Four months ago, Cheetah Mobile (NYSE:CMCM) saw its shares debut with little fanfare on the New York stock exchange, with opening-day trading around the IPO price. Shares in fact traded lower in Cheetah's first month, and shares subsequently took a sharp dive thanks to soft earnings in its inaugural quarter as a publicly-listed company. Xunlei (NASDAQ:XNET) has followed a similar trajectory since coming public. The stock launched around 14 and almost immediately headed south, falling under 10 heading into the company's first earnings report as a public company. For a company with $7/per share of cash the company's current $11/share valuation is surprisingly low. 2/3rds of the company's market cap is covered by its cash balance.
Both Cheetah and Xunlei experienced rocky trading initially following the IPO. What happened next? For Cheetah, its earnings miss would be the last time it traded near to its IPO price. JP Morgan launched coverage in June, sending the stock from 16 to 20 in a single day. Shares would continue to trade higher, heading to as high as 30 following last quarter's earnings. All in all, buyers around Cheetah's IPO price have doubled their money in just a few months. For investors that didn't take part in that trade or want to repeat the experience, Xunlei offers another opportunity to buy into a Chinese internet apps and utilities play that has experienced the initial post-IPO doldrums and is now ready for the post-earnings rally.
Cheetah and Xunlei are extremely similar companies, sharing numerous key characteristics. Both are leading Chinese internet properties. Both rely on key relationships with China's own version of Steve Jobs, Lei Jun. Both have distinctly unsexy businesses. Both have significant untapped opportunities from partnerships with Xiaomi - the world's fastest growing smartphone maker. Both are deeply embedded within a most profitable web of interlocking relationships between leading Chinese players such as Xiaomi, Kingsoft, and Tencent. Both are almost entirely reliant on desktop-driven revenues at the moment but have vast opportunities to monetize mobile revenue in coming quarters. And both traded poorly following their respective IPOs. Cheetah has obviously gotten its act together, as investor awareness has increased the stock promptly doubled. Xunlei hasn't had that happen … yet.
Cheetah And Xunlei: Similarly-Sized Leading Chinese Properties
Cheetah Mobile is known for its suite of various internet applications, the leading of these include Clean Master, Battery Doctor, the Cheetah Browser. Cheetah primarily provides unglitzy services such as security, cleaning, and battery life extension. Cheetah has a combined 362 million monthly active users as of March 2014, of which roughly 250 million reside in China. Cheetah is also the #2 internet security provider in China, according to iResearch.
Xunlei is primarily known for its accelerator product which clocks in 204 million unique users and 142 million active users. The accelerator product has 84% market share in its category. Xunlei's Kankan video platform also scores 136 million active monthly users. The company also has a subscription video service with a growing user base and it also offers web gaming. In all, Xunlei has 300 million monthly users, which places it amongst the ten largest Chinese internet companies.
On the whole, both companies have attracted 300 million or so monthly users providing unglamorous utility services. Both companies have had similar success with monetization as well. Xunlei has more than doubled revenues over the last two years growing from $87 million in 2011 to $180 million for 2013. Cheetah by comparison did $124 million in revenues in 2013, and will roughly double that figure for 2014. Based on most recent 12 months ending June 2014, both companies have generated $180 million in sales for that time span. So, both companies have similarly-sized user bases and generate the same amount of revenues. Surprisingly, however, Cheetah trades at roughly 12 times the enterprise value of Xunlei for similarly-sized businesses in the same space.
We'll explain why this value discrepancy exists, and when and how this gap will be closed further on in this article. But first, we should discuss Lei Jun, the Chinese entrepreneur whose involvement in both Cheetah and Xunlei has made both companies into compelling investments for American shareholders.
Lei Jun: Meet China's Steve Jobs
Now that Steve Jobs is no longer with us, Xiaomi CEO Lei Jun is arguably the most dynamic personality in the worldwide smartphone space. Lei Jun has been widely compared to Apple's famous visionary in leading sources such as Bloomberg, Fortune, and the New York Times. The comparison has become so widespread, in fact, that Mr. Jun has complained about the constant comparisons to Mr. Jobs.
In any case, Mr. Jun's Xiaomi in just 4 years has gone from its founding to being the biggest smartphone maker in China, already worth in excess of $10 billion, and Mr. Jun's net worth has swelled to $4.7 billion personally.
In case Xiaomi weren't enough, Mr. Jun has been busy making a second fortune through his activities with Kingsoft. Prior to founding Mr. Jun was president and CEO of Kingsoft, a leading Chinese software provider, from 1998 until 2007. He now serves as Kingsoft's chairman of the board and he serves as a director of various Kingsoft subsidiaries. As if that weren't enough, in addition he is chairman of the board and co-founder of YY.com (NASDAQ:YY) which itself is another $5 billion market cap Chinese internet property. Needless to say this guy is well-connected and has the Midas Touch as far as Chinese investors go.
