Project YOKU-zuna: Downgrading to Conviction Sell (Again)

20 Jun

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.

My new valuation is $21.37, indicating the stock has ~25% to drop from the current market price.

While I think YOKU may grow revenues at an incredible clip – ~40% CAGR over the next decade – I’m not as bullish as the Goldman analysts, who assume that significant TV ad $’s will quickly transition to online video, despite this never happening in any country that I’m aware of.  They also assume that incumbents will essentially bend over a take it, which I think is stupid, at best.  What happens when state-owned media jumps into the fray?  What happens when YOKU drives viewers to its competitors by increasingly-annoying ad-delivery techniques and removing illegally-hosted IP?  What happens when advertisers realize online video ads aren’t the panacea they were promised?  What happens when the market doesn’t grow as fast as paid-forecasters iResearch says it will?  Exactly.

Readers should note that in assuming the online advertising market will grow slower than iResearch’s predictions, I’m explicitly saying I expect YOKU to gain more market share than that implied by iResearch’s own numbers quoted by YOKU in its regulatory filings.  The firm is on a roll, and I’m not so sure viewers will jump to competition just yet.  Readers should also note that a 40% revenue CAGR is almost exactly the growth in advertising, mobile & other revenues experienced by SOHU over the past 10 years.  SOHU’s advertising business has only grown ~37%, so I think I’m giving YOKU a fair amount of credit in assuming they’ll be so successful with their mobile strategies.

I’m fairly confident that GS has semi-severely under-estimated YOKU’s cost structure.  I think costs will be markedly higher than GS assumes, driven by 1) increased content acquisition costs as they get more “legit” and are pressured (to what degree is uncertain) by IP owners to remove illegal content & pay license fees, to say nothing of the very real possibility of higher costs/unit for such content as competition for “exclusive” and other deals drives prices up 2) higher capex on servers & network equipment and bandwidth costs, as their historical/current numbers seem disturbingly low given the claimed size/scope of the business, 3) wage inflation, and 4) high sales & marketing expenses as the company struggles to maintain ridiculously high revenue growth.

Compared to my last report, though, I think management will do a MUCH better job managing its working capital, significantly so, getting AR days out down from 203 in 2010 to 30 by 2020, and AP days out down from 37 to 14.  There’s a non-zero risk that the firm will let its current liabilities get a bit out of hand if things don’t turn out as rosy as they expect, but its too soon to tell now, although I strongly suggest investors keep a watchful eye on AP and accrued liabilities (and the growth rates thereof).

Initially, I was severely concerned with YOKU’s cash balance and burn rate, but after making some adjustments (in the company’s favor), unless the firm grows slower than projected, the balance sheet doesn’t look too bad, and the firm shouldn’t face any solvency issues.  Of course, as I’ve previously started, if this happens – a very real possibility – the firm will be at the mercy of the equity and debt markets, neither of which may be receptive to the firm’s fundraising attempts.  Investors should keep a very close eye on cash burn and working capital management as any solvency issues could end up being self-fulfilling prophecies.

The Goldman report uses a beta/CAPM-driven approach to generating the firm’s equity cost of capital, and arrives at 12%.  While this approach has the benefit of being “scientific,” I think it fails to account for unique “China risks:” legal, accounting (/auditing/internal controls), and fraud.  I think something along the lines of 15% is more realistic, all things considered.  GS uses a 6% terminal growth rate which I think may be a little high, too, and in my analysis have used 4%.

All of which brings us to the final step, calculating EPS and performing the DCF valuation:

$21.37.  Less than half of Goldman’s “conviction buy” target price, and more than 25% below the current price of $29.10).  I leave it up to the reader to decide whose analysis to trust more: a firm with everything to gain by pumping up the stock price, or a former investment banker trained in the school of value investing with no position (now or ever) in the stock.

If you don’t buy my analysis/assumptions, that’s fine, but I hope this exercise has at least led China bulls to question their own assumptions, and the faith they hold in them.  China is a huge growth opportunity for sure, but prudent investors should be wary of buying into the hype around hot growth stocks.

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8 Responses to “Project YOKU-zuna: Downgrading to Conviction Sell (Again)”

  1. CH June 20, 2011 at 2:02 pm #

    No wonder why….even just try 12% wacc and 5% terminal growth. what’s your valuation?

    What’s the wacc for linkedin? What are the comps you use to calculate the unlevered beta? what’s the levered beta? and what’s the optimal capital structure you would assume for Yoku and why? what are the comps?

    Why the capex of rev % keeps rising? What’s the rationale behind it?

    At the end of the day, DCF is tricky and of course no body has the crystal ball but would need some thoughts/rationale backing up your assumptions dude.

    • The Analyst June 21, 2011 at 10:04 am #

      the terminal growth rate doesn’t make much difference but the discount rate does. There is effectively no debt so talking about levered or unlevered beta is kind of moot, no? The optimal capital structure, that’s a far more complicated question and depends on whether or not you really buy M&M.

      Because capex (computer & network equip) and intangaible assets have a similar useful life (d/a period) I took a shortcut and lumped them together. I assume their physical and intangible costs will increase as they’re both inexplicably low. Content costs are likely to increase as they seek to go more mainstream (they’re currently hosting illegal content, shocker).

      • CH June 21, 2011 at 3:33 pm #

        If everything is moot, why 15%, not 10-12% wacc for most new internet stocks? What kind of company demanding a 15% cost?! My point is DCF is tricky, or at the of the day, we all know it is joke. Stock market valuation is always on a relative basis. What’s why we just comps.

  2. wsm June 20, 2011 at 8:48 pm #

    I’ve enjoyed your series of posts on YOKU. How come you are not short the stock? Are you abstaining in order to maintain ‘independence’ in light of your posts? Or do you simply not short stocks? I would be very interested in your thoughts on shorting this in particular, and shorting in general.

    • The Analyst June 20, 2011 at 8:50 pm #

      I want to maintain my independence. Its easy to write off a relatively small guy like me as “another bitter short seller,” so I’ve avoided holding any position. My account is all cash.

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