Project YOKU-zuna: The Good, The Bad, and The Very Ugly

1 Jun

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.

Special thanks: @RyanProciuk, @timothydh, @zippertheory, @bondtrader83

*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.

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16 Responses to “Project YOKU-zuna: The Good, The Bad, and The Very Ugly”

  1. Elie Rosenberg June 1, 2011 at 4:34 pm #

    Thanks, this seems very compelling.

    Do you think they have some first mover advantage due to the network effect (i.e. they are starting with more videos than the latecomers and thus people will go there to share)? Or will the other players like Baidu be able to leverage their mindshare in other areas? It seems like a similar situation to Google Video versus Youtube.

    Either way it is so overvalued that even a modest slowdown in growth should crack it as you nicely lay out. It just might take a while in today’s markets.

    • The Analyst June 1, 2011 at 4:45 pm #

      After speaking to an American friend who has been living in China for about 2 years, it seems there is little if any brand loyalty in China, at least as it applies to video sites/services. While certainly not exhaustive, it seems much of the traffic is from copyrighted material (illegally shown). She said she has switched to Tudou primarily for that reason, which leads me to think if YOKU gets/stays big enough, they’ll surely have to crack-down (even slightly) on hosting/showing such high-traffic content. That’s one potential death-blow among many, though, from what I can tell.

      • Sean June 2, 2011 at 12:02 pm #

        Well, Yoku has shown itself to be immune to the crack-downs so far. Tudou was larger than Youku before it suffered the ire of the government for being more successful than a company without foreigners. It was slightly too slow censoring, and suffered many (non-sequential) days offline. 56.com was also doing incredibly well before it was shut down for almost a month, basically killing it. Youku has been blessed by the government, having a spotless record. That is worth a lot. Victor Koo knew exactly what censorship and contact with the government was required from his days at Sohu.

        • The Analyst June 2, 2011 at 3:19 pm #

          Victor Koo seems like a very shrewd businessman, and certainly playing nice-nice with the Government is a very smart move.

          Perhaps I’m off-base, but from my cursory research it seems Chinese internet video consumers are just as fickle as those in the U.S; they don’t particularly care what site/service they’re using, as long as they can get the content they want. It seems, logically, as Youku scales and becomes more mainstream, they may run into copyright issues, which may send viewers to other services to see the material they want without paying for it.

          We shall see, though. Perhaps Koo & Co can grow revenues and chip away at costs enough that the numbers will (eventually) make sense. I’d love to buy into the story, but color me skeptical still.

      • CH June 6, 2011 at 5:52 pm #

        hahaha, 2 years. She can’t even distinguish what is lo mei and lao mei. How could she make judgement on any enterprises, let along internet companies?!

  2. Josh June 2, 2011 at 2:22 pm #

    I agree that Yoku is way overvalued and the stock is likely to be down within the next 1-2 years; that said, this analysis is so superficial, already known by all shorts (and smart longs), reeks of ‘analysis’ done by someone who isn’t short the stock, does not have much experience shorting, etc. If I were a Maverick, etc., I would be laughing at this; it looks like something that a superstar ibanking 2nd year analyst does, NOT a serious short seller.

    My point isn’t to bash your work; kudos, in fact, for bringing attention to this bloated pig. However, if you are serious about your view, please back it up with more serious work (operational detail, due diligence, etc), something the likes of citron, muddy waters, Alfred Little, etc. have brought to market.

    If you have it, great, and apologies if the above sounds harsh; I’m sure all us who are short Yoku would appreciate it.

    • The Analyst June 2, 2011 at 2:29 pm #

      I’m posting my thoughts and analysis as I pass each checkpoint, so to speak, so this is as you’ve noticed, far from complete. In doing some of the further research you mention, though, I’ve found it hard to get really reliable information, especially on my limited budget of approximately $0.

      In terms of DD, short of spending time in China, un-announced site visits, independent 3rd party surveys, etc, I’m not sure I can add much value there. I’ve been working with a technical advisor who should be sharing his views on YOKU’s claimed technology, capex, etc in the next week or two, so hopefully that’ll fill in some of the gaps you noted.

      Thanks for the comment.

      • CH June 6, 2011 at 5:54 pm #

        Finally you admit that you have done nothing but just spreading rumors….

  3. Josh Smith June 2, 2011 at 11:10 pm #

    Fair enough and kudos. I think many people actually NEED neatly presented tables (nice tables btw), showing just how overvalued YOKUZUNA is, as you have done.

