Momo: 100% Upside When Headwinds Fade

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About: Momo Inc. (MOMO)
by: Joseph Kowaleski
Summary

Momo's fundamentals are brilliant. The risk is centered around government regulations.

The company is a leader in two fast growing segments; online dating and live streaming.

Momo has been beaten down by numerous short-term headwinds that are mostly headline risk.

Its stock is very volatile, and more appropriate for investors with higher risk tolerance.

Thesis

Momo Inc (MOMO) is a Chinese social media company that is severely undervalued. This stock is very volatile and frequently sold-off for irrelevant reasons. The stock has a beta of 2, it is not a stock for investors that can't handle volatility. Momo has been beaten down by headline fears despite being a profit machine built for long term value creation.

Momo is a straightforward business. Wall Street unfairly discounts Momo like it's a cyclical industrial name rather than the rapidly growing social media company that it is. Whether it be trade wars or Chinese regulation fears, Momo has been treated unfairly by the markets. This presents an opportunity for patient investors who are not afraid of volatility to reap hefty rewards.

Momo is in the business of connecting people, especially through online dating. A staggering 16.6% of Chinese adults have experienced mental illness at some point during their lives. Loneliness and depression rates have increased globally. Close relationships and human connections add tremendous value to our lives. If Momo can succeed in its mission of connecting people in the real world, it has a tremendous runway ahead. Large corporations tend to become grow because of the significant value they add to the ease, comfort, and joy of human life.

The idea that investors must ponder is whether the risk is worth the reward. Momo's incredible fundamentals are well known and the future is bright. Momo's risks are systemic due to the Chinese regulatory environment. If an American company had Momo's fundamentals, the stock would be worth multiple times more. This unjustified risk will reward long-term stockholders when the headwinds subside.

Overview

Momo has about 113 million monthly active users, and 21.8 million paying users across its social media platforms. Momo is often referred to as the "Tinder of China." This is not a completely accurate description. Momo is more of a broad social media company. Momo has its core app, and TanTan, its recent acquisition that is a Tinder comparable.

Momo's core app is based on location based services and helping find new connections. Momo primarily derives revenue from its live streaming services on its core app. This core segment grew by over 31% last quarter. The primary driver of future growth will be in the company's acquisition of TanTan.

Momo's value-added services segment made up 19% of revenue last quarter and grew year over year by a whopping 258%. Excluding TanTan, the segment still soared by 157%. This revenue is primarily derived from membership fees and virtual gifting. Memberships add additional features that would not otherwise be available to non-paying users. Virtual gifting is the cut Momo receives from users sending gifts to broadcasters.

Momo blew the lid off of results in the first half of 2018. The stock surged to an all-time high of $54 before crumbling to $22 after a bogus short-seller report. This dramatic climb and reversal attests to the market still trying to grasp Momo's growth story. Just as easily as the stock has retraced, strong earnings and easing of Chinese fears will ignite another more sustainable rally. The mere notion of risk has kept investors on the sidelines who would normally gobble up this combination of growth and value.

Live Streaming

The popularity of live streaming in China is unlike social media we have in America. It does however have some parallels to the Instagram obsessed culture we have in America. Most of the live streaming stars are young, attractive women. The range of live streaming content is very broad. Using market size statistics and Momo's revenue from live streaming, we can estimate that Momo has retained 17% of the Chinese live streaming market. I would expect that number to remain fairly consistent and revenue growth will be subject to market size growth.

Even if it the interactions take place through a screen, live streaming appeals to the basic human connection needs. What separates Momo from its competitors is the focus on using the digital world to connect people in the real world. While live streaming adds entertainment value, the real value to human life is real world connection. The exciting part is this dimension of Momo's scaling process has just begun.

Online Dating

eHarmony notes that 40 million Americans have used online dating. Online dating had a stigma for some time in the United States before it became more culturally accepted. China has a greater potential for online dating because of its more reserved culture. Management noted that while mobile growth user growth is slowing in China, it has addressed less than half of its potential market.

Source: Pew Research

The slowdown in growth of internet users could also be short-term in nature. Only 58% of Chinese are internet users as of 2018. Based on the above chart, these are levels the United States saw in 2001. China has a long way to go to reach numbers comparable to the United States. Chinese internet companies will be poised to benefit from this trend.

Due to more mobile applications such as TanTan and Tinder, growth in online dating is stronger amongst younger people. This is another favorable trend for Momo. Momo is selling the opportunity to connect with other people. People will pay for services that add value and connections to their lives.

Competitive Advantages

Momo's biggest competitive advantage is the network effect. As with many social media businesses, the biggest distinction is being able to build out its user base. The biggest challenge is growing the user base to a level where significant monetization is possible.

What makes Momo superior to its peers such as YY (YY) is its diversification. The live streaming market is highly competitive and competitors offer similar services. Momo is not centralized around one source of growth.

