The Chinese internet has been a hot topic for investors, with the anticipated debut of Alibaba and the growing international expansion of Wechat from Tencent (OTCPK:TCEHY). In fact, I believe Wechat may be the first platform that can gain international adoption of a Chinese platform and compete with the likes of Facebook (NASDAQ:FB). Growing up in China and being a proud Chinese, I view these developments with excitement. Yet with all excitement, we need to exercise caution. A rising tide lifts all boats, including the undeserving ones. In this case, there is one Chinese internet stock that is both overvalued and overhyped: YY Inc. (NASDAQ:YY). YY is very overvalued and should not be owned at or near current levels.
Shares of YY Inc have more than quadrupled since its IPO at a price of $10.50 per share, mostly by promoting itself as a leading social network platform with a rapidly growing user base. Further, its ability to quickly ramp up its revenue and profits relative to other Chinese Internet companies attracts Western investors looking for a piece of the growing Chinese internet market. In fiscal 2012, YY reported revenues and net income of $132 million and $14.3 million respectively. At $43 a share, YY's market capitalization is roughly $2.4 billion, over 18x its fiscal 2012 revenue.
Before even beginning to discuss the questionable financials reported, it is important to inform those who do not know that YY is not a social network platform in China. The western media has magically equated YY to the likes of Weibo and Facebook yet it is really a platform that exploits women while feeding on the ego and wallets of uninformed men.
YY's Business Model
Investors in YY should take time to understand its business model. In a Bloomberg article, the journalist quoted a hostess, Ms. Ni.
"I'm the sexy mature type, that's what they like about me," said Ni. "You feel like a star. Hundreds of people will respond to whatever you say."
YY primarily profits from financial patrons purchasing virtual gifts for hostesses like Ms. Ni. Yet the entertainment content provided by these patrons is truly unflattering. Investors should watch a video of such live interaction to understand why YY simply is not a mainstream social network platform.
While no one could dispute that connecting patrons who purchase virtual teddy bears for a "sexy mature" type of hostess like Ms. Ni may potentially fall into the category of a social network, it is certainly not a mainstream social network such as Facebook or Weibo. If anything, FriendFinder Networks may be a much closer comparable social networking platform.
Major Issues Concerning YY
As YY is set to report another quarter today after the close, rumors are rampant as the stock price surges. Words have spread that YY will beat analysts' estimates by over 50% and raise its guidance. However, before posting another record quarter, YY's management team should address concerns posted below for its investors. There are a number of major significant warning signs spelling accounting and business issues at YY, including:
- Virtually no marketing spend. YY's competitors consistently spend 15% - 20% of revenues on marketing as a necessary condition to securing more revenues. YY spends 2%. In the past we have seen a nearly identical phenomenon at Longtop Financial (etc, etc) which was delisted following the resignation by auditor Deloitte.
- High probability of undisclosed use of tuo, which may result in reporting false revenues. Relevant Chinese media reports indicate YY platform attracts individual patrons who spend tens of millions purchasing virtual gifts on YY's platform. YY's management claims its business model is unique in China and attracts extremely wealthy individuals who are willing to throw away millions in virtual gifts to patronize the hostess they like. While it may be true to a certain extent, the reported spending of over thirty million RMB by one single individual on virtual gifts defies logic and common sense. YY lacks disclosure on its revenue concentration and the identities of its major customers. It is questionable whether an auditor performed adequate procedures to ensure the individuals spending tens of millions RMB on virtual teddy bears are in fact unrelated third parties.
- The way that the revenues could be potentially fabricated is through the use of promoters (aka "tuo"). These promoters are company employees or affiliates who post fake spending numbers in YY games or its music channels as part of an effort to lure in new customers. Their efforts to lure in new customers are now coming under scrutiny in China for defrauding customers. But the real problem is whether the spending numbers they report amount to revenue fraud for investors in YY. YY never publicly disclosed the existence of promoters on its platform but research indicates its widespread existence. One industry veteran went as far as stating it is an implicit rule in the industry. The revenue recognition is potentially problematic if some reported big spenders on YY platform are in fact "tuo" or promoters, i.e. YY affiliates. We found extensive commentary on Chinese online forums discussing suspicion that some of the biggest spenders on YY platform are in fact such promoters.
