Summary
- CMCM's headline Q3 once again suggests deteriorating operating metrics and engagement level.
- Competitive pressure heating up from BIDU and QIHU. Expect higher investments ahead.
- Short CMCM. Weak operating metrics makes financial metrics unsustainable.
Event
Cheetah Mobile's (NYSE:CMCM) 3Q14 print was a mixed bag with revenue of Rmb479m (+158% y/y) beating consensus while gross margin decline of -290bps y/y and heavy spending on R&D and marketing hampered the overall profitability. Most important, operating metrics continue to deteriorate with engagement down -350bps sequentially, highlighting the aggressive nature of CMCM's attempt to expand its installment base with the hope of an eventual monetization. Management indicated its intention of investing more on R&D and overseas platform, a strategy which I view will further pressure profitability. Finally, competition from Baidu (NASDAQ:BIDU) and Qihoo (NYSE:QIHU) are ramping up and I believe this will be another headwind for CMCM.
As I mentioned before, CMCM's near-term momentum is based on the expected monetization of its mobile products, particularly from the overseas market, and the faith in Lei Jun to guide the company to success. While Lei Jun has been successful in running Xiaomi, which features a truly unique ecosystem that I view could be competitive against iOS or Android in China, I am skeptical of his role in CMCM in that its cleaner app does not differentiate from that of the competing apps and CMCM's ecosystem is not as sticky as that of Xiaomi's. (Disclosure: the author is a proud owner of Xiaomi smartphone.)
I reiterate my bearish view on the stock. (See: Cheetah Mobile: This Cat Has A Long Way To Go; Initiating With $16 Target, 24% Downside and Cheetah Mobile: Will The Real Clean Master Please Stand Up? )
Highlights
Financial metrics impress the crowd. Revenue growth of +158% y/y was driven by IVAS revenue growth of +344% y/y and online marketing revenue growth of +143% y/y. Mobile revenue growth of +628% y/y to Rmb113 (24% of total revenue) is an encouraging sign that the company's overseas mobile expansion is working. Most impressive, overseas mobile ads now generate $200k in daily revenue. Or is it impressive? To put this metric in perspective, Flappy Bird generates $50k/day in ad revenue.
Operating metrics lag behind. The most concerning aspect of this is the sharp sequential deceleration in MAU growth and engagement metrics. MAU growth of +184% y/y decelerated from +250% y/y in Q2 and current MAU base of 341m implies 39.5% engagement level vs. 43% in Q2. CMCM has been aggressive in installing its app in HTC, Karbon, and Xiaomi's RedMi to expand its installment base. I view this strategy to be dilutive to engagement metrics and engagement metrics could continue to decline in the near-term.
Competitive landscape heating up. BIDU and QIHU have been ramping up their own apps. Baidu's Dianxin now has a 550m installed base, or 64% that of CMCM's base. In terms of engagement metrics, I estimate that Dainxin could have somewhere between 200m-300m MAUs and I expect this metric to increase given the 500m MAU base that BIDU has and the ability to cross-promote Dianxin to its users. QIHU also expanded its mobile security offering and expects to leverage its 641m smartphone user base to take shares away from CMCM. Indeed, the market is getting more competitive and CMCM's investment in opex suggests that further investment is necessary for the company to stay competitive. We can expect further margin pressure to hamper profitability.
Conclusion
Short CMCM. The stock closed flat post earnings, which suggests that rationalization is kicking in and that the market is resetting its expectations. At 73x earnings, valuation continues to remain stretched.
