The meteoric rise of Youku (NYSE:YOKU) last month cast a spell over Wall Street. Financial blogs and media outlets trumpeted the arrival of the “Youtube” of China and investors immediately ran wild with it. The hype caused the stock to skyrocket to almost $50 before crashing back down to $29 and then briefly rebounding above $40 last week, where I decided to initiate a short position.
What Youku’s almost fairy tale first couple weeks of trading doesn’t tell you is that this “Youtube of China” is anything but. Most investors looking at Chinese stocks view them simply through their financial statements and their ideas of what the Chinese market looks like from their brief trips there, the couple glasses of “baijiu” pounded over lunch with management and the articles they’ve read about China. While this approach can work in a bull market, it does not substitute for on the ground knowledge of the Chinese business environment and the culture that drives it. A closer look at Youku exposes the fallacies overlooked by daytraders bidding over $4B for a company with a failing business model that lost $25 million in the first 3 quarters of 2010 and over $100 million since inception.
First off, a major mistake is misconstruing Youku for a Youtube. We all know Youtube as the website where we watch Charlie biting his brother’s finger or watch pandas sneezing. Most Youtube videos are just such user generated content (UGC). Youku started out with this business plan, but quickly decided UGC was a dead end in China (only 20% of its videos today are UGC). I’ve spent a fair amount of time in Chinese internet cafes observing the clientele who spend the majority of their time watching copyrighted full length TV shows and movies while surfing the internet or playing games. Youku realizes this too and in its early stages captured a large portion of this massive audience by allowing users to upload full-length videos, including copyright infringing videos, until recently. In short, Chinese don’t log onto Youku to watch a chipmunk with a dramatic stare, but to watch the latest episodes of copyrighted content such as Grey’s Anatomy, Korean soap operas or the news.
Not surprisingly, as Youku grew infringement lawsuits started piling up. Youku’s first response was to change its business plan again to spend millions licensing increasingly expensive professionally produced content that accounts for 70% of its videos today (the remaining 10% is expensive original content produced by Youku itself). The cost of professionally produced content, according to Youku, is astronomically rising and is the major challenge to its current business model since advertisers pay very low rates and users refuse to pay anything at all. According to Youku’s own IPO filing (page 17, available here):
The market prices for professionally produced content, especially popular movies and television serial dramas, have increased significantly in China during the past few years. For example, according to our internal records, the average license fee for television serial drama has increased in 2009 by more than 200% as compared to 2008, and such fee has increased in 2010 to date by more than 100% as compared to 2009. The average license fee for movies has also increased in 2010 to date by more than 90% as compared to 2009.
Compared to the rapidly rising costs for content acquisition, the fees advertisers pay Yokou have barely budged. Youku suffers from intense competition for advertising dollars from numerous smaller sites that still freely distribute infringing content. This is the worst kind of diseconomy of scale. The bigger Youku gets, the bigger its losses.
Pressure from the Chinese government for the larger players to remove infringing content peaked in January 2010, when Youku removed large amounts of infringing content from its servers by implementing a digital fingerprinting technology meant to root out all copyright infringing material (article here).
As the chart of daily unique visitors below shows, Youku’s site traffic immediately collapsed 75%. In October traffic rebounded somewhat but in November the Chinese government renewed aggressive calls for the continued removal of infringing material from streaming servers just prior to Youku's IPO (as stated in an article here). Youku is complying, killing its traffic, and forcing it to pour increasingly large amounts of capital into licensing fees since its December IPO. Now with most of the illegally uploaded content removed, Youku’s traffic according to Google Trends has more or less flat-lined since the IPO and is half of what it was just one year ago despite seeing an uptick since October (see chart below, click to enlarge):
Anticipating its desperate need for more revenues to pay for rising licensing costs, Youku in early 2010 began experimenting with charging for its videos via its Youku Premium service. With this latest change to its business plan, Youku hopes Chinese users will pay to view what was previously free on Youku (cue cheers from Hollywood and laughs from Youku’s legions of copyright infringing competitors)!
The company recently announced that it had bought the rights to stream the hit Warner Bros movie “Inception” on its premium on-demand paid video service (article here). But Youku has now left itself at a hopeless disadvantage to competitors who stream copyrighted material just hours after it hits the big screen in America. “Inception”, for one, was commonplace on Chinese streaming sites at least six months ago. What Chinese person is going to pay to watch it now?
Youku also recently announced a deal with Disney to stream 5 seasons of Desperate Housewives (article here). This purely “political” will further please Hollywood and government regulators but spells disaster for investors. No one seriously thinks Chinese viewers will pay for content and there is little belief that, at the end of the day, the revenue from ads and the tiny fee for a la carte video or subscription services can offset the massive cost of content that Youku admits is doubling each year! It is common knowledge in China that if one video website takes infringing videos down due to an IPO or government pressure, consumers immediately switch to smaller websites willing to stream them for free.
What the “wangba” (internet café in Chinese) user demands will be supplied! It took me only a few seconds to find exactly what I wanted (US TV shows, movies etc.) on other lesser-known websites such as ppstream.com, 56.com, zoltv.com etc. The fact remains, the Chinese will not pay for content that can easily be found elsewhere, not to mention that if it can’t be found streaming online, Chinese will simply revert back to their failsafe: BitTorrenting or just buying it from a DVD hawker on the street! The majority of Chinese internet users are living in tier 2, 3 and 4 cities and don’t have much else in the form of entertainment except to go to the internet café. None of them are going to pay 5 RMB ($0.75) to watch a movie on top of having to pay to use the internet café. It simply is beyond their budget, especially since it was free before and continues to be free from any number of competing sites. In a country where rampant inflation of food prices is already biting deeply into the average person’s disposable income, there is little chance that 5 RMB will be spent on a movie that was once free.
As Shane Farley pointed out (here), playing nice to Hollywood and charging for content actually acts as a strong competitive disadvantage creating diseconomy of scale for Youku. If you’re going to play by the rules in a market where no one else will, you will lose. Youku has boxed itself in by going legit, with site traffic stalled for a year now as users depart for other websites. Who wants to own a business losing customers with rapidly rising costs relative to its competitors? Apparently only daytraders and only for a few minutes!
With no growth in traffic, hemorrhaging $25 million during the first 3 quarters of 2010 and having already burned through $160 million in venture capital funding, according to Xiao Zhixiang of International Data Corporation Youku had no choice but to go public or go bust. In a China Daily article (link here), Xiao states
There is no other option for Youku […] except filing an IPO. If they could not get listed, it would be hard for them to get more venture investment to continue and some video websites hosted by portals and search engines, such as tv.sohu.com and qiyi.com, may surpass them in short time.
To add further confusion, before the IPO, Youku and Goldman Sachs were hoping to get a $1 billion valuation priced at $12.80. Given their knowledge of the financials and the company’s situation, they believed that $12.80 was a fare price. To jump from what was thought to be a fare valuation of $1 billion to over $4 billion in a few weeks is astonishing given Youku’s urgent need to IPO in order to keep their operation afloat.
Obviously from a financial perspective, the bloated valuation of Youku at over $4 billion looks absurd compared to its peers SINA, SOHU, and BIDU, as shown recently by Chimin Sang (here). No matter how you look at it, Youku stock is overvalued and the market is now beginning to realize that Youku’s business model is failing and will continue to fail until the company dramatically downsizes its dreams and shrinks its video offerings until they can be paid for out of its meager advertising revenues.
Three years from now, even at $3 this stock will still not be cheap.
Disclosure: I am short YOKU.