Chinese Internet Stocks Growing Up?

05/17/2011 9:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

Some highly touted names have come back down to Earth. Even better, the stocks seem to be trading off fundamentals, not froth. Here are two worth watching.

Last week was a great week for Chinese Internet stocks.

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%.
  • And Renren (RENN), the hot recent initial public offering for the “Facebook of China,” plunged 21.7.

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 did so based on fundamentals that we know and understand from the history of the US companies in the sector (although valuations for US 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. 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.

What Happened Last Week
The key event of the week was the May 11 announcement from Sina, owner of China's third-most-visited Web site 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 a result of increased spending on the Weibo service, the company said. 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 attracts 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.") Developing things to sell, marketing them, and constructing the infrastructure to collect payment and deliver them can be expensive.

Sina isn't alone in facing this problem. You can see the same dynamic at work at Sohu, the owner of China's fourth-most-visited Web site.

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 growth is projected to come from its Changyou.com (CYOU) 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 game called "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, to buy a majority stake in Shenzhen 7Road Technology, a developer of Internet games.

NEXT: Growing Pains

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Spending on Marketing Increases
Of course, when one Chinese Internet company ramps up spending on marketing and product development, cutting into its margins, it raises the bar for its competitors. 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 (TCEHY) and Sohu—to name just two of Baidu's competitors—with noticeable consequences for Baidu's bottom line.

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 and development costs (as the company expands its platforms to offer new services).

Higher market costs have started to show up in the company's overall operating margins. The operating margin of 49% in the first quarter of 2011 was up from 41% in the year-ago quarter, but down from 52% in the fourth quarter of 2010.

These trends are not unique to the Chinese Internet—which is exactly my point. Investors looking to value China's Internet stocks will find themselves asking the same kinds of questions they 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. But then they raised an eyebrow or two at the fast growth in costs at the company.

Operating expenses grew by 55%, as the company added staff as part of its investment in mobile, local, and social products. 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. The effort to extend Google's reach seems to me to be worth the risk, but there is no doubt that launching and marketing Chrome is expensive and risky.

It should be clear that when you try to value Google's stock, you need to include these rising costs and risks. But investors have some history to build that valuation on.

Google has a good track record in attacking new markets. The company had been a laggard to Internet display advertising, but thanks in part to its acquisition of DoubleClick, Google has gathered share in this market.

Its $2.5 billion in display advertising in 2010 put it ahead of Yahoo's (YHOO) display advertising revenue for the year. 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, 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. It also expects a decline in operating margins to 35% or less in 2011, as Google continues to invest in its businesses. From that, Morningstar calculates what it calls a fair-value estimate of $720 a share, on a price-to-earnings ratio of 24 times 2011 earnings.
  • 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 a share.
  • Credit Suisse 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 a potential 33% gain.

You can argue about any of these assumptions. For example, I think online ad growth will be slower in 2011 than these calculations project, because I'm looking for a bigger slowdown in the US economy.

That gives me a 12-month target price of $650, roughly where the stock was at its January 2011 high. That's still a 24% gain from today's price.

NEXT: 2 Stocks Worth Your Time

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My 2 Favorite Chinese Internet Plays
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.

My read on Baidu is that the company has entered a period of investment in products and marketing, which will cut into operating margins for the next quarter or two. I get a $160 12-month target price for the stock, but only after a rollercoaster ride that takes the stock down from even its recently depressed level near $130. I'd like to see it cheaper before I add shares for the upward ride.

For Tencent, I get a target price roughly 17% above today's price of 219 Hong Kong dollars (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.

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 $13.25 on May 16. Gain by the momentum, lose by the momentum.

Fortunately, I see evidence that 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Baidu and Tencent 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 here.

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