YY Group: Big Returns With The YouTube Of China

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About: YY Inc. (YY)
by: Brian Yu
Summary

YY's core business is very profitable and difficult to replicate, given its huge network and structural advantage.

YY has a fortress-like balance sheet and little to no debt.

It trades at an adjusted P/E multiple of less than 1x!

The dirt-bottom valuation presents a very solid prospect and case for a multi-bagger, with very minimal risk.

Secret financial metrics revealed in this article to help further understand YY's growth story.

Editor's note: Seeking Alpha is proud to welcome Brian Yu as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

The article is split into three sections:

Part I: Growth and Profitability:

Is YY Group’s (NASDAQ:YY) intrinsic value expanding? This is very critical if we are aiming to achieve an outperforming compounder. Five key metrics discussed in this article will really help us understand the growth story behind YY - how well does YY Group play the attacking game?

Part II: Financial Strength:

Can the company survive hard economic times? High debt levels are concerning. Even great businesses can go through hard times and a poor corporate structure can put the company at a bigger risk for insolvency and/or bankruptcy. In other words, that would likely mean us losing all our invested principle in YY. Unlike the growth topic, here we ask: how well does YY Group defend itself in times of financial stress?

Part III: Valuation and Financial Analysis:

The third and last section deals with: What price we should pay for YY? What valuation is appropriate for YY Group, given its growth and financial strength?

Part I: Growth and Profitability

Five Key Profit and Growth Metrics to Understand YY’s Growth Story

Before we go into an analysis of YY Group, let me brief you on the basic premise of what YY is and why I am so bullish on this company. Directly quoting from YY.com, here is what they have to say:

YY is the leading live streaming social media platform in China. According to independent data, we consistently top industry metrics in areas including monthly active users, daily active users, and total time spent by users. Through YY Live, our live streaming platform, and Huya, our live game broadcasting platform, we enable users to interact with each other in real time, offering users a unique, engaging, and immersive entertainment experience. Our highly engaged users contribute to a vibrant social community by creating, sharing and enjoying a vast range of entertainment content, which fuels further content creation and fosters a positive cycle that sustains our growth.

We have a large and highly engaged user base. Our growth is driven by:

  • Our broad range of entertainment content and activities, which grows our user base and increases the level of user engagement. We continuously expand our content categories to cover both traditionally popular genres such as music, dance, talk shows, and online games as well as emerging and long-tail categories such as the outdoors, finance, sports, and anime. In addition to our live streaming genres, we also offer content that best complements live streaming, such as user-generated short-form videos. Our platform also features highly engaging activities to attract and engage users, including online dating shows, live performer battles, and trendy social games such as Happy Werewolf Kill.
  • Our proprietary technology, which provides a superior user experience. Our platforms are supported by our highly scalable infrastructure throughout China, which includes our proprietary algorithms, software, and mobile devices that are tailored for optimal live broadcasting performance.
  • Our pioneering business model, which leading industry players adapted. Our business model optimizes the seamless integration of traffic generation, user engagement, and monetization. We capitalize on our large and highly engaged user base by continually exploring additional monetization opportunities and diversifying our revenue sources.

Source: YY Group

It is a mix of YouTube (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (NASDAQ:FB), gaming, and many other types of unique online entertainment, all neatly packaged into one social media site. YY is not just simply a carbon copy of American companies. Growing at more than 20% at a single-digit earnings multiple, flush with cash, and with virtually no debt, YY Group is truly the security I like best. Source: YY Investors Relations

They have one of the largest networks of audiences; that translates to a tremendous structural advantage. Anyone can make a better-looking social media interface than YY, but without a vast range of audiences, it is very difficult to sustain capture of any business from YY. The most important driver for YY is arguably the number of monthly active users and live paying streamers. It is easily the most tangible way to see the structural moat of YY deepening and getting stronger not just every year, but every single quarter. This brings us to our first growth metric:

Growth Metric #1: Active User Growth

The Past Five Quarters of YY:

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

Source: YY Earnings Call Transcript

Growth Metric #2: YY’s Profitability

Return Metrics: ROIC, CROIC, ROE, & ROA from 2013 - 2018

2013 2014 2015 2016 2017 2018

ROE

25.31%

34.45%

31.90%

30.20%

23.50%

14.75%

ROA

18.39%

15.51%

14.15%

15.57%

17.24%

11.85%

ROIC

34.58%

18.30%

21.89%

23.94%

30.96%

34.87%

CROIC

44.28%

19.63%

27.59%

28.90%

29.64%

29.64%

Source: OldSchoolValue

Return Metrics: ROIC, CROIC, ROE, & ROA

A common way to understand the long-term growth rate is to look at what the return on equity, assets, invested capital indicate. ROA is least helpful in this sense as not all assets are relevant to YY’s profitability, but all other metrics point to a 20-30% long-term growth rate. The formula for the Invested Capital used here is:

Invested Capital = Shareholder's Equity + Interest Bearing Debt + Long and Short Term Interest-Bearing Debt

Growth Metric #3: Revenue Growth Over the Last Five Years

Revenue Growth from 2013-2018:

(In Mil.)

