Project YOKU-zuna: Failure to Execute

15 Jun

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:

  1. 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.
  2. 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.

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17 Responses to “Project YOKU-zuna: Failure to Execute”

  1. Sean June 15, 2011 at 5:13 pm #

    Go do this analysis on other Chinese internet companies circa 2006.

    You do not even understand how conservative your margin estimates could be. Like I wrote in a previous comment: Baidu generated incredible margin leverage after it went public. Take a hard look at Baidu’s financials. Start with their 2005 20-F before looking at anything after. Ask yourself whether you would be writing a similar post on them. Look at the online gaming companies, and see how their margins explode once network effects kick in.

    From what I can quickly calculate, it seems you think that Youku will be paying $0.80-90 for every dollar of additional revenue. Baidu paid much less even in its early days.

    OpMargins per year using
    Year: Your Yoku estimates // Baidu Comp Year (2003+)
    2010: -43.8 // -22.9
    2011: -12.5 // +9.4
    2012: -1.3 // 11.2
    2013: 10.1 // 31.4
    2014: 19.2 // 31.4

    Why should anyone listen to you when you can’t even put the VC-case in your “lofty goals”?

    • Sean June 15, 2011 at 5:21 pm #

      I should point out again that I largely agree that Youku is incredibly risky, and I think is still offers worse risk-reward to some other Chinese interenet plays. The crash has affected Youku worse than the others, but even usually-boring Sohu is down 30%.

      But the hyper-aggressive assumptions in Youku are coming from optimistic experience, not delusional imagination.

    • CH June 16, 2011 at 9:40 am #

      Btw, it’s 12% up now, GS upgrade it with $55 price target

      • The Analyst June 16, 2011 at 9:49 am #

        Gs had a report earlier this year before the secondary showing how it *could* get to mid $50’s, but their target was still significantly les than that. I’m curious what’s changed that they decided to go with the higher price as their target now. If you check my 1st post “the good the bad & the ugly” linked to at the top of this one you can see my wacc and terminal growth rate in the images.

        • CH June 16, 2011 at 10:21 am #

          Dude, I used your EBITDA numbers and took 50% as FCF (quite conservative rite?) Assume 3% terminal growth and 12% WACC (reasonable right?) This is a 170% upside stock!~~not sure how the DCF is that different?!

  2. hemp June 15, 2011 at 6:05 pm #

    I am more of a traditional value investor and tend to ignore growth opportunities in the absence of unusually low valuation multiples. This analysis is more suitable to growth investors who are willing to pay a premium for rapid and sustained revenue growth. We can use the to find technology companies traded on US exchanges with 100M of annual revenue that have 20 10-year compound revenue growth rates and normalized P E ratios of less than 20.

  3. CH June 16, 2011 at 9:39 am #

    With respect, I am curious what terminal growth and wacc you are using…..

  4. CH June 16, 2011 at 9:51 am #

    Took a very quick model. Without knowing your assumption on capex and working capital nor terminal growth nor wacc, one big mistake is the TAX assumption is WRONG. China has 25% tax rate cross the broad plus for such high tech company, they can always get tax incentives thus I would assume a 17-22% effective tax rate!!! NOT 35% in USA….

  5. CH June 16, 2011 at 9:59 am #

    And to your point on credit facility, don’t forget this is cash rich biz. They are printing money. Except from the content acquisition cost, I don’t see they have major investment. They have 250mm on balance sheet before the follow-on, man~!

    • The Analyst June 16, 2011 at 10:25 am #

      YOKU’s cash all comes from financing activity, not operating. If you assume no further stock sales/debt issuance, they’re likely cash-flow negative through 2015.

      Not exactly a cash-cow…

      • CH June 16, 2011 at 10:28 am #

        sorry that I was talking about the biz model itself. Of course now it is not at its run rate yet. Once the top line ramps up, it is not a long AR day type of biz like manufacturing companies.

      • CH June 16, 2011 at 11:30 am #

        I am doing simply math and using ur EBITDA number and assume 50% as FCF. 12% WACC and 3% terminal growth will bring this company to >9bn valuation… not sure how you end up with your share price….

  6. Josh June 16, 2011 at 10:13 am #

    CH, you’re an idiot. True fool of randomness. Grow a pair and go long YOKU (if you haven’t already) if you feel so strongly.

    Cash rich business? LOL Needs no response. Refer to my idiot comment.

    The Analyst is infinitely more credible than you. If you or I were Goldman, the only thing we can do is upgrade YOKU absent a terrible quarter, fraud, etc. Why? Goldman’s compensation is not driven by truth, but capital raising,etc. Goldman is Cheerleader in Chief here (YOKU’s blowjob queen).

    YOKU (on the record here) is very vulnerable to a Muddy Waters or similarly credible shop coming out with a report.

    • CH June 16, 2011 at 10:18 am #

      hahaha, now I know your real incentive for all of these. Naive dude.

      You are being Jealous to the big bucks paid to I bankers…..silly and naive, like a baby.

    • CH June 16, 2011 at 10:26 am #

      I also don’t understand why you put too much personal sentiment into this~~another sign of a naive dude…

  7. Josh June 17, 2011 at 11:11 pm #

    Despite some of my brutal comments on this website (though I’m fairly equal opportunity), I do want to publicly give a shout out to our beloved “The Analyst”

    Whether his opinions are correct or not, he has some major cojones to call ‘bullshit’ on the fiercesome giant bloodsucking vampire squids of the world..I mean Goldman Sachs.

    Good weekends to all, even China permabulls.

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  1. Morning News: June 16, 2011 | Crossing Wall Street - June 16, 2011

    […] Stone Street: Project YOKU-zuna: Failure to Execute […]

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