IPO Preview: Taomee Holdings

| About: Taomee Holdings (TAOM)

Based in Shanghai, China Taomee Holdings (NYSE:TAOM) is scheduling a $72 million IPO with a market capitalization of $362 million at the price range mid-point of $10 for Thursday, June 9, 2011. Each ADS represents 20 ordinary shares The IPO calendar for this week includes two IPOs.

SUMMARY -- TAOM is one of the leading children's entertainment and media companies in China. For the quarter ended March 31, 2011 revenue increased 89% to $12.3 million from $6.5 million from the March 2010 quarter. . Net income for the quarter ended March 31, 2011 increased 152% to $9.1 million from $3.6 million from teh March 2010 quarter.

But TAOM expects a decline in both revenue and profits for the June quarter, see below.

VALUATION -- Except for the uptick in the March 2011 quarter (seasonally strong because of the Chinese New Year and extra school vacation days), performance for the past four quarters has not been impressive. Sequential quarterly growth has plateaued.

At the price range mid-point of $10 TAOM is valued at 20 times adjusted earnings, annualized for the March 2011 quarter, 7.3 times annualized sales and 10.4 times tangible book value.

TAOM Valuatiion Metrics

CONCLUSION -- Because sequential quarterly growth has plateaued and because TAOM expects June quarter results to be less than results for the March 2011 quarter – the question is “Is a P/E of 20 (annualizing the six months ended March 2011) worth the risk?”

Competitors have clearly targeted TAOM and its market, including Tencent, a very large major competitor. Also, consider that China-based stocks have a dismal history in the IPO after market. See our article 23 China IPO disasters

BUSINESS -- TAOM is one of the leading children's entertainment and media companies in China. In 2010, TAOM ranked as the largest online entertainment community for children in China, measured by market share and active accounts, according to the iResearch Report.

RISKS -- The virtual world industry for children, from which TAOM currently derives most of its revenues, is a relatively new and evolving industry and concept. The growth of the virtual world industry for children and the level of demand and market acceptance of TAOM's virtual worlds are subject to a high degree of uncertainty.

TAOM's own new virtual worlds may attract users away from TAOM's established virtual worlds, particularly with respect to virtual worlds with similar story lines.

TAOM relies on distributors to distribute prepaid cards, through which users pay subscription fees and purchase online virtual items. TAOM's distribution agreements are not exclusive and do not prohibit distributors from selling TAOM's competitors' game cards.

TAOM is a holding company, and TAOM relies principally on dividends and other distributions from its subsidiary in China for cash requirements. This arrangement is subject to abuse and has been abused by other companies based in Chna.

REVENUE ISSUES -- TAOM's net revenue decreased slightly in the fourth quarter of 2010, as compared to the third quarter of 2010, as a result of a decrease in net revenues from our online business, primarily due to increased competition as more competitors entered into the market of online virtual communities for children in the second half of 2010. In particular, Tencent offered Roco Kingdom, a virtual world similar to Mole's World and Seer, for free between July 15, 2010 and January 8, 2011; and seasonality factor as there were generally fewer active users in the fourth quarter due to the lack of school vacations.

In the first quarter of 2011, increases in total revenues from the online business was primarily due to the continued success of Seer, the growing popularity of Gong Fu Pai and a third-party online casual game TAOM operates on its platform, increases in ARPU, and seasonality factors.

TAOM EXPECTS DECREASE IN JUNE QUARTER REVENUE & PROFIT -- TAOM expects total net revenues for the second quarter of 2011 to decrease as compared to the first quarter of 2011 primarily due to the seasonality effect.

TAOM also expects to incur higher operating expenses for the second quarter of 2011, primarily due to expansion of the business as well as the accrual of additional expenses as a public company.

As a result of the aforementioned factors and TAOM's US$3.7 million gain recorded for the first quarter of 2011 from disposal of an equity interest in Elyn Corporation in February 2011, TAOM expects net income for the second quarter of 2011 will decrease significantly as compared to the first quarter of 2011.

SEASONALITY -- Seasonal trends in revenue generation as a result of seasonal fluctuations of online play time, which peaks during summer and winter school vacation periods, which usually occur in the first and third quarters of each year when children have more online playtime, and falls during second and fourth quarters of each year. Revenue generally increases during the Chinese New Year holidays, which occurs in the first quarter of each year, when children are given extra pocket money.

COMPETITION -- Principal competitor in online children's entertainment in China is Tencent Holdings Limited (OTCPK:TCTZF), the developer of Roco Kingdom. Other competitors include BaitianInfo Co., Ltd., the developer of Aobi Island, and Zhejiang Bcast Education Software Co., Ltd., the developer of Hezi World.

Potential competitors also include major Internet portal operators, other domestic and foreign virtual world developers and operators, media companies focused on children's entertainment and alliances between TAOM's existing and new competitors.

TAOM's competitors may adopt loss-leading pricing or other tactics or business models, and if these prove to be more attractive to children on a temporary or permanent basis, TAOM's users may switch to competitors' services and products at TAOM's expense.

For example, when Tencent introduced Roco Kingdom on July 15, 2010, it offered a six-month free trial period and did not charge users until January 9, 2011. TAOM believes Roco Kingdom targeted the same user base as TAOM's virtual worlds and the free trial period may have attracted some of TAOM's users to try their product.

USE OF PROCEEDS of $62 million -- $10.0 million for the online business, $10.0 million for the offline business, and the balance to fund working capital and for general corporate purposes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.