Some Perspective on YOKU’s Warner Brothers Deal

While something akin to Netflix is still a relatively new concept in China, I think we’re in serious need of taking a step back from today’s ridiculous reaction (judging by the stock rising 35% today) to YOKU’s new deal with Warner Brothers.

China’s Youku Inc (YOKU.N) has agreed with Warner Bros Entertainment’s local joint venture to offer pay per view movies on its newly launched online paid content platform, Youku said on Tuesday.

Under a three-year agreement with Warner Bros, Youku will add 400 to 450 Warner Bros movies to its Youku Premium library.

“People are increasingly willing to pay for high-quality content, and we take the growth of Youku Premium as a sign that the market is improving for paid services,” Dele Liu, Youku’s chief financial officer, said in a statement.

Great, so YOKU is paying (paid) a lot of money for content it now has to try to sell into a market that may or may not exist.  Let me rephrase that: In order for this deal to be break even (let alone be profitable), YOKU has to convince users not accustomed to paying for “premium” content to…pay for it.  Has this strategy worked anywhere in the world?  I can’t think of any examples of any similar size/scale.

Youku Premium, officially launched on Tuesday, began beta testing in October 2010. Since then, the service has processed 200,000 paid transactions for its library of more than 300 movies and 3,880 educational programs.

According to YOKU’s annual report, they had roughly 280 million monthly visitors.  In 8 (or 9) months then, assuming this number hasn’t changed, they’ve had 2,240,000,000 visits. Two point two BILLION.  In that time, their “beta” test of Youku Premium resulted in 200 thousand transactions.  I’m not entirely sure of the scale of the beta test, but only 0.009% of site visits resulted in a transaction. That’s only 8 or 9 out of every 100,000.

While this number will surely increase significantly when Youku Premium is rolled out across the site, I’m FAR less optimistic than other participants.  I’ve been privy to semi-confirmed reports of illegally-hosted copyrighted content not just on YOKU’s competitors’ sites (of which there are many), but on YOKU’s platform, too.  Ultimately, there are two questions investors must ask themselves:

• Why would Chinese users accustomed to getting content for free pay for it, when it can still be accessed for free with minimal effort/inconvenience?
• YOKU hasn’t filed a 6-k yet, but from the myriad of news reports I’ve read, this is NOT an exclusive deal, i.e. the content will still be available elsewhere and Warner Brothers is still free to strike similar deals with YOKU’s competitors.  This isn’t even the first such deal Warner Brothers has struck!  Is Youku’s brand strong enough to keep users coming back?

The company is growing revenues at an incredible rate (so they claim), and the market is growing.  But in evaluating how much to pay for the stock, we have to consider more than just headlines.  Is a company worth 35% more because they signed a non-exclusive to sell content into a market not accustomed to paying for it?  I highly doubt it.

At Goldman Sachs, Chinese Tech Companies Apparently Have the Same Risk As U.S. Ones

I’ve been analyzing YouKu.com (YOKU) for the past three weeks, and as I said most recently, I can’t possibly see how the stock could be worth more than about $21/share, using what I think are pretty optimistic assumptions.  I read Goldman Sachs’ – YOKU’s lead cheerleader underwriter – report before I published, and I’m still going through it and finding data, figures, conclusions and other “analysis” I find very puzzling, to put it nicely.  I’d made a note to myself during my first read-through to go back and check GS’s WACC calculation, since their Cost of Capital was only 12%, which seemed pretty low to me considering we’re trying to value a high-growth, relatively high-risk company in China.

Today, I finally went back and checked GS’ work, and what I found is at the very least EXTREMELY confusing, and at worst, deeply, deeply troubling.

Here’s why:

Project YOKU-zuna: Failure to Execute

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!

Project YOKU-zuna: The Good, The Bad, and The Very Ugly

As many of you know, I’ve spent the past two weeks analyzing “the Netflix/YouTube of China,” Youku.com.  From the first second I looked at the Yahoo! Finance summary page for the stock, I was EXTREMELY skeptical that a firm hemorrhaging money had a ~$5bn valuation.  When I looked at the competitive landscape, I became even more skeptical.  Sure, the company has experienced massive triple-digit revenue growth in the past few years (assuming, of course, you trust the financial statements, which may or may not be made-up) and appears to be one of the top two firms in the Chinese internet video space, but with incumbent sites like BIDU, SINA, and SOHU developing and rolling-out their own web-based video services, I find it hard to believe growth is going to continue for much longer at anything even close to those lofty rates.

I’ve encountered a number of hurdles in attempting to value this company, for instance, the lack of any half-decent comps, public or private.  I checked out as-yet-to-go-public competitor TUDU, but for all I know and care, their financial statements are just as uncertain (read: made-up) as YOKU’s, so in establishing my assumptions for the model, I tended to rely more on larger, more established firms’ financial statements, even if their businesses don’t really line-up very well with YOKU’s.  Think BIDU, SOHU, etc.

Thus, I developed 5 separate cases for P&L (income statement) and capex growth rates (% sales, % cogs, etc) none of which are really THAT conservative.  All assume the company’s financial statements are not only free of material misstatement, but will continue to be so over the course of the forecast period.  Personally, considering the ridiculous amount of (apparently) fraudulent Chinese companies we’ve seen over the past 6-12 months, I find this assumption hard to make, but I’m giving the firm the benefit of the doubt, deserved or otherwise, for the purposes of this exercise.*  Here are my assumptions for the income statement and capex:

Project YOKU-zuna Update: 10-Year Projected Income Statement

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…