This column originally appeared on CNBC
Chinese online video site Tudou (NASDAQ:TUDO) beat the odds in a terrible market and went public on Wednesday August 17, 2011. Tudou's bankers sold six million American depositary receipts at $29 each. They raised $174 million dollars and gave Tudou an $822 million market capitalization. They probably should have delayed the offering.
Reality about Tudou's business model and financial health set in soon after trading started. Investors recalled the maxim that profits and not dreams eventually determine share price.
Tudou’s shares plummeted 33.7 percent to $19.24 by the end of the first trading week. After all, Tudou has already lost tens of millions of dollars this year and is not expected to turn a profit until 2013 at the earliest.
Its biggest competitor Youku (NYSE:YOKU) has seen its share price nosedive 60 percent from its mid-April peak of $69.95 and remains unprofitable. Even with the share prices drop, I am concerned share prices are still way overvalued and short-selling investors will come crawling out.
Whenever stock analysts mention Tudou or other Chinese internet stocks, all I hear is that China has 480 million internet users, young people with increasing amounts of disposable income. Also mentioned is the fact that millions of Chinese will have Apple iPhones and other smartphones soon and will want to watch videos on the go.
Who cares? Myspace had tens of millions of monthly visitors when Newscorp (NASDAQ:NWS) sold it at a loss. Eyeballs don’t matter if consumers won’t pay for content or if advertisers won’t allocate enough budgets. Even though Tudou boasts clients like Yum Brands (NYSE:YUM), Pepsi (NYSE:PEP) and Procter & Gamble (NYSE:PG), the reality is that most multinational firms’ digital marketing budgets in China remain at only 3 percent to 5 percent, far below the standard 8 percent to 12 percent in the U.S.
That won't change much anytime soon. Yet at the same time, more and more internet sites, from microblogging sites like Sina Weibo (NASDAQ:SINA) to Groupon -like buying sites, are emerging. In other words, there is increased competition for fairly small advertising outlays.
I expected after the IPO, Tudou’s investors and management would talk about how Tudou would use its war chest to develop profits. Instead David Orfao, a Tudou board member and managing director of venture capital firm General Catalyst, focused on what Tudou would buy in an interview with the Wall Street Journal. He said Tudou “ need(s) to continue to buy quality video content. They need to scale their infrastructure. Delivering these videos in a quality manner with minimal delay is key."
The founder of Tudou, Gary Wang, told the blogger Gang Lu after the IPO that the proceeds raised would be used mainly for content, bandwidth and platform upgrades.
Orfao and Wang barely touched upon how Tudou would actually start to generate more revenues and profits, but on how they would buy stuff. That is deeply concerning for a company losing tens of millions a year.
If Tudou can figure out a way to develop a sustainable business model and lower bandwidth and other costs investors might want to take a look especially if the price drops further as they might become a takeover target for well capitalized firms like Baidu (NASDAQ:BIDU).
Aside from not adequately developing a sustainable business model, there are two other risks investors should heed:
First, investors should not underestimate increasing regulatory risk in the internet sphere in China. The government sees video sharing and social media sites as potentially causing instability. With tensions flaring because of severe inflation that hit 6.5 percent last month and with the leadership transition taking place in 2012, the government will increase internet crackdowns.
Second, because budgets for digital marketing are so low, most multinationals outsource decision-making on what media to run advertisements on to media buyers. The dirty little secret in media buying is that they often allocate where they get the best rebates rather than to the most effective advertising channels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.