The Best Laid Plans of Mice & Men: YOKU Summary Thesis Update

28 Jul

A friend sent me an email about YOKU because he’d read my previous work, and I set out to respond quickly and concisely.  However long and about 1,200 words later, I realized I’d inadvertently (basically) summarized my outlook on YOKU in a kind of stream-of-consciousness style.  With the caveat that this is neither my full nor formal analysis, I’ve decided to publish my response to that email for those of you interested in my take on YOKU.

With all that being said, here goes:

I don’t think YOKU is a fraud, although there may be some relatively minimal finagling of some numbers esp in the PP&E. they’re going to be youtube size soon, they lease alot of their equipment/bandwidth but claim to operate a proprietary content delivery network with like >6000 servers all over China, but carry “servers & network equipment” on their balance sheet at like $24 mil? Youtube probably has 100-500x that (they dont disclose much).  I fully expect their capex costs to increase (although bandwidth cost tends to scale, server & network equipment costs may get a bit heavy if they continue to grow so much/fast).

I spent some time watching videos (in Mandarin, so no clue what they were saying) to observe ads; brand/company, frequency, type of ad, duration, etc.  I saw ALOT of ads for YOKU-produced/developed content, perhaps disproportionately so, indicating that perhaps they are not selling alot of their inventory (if you wanna give them the benefit of the doubt, possibly this could be result of any ad-targeting algos that go on the fritz with IP’s outside China).

As far as I know, YouTube loses money, and Google is the best internet company on the planet at monetizing content (debatable, but at the least they’re top 3).  Besides Hulu (supposedly), I can’t name a single online video company that actually makes money off the top of my head.  Add to this fact that  Chinese consumers have FAR less discretionary income (and will for at least a decade, if not two or three), and FAR more % of their population is rural/remote.  Internet adoption rates will surely increase, but I think YOKU’s price (and GS $55 estimate) imply they’ll be extremely fast and widespread, faster than even my most aggressive bordering on retarded expectations.  I fail to see how this company is going to turn a profit by possibly late 2012/early 2013 (GS estimates 2013 p/e at >40x).

Another major area of concern: content acquisition costs are going up almost exponentially around the globe, and China is not immune to this phenomenon.  As YOKU goes more mainstream it will invariably (at some point) face more pressure from intellectual property owners to police its site (it current has 300 contract workers filtering inappropriate/illegal content).  I talked to a friend in China about this, and she said her and her friends like Tudou & competitors better because you can get more movies/tv shows you actually want to watch (largely illegally hosted).  Because the online video watching market in China is so young (relative to the US), and technologies like bit torrent are more widespread, viewers are not going to pay for content they can get (relatively easily) for free elsewhere.

Its not like here in the U.S. where most middle class households can afford the $10/month for HBO/NFLX/etc & do so because they’re too technologically inept to figure out bit torrent/websites that illegally host content.  The more popular YOKU gets, the more pressure they’ll face to remove illegal content & buy it, less they drive mass viewer attrition to competing sites/technologies.  YOKU can’t just keep issuing stock to pay for all of this; at a certain point they’re going to need to generate some cash flow to afford all of this

My issue with YOKU vs The Street (eg Goldman) is they are assuming insane revenue growth and margin expansion, despite deep-pocketed competitors (e.g. BIDU’s QIYI video) coming after them.  GS’ whole thesis is that online video (advertising) in China is going to be a “winner take all” market, which I’m not so sure it will be, or if it is, I don’t think YOKU will get the market share analysts expect.  Implied growth rates and market share gains right now are absolutely ridiculous despite all of these concerns.

Additionally, what might be the biggest systemic issue here, (I’ve written at length on this but havent published my entire study, available upon request), Goldman uses 6.5% for Equity Risk Premium across ALL of their offshore (HK and US listed) China stock coverage.  Another part of GS has Europe ERP at 6.3%, and NYU’s Damodaran has the US ERP at 5.72%.  Does it make any sense, even intuitively, that risky tech stocks that are essentially 100% Chinese businesses (where they’re listed shouldn’t affect ERP, just beta) are only 20-75bps more risky than developed country large/mega-cap stocks?