- The extent of YY's overstatement on the number of registered users and active users is unprecedented. Evidence includes Taobao page where individuals can purchase 310 registered accounts for 1 RMB (value 15 cents). At the Taobao quoted price, one can technically acquire YY's entire user base or 530 million users for approximately 1.7 million RMB or 220 thousand USD. YY further creates incentives for the registration of zombie users. Meanwhile, multiple third party software apps exist to facilitate the log-in of multiple user accounts. YY's official channel policy incentivizes its users to use such software. In addition, proprietary data indicate YY's highest paying subscriber count experienced substantial decline in the last three months. The most expensive form of subscription, "King account," experienced a decline from 133 subscribers at the end of March to 73 at the end of June.
- Research through Baidu Trend and Weibo survey all indicate lack of interest or general awareness of YY platform aside from avid gamers. Baidu Trend shows consistent decline since peaking in 2011.
- A lack of mobile strategy due to data limitations of Chinese network providers
- Entity controlled by Lei Jun sold over 500,000 shares at $27 per share
- Spotty track record of the CFO's involvement in Giant Interactive's fraud class action lawsuit following its IPO. CFO Eric He was the CFO of Giant Interactive before its IPO and the fraud class action was subsequently settled for $15 million.
Inconceivably Low Marketing Spend
For many long and short investors who were involved in Longtop Financial (NYSE:LFT), the biggest red flag indicating fraud was simply in plain sight for the whole time. Citron Research's fateful April 2011 report on LFT noticed the substantial gross margin irregularity in Longtop. While all the software peers were reporting gross margin in the mid 30% range, Longtop was reporting gross margin in excess of 60%. We believe certain line items in YY's reported financials indicate even greater irregularity than Longtop's "industry leading" gross margin. Compared to all of its major competitors, YY spends a tiny fraction of its revenue on sales and marketing. The chart below shows the sales and marketing spending as a percentage of its total revenue for fiscal year 2012 and is compiled using data from 20Fs filed by the referenced companies.
While other leading social media, video and platform companies in China spend a significant percentage of revenue on marketing in order to achieve growth, YY seems to be able to do the same with minimal or nonexistent marketing spending. YY's sales and marketing expenses from year 2009, 2010, 2011 and 2012 are 5 million RMB, 12 million RMB, 13 million RMB and 17 million RMB respectively. With the exception of doubling in the year 2010, the number has largely remained a flat line. As a percentage of revenue, the number declined from 15% in 2009 to a mere 2% in the year 2012.
The management attributes such low sales and marketing spending to word of mouth. In Morgan Stanley's initiation report, the analyst also noted word of mouth as the reason for YY's spectacular low customer acquisition costs when compared to its peers. Such explanation is simply extremely implausible because while Weibo, Yoku and Renren are household names in China, YY is a brand few people in China have heard of. If anything, YY should be spending much more marketing dollars to expand awareness, not less. A sell-side initiation report also includes the customer acquisition cost for YY and its customer acquisition is a tiny fraction of its peers.
YY's management also allocated almost zero additional marketing spending in year 2011 and 2012 while reported revenue numbers were exploding. This of course defies common business sense. To further demonstrate the implausibility of its sales and marketing spending, additional analysis on marketing spending was performed on each individual business segment of YY.
A Direct Comparable of YY Music
A few months ago, Bloomberg published a profile article featuring YY. The article discussed the aspects of YY's business that are less mentioned in YY's regulatory filings. Part of the true appeal of YY seems to stem from the sexual appeal of attractive girls wearing low-cut tops. Entertainers are compensated by luring users to buy virtual teddy bears and necklaces. In the same article, the journalist listed 9158.com as another live broadcasting firm with virtually identical business model. Investors should navigate the website of 9158.com and yy.com for comparison purposes.
The curious case of YY's incredibly low sales and marketing spending is only marked with further implausibility when the CEO of 9158.com gave a substantially different marketing spending figure when discussing the profitability at 9158.
