While his legacy is still being written, YouKu CEO Victor Koo has achieved success seen only by a very select group of revered business leaders, visionary CEOs with an ability to not just dream it, but do it. His previous effort, Sohu, is one of the most successful internet firms in China, and if the past few years are any indication, he’s well on the road to a repeat performance with YOKU.
I’ve been analyzing this company (stock) for the past two weeks or so trying desperately to essentially over- value the firm. When I started, the stock was trading around $43/share, and even with aggressive 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: Just because a firm operates in a major growth sector in a major growth market, profits are far from guaranteed. Running a several billion dollar company is NOT an easy task, and while some have been able to handle it (and then some), the path to sustainable success is littered with the carcases of corporate failure. Many and myriad are the chances to slip-up, while those to achieve lasting prosperity are fewer and farther between.
That being the case (like it or not), this week I’m playing around with my original assumptions to see how the valuation changes if the company – led by Victor Koo – fails to attain the lofty goals I set with my assumptions. I’ve made some relatively small changes/fixes/improvements to my model and its assumptions too nuanced and numerous to mention here (those with financial modeling experience should understand, model is now more consistent/accurate/flexible, formulas less clunky, etc), but the cumulative result is that the DCF value is now higher – 17% higher in fact or $27.77 – than the $23.76 from my initial effort. Using this new, higher value and the assumptions driving it, let’s see what happens when we make some changes.
Here is the income statement along with growth rates and margins:
As you can see, that $27.77 valuation is predicated on some serious revenue growth – 58.1% CAGR – and gross margin expansion – 75.5% CAGR – over the next decade. It is these two assumptions that I want to address today, to see what happens if YOKU fails to grow as fast as projected. We should be publishing more in-depth report on YOKU’s operating costs soon.
I use comps (SOHU, Tudou, etc) and industry reports (e.g. the iResearch data cited by both YOKU & Tudou) to help generate my assumptions for revenue growth and gross margin expansion/contraction, which is what I’ve done here (see my last post on revenue growth assumptions). I then use a multi-step approach – to reflect the business (growth) cycle – et voila, an oversimplified explanation of where these numbers come from. For YOKU’s top-line growth and gross margins, though, I focused primarily on the rates for the next year or two and assumed those rates degrade constantly over time, i.e. for 2011, I assumed a 110% growth rate, which decreases 10% each year, and cost of goods (services) of 75%, which similarly declines 10%/year. While this is not very likely to reflect the firm’s actual performance over time, it makes it far easier to sensitize the valuation to changes in growth rates.
I think using 10% decay for both of these figures is fairly generous; I’d be surprised if YOKU management can get costs in line that well, even as the business scales and matures, considering significant wage growth and inflation in China. If we adjust the decay rate for cogs to -7.5%/year from -10%/year, all else being equal, the valuation drops from $27.77 all the way down to $19.37!
If we assume cost of goods decreases 10%/year, but that revenue growth will come up a little short of my initial estimates, say this year will still be 110% growth, but that will decay by 12.5%/year thereafter, the value drops all the way down to $19.02!
If we assume that both revenue growth and gross margins will be strong this year, but will be increasingly less so going forward, lower than my initial assumptions (of -10% sequential decay), say -12.5% for revenue growth and -7.5% for cost of goods, the value goes all the way down to $13.14!
It is worth noting that in the first and third cases presented here, unless I’ve fairly royally screwed up the cash flow portion of my model (possible, I suppose), YOKU will have to sell more shares to the public and/or borrow money by 2015. There are two problems I can see if this scenario comes to fruition:
- After YOKU’s secondary last month, allegations by Muddy Waters that Chinese company Sino-Forrest is a ponzi scheme, and general hesitance to contribute new equity funding to not-yet cash flow positive firms, I’m not so sure investors are going to be willing to pony-up for more shares.
- Second, as far as I can tell, YOKU does not have an existing revolving credit facility, and I can guarantee you that if they (seek to) establish one, bankers will certainly not be using the same revenue/margin growth assumptions I’ve used here. If we use a less aggressive case – closer to that likely to be used by credit bankers – YOKU won’t have positive interest coverage until 2014, earliest, and even then, debt/equity could ramp up to over 12x! I have a little experience in this area, including during the fun lending environment that was 2006, and I’m not so sure – even with a very high interest rate – a bank (or more realistically, a syndicate thereof) is going to want to lend money to a firm like YOKU, even if they would have high asset coverage. I’m assuming here that Chinese advertising receivables and quickly-depreciating computer/network equipment aren’t very high-quality assets against which to secure a loan. I suppose there’s a chance of some dumb/greedy money laying around that YOKU could factor their receivables or otherwise get a credit line secured by them, but I don’t think the prudent investor would put much faith in that happening (or providing that credit!).
Is it possible that YOKU not only grows revenues faster than I’ve assumed but reduces costs faster as well, all without missing a beat? Sure, but I think even a levered China bull would assign a relatively low single digit probability to that scenario. If there are any upside surprises, I’d think they’d be on the revenue line, not the gross margin one. We should have more detail as to our skeptical stance on YOKU’s costs in the next week or so.