While the threat of regulation by the Chinese government is a risk, this is also an advantage. China's internet companies operate in a vacuum, free from outside competition. Momo won't ever have to worry about competition from Facebook (FB) or Match (MTCH) impeding their online dating dominance. China's strict policies create high barriers to entry for internet companies. Momo's ability to scale their platform displays their situational awareness and disciplined approach to dealing with regulatory challenges.

Momo's young, competent, founder led management team is also a distinct advantage. Tang Yan has led the company from zero revenues in 2012 to nearly 2 billion in 2018. Yan was regarded in Fortune Magazine's annual "40 under 40" in 2014. Momo's core platform will continue to grow, but at an ever decreasing rate as the market matures. This management team understands the principle of building applications with massive appeal and effective monetization. Some analysts believe Momo overpaid for the 613 million dollar TanTan acquisition. I believe management clearly understood they could repeat their process, and in fact got TanTan at a great price. TanTan could very well become larger than Momo's core app.

Risks

Recently the stock has sold off for the Chinese government suspending Momo's newsfeed feature for a month while it cleans up content. Momo's risks are more systemic than relating to the business itself. Government crack downs that have a material impact are certainly of concern, but this far from makes Momo a speculative investment.

This suspension is noted as being short-term in nature. However, as seen in the past, Momo is a very volatile stock. Short-term thinking and panic can set in very quickly with Momo. The stock could see more downside in the near term. The social newsfeed suspension is a somewhat more niche of Momo's business rather than the content that Momo has monetized. It seems like this will have very little material impact in revenue. Resolution of regulatory issues will likely cause a short-term rally back to previous levels.

Chinese macroeconomic fears and trade wars have very little impact on Momo's business. It's very intriguing that Momo has a very high beta and frequently experiences worse days than its peers on macro concerns. Momo has continued to grow revenues even as China's GDP growth has slowed. The macro environment only adds headline risk to the stock, evidenced by the high beta.

Chart

It's important to price in potential risks to Momo's future cash flows. The stock is incredibly cheap, the market has discounted it far too much. The expectation is that growth stocks tend to be more volatile is reasonable. Logically, growth stocks have more assumptions to price in. As expectations and assumptions can change quickly, results do not. Momo's results speak volumes.

Valuation

Momo is priced like business is going to go the wayside. This is a company that grew revenue by 50% last year and trades at a forward p/e of 10. While Chinese companies appear to trade at a discount to American companies, Momo trades at a discount to its peers. YY is also a live streaming business and trades at a discount as well to Chinese peers. From this, we can infer the market is skeptical about the live streaming business. Growth trends prove this fear is overblown. Live streaming isn't going anywhere in China.

Chart Data by YCharts

The market is heavily discounting Momo's live streaming future. I don't think this assertion is fair. Momo is on its way to becoming the next Match Group, not the next MySpace. Social media is ingrained in 21st century culture, for the reasons of seeking human connection. The market understands Momo's potential, but it can't quite get past the perceived risks.

Momo performed better in the first half of 2018 on the bottom line. I expect margins to move higher after one-time factors are no longer in play. Momo produced a television drama in the back half of 2018 that pressured margins. It also renewed contracts with many of its popular broadcasters. Finally, TanTan is still losing money and placing a drag on margins.

Momo is financially strong as evident by its recent special dividend. This shows shareholders Momo has an emphasis on returning capital and creating value. It's unusual a high growth company would be able and willing to pay a dividend to shareholders.

We can conservatively model this reality where Momo is easy double. Despite factors that placed pressure on margins, Momo grew net income by 28% from 2017 to 2018. Even without such headwinds, we can modestly model 20% earnings growth. Then we use a terminal multiple of 15 after 5 years to represent Momo returning to a market neutral p/e ratio of 15. Then using a significant discount of 10% we come to a fair value of $62.52. This model could easily be conservative due to TanTan scaling and the generous discount. I think it's necessary to discount above average risk, but even so, Momo is a double.

Conclusion

It's hard to find something to dislike about Momo's fundamentals. Very few situations will enable a stock with such impressive growth to trade at such reasonable multiples. Momo is one a few hidden gems where this is indeed the case. Risks to Momo's future cash flows appear far overblown. Momo is a dominant player in live streaming and online dating in China. These trends are expected to grow and will result in very happy Momo shareholders.

Momo is characterized by a myriad of short-term headwinds. Investors should be focusing on Momo's numerous long-term value creation initiatives. The stock is very volatile and investors with stronger risk tolerance should consider taking a look at Momo. As perceived risks fade over time, the stock could see rapid appreciation. Investors stomaching Momo's rollercoaster ride can find solace in the company's strong and improving fundamentals.

Disclosure: I am/we are long 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.