    Two big things that leave me scratching my head (and you point out):

    (1) Traffic – YOKOU (and the other internet video sites) gained traffic really through allowing illegal content (streaming movies before they came out on screen); Does the current traffic have real legs? Why do chinese consumers go to yokou TODAY? Is the draw still unlicensed (and therefore illegal) content? YOKOU recently announced the launch of some video search engine.. as a chinese consumer, what would I be searching for? Illegal content? As we’re learning via NFLX, content + bandwidth are expensive.

    (2) How do they monetize? Youtube’s financial success (that is cash flow generation) has been questionable at best..it seems yokou monetizes via ads, as does youtube i believe. Can this be financially viable? Even if they try to go with a netflix, subscription based model, are chinese consumers willing to pay? There are alternatives, tudou, ku6tv, etc.. not to mention a chinese economic slowdown and inflation would shrink consumer and ad spend…

    • The Analyst June 3, 2011 at 5:02 pm #

      Great points/questions!

      1. I think whether in China or the US – while there are cultural and local preference differences – people prefer to get things on the internet for free so long as its easy and seemingly guilt-free. Sites like Youku face a bit of a conundrum; as they get bigger and presumably more mainstream (and face some greater scrutiny), they have to show efforts to stem illegal copyright material while working to obtain it legally (ie paying for it). In so-doing, though, they risk alienating users and driving them to the competition, not yet burdened by the scrutiny of a larger, more visible player.

      Also, as a new post next week will likely mention, their content acquisition costs are a bit curious, at the very-least something to keep a very close eye on…

      2. Does anyone like watching ads when they don’t have to? Sure, there’s oodles of stupid advertising money being thrown around, but I’m not sure I buy Victor Koo’s line that Chinese will watch ads with glee to get familiar with brands they don’t know about yet. Sure, it may be easier to sell ads on licensed content (going back to what I said in 1) than cute kitten videos, but are advertisers going to pay out the ass to have ads shown to people who are possibly not even watching them?

      We shall see. I think its an interesting story, but there’s alot of orange flags in the bull thesis imo.

  4. Cat Fancier June 15, 2011 at 4:35 am #

    I won’t comment on your analysis or this specific company as I dont have sufficient company specific knowledge. I would summize however, that at any point in time there will be a raft of immature internet businesses that one could show via traditional fundamental analysis are overvalued as a group. However, in the future a subset of those companys will go on to achieve the very optimistic growth rates you discuss, and better, such is the nature of these businesses.

    What I do take umbrage with is your “guilt by association” comment regarding Chinese frauds. I find this an ill thought out and somewhat naive comment, that does not belong in any serious piece of analysis.

  5. MT June 21, 2011 at 1:38 am #

    wait until yoku is around $15 then BUY

Trackbacks/Pingbacks

  1. Thursday links: having it all | Abnormal Returns - June 2, 2011

    […] A look at the good, bad and very ugly of Yoku (YOKU).  (Stone Street Advisors) […]

  2. Project YOKU-zuna: Deconstructing Questionable Revenue Growth Assumptions « Stone Street Advisors - June 6, 2011

    […] Such, I believe, is the case with the stock price of Youku.com (YOKU).  As I shared last week, I believe the firm is grossly over-valued even when assuming amazing revenue growth and margin expansion over the next decade.  We’re […]

  3. Project YOKU-zuna: Failure to Execute « Stone Street Advisors - June 15, 2011

    […] assumptions for revenue growth, margin expansion, and other measures of management effectiveness, I couldn’t figure out how the company could be worth more than mid $20′s/share (for whatever its worth, the stock closed yesterday at $29).  Investors should make no mistake: […]

  4. Project YOKU-zuna: Downgrading to Conviction Sell (Again) « Stone Street Advisors - June 20, 2011

    […] Last week Goldman Sachs (Asia) LLC (YouKu.com’s lead cheerleader underwriter) upgraded YOKU to a buy with a $55 12-month target price.  I’ve read the report, and I think the GS analysts are even more bullish than some of the silliest blind China bulls I’ve encountered.  The report is also riddled with non sequitur, stating, for example, that smaller competitors must be profitable in order to continue operating and that firms are under U.S. sort of obligations to pay for content (like TV shows and movies).  Such naivete aside, I’ve re-worked much of my model and assumptions, in many cases giving the company significant benefit of the doubt, but I still can’t rationalize the current stock price (~$29).  My analysis suggests the stock is STILL significantly over-valued, even after declining ~45% since my initial report. […]

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