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:
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.
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!
I don’t like stating the obvious, except when it seems many if not most are seemingly oblivious to it. 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 talking 70% average revenue growth for the next 10 years. Off the top of my head, I’m not sure any firm of this size has achieved a decade-long run that impressive in the history of the corporation!
This should be obvious, but firms can only grow so much, so fast. YOKU makes substantially all of its money from online advertising, which means its revenue growth is bounded by two factors: the growth rate of the Chinese internet advertising market, and its share of said market. The very-same “independent” research firm YOKU cites in its regulatory filings – iResearch – says the market only (yes, only) grew 54% last year, yet YOKU’s revenues grow three times as fast (152%)!
The only way for this to happen (and continue to happen) is for the market to grow faster than estimated, the sub-market in which YOKU operates – online video advertising – grew (and will continue to grow) faster than the broader internet advertising market as a whole, and/or YOKU made (and will continue to make) HUGE market share gains last year. (YOKU could also expand into new markets, but for our purposes, we’ll assume the company invests most of its capital in the internet video space.) Of course there is another way – falsifying revenue – but as I have done in my financial analysis, I’m working on the (very possibly unrealistic) assumption that YOKU’s financials are fraud-free.
In order to rationalize YOKU’s current (at the time of my analysis last week, around $42/share) price, not only did YOKU’s revenue growth rate have to significantly outpace that of the industry rate, but going forward, it will have to continue to do so for years to come! Even if Victor Koo is the most brilliant CEO the World has ever seen, he is still (using our no fraud assumption) faces real-world constraints in how fast he can grow the company.
If we take a deeper look at the industry and YOKU’s position within it, I think it will become even more crystal clear that YOKU’s share price – driven largely by unrealistic revenue growth assumptions – is grossly over-valued.
I’m still not done modeling YOKU‘s projected financial performance, but so-far I think I’ve done enough research to put together a preliminary (set of) income statement(s). The image below shows an income statement which combines generous revenue growth and margin assumptions, each semi-possible – although by no means probable – if we look at those of YOKU’s “comps” over the past 5-10 years.
I haven’t finished the model yet so I don’t have accurate cash flows, but even using these very bullish assumptions I’m extremely skeptical I can get to the current valuation (~$4.5 BILLION). The stock price has dropped significantly following the (announcement of) the secondary offering, but it looks like its still over-valued by about 15-20%, at the very least…
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