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China's Internet stocks: They're cheaper and easier to value too
05/17/2011 8:30 am EST
Oh, not for their share prices. Last week was grim on that front.
Baidu (BIDU), the operator of China’s most popular search engine, was down 7.1% for the week. And that’s about as good as it got in the sector. Sohu.com (SOHU) which runs an Internet portal, fell 11.3% for the week. Sina (SINA), an operator of online content sites, dropped 14.6% for the week. Renren (RENN), the hot recent initial public offering (IPO) for the Facebook of China, plunged 21.7% in the week.
But for investors hoping to figure out if there is a fundamental case for investing in this sector—and in specific stocks--it was a super week. The Chinese Internet stocks that plunged, plunged on fundamentals that we know and understand from the history of the U.S. companies in the sector. (Although valuations for U.S. Internet companies don’t always reflect these fundamentals.) The drop, painful as it was demonstrated that China’s Internet stocks aren’t just playthings of momentum where nothing counts but the enthusiasm of the moment.
Last week’s drop said that Chinese Internet stocks obey—albeit with even more volatility that their already volatile U.S. counterparts—the fundamental rules that govern Internet stocks in the United States and other financial markets. After the plunge I think you could feel a whole lot more confident about investing in the sector—and not just because the stocks had become 10% cheaper.
The key event of the week was the May 11 announcement from Sina, owner of China’s third-most visited website and the Weibo social messaging service, that it had missed first-quarter earnings estimates. Earnings fell by 39% from the first quarter of 2010 to $15 million. That was below the $15.4 million consensus among analysts who follow the stock. The shortfall was due, the company said, to increased spending on the Weibo service. Total investment in Weibo, which claims 140 million users, may reach $100 million.
So what’s the big deal about Sina’s quarter? It was a simple reminder that attracting eyeballs isn’t the end of the story but just the beginning. Once a company has attracted the eyeballs, it has to extract actual revenue and profits from those visitors. It has to sell them something at a price that results in a decent profit margin. (It’s not enough to say, “We lose money on every sale but make it up on volume.)
And the process of developing things to sell, marketing them and constructing the infrastructure to collect payment and deliver those things can be expensive.
Sina isn’t alone in facing this problem. You can see exactly the same dynamic at work at Sohu.com, the owner of China’s fourth-most visited website. On April 25 the company announced a 48% increase in first-quarter profit. Net income came to $45 million, or $1.01 a share, up from 73 cents a share in the first quarter of 2010. Sales climbed by 35% on a 45% year over year increase in ad revenue.
A big part of the company’s future growth is projected to come from its Changyou.com game unit, which showed a first-quarter increase in profit of 33% to $53 million.
But that growth will cost money. Changyou is set to introduce a new game Duke of Mount Deer—and that will mean an increase in marketing costs. That will shrink profit margin in the second quarter, the company noted in its post-earnings conference call. In addition Changyou will spend as much as $101 million, according to Sohu.com, to buy a majority stake in Shenzhen 7Road Technology, a developer of Internet games.
Of course, when one Chinese Internet company ramps spending on marketing and product development, cutting into its margins, it raises the bar for all its competitors too. You can see this at Baidu, for example.
Baidu dominates the paid search ad market in China. That dominance produced 88% year-over-year revenue growth in the first quarter of 2011 and a doubling of net profits. But, as you’d expect that growth has attracted competition in paid search from Tencent Holdings (TCEHY) and Sohu—just to name two of Baidu’s more well-known competitors—with noticeable consequences for Baidu’s bottom line.
For example, Baidu’s costs for acquiring traffic as a percentage of sales climbed in the first quarter to 8.2% from 8.1% in the fourth quarter. That may not seem like much of an increase but it reverses the downward trend of 2010. Rising traffic acquisition costs added to higher research & development costs (as the company expands its platforms to offer new services) sand higher market costs have started to show up in the company’s overall operating margins. Operating margin of 49% in the first quarter of 2011 was up from 41% in the first quarter of 2010 but down from 52% in the fourth quarter of 2010.