Lei Jun: The Cheetah/Xunlei Connection
Unfortunately for American investors, only one of Lei Jun's principal companies - YY.com - is publicly listed in the US. Xiaomi, the crown jewel, is still privately held, and Kingsoft is only listed in Hong Kong. Investors wanting to share in Mr. Jun's rising fortunes have had few options to participate alongside China's Steve Jobs. Xiaomi has gone from zero to $10 billion in four years. Kingsoft stock is up a cool 504% over the past two years in Hong Kong. And YY.com has risen from $15/share two years ago to $85/share today. Obviously investing aside Mr. Jun has been a most excellent practice.
The listing of Cheetah Mobile and Xunlei have now given investors two new Jun-backed companies to invest in, both with convenient US stock listings. Cheetah Mobile was originally founded inside Kingsoft serving as its security division. Kingsoft decided to refocus its operations, and realized that spinning off Cheetah would likely lead to a better combined valuation for its component companies. Given that Cheetah has doubled in its first four months as a public company, this hunch played out most accurately. Lei Jun's fingerprints are all over Cheetah, as he is obviously deeply involved with corporate parent Kingsoft, and Jun has also served since 2011 as Cheetah's chairman of the Board of Directors, a post he still holds to this day.
For Xunlei, Lei Jun's involvement has just begun. And as of yet, the market seems unaware of this development, in any case, Xunlei has yet to experience the effects of Mr. Jun's Midas Touch. Xunlei's stock is the only of Mr. Jun's properties that hasn't yet turned to gold.
Jun's involvement with Xunlei began this March, when Xunlei raised $310 million in its last venture financing round prior to the IPO. Lei Jun accounted for nearly all of this money. Jun's flagship company Xiaomi accounted for the lion's share of the round, contributing $200 million, meanwhile Jun's other primary company, Kingsoft contributed $90 million. In all, Jun accounted for $290 million of the $310 million financing round. Prior to the IPO, Xiaomi was Xunlei's largest holder, with 27% of the stock outstanding, and Kingsoft owned another 12%.
Since the IPO, Xiaomi has entrenched itself further into Xunlei's affairs, uping its ownership stake from 27% to 41%. Between Xiaomi's dominant stake and Kingsoft's further sizable chunk, Lei Jun for all intents and purposes has control over Xunlei and can lead it wherever he may wish. For Xunlei's investors, this is a most exciting prospect particularly since Xunlei has struggled with a lack of focus and a shifting business plan over the years. Now under the steady control of one of China's leading businessmen, the future is much brighter.
Xunlei and Cheetah: Conquering the Mobile Frontier
As noted above, Xunlei and Cheetah share a lot of similarities. But there's one key difference, the reason why Cheetah is merely an interesting growth story whereas Xunlei is one of the best bargains listed in New York. The simple fact is that though Xunlei and Cheetah have similar sized businesses and user bases (and for what it's worth, Xunlei is more profitable), Cheetah trades at 12x Xunlei's enterprise value!
There is one word that explains the difference: mobile. Cheetah Mobile made this obvious by aspirationally affixing the word "mobile" to its corporate name even though virtually all of its revenue come at present from desktop, not mobile. But the future for Cheetah is clearly in mobile, its mobile user base is growing rapidly, and mobile revenues are starting to emerge as the company begins a concentrated effort to monetize its mobile user base.
Xunlei, by contrast, has not yet begun serious monetization of mobile. Its revenue base comes primarily from ads it serves up to free users of its accelerator product, and also from subscription revenues for the paid version of the accelerator product and subscribers to the video on demand service. This is changing however, Xunlei has announced its new business strategy that will make it a leading cross-platform content distributor. How will Xunlei accomplish this? Certainly there are plenty of competing content ecosystems out there.
Here's where the Lei Jun connection comes into play. Xiaomi is the world's fastest growing smartphone maker, having sold its first smartphone in 2011 it's already up to 60 million units of sales in 2014. A truly stunning rate of growth. 2015 will see it topping 100 million phones, passing Apple's global sales, making it #2 smartphone marker in the world. Xiaomi is already China's #1 phone maker, having just passed Lenovo and Samsung for that honor. Xiaomi is also a leading Chinese SmartTV maker, and furthermore Xiaomi is entering the tablet space.
