Click Caution on Chinese Internet Stocks

 | Jul 02, 2013 | 1:00 PM EDT
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An amended 13G filed with the Securities and Exchange Commission has placed Steadfast Capital Management's total holdings at over 19 million shares of YY (YY), a $1.6 billion market cap Chinese online communications software company.

This is up from the more than 14 million shares that Steadfast, which is managed by Robert Pitts, had reported owning in March and gives the fund ownership of almost 11% of the total shares outstanding. YY became publicly traded in November 2012, and was trading at about $14 at the end of that month; it is currently priced at about $29 per share.

YY operates a chatting platform that allows users to communicate with each other or to join groups. It earns most of its revenue from a combination of music sales and games.

The rise in the stock price has come along with very high growth in YY's financials. In the first quarter of 2013, the company reported that revenue was up over 130% versus a year earlier with profits up strongly in percentage terms as well. To some degree, markets have acknowledged the opportunities offered by YY, and so the current stock price represents a valuation of 48 times its trailing earnings.

Wall Street analysts expect YY to earn 93 cents per share this year, which at current prices makes for a price-to-earnings multiple of 31. That's a high earnings multiple, even for an internet stock. We have seen, however, that the business has been growing rapidly in recent quarters.

Even though YY won't be able to sustain this high growth over a period of years, we believe it is good that it isn't as dependent on one sole source of revenue (as opposed to many Internet companies which rely on advertising). And we presume that even if YY's growth rates come down, it's possible that the financials will improve enough to justify the current valuation -- as long as they remain strong.

The closest peer for YY is Renren (RENN), which operates a social network in China. Renren was unprofitable in each of its last four quarterly reports, according to adjusted earnings numbers. While the company did beat expectations in the first quarter, forward projections show profits remaining negative both this year and next year -- in contrast to YY, which has actually been delivering positive earnings. Renren even has negative earnings before interest, taxes, depreciation and amortization.

In contrast to YY's strong performance since going public, Renren is currently down over 80% from its levels shortly after its May 2011 IPO. The majority of its market capitalization is in the form of the cash reported on its balance sheet. Clearly, YY is doing much better than its peer here, which we suppose would raise the question of why that is the case.

Sina (SINA) and (SOHU) are Chinese Internet portals. Sohu is priced at a considerable discount to both Sina and YY on a forward earnings basis, with a price-to-earnings ratio of 18. But the company's margins have been down recently and as a result earnings growth has been sluggish. Sina carries a forward earnings multiple of 30, which represents very high expectations from the Street over the next year and a half.

Sina's revenue rose 19% in its last quarterly report compared to the first quarter of 2012, but we still think that we would avoid it until the company performs more in line with the trajectory set forth by analysts.

None of these three peers looks like a particularly attractive investment. YY is also dependent on growing its net income enough to match the predictions set forth by the sell-side. Revenue has been surging enough over the last year, however, that it might be worth looking into how the business has done so well and what kind of growth rates we can expect for the future.

The valuation looks too high right now for it to be worth the risk, but if another quarter or two of good results bring the earnings multiples down some it might well be worth investigating.

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