Is China’s Internet Bubble Popping?

05/10/2011 2:45 pm EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

As investment legend John Templeton observed, the words “this time it's different” are the four most dangerous words in investing. Don't be fooled into thinking that wisdom doesn't apply to Chinese Internet stocks, writes Nicholas Vardy, editor of The Global Guru.

For all of the worries about the Chinese economy, the country’s Internet sector is acting just like the Energizer Bunny—it just keeps “going and going.”

Two of the best-performing stocks in the world over the past 12 months have been Chinese Internet giants Baidu (BIDU) and Sina (SINA). Sina alone has more than doubled in 2011. Online-video platform Youku (YOKU) is up by a similar amount since it listed in December.

Interest in Chinese Internet stocks reached frenzied levels after “China's Facebook,” Renren (RENN), raised almost $750 million when it listed on the New York Stock Exchange last week.

With 457 million online at the end of 2010, China already boasts the largest number of Internet users in the world. Brokerage CLSA expects that number to increase to more than 800 million by 2013. With numbers like that, the Chinese Internet market seems like one of the few “no-brainer” investments of the next decade. 

However, the listing of Renren just might signal the peak of the Chinese Internet bubble. So if you lost money after the collapse of the last dot-com boom in 2000, pay close attention.

Baidu: China’s Google
Baidu is the Chinese search giant that beat Google at its own game. Baidu’s stock has more than tripled since Google announced plans in January 2010 to pull its search engine out of China. Robin Li, head of Baidu, is now the richest man in China.

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But comparing the companies on a fundamental basis may leave you scratching your head. While Google's enterprise value/revenue ratio is 4.61 to 1, Baidu's is 41.44 to 1.

Baidu's enterprise value of $50.4 billion is more than a third of the $143.36 billion EV attributed to Google. That's despite Google posting more than 25 times Baidu’s revenue in the last full year, or $31.12 billion versus $1.22 billion, respectively.

NEXT: China’s Twitter

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Sina: China’s Twitter
As subscribers to my Bull Market Alert trading service can confirm, Sina has been justifiably called “The Hottest Internet Stock on The Planet.”

The stock has gained 160% since I first recommended it on October 2. Over the past six months, Sina has made investors more money than the higher-profile Baidu.

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As the third-most-visited portal in China, Sina was an also-ran behind market leader Baidu. But last year, Sina developed its own Twitter-like service, Weibo—the most popular Twitter clone in the world by far. With over 100 million registered users, Weibo has evolved into a much richer experience than the original Twitter.

Although Sina is trading at an EV/revenue better than Baidu’s, the stock recently took a hit when Goldman Sachs downgraded it to a “sell.” Apparently, the investment firm concluded that Weibo’s potential is now fully reflected in Sina's stock price.

Youku: China’s YouTube
If you're getting the sense that fundamentals have little to do with Internet stock performance in China, you're right. Youku, which has booked combined net losses of 681 million yuan ($105 million) since 2007, has almost doubled in value since its initial public offering on December 7.

In fact, it has just about matched Sina.com's red-hot performance:

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With an enterprise value of almost 100 times its revenue, Youku (YOKU) just might be the most overvalued among all of China’s Internet stocks. Yet Youku hardly has Baidu-like traction among Chinese Internet users.

While about 27% of global Internet users visit YouTube, only 1.7% of them visit Youku. Put another way, Youku accounts for just 20% of China's fragmented online-video space. That's less than one-third the market share that YouTube commands in a larger US online-video market.

Google was hassled by investors for paying $1.65 billion for YouTube back in 2006. Yet today, investors are pegging Youku at an enterprise value of a whopping $5.8 billion—less than five years later.

NEXT: China’s Facebook—The Mother of all Bubbles?

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Renren: China’s Facebook—The Mother of all Bubbles?
If Youku is the most overvalued Chinese Internet company, it may soon cede that crown to Renren, the “Facebook of China.”As I’ve said earlier, Renren—whose name means “everyone” in Chinese—listed on the New York Stock Exchange last week.

But although Baidu and Sina have been big moneymakers for US investors over the past few years, I don't think that will happen with Renren. For one, the company is such an obvious Facebook knock-off that getting sued by Facebook is set out as a risk factor in the prospectus.

At the initial offering price of $14, Renren traded at 72 times last year’s sales. Compare that with 25 times for Facebook. If investors valued Google the same way, it would be trading at around $6,000 per share—more than ten times its current stock price.

Renren had 117 million users as of March 31, less than a quarter of the 500 million-plus users Facebook has globally. Nor is Renren as much of a part of the fabric of Chinese Internet life. Facebook had 153 million active monthly users in the United States, equal to about 60% of the online population. Renren's 31 million users equal a mere 7% of Chinese Internet users.

There are other red flags. Renren has recently ratcheted down estimates of its break-neck growth by almost a third. The chair of its audit committee has just resigned. Meanwhile, the real Facebook is in talks with Baidu to launch its service in China.

[And, in fact, Renren has dropped consistently after a brief pop as high as $24 on the opening day. In Tuesday morning trading, the stock is barely holding above its $14 offer price—Editor.]

How to Play China’s Internet Stocks
Between exorbitant valuations, questionable statistics, and a general feeling of investor froth, I'd stay away from Renren’s stock.

If you own other Chinese Internet stocks, hold on them for now. After all, the “trend is your friend.” And as English economist John Maynard Keynes observed, “The market can remain irrational a lot longer than you can remain solvent.”

Just make sure you have an exit strategy in place to avoid the worst of the inevitable collapse. It's okay to party like it’s 1999...just make sure you don't wake up with a serious hangover.

[Jim Jubak issued similar warnings last week about the Chinese Internet IPOs, arguing that “fuzziness” in the data was leading investors to follow the next momentum play instead of focusing on fundamentals...a prime sign of a bubble at work—Editor.]

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