I think not.
Using their 6.5% ERP for YOKU, GS gets a WACC of 11.9%.  In my model, I used 15% WACC (ERP of somewhere around 7.5-8% if memory serves, don’t have it in front of me).  If I use their WACC the valuation jumps 80%!!!!!  Approximating, if they’d used 15% WACC instead of 11.9% in their model, their target price would drop from $55 to somewhere around $30-$35.  Earlier this year, Damodaran estimated the China ERP at 7.6% (whole market, probably still too low for a risky, money losing tech company), which in YOKU’s case would produce a WACC of 14.5%.  Had Goldman used this number, their estimated valuation would be again around the $35, not $55 range.

In terms of valuation practices, its one thing to BS your way to a high valuation using super aggressive revenue growth and margin expansion (cost reduction) assumptions, that’s just poor/incorrect form, but hardly out of the ordinary (not surprising coming from an underwriter/advisor, but that’s another topic for another time).  Its also not out of the ordinary to assume said firm will grab more market share than is reasonably probable (especially with aforementioned well-monied competitors coming at you from all sides).  But when you start screwing with the discount rate (ERP), then you are really pulling out all the stops in my book (short of using blatantly impossible assumptions, etc).

YOKU is trading at a pretty big discount to my estimate in the low 20’s, using what I think are pretty damn aggressive assumptions: a 40% 10-year revenue CAGR, 55% gross margin CAGR, etc.

I think the only possible saving grace for YOKU is if advertisers in China fall even harder than they have in the US for the “video ads are more effective” bullshit (who watches video ads?????).  This is a distinct possibility, although from conversations with some in China, there’s no love for ads, especially video ones there, either, so even if there’s an ad bubble, eventually some brand executive is going to ask why they’re spending X millions on video ads when even their own kid is telling them how annoying they are.

That’s pretty much my YOKU thesis boiled down into as short as it gets  It will likely continue trading at high/inflated levels as each quarter’s earnings continue to show ~100% revenue growth and investors anchor onto that and assume it’ll continue almost indefinitely into the future (despite the challenges I mentioned).  I think the China tech/internet trade has alot of potential to mirror our internet bubble v1.0 with a few differences (eg actual revenues and in a few cases, profits), but I think they may learn the hard way that 1. web metrics lie, and even if they told the truth, they’re still bullshit, 2. effective targeted advertising has been promised for a decade but even the leaders in the space still fail with alarming frequency and magnitude, and 3. who watches the ads on/next-to/before/after online videos?

One last potential concern: Once growth naturally starts to slow, I fear management is going to truly feel the pressure of politicians to keep the growth high (a bunch of the frauds have been driven in some part by these pressures, or so the CEO’s claim).  Whether Victor Koo will jump ship (like he did from Sohu) or stand strong in the face of inevitably mounting political pressure is a real question I think.  New management that doesn’t have the Founders’ ethic/pride behind them may give in to such political pressure which may open up the firm to very funky/fraudulent accounting/reporting down the road.  I can’t quantify this concern, but I think its one worth considering.

Getting a high valuation for delivering record growth rates is both a blessing and a curse; investors are myopic and are often just as quick to punish a stock for failure to live up to impossible expectations as they were to praise it for doing so in the past.

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This quick summary is a glimpse into our research approach, and more and more detailed analysis is available to institutional and high net worth investors.

If interested, please contact us, information (at) stonestreetadvisors (dot) com.

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One Response to “The Best Laid Plans of Mice & Men: YOKU Summary Thesis Update”

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  1. Morning News: July 29, 2011 | Crossing Wall Street - July 29, 2011

    […] Stone Street: The Best Laid Plans of Mice & Men: YOKU Summary Thesis Update […]

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