4 China Internet Stock Opportunities

by: GuruFundPicks

The average China Internet stock fell almost 30% last month as a perfect tsunami hit the group, including global macro-economic issues, a slight contraction in the Chinese manufacturing sector, government censorship, regulatory concerns, and finally capped off by reports suggesting that U.S. authorities are investigating accounting irregularities at many U.S.-listed Chinese companies.

While the Chinese Internet stocks have never been for the faint-hearted, the volatility and repeated steep plunges last month were enough to challenge into submission even the most audacious market players. While one has to tread carefully among the rubble, the near collapse in the group also presents an opportunity to buy many of these Chinese Internet companies at prices not seen since over two years ago. The following is our review of some of the best opportunities in the group:

Buy Baidu Inc. (NASDAQ:BIDU): BIDU is a leading Chinese provider of internet search, targeted online advertising and other internet content services. Often touted as the Google (NASDAQ:GOOG) of China, its shares were the highest dollar losers in the group, falling 27.5%, or losing $14.0 billion, in market-cap last month.

Now trading at just over 24 forward price-to-earnings (P/E) ratio, we believe that this is by far the best opportunity in the group. Not only is it trading at a heavy discount to projected earnings growth of 65%-70% between 2010 and 2012, but also it may be the safest in the group. Its growth is closely tied to the fast-growing Chinese economy where Internet users and usage are expected to remain in a strong growth trajectory for the coming decades, relatively immune to global macro-economic turmoil in the developed economies.

Furthermore, it has a dominant share of the Chinese Internet search market that it can capitalize on with more services, ala GOOG. And finally, as one of the largest Chinese companies trading in the U.S. market, it is owned and has been vetted by most large and sophisticated hedge and mutual funds, and hence has minimal fraud risk. This makes BIDU’s steep near 15% plunge last week, after reports surfaced mid-week that U.S. authorities were investigating accounting irregularities at U.S.-listed Chinese companies, irrational.

We believe that BIDU shares have been unfairly pulled down as turmoil hit the group last month. As explained above, BIDU is relatively immune to slowdown risks, and it does not have the same risk profile as lesser-known and smaller Chinese companies. Current share prices offer a once-in-a-long-time opportunity to buy a high growth company in a high growth sector of the fastest growing economy in the world at deep value prices. With BIDU shares currently in free-fall, normally we would recommend buying it in stages, but we make an exception in this case as we believe that the discount offered at the end of last week is an aberration and will not last for long.

As a comparison, GOOG shares in 2004, when revenues, earnings and growth were comparable to BIDU today, were trading at a market-cap in the $40 billion range, compared to BIDU's current $37 billion market valuation at Friday’s closing price. GOOG shares subsequently rose five-fold in the next five years.

Buy Renren Inc. (NYSE:RENN): RENN, often called the Facebook of China, is a Chinese operator of a social networking platform that enables users to communicate and share information via Renren.com. Its shares fell 30.5% last month, not on any company-specific news, but amid broad based selling in the group. We reviewed RENN last week, arguing that at $5 RENN is a compelling buying opportunity.

RENN was a huge relative outperformer last week, falling only 3.2% while the group on average dropped almost 10.0%. The outperformance was at least in part as the company announced on Monday after the market closed that it was acquiring Chinese online video sharing site 56.com for $80 million in cash, where users can upload, view, and share videos. The acquisition strengthens RENN’s competitive position as it marks its entry into the high growth online video advertising market, thereby enabling it to compete with Youku (NYSE:YOKU) and Sohu.com (NASDAQ:SOHU).

We continue to believe that RENN, with over a 50% market share of the China social networking space, growing at over 60% in revenue, and with over $1.2 billion or over $3 per share in cash and short-term investments (and no debt), is a compelling buy at $5. Furthermore, on a comparables basis, RENN is extremely under-valued, trading at a cash-adjusted valuation of less than $1 billion, a fraction of Facebook’s current valuation in the $50+ billion range.

Buy Sohu.com Inc. (SOHU): SOHU is the third largest internet portal and a leading brand in China. It offers Chinese language web navigational and search capabilities, twelve main content channels, Web-based communications and community services, and a platform for e-commerce services. Its fall last month was among the sharpest declines in the group, falling 40.9%, including a 17.3% rate during the week.

We believe SOHU is a compelling buy at current levels, especially in comparison to its peer Sina Corporation (NASDAQ:SINA). At Friday’s closing price of $48.20, it trades at a forward 8 P/E, while earnings are projected to grow at 17% compounded growth between $4.21 in 2010 and a projected $5.76 in 2012. In comparison, its closest peer SINA trades at a 44 forward P/E, while earnings are projected to be almost flat between $1.56 in 2008, $1.73 in 2010 and a projected $1.61 in 2012. Furthermore, SOHU has consistently beaten earnings estimates every quarter for the last six quarters, including a 9c beat in the latest June 2011 quarter.

We believe that SOHU is a bargain at Friday’s closing price of $48.30, trading at a range it first traded at in 2007 when earnings at $1.11 in 2007 were a fourth of current levels. Further, its forward P/E at 8 is a steep discount to both its closest peer SINA, and to its own growth rate. Technically too, the stock is over-sold and is ready for a rebound. Just like BIDU above, we believe that SOHU shares here are a screaming buy, and the discount being currently offered is an aberration and will not last for long.

We covered its peer SINA last week, recommending a sell on the basis of valuation and concerns about Chinese government threats to its twitter-like Weibo service. We believe that one could construct a hedge-like long SOHU / short SINA paired trade as a way to play the China Internet space.

Buy E-commerce China Dangdang (NYSE:DANG): DANG is a Chinese online retailer offering books and other media, personal care and general merchandise via Dangdang.com. Often called the Amazon (NASDAQ:AMZN) of China, DANG is the number two e-Commerce player in China, behind TaoBao. Its business model is similar to AMZN except that it employs a courier-based delivery system that collects cash on delivery. Its shares suffered the most severe losses at 57.4% last quarter, with most of the losses after it reported a disappointing June quarter on August 16th, missing earnings estimates (6c losses versus 2c loss estimate), while narrowly beating revenue estimates ($122.3 million and $120.6 million) and guiding September revenue higher (RMB 916-928 million versus RMB 895 million).

We believe that DANG shares are a bargain at Friday’s closing price of $4.94, now down over 85% from the $34.46 peak that the shares hit in the days after the IPO in December 2010. As we explained in a prior article, we believe that the June quarter miss was a part of the growing pains challenge as the company ventures into the general merchandise category and strengthens its fulfillment capabilities. Overall, its shares trade at a steep discount compared to when AMZN was in a similar growth trajectory, and hence we would be buyers here.

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