There’s nothing unique to the Chinese Internet sector in these trends—which is exactly my point. Investors looking to value China’s Internet stocks will find themselves asking the same kinds of questions that investors ask about Google (GOOG) or Facebook—and I think that’s reassuring for those of us looking for fundamental value instead of the latest momentum trend.
So, for example, when Google reported its first quarter 2011 results on April 15, investors cheered the company’s 27% year-over-year growth in revenue. And then raised an eyebrow or two at the fast growth in costs at the company. Operating expense grew by 55% as the company added staff as part of its investment in mobile, local, and social products. But the increase in sales and marketing costs grew at a 70% rate. The company explained that the increased marketing costs were related to its efforts to build market share for its new Chrome browser. If Chrome becomes a successful user platform, that spending will have been worth it. And the effort to extend Google’s reach in the Internet seems to me to be worth the risk, but there is no doubt that launching and marketing Chrome is expensive and risky.
And that when you try to value Google’s stock, you need to include these rising costs and new product risks. But investors do have some history to build that valuation on. Google has a good track record, for example, in attacking new markets. The company had been a laggard to Internet display advertising, but thanks in part of its acquisition of DoubleClick Google has gathered share in this market until its $2.5 billion in display advertising in 2010 put it ahead of Yahoo’s (YHOO) display advertising revenue of the year. And the company continues to spend to innovate in the space with improvements in real-time bidding and audience targeting.
From all of this you can calculate assumptions and build a target price. Morningstar.com, for example, assumes revenue growth of 14% annually over the next five years—that’s in line with projections for Internet ad growth in general—and a decline in operating markets to 35% or less in 2011 as the company continues to invest in its businesses. From that Morningstar calculates what the site calls a fair value estimate of $720 a share on a price-to-earnings ratio of 24 times 2011 earnings per share. Standard & Poor’s projects slightly higher revenue growth—23% in 2011 and 19% in 2012—and an improvement in operating margins in 2012 after a dip in 2011. Analysts there come up with a 12-month target price of $700 as share. Credit Suisse, to take another example, lowered its 12-month target price to $700 from $750 after the company’s first quarter earnings report. At a recent price of $525, a $700 price represents as potential 33% gain in the share price.
You can argue about any of these assumptions—for example, I think online ad growth will be slower I 2011 than these calculations forecast because I’m looking for a bigger slow down in the U.S. economy. That gives me a 12-month target price of $650, roughly where the stock was at its January 2011 high. That’s still roughly a 24% gain from today’s price.
But the point is that investors can create these models for Google and then disagree and tweak assumptions. And I think you can do much the same right now with Chinese Internet stocks such as Baidu and Tencent, my two favorite Chinese Internet companies for the next year or two.
For example, my read on Baidu is that the company has entered into a period of investment n products and marketing that will cut into operating margins for the next quarter or two. I’d get a $160 12-month target price for the stock but only after a roller coaster ride that takes the stock down from even its recently depressed level near $130. I’d like to see it cheaper before I added shares for the upward ride. For Tencent I get a target price that’s roughly 17% above today’s price of $HK 219 or $US 28. That’s not enough for me to jump up and down about. I’d get more excited if the shares got cheaper in the next few months.
But this kind of valuation is very different from the kind of sentiment and momentum driven pricing that ruled the market for Chinese Internet stocks in the run up to the May 4 IPO of Renren, the Chinese Facebook. That offering priced at $14, the top end of its range, and then quickly climbed to $18. That valued the company at 75 times revenue—that’s revenue and not earnings. Facebook, known now as the Chinese Renren, was valued at about 25 times revenue in a purchase by Goldman Sachs (GS) of a stake in the still private company. Not bad in either case—Renren or Facebook—for companies that are really just at the beginning of the hard part of life on the Internet, converting eyeballs into revenue and earnings.
Renren opened at a price of $13.25 on May 16.
Gain by the momentum, lose by the momentum.
Fortunately, I see evidence that there’s it makes sense to value some Chinese Internet stocks on fundamentals that last for more than two weeks.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Baidu and Tencent Holdings as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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