"Bo Zhengjun, the CEO of 9158 stated that while many think it is an extremely profitable business, profitability is in fact very difficult. We spend 40% of our revenue as paid commission to our entertainers, another 20% on sales and an additional 20% on marketing. There are a lot of other costs associated with the business such as costs related to bandwidth and R&D personnel."
Assume Mr. Bo was stating the truth, 9158 would be spending close to 40% of its revenue on sales and marketing. Yet YY spends approximately 2% while operating a substantially similar entertainment platform. Such discrepancy is simply irreconcilable.
Online Games and Others
Aside from YY music, YY generates revenue from gaming related products. The online gaming segment is notoriously known for its high costs of sales and marketing promotion. Both Renren and Qihoo operate web game platforms. While Qihoo and Renren have significant presence in China and are well-known brands, they still spend heavily to promote their gaming platforms in order to maintain growth. YY operates its gaming platform through a website called duowan.com. Duowan is one of the leading gaming informational portals in China and is a direct competitor to 17173.com. According to Alexa, 17173.com is ranked as the 134th most trafficked site in China while Duowan.com is ranked as the 102nd most trafficked site in China.
To further show the implausibility of YY's sales and marketing spending claims, investors should look at a transaction to sell 17173.com. Per relevant disclosures, the sales and marketing spending related to 17173.com as a gaming information portal was roughly 10% of its total revenue at the time of the transaction. Regardless, YY's extremely low sales and marketing spending is incredibly difficult to conceive in an industry where better known competitors are spending a substantial percentage of its revenue to maintain brand awareness and popularity.
YY's Revenue Integrity Issues
Despite a lack of traction and the scant marketing spending, YY has thus far managed to report record revenue since going public. As the Company is set to report its latest earnings, rumors abound that the Company will beat the estimates by over 50% and raise its guidance to the investing community. The stock doubled in the last month alone. Investors thus far haven't asked any questions regarding its revenue integrity.
But YY's revenue integrity should be a top concern for its investors. Per relevant Chinese media reports, YY user spending is extremely skewed. In a news article dated May of 2013, it was reported that in order to support their favorite hostess in channels, the top spender, Brother Bao, threw 5.2 million RMB to get on top, followed by another user spending 4 million RMB. It was further reported the other eight users within the top 10 spent no less than 1 million RMB each. So, in aggregate, ten individuals spent well over 20 million RMB in a single event on YY's platform.
Logic of such spending aside, it presents a unique challenge to the auditors and it is equally concerning YY never disclosed to its investors how spending on its platform is distributed. There are certain SEC rules governing the disclosure of major customers. Auditors need to make sure that each business transaction is conducted on an arm-length basis. It is much less common and much more difficult for any auditor to verify individuals to ensure the arm-length criteria are met.
It is unclear whether the auditor and the Company have taken appropriate measures to ensure the individuals who spent 10 million RMB are indeed trying to support a hostess and not trying to boost the top line of YY with round-tripped revenue. To add to the suspicion, multiple Chinese online sources also suspect employees of YY may be posing as customers to bid up virtual gifts and boost spending on its platform. In a Chinese article discussing YY's business model, the journalist mentioned many YY users suspect one of the top spenders to be a "tuo" of the company i.e. a promoter who spends money to induce others to spend more. In a separate Q&A platform, somebody answered definitively that platforms like YY do have "tuo" to induce its customers to spend more. YY does not disclose whether it uses "Tuo" in its public filings and this raises significant questions as to the integrity of YY's revenue stream. Is 100% of the revenue reported by YY coming from independent legitimate third party customers?
Included here are a list of Chinese media articles on YY and the use of Tuo
- Grassroots Organization on YY and 9158 Chinese English
- Web Game Operator Plays Dirty; Gaming Company Employees Work as "Tuo" to Induce Spending Chinese English
- Tuo Allegations Concerning YY, 9158 and similar platform
These referenced articles raise significant questions regarding the independence of YY customers. Chinese internet users have long suspected some big spenders on YY platform are in fact employees posing as customers to induce additional spending. While it may be a good marketing strategy, YY's management needs to be forthcoming with U.S. investors on its usage and how its revenue is properly recognized. If the media reports were true, it is highly suspicious that a significant number of wealthy Chinese internet users would in fact engage in a competition to throw away money. Moreover, YY's management should disclose to the investing community the percentage of its revenue coming from the top 30 spending individuals and auditors should perform customary audit to establish the arm-length criteria on those customers.
