Pinduoduo’s free cash flow conundrum

Pinduoduo is growing fast, but it’s burning cash to do it. Can they keep this up?

They have 113 million more active buyers on an annual basis than JD.com and grew revenue 652% last year. But they spent more than their revenues on sales and marketing, which includes discount promotions. Sales and marketing expenses grew even faster than revenues last year at 900%.

The key question is whether the company is bringing in enough cash to cover its spending. This is measured by a figure called free cash flow, a measure of the cash produced that is free to be used by the firm for whatever they want.

If Pinduoduo is free cash flow positive they’ll likely be able to continue their growth spend and get even larger. If its free cash flow negative, the growth plan will put too much strain on their cash position and, it will eventually fail. To say it simply: the stakes are high.

Pinduoduo announced 2018 results on March 13, and at first glance it looks like Pinduoduo is producing tons of cash: “net cash provided by operating activities” was over RMB 7.7 billion (about $1.15 billion).

But wait—they are including restricted cash in this figure. Restricted cash cannot be included in free cash flow, because it isn’t freely usable by the company.

Pinduoduo’s most recent press release does not give the components of net cash from operating activities, so I need to go back to their Form F-1 filed on June 29, 2018. There you can see three large changes in operating assets and liabilities: restricted cash, payables to merchants and merchant deposits.

What are these items, and how much of it is free for Pinduoduo to use? According to “Note 2: Summary of Significant Accounting Policies” in Pinduoduo’s IPO prospectus: “Restricted cash represents cash received from consumers and reserved in a bank supervised account for payments to merchants.” Restricted cash is not freely usable and therefore should be excluded from free cash flow.

Payables to merchants appear to arise when a customer orders a product, pays for it, and the cash is held in an account waiting to be paid to the merchant. Pinduoduo’s merchant FAQ website says merchant withdrawals are typically fulfilled within 2-4 days of a request. It sounds quite like the restricted cash definition above.

I would like to point out that payables to merchants reflects transactions on Pinduoduo’s marketplace, and does not contribute to Pinduoduo’s revenue. Pinduoduo’s revenue is composed of online marketing services and commissions on transactions. Payables are a function of their “GMV”—an acronym which resembles the gross merchandise volume reported by other platforms, but which is calculated with a non-standard approach that includes all orders “regardless of whether the products and services are actually sold, delivered or returned” and likely includes many merchant shipping fees. Pinduoduo does not spell out the acronym.

Merchant deposits, according to the merchant FAQ website are required by personal or enterprise accounts in order to unlock the restrictions on the “free” merchant accounts, such as the ability to withdraw funds. Deposits will be returned to the merchant after they close their virtual shop.

The reader may be familiar with what happened to Ofo, the bike-sharing company, when they allegedly mismanaged customer deposits: 10 million users applied for refunds and their CEO was placed on government blacklist.

Here’s the big question: to what extent is the cash in payables to merchants and merchant deposits freely usable by Pinduoduo?

My opinion, based on reading the filings available as of today, is that payables to merchants are restricted cash, and that merchant deposits may be freely usable if there isn’t a wave of requests in a short time period—call it 50% freely usable.

A prudent free cash flow calculation for Pinduoduo might look like this:

Pinduoduo has proven they can grow their marketplace with growth spending: promotions, advertising, online/offline marketing and so on. If they are free cash flow positive, then awesome! They can keep growing. But if not, it’s going to require a change in strategy. It could force them to back off their growth spend and, growth could flatten—or worse, decline. Worst case, if the company is using “restricted cash” accounts as free cash it could experience a bank-run type situation as merchants request their deposits back and its payables to merchants account declines.

What could change my view? More clarity and disclosures around the nature of payables to merchants and merchant deposits: to what extent are these accounts restricted? Pinduoduo will file a Form 20-F in the coming weeks and they are required to disclose the nature of the restrictions on cash. I will be waiting with bated breath.