YY: The Most Important Metrics That Nobody Is Talking About

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About: YY Inc. (YY), Includes: HUYA, MOMO
by: JG Investment Research
Summary

Why the JPMorgan downgrade does not make sense.

Nobody is talking about these important metrics.

Total live streaming paying users and monthly active users made its biggest jump in company history.

YY's investment in BIGO is about to pay off.

Shares remain undervalued!

Investment Thesis

Shares of Chinese tech companies in the U.S. have fallen sharply over the past couple of months due to trade war fears between the United States and China. One of the most beaten down companies right now is YY (YY) - one of China's top social media companies. So far, this year, shares have fallen by more than 50% since hitting an all-time high of $142.97 earlier this year.

"Buy low, sell high" is the famous adage on Wall Street, and it's exactly that time again for investors in YY. Here's why we believe contrarian investors stand to make a great return at these prices.

The Metrics Nobody Is Talking About

As we pointed out YY reported Q3 earnings that beat Wall Street expectations on both the top and bottom lines last week. Revenues increased 32.6% to $597 million to go with earnings per share of $1.76. This topped analyst expectations of $576.8 million and EPS of $1.67.

However, the biggest takeaway that nobody has been talking about is the massive growth in YY's live streaming user base this past quarter. In the table below, you will see the big jumps in the company's monthly active users ("MAU") in Q3 2018, as well the sharp increase in the number of paying users.

Q3 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018
Monthly Active Users 73.0M 76.5M 77.6M 80.2M 88.1M
Streaming Paying Users 6.3M 6.5M 6.9M 6.9M 8.0M

* Data compiled from YY's earnings report

Despite all the negative headlines and trade war rumors, YY remains one of the top social media platforms in China and continues to grow in popularity with each passing quarter.

As the table above shows, Q3's results were significant for YY as the company reported phenomenal numbers. First, its user base grew at record levels jumping from 80.2 million in Q2, to 88.1 million in Q3. That's nearly double than what the company has ever seen since its IPO debut in 2012.

Live streaming paying users also saw its biggest spike in company history as it jumped from 6.9 million in Q2, to 8.0 million in Q3. With paying users growing just 3% from Q3 to Q4 in 2017, 6% from Q4 to Q1 and seeing paying users stay flat from Q1 to Q2 this year, YY's 16% growth in paying users for Q3 deserves some much needed attention as the company ramps up its efforts to increase users and the revenues that follow.

Management stated on the conference call that the company was able to continue executing its growth strategy in three key areas: 1) Content enrichment and upgrades; 2) Product enhancements; 3) Artificial intelligence. These key areas will help the company see higher user growth and stickiness, which in turn, will create more monetization opportunities.

Through its new and improved algorithms, which have increased user stickiness and better monetization opportunities by matching what each customer wants to see, the average time spent on YY Live has dramatically increased compared to last quarter. Management also mentioned that it's utilizing its network technology to quantify the level of interaction between host and fans, by motivating hosts to produce new and engaging content to boost or sustain their popularity ranking. This has led to the huge increase in the number of monthly active users as well as the number of paying users which saw record growth this past quarter.

Bing Jin, YY's Chief Financial Officer told analysts this on the call about user growth and paying users:

"In terms of paying user growth, we saw healthy growth in the third quarter, due to several reasons: we continue to add new features and have also integrated some of the operation activities to drive the paying user behavior. Currently, we have integrated a lot of AI-driven mechanisms in terms of matching the best quality content for each audience, so that whenever they view the content, they feel more comfortable when they pay. In the future, we will continue to add new features and also we'll continue to integrate more and more AI machine learning capabilities, hopefully, to continue to drive the paying regional. As I said to many investors and analysts before, in terms of paying ratio, we still have massive room for growth."

With talk of a slowdown, YY bucked the short notion with another standout quarter. As we've said before, the ongoing saga between the United States and China has sent shares of Chinese companies - including YY - tumbling, despite it having little impact on the company's business model. Despite all the naysayers, recent tariffs on steel, aluminum, furniture and appliances aren't going to derail YY and Q3 showed that with a record-setting quarter.

Huya/Bigo

This year, YY spun off its live streaming gaming unit Huya (HUYA), which is currently the second largest game streaming platform in China. Shares were priced at $12 during its IPO, valuing the company around $2 billion. Since then, shares initially climbed as high as $50 per share for a valuation of $10 billion this past summer.

Currently, shares are trading around $17 per share, putting the company's market capitalization at $3.6 billion. In March, Tencent invested $461 million for a stake in HUYA and has the right to purchase 50.1 percent of the voting power in the next 2-3 years.

So, what does this have to do with Bigo? First off, it shows that YY knows how to successfully grow its platforms and that investors should have confidence in management which looks to deliver the next big thing with Bigo.

Bigo, a Singapore-based company which operates live streaming app Bigo Live, received a big boost when YY invested $272 million into the company during a series D round this summer. Also significant is that David Li, the founder and acting CEO of YY, used his personal funds to join the round too. This should only emphasize just how confident management is about the company and its future prospects.

When asked to describe itself, Bigo's management team stated that its product is a combination of Huya, YY, and Momo (MOMO), which incorporates the features of game streaming, pan-entertainment streaming and stranger social networking.

According to reports, Bigo quickly outgrew its boarder and is now a global company. Bigo Live is one of the top social media apps in the world with strongholds throughout Asia, including India, Thailand, and Indonesia, as well as countries such as Brazil, Australia, Saudi Arabia, and Pakistan.

Most notably about the investment is that YY not only has become the largest shareholder, but has now obtained the right to purchase a majority share (50.1%) in the startup, which can be exercised in May of 2019.

