although the ratio ticked up significantly in the quarter just reported.

Below you can see PDD Holdings’ AR to sales ratios for the last four years.

So, the ratio is not high and is trending mostly downward. However, in the quarter just reported, the ratio suddenly ticked up to 12.7%. That’s a pretty big jump, although it’s mainly a function of the Q4 and TTM accounts receivable numbers being identical in SA quant. Overall, I do not see any red flags in PDD’s AR/sales ratio.

Another metric we can look at is how well cash flows support earnings. Here we can use operating cash flow to net income, which is shown in the table below:

These annual figures are followed by $5.195B in OCF and $3.279B in net income in the most recent quarter, for a 1.4 ratio. These ratios do not suggest low quality earnings by any means: higher operating cash flow than net income is taken as a positive. However, these ratios peak in 2021 and decline from there, so the level of support for earnings provided by cash flows is declining.

As a final test, I decided to look at “net change in cash to net income.” Net change in cash is a more stringent cash flow measure that operating cash flow, because it incorporates the all cash coming into and out of the company. I also could have used free cash flow (“FCF”) but PDD does not report FCF itself, and its net change in cash figures are lower than the FCF figures that Seeking Alpha Quant calculates for the company. So, going with net change in cash here is more conservative than using third party FCF estimates.

These annual figures are followed by a $1.469B cash inflow and $3.279B in net income in Q4, for a 0.448 ratio. This ratio is definitely declining.

A final ratio we could look at to try and gauge PDD’s earnings quality is the inventory/sales ratio. However, the company doesn’t report any inventory in its recent financial reports. This makes sense, because the company facilitates sales by third party vendors. So, this metric is unavailable to us.

What do the trends in AR/sales and cash flows tell us? The accounts receivable to sales ratio improving means that the company’s sales are mostly coming from immediate cash purchases. That’s a good thing. The OCF/NI ratio is very healthy, but is declining: the trend is not a positive one. It’s the same story with the ratio of change in cash to NI: it’s declining, but not at an unhealthy level.

A final factor we need to look at is why cash flows are growing less rapidly than net income. If anything in PDD’s financial statements raises a red flag, it’s the deceleration in cash inflows. These go against the trend of acceleration in net income, so it’s worth investigating further.

It looks like PDD Holdings has big cash outflows from investing. In 2021 and 2022, it made large investments in marketable securities. Apart from that, there were increases in “other investing activities.” Financing activities also show a $1.2 billion outflow. On the whole, there are no red flags in these categories although their rising faster than earnings have resulted in an overall cash flow performance that isn’t as good as the earnings performance.

Aiming to Reduce U.S. Revenues As a Percentage of the Business Mix

Another factor that might be holding PDD shares back is the company’s plan to cut the U.S. down to 30% of TEMU’s current business mix, down from the current 60%. If that sounds like a sound diversification strategy, it is. However, investors may have taken it as a signal that the company is about to be kicked out of the U.S. market, as U.S. politicians have begun investigating TEMU and demanding that it pay import duties.

What’s TEMU Worth?

Pulling everything together, what can we say about PDD’s blowout earnings and subsequent crash?

That the company’s earnings yield is growing ever-higher, and will grow higher still if the stock doesn’t trade properly. PDD continues to be one of the fastest-growing tech companies in the world, while trading at 18.96 times earnings, 4.75 times sales and 6.35 times book value. The company could afford to pay import duties and still be profitable. Unless TEMU ends up getting completely kicked out of the U.S. market, this stock will someday end up looking like an obvious buy at today’s prices.