12/31/2013

12/31/2014

12/31/2015

12/31/2016

12/31/2017

TTM

Revenue

$296.92M

$596.12M

$937.84M

$1.23B

$1.72B

$2.25B

Source: Oldschoolvalue & Seeking Alpha

Revenue is the beginning and end of all the real growth that a company achieves in its lifetime. Very few companies become outperforming multi-baggers from only increased profit margins. It's not sustainable. Fortunately, YY's revenue growth looks extremely promising.

  • A 35% growth rate in the last three years (66% for the last five years) is excellent.
  • I like to look for a consistent revenue growth rate of 20% or more for excellent growth prospects.

Growth Metric #4: YY’s Research and Development

Research and Development Expense from 2013-2018:

(In Mil.)

12/31/2013

12/31/2014

12/31/2015

12/31/2016

12/31/2017

TTM

R&D Expense

$43.48M

$69.88M

$87.28M

$101.43M

$115.69M

$174.1M

Source: Oldschoolvalue & Seeking Alpha

For technology and pharmaceutical companies, R&D is not only a huge indicator of a company’s willingness to expand their business operations, but also shows the capability to expand. A 31.3% growth rate for the last five years in R&D expense indicates YY is very committed to expanding.

Now, I promised you some “secret” ratios to help you valuate YY Group. Here is the first one.

Secret Ratio #1: The Enterprise Value to Research Ratio (EV/R&D)

= (Enterprise Value) ÷ (R&D Expense TTM)

YY has $174.1M of R&D expense TTM. Its enterprise value, EV, is $3.0B. Read on to Part III if you are not sure what EV is. EV refers to the enterprise value, and we get the EV by adjusting for the net cash or debt a company has to get the "real" market cap of the company. YY's EV/R&D multiple is:

$3.0B / $174.1M = 16.85x

A couple of things I want to point out for the EV/R&D Ratio:

• Research has value. Paying less than 15x EV/R&D expense is a good indicator of value. YY has an EV/R&D multiple of 16.85x. That is slightly on the high side, but this metric is only useful for figuring out whether a company is undervalued. A high EV/R&D ratio doesn't necessarily equate to overvaluation. Some companies just don't spend that much. The flip side is that it's very promising when the ratio comes out low.

• This ratio is better than the traditional price-to-research ratio, because EV/R&D accounts for the company’s capital structure as well. Penalize bigger debt. More leniency for bigger cash balances.

• Like any other ratio, there are some significant drawbacks to this metric.

• Some firms, like Apple (NASDAQ:AAPL), have historically spent very little on R&D but have had spectacular growth.

• R&D masks the true asset value since it is expensed and not recorded on the balance sheet.

• A good alternative would be to capitalize it and treat it as an asset in order to get a more accurate look at what its book value is.

Growth Metric #5: Growth in EBIT/Operating Income

YY’s EBIT growth from 2013-2018

(In Mil.)

12/31/2013

12/31/2014

12/31/2015

12/31/2016

12/31/2017

12/31/2018

EBIT

$78.63M

$173.89M

$178.95M

$254.91M

$414.50M

$459.00M

Source: Oldschoolvalue & Seeking Alpha

Operating income looks at the heart of the business and helps evade a lot of accounting discrepancies. A 41% growth rate over the last five years is excellent. Net income sports a near-identical growth rate.

Putting All Five Key Growth Figures Together:

Key Metrics Growth Rate: (Last 5 Years)

Growth Rate:

Live-Paying User Growth (YoY):

26%

ROE, ROIC & CROIC Average:

25%*

Revenue Growth Rate:

35%**

R&D Expense Growth Rate

31%

EBIT Growth Rate:

41%

Average Rate of Growth:

31.3%

* Seeing how the Return Metrics have been mostly in the 20-30% range, I used the average.**I used the 3-year growth rate since 66% is too high and likely unsustainable and it is more recent.

The average growth rate that we got from the five key metrics will be our estimated growth rate going forward for the valuation section.

Part II: Financial Strength

The Balance-Sheet checkup for YY

Considering that YY has almost no debt, I will admit that Part II’s purpose in valuating YY is not as necessary, but for the sake of due diligence, we will go through the balance sheet quickly. We are mainly checking just to see if YY has any large, concerning debt - which it does not. The balance-sheet checkup is to make sure YY can defend itself in times of economic distress. To say YY’s balance sheet is a fortress is an understatement.

