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China Economic Review analyses Chinese companies and sectors to produce reports, both custom designed for individual clients and for wider distribution. We conduct analysis that allows for actionable investment decisions. We make use of our extensive local resources, local knowledge and... More
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  • Fool's gold: Why Youku is a sell 1 comment
    Apr 1, 2011 2:38 AM | about stocks: YOKU
    2011-04-11: Youku will encounter significant difficulty. We believe it may survive in the long run, but it will never be able to deliver the profit margins and growth investors seem to expect.
    Foreign investors are clearly very excited about China internet plays. In the case of Youku (YOKU.NASDAQ), dubbed – inaccurately – the “Chinese YouTube,” they have made a sizeable investment in the wrong direction. Youku, YouTube (Google; GOOG.NASDAQ), Ku6 (KUTV.NASDAQ) and Tudou have yet to prove a profitable revenue model for online video. Even if they do, it will never exhibit the same growth characteristics of pure dot-com plays like Google, Facebook or even Baidu (BIDU.NASDAQ). 

    For Youku, growth will always be expensive, and competition will always be intense. Whether the company goes bankrupt or not, its current valuation is based on unrealistic anticipations for profitability, and is thus unsustainable and cannot but erode.

    Youku is not a case of defrauding investors so much as a case of investors fooling themselves. The company has always been upfront about losing money; in 2010 the company lost US$31 million, 12% more than it lost in 2009, and now has a profit margin of -53%. But revenues spiked 183%, and investors ignored the former number in favor of the latter. Youku shares set new record highs following its announcement of fourth quarter results. 
    There are two primary reasons why the company will disappoint investors at its current valuation.

    First, Youku has, and will always have, a high cost structure that makes the marginal cost of adding a new user much higher than your typical dotcom, or even a television station. Every time a video is downloaded, Youku must spend additional money on bandwidth and server resources, and video is the most bandwidth/resource-intensive content one can download. This cost is incurred regardless of whether the company has managed to sell advertisements into the file or not. 

    Youku can use technology to reduce its costs, make its servers more efficient and so on, but the room for improvement is limited. Any cutback on bandwidth would likely drive away users, who demand high quality from online video. And there is no shortage of cheap competition from other sites and from the pirated DVD shops, which holds down advertising revenues per download. 

    Content costs – in the form of licensing fees and administrative overheads – are also high, and increasing as anti-piracy enforcement intensifies. Youku must make sure its members are not uploading pirated videos (which they currently do a lot of) and that they aren’t uploading content banned by Beijing. 

    Of the two, licensing is actually a more serious problem at present. To sell ads, Youku needs to buy content that advertisers are willing to pay to be next to – cat videos don’t count, and pirating from state-owned television is a bad idea, According to Youku’s internal records, the average license fee for television serial drama increased by more than 200% year-on-year in 2009, and by another 100% in 2010. The average license fee for movies also grew by more than 90% year-on-year in 2010. 

    The second issue is competition. There are barriers to entry in this sector: to host an online video platform, one must invest heavily in hardware and bandwidth. But these are only questions of money, and Youku already faces well-heeled competitors in the form of Baidu’s Qiyi and state-owned CCTV. The latter already has an online video product, and Zhejiang TV is creating one as well. 

    Youku is proving the market, showing what works and what does not. When it is clear how to proceed, the content owners will move in. 

    In short, Youku is at present growing into financial difficulty. In the long run it may manage to survive, but it will never deliver the profit margins and growth investors seem to expect, because it can’t. The sooner investors realize this, the sooner its inflated valuation will pop.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Stocks: YOKU
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  • SilverLeaf
    , contributor
    Comments (51) | Send Message
    one word to describe: cuckoo! If you study the price action, it makes you wonder if the shares are being manipulated...
    15 Apr 2011, 12:11 AM Reply Like
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