Adding to the concerns, YY went public under the JOBS act, which exempted the Company from an internal control assessment by the auditor. The auditor identified two material weaknesses in their assessment. One of which is the lack of accounting resources to fulfill GAAP accounting. While many firms went public through JOBS may have internal control issues, it certainly becomes much more of an issue when combined with other issues on its reported financial statements.
Unprecedented User Base Inflation
For many institutional investors, investing in a social networking company is about investing for the future. Investors often pay less attention to the current monetization opportunities but focus more on the company's user base and its ability to engage its user base. On the surface, YY is doing a phenomenal job growing both its total registered user base and its active user base. As of the end of 2012, YY's total registered user accounts stand at 457 million and its monthly active users also stand at 70 million. YY currently boasts a total registered user base of 530 million.
Even if we ignore the total registered user accounts, which is clearly an inflated number, a 70 million monthly active user is still an incredibly substantial figure. If this were an accurate representation of YY's business, roughly 15% of Chinese internet population would be signing into YY on a monthly basis. Does this figure reflect the reality of YY's business? If not, how inaccurate is the figure?
YY publicly acknowledge in its risk factors that its reported registered and active user count does not reflect its unique user base. Investors understand that all social network platforms have some level of overstatement in its registered and active user count. But they may not be aware in the case of YY, the inflation is unprecedented.
To demonstrate, investors simply need to look at a Taobao posting which sells 310 YY accounts for 1 RMB or 15 cents. For investors who are less familiar with the YY platform, this probably comes both as a surprise and a puzzle. Why on earth would anyone want 310 YY accounts? To understand the issue, investors need to understand YY's own community policies.
YY's Skewed Community Policy Calls for Abuse
While companies regularly disclose risk factors, it is investors' job to understand and properly assess such risks. Even though YY did disclose the risks of abuse, it certainly failed to highlight to investors how pervasive and substantial the issue is. The business model of YY involves channel owners, entertainers and patrons. Through YY's platform, an individual can apply for a channel and as the channel gains popularity, it can become classified as a lesser digit channel. For example, a four-digit channel is more prominently displayed and therefore more popular than a six-digit channel. Given that entertainers and channel owners are paid a percentage of the virtual gifts purchased by the patrons, they have substantial incentives to obtain and keep a low-digit channel. Per YY's own policy governing the application, usage and forfeiture of channels, a 4-digit channel can be applied if during the seven days prior to the application, the channel achieves a maximum of 150 concurrent users for a two hour period for a total of five days. Upon obtaining the channel, the channel owner still needs to maintain the 150 concurrent user number requirement for two hours for no less than fifteen days in a thirty day cycle. Given the strong financial incentives for the channel owners to apply and maintain low-digit channels, which are inherently more popular and profitable, it is common practice for channel owners to create multiple accounts and have them logged in all at the same time to meet the popularity requirement in order to maintain their ownership of low-digit channels. Such practices are so pervasive that there are software programs specifically created to facilitate logging into multiple YY accounts.
There are 21 different software programs specifically dedicated for users to log into multiple YY accounts listed on one of the websites frequented by YY users. Investors would have to download and use one of these programs to understand how substantially overstated the active user count is.
A number of screen shots are provided to show the extent of the issue.
Such programs allow users to login a substantial number of accounts using a single computer. The worst part, YY's own policy in fact strongly incentivizes the channel owners to do exactly that so they can apply for a more popular channel or keep the more popular channel. The overstatement in YY's reported active user count is likely many orders more substantial than the similar numbers reported by companies like SINA and Renren due to the incentive misalignment.
The management of YY is certainly well-aware of the extent to which its active user base is overstated. It is doubtful they are benign enough to alert investors to these important issues. As a matter of fact, it is almost comical that YY's management highlighted its lack of ability to validate the identity and registration information of its users in its risk factor disclosure. Register for an YY account may just be the easiest registration process in the world. Most notably, users are not required to even provide an email address in order to register for an account, not to mention an email notification process that is required by many websites. We suppose management is telling investors about its inability to police the registration process when in fact it is simply unwilling to police such process.