Financial Metric #1: Debt/Equity Ratio

A D/E ratio of less than 0.5 indicates conservative financing and a strong balance sheet. YY has a D/E ratio of only 0.03.

Financial Metric #2: Current Ratio

A current ratio of 5.1 is very strong. Anything with a current asset to current liability ratio of 2 or more indicates liquidity.

Source: Yahoo Finance Inc.

Part III: Valuation and Financial Analysis

Buying $1 with 10 Cents

We finally come to the most important bit of the whole analysis: Valuation. What is YY’s core business valued at?

The key thing is to understand is: what is the real multiple we are paying for, whether we are using the P/E, P/FCF, EV/EBIT, etc.? How many dollars am I willing to pay for each dollar the company earns each year? Hopefully, the price you pay to acquire the company’s earnings per share will grow in the future. That is the ultimate goal. But, we have to make sure we aren’t paying too much for each dollar a company makes each year. This is the basic starting point in order to understand what valuation is appropriate for the company.

Due to the fact that there are so many factors not accounted for in the “P” (Price) for the classic P/E ratio, we will use EV/EBIT. You can use EV/E. Both are similar in this case and will give us a more accurate earnings multiple, given its huge cash position.

#1) YY’s Enterprise to Operating Earnings Multiple (EV/EBIT):

We need to first calculate the enterprise value. Therefore, the formula is:

Enterprise Value = Market Capitalization - Excess Cash Net Debt

You can find this information easily on Yahoo! Finance, but for clarity, it is:

YY's Enterprise Value: $4.7B + $0.4B - $2.1B = $3.0B

Right off the bat, using EV will yield a lower EV/E than a regular P/E. Why? Because this multiple tells you how much net cash YY has. The more cash a company has, net of debt, the cheaper the firm is. Let's use an example: You've paid $1 million for a house, and you discover another $500,000 in the basement even after you've paid for all the debt and mortgage costs. That means the real cost of the house was $500,000.

The house's business operations will continue to perform regardless of whether there was money found in the basement - the rent you get from this house has not changed. But the price has.

Same business, but at a lower price.

Just as we want to understand how much rent profit we can make, we also want to understand how much we are earning from YY relative to its enterprise value by using the operating income. For YY, there is a net cash balance of $1.6B after accounting for all its debt. The operating income for YY is $459m.

The EV/EBIT multiple is, therefore:

YY's EV/EBIT: $3.0B / $459m = 6.5x

The $3B represents the EV, while the $459m is the operating income. This means the EV/EBIT is about 6.5x.

Anything below an earnings multiple of 10x in a quality company is great.

YY is already a great undervalued growth stock when only accounting for its low multiple and high growth rate.

But there’s more.

Let's take this one step further. YY’s core business would be even cheaper if we eked out a rough approximation of the subsidiaries' valuation. Remember my house analogy? Let’s see what other “money” we can find in the basement after buying our YY “house”.

#2) Accounting for YY’s Subsidiaries: HUYA and BIGO

Let’s account for HUYA first. We do this by subtracting HUYA’s value and multiplying it by its percentage ownership in HUYA, which comes to 48%. YY owns about 48% of HUYA to date. This represents YY’s stake in HUYA. In other words, this is the value you get that comes from HUYA, when you buy into YY. (Think of it as “money” or “treasure” in the basement you found in the YY “house”.)

Now another question comes to mind - what is the fair value of HUYA?

This is admittedly subjective. Valuation is always subjective, and we should always err on the conservative side by having an appropriate range for the intrinsic value we arrive to. Remember that investing is always more art than science.

What do I think of HUYA’s intrinsic value? Well, to be completely honest, I’m not entirely sure. It is a great business and they are a major player in the China e-sports industry, but they don't have much in the way of earnings right now. Their market cap is $5.4 billion, meaning a $2.5 billion stake would be towards YY, but that to me is very high. (Had they been fairly valued to me, the title of this article would have been: “Buy YouTube’s China for Free!” because YY’s stake in HUYA at current market cap is almost the same as YY’s enterprise value.)

Source: Business Insider

According to Business Insider's financial projection, Huya’s forecasted revenue is $1.02 billion for 2019, and for a business with a huge moat like HUYA, a price-to-sales of 2x is pretty conservative, so we will pretend its real worth is actually $2 billion. This means YY has a stake in HUYA conservatively worth about $960 million (about $1 billion). If we were to account for that in YY’s enterprise value, we would use the second secret ratio in this article:

Secret Ratio #2: The Subsidiary Adjusted EV/EBIT

= ((EV - (Subsidiary Fair Value x Ownership % of Subsidiary)) ÷ EBIT

So YY’s adjusted EV with HUYA is:

$3.0B - $1.0B = $2.0B

Now, let's account for BIGO.

