Is YY a No-No?

 | Dec 04, 2012 | 4:00 PM EST
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A recent filing with the Securities and Exchange Commission has disclosed that Steadfast Capital Management, a hedge fund run by Robert Pitts, owns nearly 30 million shares of YY Inc. (YY). The Chinese social networking software company went public in late November at a price of $10.50 and is currently trading close to $14. YY users form and interact with online groups on PCs and smartphones, and YY provides entertainment-based communities for performing artists and gamers. The current market capitalization is less than $800 million, but it has traded at least 200,000 shares each trading day since going public and so the daily dollar volume is well over $2 million for now.

This was the first Chinese initial public offering in the U.S. in about eight months, as a number of factors -- including poorer economic numbers in the country as well as ongoing concerns about accounting practices -- have led to the market souring on Chinese companies. YY boasts an impressive collection of investors, including Tiger Global Management, Disney (DIS) and Steadfast. Of course, being Chinese is only half of being a Chinese social networking company, and investors are well aware that companies such as Facebook (FB) and Zynga (ZNGA) have seen declining stock prices this year. That seems to have also affected YY's valuation: a fundraising round about two years ago valued YY at about $1 billion and the current market cap is a good bit lower than that.

In the first half of 2012, YY had about $3 million in earnings, so the company is dependent on rapid growth to justify its current valuation. The Chinese gaming community is a common investment thesis. Three different publicly traded companies have at least some focus on online gaming in China, though it's possible that these businesses are lighter on the social networking side than YY is. Shanda Games (GAME), Perfect World (PWRD) and (CYOU) all trade at around 4x to 5x times trailing earnings. Clearly, the negative attitude towards China is affecting these companies. Their market caps are in roughly the same neighborhood as YY's despite being profitable (though earnings growth has been negative at the first two peers).

Alternatively, we can look at Chinese social networking company Renren (RENN), which went public in early 2011. Renren is expected to be unprofitable this year and next year, and it looks to us like most of its valuation comes from its reported cash position. It seems that markets aren't giving Renren much credit for its social networking business, so even if YY is stronger in that area than the gaming companies we've discussed, we're skeptical that the stock should get much credit.

It seems to us that even if YY continues growing rapidly (revenue doubled in 2011 compared to the previous year), the company would probably have to have around $20 million in trailing earnings for an $800 million market cap before we'd look at it relative to its peers. Even then it would likely trade at a massive premium on a price-to-earnings basis, and would have to justify its valuation by showing a sustainable growth trajectory.

We don't recommend YY as a buy right now.

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