As many of you know, I’ve spent the past two weeks analyzing “the Netflix/YouTube of China,” Youku.com. From the first second I looked at the Yahoo! Finance summary page for the stock, I was EXTREMELY skeptical that a firm hemorrhaging money had a ~$5bn valuation. When I looked at the competitive landscape, I became even more skeptical. Sure, the company has experienced massive triple-digit revenue growth in the past few years (assuming, of course, you trust the financial statements, which may or may not be made-up) and appears to be one of the top two firms in the Chinese internet video space, but with incumbent sites like BIDU, SINA, and SOHU developing and rolling-out their own web-based video services, I find it hard to believe growth is going to continue for much longer at anything even close to those lofty rates.
I’ve encountered a number of hurdles in attempting to value this company, for instance, the lack of any half-decent comps, public or private. I checked out as-yet-to-go-public competitor TUDU, but for all I know and care, their financial statements are just as uncertain (read: made-up) as YOKU’s, so in establishing my assumptions for the model, I tended to rely more on larger, more established firms’ financial statements, even if their businesses don’t really line-up very well with YOKU’s. Think BIDU, SOHU, etc.
Thus, I developed 5 separate cases for P&L (income statement) and capex growth rates (% sales, % cogs, etc) none of which are really THAT conservative. All assume the company’s financial statements are not only free of material misstatement, but will continue to be so over the course of the forecast period. Personally, considering the ridiculous amount of (apparently) fraudulent Chinese companies we’ve seen over the past 6-12 months, I find this assumption hard to make, but I’m giving the firm the benefit of the doubt, deserved or otherwise, for the purposes of this exercise.* Here are my assumptions for the income statement and capex:
China bulls will no-doubt suggest all but case 4 – the most bullish one – are too pessimistic and discount both the size and growth of the Chinese online video market. To those bulls, I ask: Do you really think wages, disposable income, and ad dollars (er ad renminbi) are going to grow so fast and to such levels that the online advertising market in China is going to be worth more than the one in the U.S. in just ten years? I don’t. Maybe in 20 or 25 years, but not 10.
The next step is to estimate the firm’s cost of capital. Currently, the company has almost zero long term debt, and plans to retire it over the next 1-3 years, which I have accounted for. Unfortunately, in all but the most bullish case, the firm needs to draw on a revolving credit facility in order to fund its operations. More unfortunately, as far as I can tell from reading the financial statements, exhibits to the financial statements, and checking both Bloomberg and ThompsonRetuers LoanConnector, the firm does not currently have any such credit facility, which means it either needs to establish one and/or, in all but the most bullish case, sell more shares to fund its operations. Whether the firm will be able to do these things at beneficial terms/prices is uncertain, but again, for the purposes of this analysis, I’ve assumed the firm is able to establish a revolving credit facility at a slightly less than ideal price (rate). In the Weighted Average Cost of Capital calculation, though, the cost of debt is a relatively small (<10%) number, so I don’t consider this rate to be of too much importance in the grand scheme of things, given income statement assumptions.
Some of you may no-doubt take issue with the cost of equity being so high at 15% when others have used a much lower rate, like Goldman Sachs, which uses the CAPM rate of 11.9%. I’ve taken the CAPM rate and multiplied it by slightly under 30% to account for the significantly higher risk to ADS holders from VIE legal structure and questionable financial controls and accounting that Chinese technology firms are increasingly known for. (For those who have other views on the cost of equity (Re), I’ll address those in a bit.) Now that we have established operating assumptions and our discount rate, the next step is to discount free cash flows back into today’s dollars. With more of a history and public comps, this calculation could be a bit more elaborate, but I think for our purposes, a simple DFCF approach is entirely suitable.
For the above valuation/image, I used the second most bullish case (case 3), and for a little comparison, I decided to include Google’s revenue growth from when it was at a similar level until now. Using the second most bullish set of assumptions, I’ve arrived at a DCF price of $23.76 per each YOKU ADS, a 44% discount from the closing price yesterday (5/31). This price includes the terminal value of cash flows, itself using an incredibly generous terminal growth rate of 6%. A more realistic rate would be in the 3-4% range, tops, and would decrease the projected price/share by a few dollars. Because the DCF value varies significantly with inputs, I’ve sensitized it to both the cost of equity and income statement growth rates (assumptions).
The numbers in red are the projected stock prices and % the stock is over-priced relative to yesterday’s close, respectively, while the green ones are stock prices and % the stock is under-valued relative to yesterday’s close. What should be profoundly clear by now is that even using what I consider to be EXTREMELY optimistic inputs, the stock is STILL over-valued in the vast majority of cases!
So what does all of this mean?
To me, YOKU is a SCREAMING short stock/long put trade. I intentionally tried to over-value this company by using fantastically generous revenue and margin growth rate assumptions, and despite my best efforts, I simply can’t rationalize the current stock price! You may have a more optimistic outlook on both the China growth story and YOKU’s as well, and if that is the case, I’d strongly suggest you dissect the assumptions supporting that outlook. While the Chinese internet advertising market is obviously growing at a high rate, YOKU – an early leader – is and is set to face increasing competition from all sides. Its unexceptional financial position both now and projected may severely limit management’s ability to respond or better, preempt the competition, the vast majority of which has far more financial and operational flexibility. It’s worth mentioning that unless reports are horribly inaccurate, the leading online video site in the U.S. – YouTube – is a significant money-loser for Google. Sure, YOKU may have much more legally syndicated content (i.e. TV shows), but if YouTube can’t make money (primarily) with the support of Google in the U.S., how good are the odds for YOKU?
Additionally, you should consider the very real probability that the company has or will report fraudulent numbers in its financial statements. If you think this number is close to or worse, equal to zero, I strongly suggest you learn from the mistakes of one extremely naive doubter.
*For those not familiar with establishing such inputs, I should clarify that so doing is a bit more art than science, so you may take issue with my choices. If you can make a well-reasoned argument why one or more of my cases should be different, leave a comment and/or shoot me an email with the changes and if they make sense, I’ll run them through the model and let you know the output.