YY Group, a leading live streaming social media platform in China, today announced that it has further invested US$272 million in the series D preferred shares of Bigo Inc. (“Bigo”) as the lead investor. YY is an existing shareholder of Bigo and has become its largest shareholder after the series D financing. In addition, YY has obtained a right, exercisable after the first anniversary of the closing date, to purchase additional Bigo shares at the then fair market price to exceed 50.1% of the voting power in Bigo. Together with YY, other investors also participated in the series D financing, including Mr. David Xueling Li, Chairman and acting CEO of YY, who invested in Bigo using his personal funds.

Source: YY's Press News Release

YY’s investment in BIGO is $272M (As of Feb. 2019). So YY’s stake is worth $272M. So, accounting for both HUYA and BIGO:

$3.0B - $1.0B - $.272B* = $1.73B

*(Accounting for BIGO with the $.272B)

The real adjusted EBIT earnings is, therefore:

$1.73B/$459M = 3.7x

The $1.73B is the EV adjusted for all the subsidiaries and $459M is the EBIT. If you wanted to be more aggressive in HUYA’s valuation, you could give it the full $2.4B it currently has on market cap. Had you done that, it would have been:

$3.0B - $2.4B* - $.272B = $330M

*$2.4B being the aggressive valuation of HUYA.

Divide that by the EBIT of $459M and you get 0.72x earnings. That is less than a P/E of 1x. The valuation is almost absurd. But stick to 3.7x if you are unsure about HUYA’s valuation like me. Using $2.4B is a very aggressive assumption.

Finally, after we come to the subsidiary-adjusted EV/EBIT, we also want to make sense of how low the earnings multiple is in relation to the company’s growth. The PEG method, popularized by my favorite investor of all time, Peter Lynch, is the main way I use to make sense of whether or not a company’s P/E ratio is expensive. This leads me to the third and last secret ratio.

Secret Ratio #3: The Subsidiary-Adjusted PEG Ratio

= Subsidiary-Adjusted EV/EBIT ÷ Growth Rate % (Last 3-5 Yrs.)

A PEG of 0.5 and below is considered undervalued. If we use 3.7x as the adjusted EV/EBIT multiple and 31.3% as its growth rate (taken from Part I), we will get about an adjusted PEG of .12x. A PEG of 1x is considered fairly valued.

That’s almost a 10x upside.

A 10x upside is, of course, the very upper range. Even if the stock goes up 5 times, it is still cheap. This article's main focus is this: do the numbers prove YY’s incredible growth story? Absolutely. Part of becoming a great business person will mean having a strong understanding of the numbers presented.

A Final Word on YY:

Every company has risks. YY is no different. I do however strongly believe that the low valuation has already accounted for the bulk of the risk that could possibly cause a material effect to YY. You don't need much to go right when you calculate that a company is trading at an adjusted one times its earnings. Competitors like MOMO Inc. (MOMO) can take away market share from YY's live streaming business, but the fast-growing internet industry in China should allow ample room for both tech titans to grow at very high rates for years to come. Furthermore, companies in the social-media business are often very differentiated and target different niches. Their high-profit margins reveal that this is a very good industry to be in. The second-biggest risk I see is government regulation. An article I found in Time talks about the government regulation of social media platforms, notably Weibo (WB). WEIBO is also a tech titan in its own right. The article says:

Earlier this month another regulator, the Beijing Cyberspace Administration, ordered internet companies to terminate social media accounts that cater to “the public’s vulgar taste” and disseminate celebrity gossip, AFP reports.

Source: Time

Now, let's just reflect for a moment. Fake news is an actual issue. So is pornography, hate messages, and public speculation/rumors. This is almost the exact same issue Facebook had this year. The government is responsible for preventing the instability that results from false information. Whether that is their only political agenda is an uncertainty. The Chinese government has only, at most, regulated and censored certain types of information.

Our margin of safety is the fact that YY is a fraction of what I believe it is worth. It is true that the government can crack down on social-media companies. However, government regulation does not equate to taking down a company. It very likely means censorship of certain things and "censoring" of certain business growth opportunities. YY has many segments, including HUYA, its sports-streaming business, and many live-streaming and gaming programs. They have a lot of avenues for growth even if a censorship crackdown does happen.

Start with the numbers. Then try your best to see if you believe the risk in YY is so great that it can materially affect the intrinsic value of YY to the point that no margin of safety is actually there. That would mean that YY lost 90% of its intrinsic value and has effectively, no upside whatsoever from here on out - very unlikely, but not impossible. I suggest you bet on the side the house is on. The odds are better there.

If you have any questions, opinions, or constructive feedback, please leave a comment below.

Disclosure: I am/we are long YY, MOMO. 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.

Additional disclosure: YY is the biggest position in my private fund. It would be pretty disingenuous to be so bullish and not have much of a stake in YY.