Xiaomi has apparently decided to make Xunlei its effective subsidiary. Xiaomi attempted to build some of Xunlei's content business independently, for example, Xiaomi launched its own Web TV service back in 2012, but had to shutter it thanks to government regulation. Xiaomi's investment in cloud computing also seems to have been a bust - another area where Xunlei has aggressively expanded recently. Xiaomi, which sells its hardware at near cost, needs to figure out some way to monetize its massive user base. With its organic attempts to build media and software in house struggling, Xiaomi appears to have decided to outsource this, taking a dominant stake in Xunlei and using it as its media and software subsidiary.
Xunlei's various products will now come pre-loaded on Xiaomi's 60 million a year and growing smartphone base along with its smartTVs and tablets. For Xunlei, which has until now been nearly entirely dependent on desktop revenue, these new markets offer a transformational shift for its prospects. Xunlei's valuation is presently depressed because investors view it as a slow-growing desktop play. When Xunlei starts to cash in on its new mobile position, investors will ratchet up their assessments of Xunlei's value. One more thought, as Xiaomi takes over the Chinese smartTV space - a field with a CAGR growth rate of nearly 100% over the next 4 years - Xunlei will have the opportunity to serve up its video website and subscription video service on all those smartTVs. That could quickly turn into a most beneficial of situations for Xunlei.
We're not going to go far as to say that Xunlei will ever be valued at the same enterprise value that Cheetah fetches, but any closing of the gap will reward Xunlei shareholders greatly. At present, Xunlei's enterprise is valued at roughly 8% of Cheetah's, despite their same-sized user bases and revenues.
Xunlei sports a market cap of $720 million, and has $450 million of cash on its balance sheet, meaning the business is only being valued at roughly $270 million. Cheetah's enterprise is valued at north of $3 billion. If Xunlei's operations were worth 1/5th of Cheetah's business, Xunlei shares would be worth $17, if Xunlei were worth 1/3rd of Cheetah, Xunlei shares would come in at $23.50, a Xunlei worth half of Cheetah computes to $32/share, and a Xunlei that drew 2/3rds the enterprise value of Cheetah would be worth $40/share.
What's the correct valuation ratio between Xunlei and Cheetah? You can make a decent case for a variety of ratios, but the market's present 8% ratio surely isn't the right number. Xunlei has the same user base, revenues, more profitability, and the same key involvement of China's rainmaker Lei Jun as Cheetah, and yet it is valued as if there's something gravely wrong with the underlying business. Backing out the half billion in cash, Xunlei sells at just 1.5x its sales, which is preposterously low for a profitable top 10 Chinese website. Other recent vintage Chinese web IPOs such as Leju (NYSE:LEJU), Zhaopin (NYSE:ZPIN), iDreamSky (NASDAQ:DSKY), Sungy Mobile (NASDAQ:GOMO), and Cheetah Mobile all trade north of, and in many cases well north of 4x sales.
On the absolute worst case, value Xunlei's entire business at zero. Precisely zero. The web accelerator fades off into the sunset as Chinese internet pipes suddenly take a quantum leap forward in speed. The video website gets shut down by government regulation or something. The Xiaomi partnership entirely collapses for reasons unknown. The entire business, currently a top 10 Chinese web property all implodes. Worst case, you value Xunlei at only its cash, arriving at a valuation of $7/share.
Xunlei's Massive Upside: Likely a Double or Better
There's your worst-case scenario, $7/share, and it'd take a long series of utter fiascos to get there. Whereas based on its Chinese web peers, Xunlei should be trading at $20-25/share minimum. The risk/reward here is truly incredible. If Xunlei follows Cheetah's course, doubling after a soft-post IPO period, Xunlei trades in the mid-20s before year end 2014. Returns on December 2014 XNET call options would exceed 10x should Xunlei follow Cheetah's footsteps.
Out of Lei Jun's primary investments, the poorest performer over the past two years is YY.com, which is up only 400% or so. If Xunlei hits that, let alone Kingsoft or Xiaomi levels of success, Xunlei trades in the 50s. While they may sound downright crazy, consider that Chinese web plays including Qihoo 360 (NYSE:QIHU), YY.com , Kingsoft, and Vipshop (NYSE:VIPS) have all quintupled over the past two years. If Xunlai can execute the integration with Xiaomi correctly, there's nothing stopping it from seeing similar gains.
Hot Chinese web properties that execute their businesses properly make for most excellent investments. Xunlei is set to follow in Cheetah Mobile's footsteps, doubling over the next quarter and in the longer run potentially heading much higher than that. With China's Steve Jobs intimately involved in Xunlei's affairs, and the company just now rolling out its new mobile and smartTV strategy that will fundamentally transform Xunlei from a sleepy desktop play into Xiaomi's media/software arm, the stage is set for truly explosive gains in the company's shares in the near future.
Disclosure: The author is long XNET, CMCM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.