Third-party Checks Show Popularity Waning
YY has been reporting significant growth in its user base over the past few years, but some simple checks show the popularity has in fact been waning.
Baidu Index Search
YY operates a platform YY client, YY.com and Duowan.com. Baidu Index tracks the popularity of certain key phrases and could be helpful in understanding the trend. Baidu Index results tracking the popularity of YY to primary brand names suggest their popularity has in fact been waning.
Alexa traffic paints a similar picture although it is less reliable due to the platform and client software nature of YY's business.
Chinese Internet Users' Response to YY's IPO
Immediately prior to YY going public, a poll was conducted on SINA Weibo where Chinese internet users were asked about their thoughts on the upcoming IPO of YY. The result of the poll is very revealing.
- It hasn't been easy for YY, Tencent somehow overlooked a niche market. (31 users, 24%)
- 400 million users, they must really been YY or Yiyin (Chinese online slang for being delusional), the total internet users in China only amount to 500 million. (38 users, 29%)
- Number does not equate to loyalty, YY has substantial limitation. (19 users, 15%)
- Once again, it's proven that the real high-value customers are financial patrons. (28 users, 21%)
- The Panda (YY's mascot) managed to gloriously turn the corner; it's no longer just instant noodles (Panda was also used as the trademark for a popular brand of instant noodles in China). (11 users, 8%)
- WOWers: YY, we can only help you this far (23 users, 18%)
- YY still may face fierce competition from Tencent! The end game is unknown. (13 users, 10%)
- Great! Very optimistic about YY's push into education. (14 users, 11%)
- YY has not shown any potential or competitiveness in mobile. (10 users, 8%)
- Online Karaoke plus social networking can produce a real public company. (5 users, 4%)
Of all the votes cast, 30% of the surveyed do not believe YY's popularity comes even close to what was stated on its prospectus. Obviously, the management claimed the user base has been growing even further since then. According to the most recent quarterly results, YY commands total registered users of 526 million. Ironically, people cast the lowest number of votes on item number 10, suggesting a substantial amount of the surveyed individuals do not believe YY has a realistic business model to even merit being a public company. While the vote itself does not conclusively prove the lack of popularity of YY's platform, it should be included as an important piece of information when evaluating the strength of YY's platform and the quality of its user base.
Challenges Abound in YY's Mobile Strategy
In the most recent quarterly conference call, YY's management attempted to alleviate some prior concerns investors had about its mobile strategy. Investors betting on YY's success in mobile should keep a few things in mind.
- 3G data usage concerns. YY operates as a live video streaming platform and therefore requires significant data usage to support the interactive features afforded by its platform. Most Chinese smartphone users do not purchase nearly sufficient amount of data to allow for extensive usage of live video streaming.
- Mobile live broadcasting introduces further regulatory uncertainties. In May of 2011, Ku6 (NASDAQ:KUTV) introduced a similar platform, which allows for mobile broadcasting and live streaming of UGC. The platform turned out to be a flop and was subsequently shut down. Sources stated that part of the reason for the shutdown relates to regulatory issues and the difficulty in policing such UGC. It is simply too easy to broadcast certain censored materials through mobile. For example, somebody may broadcast a gambling game or a fight when such content would typically be heavily censored in traditional video uploading sites.
Lei Jun, a well-respected Chinese VC investor has sold over 500 thousand shares on behalf of his firm at $27 and the stock is currently trading at $43.6.
At its current valuation, YY presents a compelling short opportunity. In addition to an incredibly rich valuation, significant fraud risks exist due to its substantial growth with unexplained low sales and marketing spending. Further, its user base is much more substantially overstated compared to its peers. Finally, YY's platform expansion may be limited by its initial market position and its defined user base. Much of its user base appears to be either avid gamers or financial patrons of young attractive female entertainers. It is simply a much different platform than the mainstream social networking platforms such as Facebook or Weibo, and it is loaded with red flags and high fraud risks for all investors.
Disclosure: I am short YY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.