With a user base soaring to over 200 million users, and with over 40 million monthly active users, Bigo doesn't show any signs of slowing down. In Q1 last year, Bigo had just over 60 million total users, and since that time, Bigo has more than tripled its user base.

We believe Bigo is going to be a huge catalyst for YY going forward and that many investors and analysts are not even factoring in its potential. With over 200 million users, Bigo is expected to do $1 billion in revenue in 2018 with profits north of $200 million. Sorry shorts, so much for a slowdown!

YY/Xiaomi Agreement

As we've already noted in a previous article, the solid growth in YY's user base reflects the company's ongoing efforts to expand and grow its platform. One of the biggest surprises on earnings day was the company's announcement that it has entered into a strategic cooperation agreement with Xiaomi. This is just another positive catalyst for the company as it spreads its wings.

This, of course, gives YY the exclusive right to operate entertainment live streaming services on Xiaomi's platforms. Both parties stand to benefit tremendously from the monetization opportunities and will help YY continue to grow its market share and future growth.

Xiaomi is the fourth-largest smartphone maker in the world. The company sold 92 million smartphones in 2017, nearly doubling its sales in 2016 from 53 million. In Q2 this year, the company sold 32 million phones. Overall, the company is on track to sell more than 100 million phones in 2018, with 2019 looking to be an even bigger year.

Even if YY was able to convert just 5%-10% of those customers into dedicated users, the company would be looking at significant growth, more than doubling its total live streaming paying users at the moment.

The strategic cooperation also means that Xiaomi bears all the front-end costs with YY being responsible for managing the deals, content, etc. With the front end being managed by Xiaomi, YY does not bear additional costs in the cooperation, which is great news for shareholders.

Q4 earnings won't see much of an impact as the cooperation starts in December and will take some time to get it up to scale. Lastly, with what management has been able to do, there is no reason to doubt in what looks to be great growth opportunities for 2019, 2020, and beyond.

"YY" The Downgrade?

On Tuesday, JPMorgan analyst Alex Yao downgraded YY, Inc. from Overweight to Neutral and cut his price target from $85 to $70, implying upside of just 6-7% from Wednesday's closing price ($65.61).

As we noted in past articles, analysts always seem to be late to the game with YY. In the report, Yao downgraded shares because he believes the company has a lack of catalysts in the near future and because he expects growth to dramatically slow in YY Live in 2019. We don't believe this is the case as we've outlined already in this article with Bigo and the Xiaomi Agreement.

Earlier this year, Yao upgraded shares of YY to overweight and were given a price target increase from $70 to $140. It was raised to $155 this summer before shares were downgraded to $70 last week. This isn't a knock on Yao but goes to show that the price target volatility leads us to believe that a number of analysts do not fully understand YY's true value.

We feel the downgrade is mostly due to the way shares have traded the last few months and is not directly tied to YY fundamentals, as well as how the company has positioned itself for future growth. Remember, YY has beaten analyst estimates every single time this year which is why the downgrade is so surprising and perplexing at the moment.

Conclusion/Risks

Make no mistake, YY is currently trading at a cheap valuation at just 7-8 times expected earnings in 2019, especially considering that the company has nearly $2 billion in cash and cash equivalents on top of its nearly 50% ownership stake in Huya. Basically, YY is almost trading at cash value at the moment, so the upside clearly outweighs any downside, in our opinion.

Also, the cash on hand gives YY a number of resources to grow and expand its platforms as well as the ability to go ahead and purchase a majority share (50.1%) in Bigo, which can be exercised in May next year.

Factoring all of this in, we feel fair value - or the "Chinese discount" - for YY is $125 with a conservative P/E ratio of 15 based on 2019 expected earnings (8.20). Because fears have been overblown regarding the trade war between the U.S. and China - of which both countries just agreed to a 90-day trade truce - we feel based on YY's growth and potential, the company should be trading at the industry standard with a P/E ratio between 20 and 25. This would put a price target between $164 and $205.

Despite shares being heavily undervalued, there are still some risks for investors. First, gross margins have come down due to the increase in revenue sharing with its users as well as fees and content costs. While this is certainly a drawback, the increase in revenue sharing does seem to have helped the company expand its user base and retain users, which is a great sign for shareholders.

Second, trade war talks will continue to dominate headlines until a deal is reached. And because of this, Chinese stocks, such as YY, will continue to be volatile. Make no mistake, many investors are on the sidelines now just waiting to get jump back in. It's no coincidence that every time President Trump tweets something positive about trade talks with China that shares of Chinese equities soar on the news.

Lastly, because YY operates as a social media platform in China, the company is often at the mercy of the Chinese government, which is continually cracking down on companies and the social and gaming industry with new rules and regulations. For example, China officials have expressed concern about the impact video games have on the country's youth. As a result, Chinese regulators have slowed the approval process for new games. With the government reluctant to approve new games or allow monetization for popular titles, companies like YY in the social media and gaming industry are losing potential revenue. However, the recent regulations do not justify a 50% drop in share price in our opinion, as it will a minimal impact YY.

However, despite it all, YY keeps chugging along and as it spreads its wings beyond China. This, of course, will continue to help the company reduce the impact of Chinese regulations as it continues to grow globally. With another standout quarter, beating analyst estimates on both the top and bottom lines and great growth opportunities in the years ahead, YY is a BUY and a no-brainer at this point!

We believe another run into triple-digit territory is in the cards in the next few months, especially if trade talks are resolved between the U.S. and China, which seems very likely at the moment. So, to conclude, ignore the noise about YY's recent downgrade and focus on the metrics that nobody is talking about. With user growth arguably as healthy as ever, YY is set to continue to thrive and is a convincing BUY at these levels.

Disclosure: I am/we are long YY.

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.