YY's Shares Have Fallen Off Too Much

Summary

• Investors were apparently disappointed by Q4 figures and outlook, as the shares sold off substantially.
• Growth is indeed slowing down a tad but it is still very solid, and competitive worries are overblown according to management.
• The company still has numerous expansion opportunities and the shares are fairly cheap.

YY (NASDAQ:YY) is a Chinese life streaming media company where people perform life (a big hit in China) and play games (their Huya platform, which the company is about to spin off).

Fortunes seem to have shifted quite a bit with the share price off considerably the last month:

The shares have given up 40% or so (at the time of writing) since the peak only a month ago. This seems somewhat surprising in the light of fundamental performance:

YY Revenue (TTM) data by YCharts

The company has been growing rapidly on all metrics in the past five years. The stock price seems to have reacted negatively to the Q4 figures, out early March.

It's not entirely clear what caused this investor disappointment:

• Non-GAAP diluted net income per ADS increased by 45.2% to RMB14.77 or US$2.27, which was a considerable beat by $0.43.
• Revenues grew by 46% in the quarter and also produced a (slight) beat of expectations.

Yet there are indications of a growth slowdown:

• Q1 Revenue guidance wasn't particularly strong although management blames this largely on shifting holiday (Chinese Spring festival) dates.
• The growth in the total paying users is also slowing down with an increase of 25% in Q4 to 6.5M.

We think this is to be expected as a consequence of the law of large numbers and a maturing market with new entrants, but it looks like investors were hoping for a little more.

Expansion

The company still has significant expansion possibilities:

• Globally, as live streaming is still in its infancy worldwide. Management is looking at the opportunities, even in the US.
• New users, for instance, broadening the content to appeal to newer generations, as the company is doing with Happy Go (a casual game collection platform) and Happy Basketball and upcoming Happy Contest.
• Acquisitions, the company has a pile of cash and has just sold its stake in Tantan (which was sold to Momo).
• New content, like education (in its infancy) or short videos.
• New technology, like the use of AI embedded in casual games like Happy Basketball, which was a hit, or their online/offline combination.
• Advertisement, there is fast growth already, albeit from a small base.
• Ways to convert more users into paying users.

This list is by no means complete of course. We should not forget that this is an Internet platform that gathers a whole host of eyeballs. As such, it is offering management opportunities to come up with different manners to monetize these eyeballs. Life streaming and games are obvious ways, but they have a platform to throw things up and see what works.

Another thing that is in the works is the IPO of Huya, that has now been filed, so this train is set in motion. Apparently this can fetch up to $200M. Also, some details have been made public from that business (from Reuters):

* HUYA INC SAYS HAD 86.7 MILLION AVERAGE MAUS IN Q4 2017, REPRESENTING INCREASE OF 17.2% FROM 74.0 MILLION AVERAGE MAUS IN Q4 2016

* HUYA INC SAYS HAD 38.8 MILLION AVERAGE MOBILE MAUS IN Q4 2017, INCREASE OF 47.6% FROM 26.3 MILLION IN Q4 2016

One can compare these with the combined figures:

• Mobile live streaming MAU increased by 36.6% year over year to 76.5 million.
• Total live streaming paying users increased by 25% year over year to 6.5 million.

So at least on mobile, YY Live and Huya are of equal size.

Risk factors

We see a number of risk factors, the usual suspects:

• Increasing competition and margin pressure as a result of increasing revenue sharing.
• Maturing market and slowing growth.
• Increased government regulation.

New players continue to enter the live streaming market, this time around with big Internet platforms. Here is what management had to say on that (Q4CC):

Actually, the competition in live streaming is always there and we have gone through several cycles. I think the recent trend of some big players coming into this live streaming actually is good for us, because it arouses more people’s interest and actually helps converting more ordinary people into streaming viewers. So I think in general that’s good for the industry, and that’s only good for the big players by the way due to recognition concerns, but it will be tougher and tougher for smaller players.

Investors don't seem entirely reassured by this, and we have some sympathy for that. On the possibility of higher revenue sharing (as a result of the competitive pressures), management had this to say (Q4CC):

There is abundant supply in China for top quality music and dance or other category kind of entertainment live streaming host, so we don’t think there will be a lot of pressure in terms of acquisition of those hosts.

Management also predicted margins will be stable and mentioned a community feeling, which suggests some (emotional) switching cost, but that doesn't eliminate the problem of getting new people to join in a more competitive landscape.

There are also players venturing out from their stronghold in the short-video space such as Kwaish, Bini Bini and Huoshan. We'll give you the full answer from management, as we're not entirely sure what conclusions to draw from it (Q4CC):

In terms of the development of the short form videos, we know notice for the short form video content is more like FMCGs, which is useful for the short-term of the consumptions. But in terms of the live streaming content that is more immersed kind of more of a company related of kind of content. So that’s what we think in terms of the consumption of that usage. Going forward definitely it will be converts from those kind of cell phone video fast -- FMCG types of the consumption into the immersive consumption which is coming from the live broadcasting in the long run. So for our practice, the success of other cell phone video platforms, we are still very confident of obtaining of and retaining the subscribers from those kind of -- from the live streaming of the services going forward.

As the immersion level differs quite notably, there are different audiences but whether that is a sufficient barriers for these players not to make inroads to the life streaming market we don't think that's necessarily the case.

On the other hand, YY itself is hosting short videos, and the numbers are increasing pretty rapidly (Q4CC):

In terms of the updates of the short form videos, so the first maybe the short form section end of the YY Live which is -- its video views number has been continue to double in the last quarter compared to the previous three quarter.

Guidance

Revenue growth will be between 32.3% and 39%, which indicates a slowdown in growth, but we would argue is still rather substantial.

Margins

YY Gross Profit Margin (Quarterly) data by YCharts

The fall in the gross profit margin has been arrested the last two years suggesting that revenue share rates have stabilized.

One should keep in mind that for the year, there was $39.6M in share based compensation, which creates a bit of a wedge between GAAP and non-GAAP figures.

GAAP net income was $383.2M, adding the share based compensation arrives exactly at adjusted net income of $422.8M. At just 2.2% of revenues ($1782M), it really isn't a big deal, we've seen far worse.

Cost of revenue increased by 40.8% (y/y), revenue sharing fees and content cost increased by 49.6% (y/y) in Q4. That still slightly slower than revenue growth, so gross margin increased to 39.4% from 37.2% a year ago.

There was considerable operational leverage as operating expenses only increased by 31.8% (the GAAP figure is 32.2%). Non-GAAP operating margin increased from 26.1% a year ago to 28.4% in Q4. GAAP margins decreased from 25% a year ago to 22.7% in Q4 (as is depicted in the graph above).

Cash and balance sheet

The company generated $559.1M in cash from operations in 2017, $213.9M of that in Q4. Its balance sheet is cash rich, from the earnings PR:

As of December 31, 2017, the Company had cash and cash equivalents of RMB2,617.4 million (US$402.3 million), short-term deposits of RMB6,000.1 million (US$922.2 million), and restricted short-term deposits of RMB1,000.0 million (US$153.7 million).

That's cash and cash equivalents of $1.478B, really a quite substantial $21 per share with no debt.

Valuation

YY PE Ratio (TTM) data by YCharts

We continue to think that valuation levels are fairly modest for the growth rate the company is growing at. One also has to realize that the metrics in the graph above are backward looking and GAAP figures and as such they have absorbed a hefty dose of stock-based compensation. On a non-GAAP basis, the company is substantially more profitable.

What could explain this modest valuation? No doubt a China discount as well as the other risk factors we mentioned in the article above. Still, the graph below is pretty impressive:

YY EPS Diluted (TTM) data by YCharts

And non-GAAP EPS per ADS increased 57.2% in 2017 to $7.00 (the GAAP figure is $6.35). Analyst expect this to rise modestly to $8.18 in 2018 and $10.07 in 2019.

Even at the GAAP EPS of $6.35 for the past year, the shares are really fairly cheap, given the growth rate of the company. But we do warn that we noticed in a previous article how between 2014 and 2016 the shares basically halved in price while the growth and financial performance was stellar. Below is a reminder:

Conclusion

Given the growth rates, even if these are slowing down the company is still solidly growing. Further, it has a very solid balance sheet so the shares really are rather modestly priced.

We feel there are a number of risk factors that explain part of that, but with the expanding track record and continuous evolution and innovation of the company, we think the shares are too cheap.

Then there is the possibility of the spin-off of their Huya platform which could provide a bit of a cash bonanza for the company, depending on the exact nature of their plans.

It isn't our favorite stock in the Chinese Internet space (which is Baozun, which is even cheaper on an EV/S basis and has a much longer growth path, in our view), but we see these shares as under-prized.

Our biggest worry here is actually the erratic movement of the share price, which for a lengthy period seemed to have no relation to the company's financial performance.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in YY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.