HUYA: Risky, But After A Big Dip, Call Options Are Looking Attractive

Summary

• HUYA is a large, fast-growing video game streaming company based in China.
• The company offers an attractive P/E multiple, relative to its expected future growth.
• This valuation is largely due to fears surrounding regulatory concerns in China, as well as short sellers driving the company's stock down in order to benefit from a potential merger.
• Although the stock is reasonably priced given the above, call options on HUYA may still present an attractive risk-reward profile, due to their ability to limit downside exposure.

Photo by chee gin tan/E+ via Getty Images

HUYA Inc. (NYSE:HUYA) is a fast-growing video game streaming company. Despite the company's great growth at a cheap valuation, the stock suffers from fears of a crackdown from Chinese regulators, as well as a high short-interest, due to its proposed merger.

Recently, HUYA stock took a huge dive along with the rest of Chinese tech, potentially representing an opportunity to buy. However, investors considering the company should still exercise caution in a highly uncertain regulatory environment.

What is HUYA

HUYA is a market leader in video game livestreaming within China. The company offers viewers the opportunity to watch live gaming content from several online content-creators. Furthermore, HUYA also enjoys a strong foothold in the Chinese esports market, broadcasting several major competitive esports events.

The company, often likened to Twitch.tv in the West, generates its revenues through a combination of "virtual gifts", which once purchased can be sent to streamers, as well as advertising revenues.

HUYA is positioned well going forward to establish itself as a major player in the Chinese gaming scene, benefitting from strong shareholder backing in the form of gaming, social media and fintech goliath Tencent (OTCPK:TCEHY), which recently increased its stake to over 50% of the total business. Tencent's support offers a plethora of opportunities for growth, through synergies with the goliath's other products, coupled with the possibility for more aggressive expansion through Tencent's network of investments (more on this later).

The Bull Case For HUYA

By the numbers alone, very few would argue that HUYA isn't undervalued.

The company currently trades at a P/E multiple of 34.58. Although HUYA comes with a steep price to earnings multiple, upon closer inspection, it still looks highly attractive by the numbers, as margins continue to expand and earnings grow at a blistering pace. As of writing, according to Finbox, HUYA trades at a PEG ratio of 0.4, well below 1, which is typically considered good value.

Furthermore, the company should be able to continue growing earnings at a rapid pace for many years to come, due to its large number of unpaying users relative to its total users. Now that the company has established some dominance in its niche, it'll begin to focus on converting more of its non-paying customers to paying customers. According to HUYA, in Q4 of 2020, Huya Live had 178.5 million monthly active users, compared to just 6 million paying monthly users. This gigantic discrepancy between paying and non-paying users means that HUYA may still have a long runway of growth, as they leverage their large audience to increase revenues, whilst costs grow at a much slower pace.

Graphs of HUYA's TTM revenue, TTM EBITDA and EBITDA margins overtime.

Source: Macrotrends

All this growth at a great price makes HUYA look highly attractive by the numbers.

HUYA's Merger And High Short Interest

In late 2020, HUYA and streaming competitor DouYu International Holdings Limited (DOYU) announced a merger agreement. The deal, likely driven by Tencent would result in a behemoth of videogame streaming, with a market share of 80%. Tencent would own 68% of the merged business, due to its sizeable stake in both companies. The merger, scheduled for the first half of 2021, must still overcome significant regulatory and antitrust hurdles.

Although at first glance, this may seem like a hugely bullish announcement, post announcement, HUYA shares actually took a huge dive. The deal stipulated that for Every share of DouYu an investor owns, they should be granted 0.73 shares of HUYA once the merger is complete. This represented a massive premium to DouYu's share price, creating an opportunity for merger arbitrage, by shorting HUYA's shares and going long DouYu stock.

Because HUYA's 33.57% short interest (as reported by Seeking Alpha) may be due in large part to institutions implementing a merger arbitrage strategy to take advantage of the ratio at which shares will trade by the time the companies merge, this high short interest isn't necessarily an indicator that the market believes HUYA is overvalued. To better understand this, we need to take a look at how individuals may seek to benefit from a merge:

Consider the following example:

1. HUYA's share price is currently 20 dollars, DouYu's share price is 10 (hypothetically). One share of DouYu is therefor worth 0.5 shares of HUYA.
2. A merger is announced and per the merger terms, DouYu shareholders will be given one share of HUYA for every share of DouYu.
3. This means that if the merger goes through, shares of DouYu should be trading at a roughly 1 to 1 price ratio with shares of HUYA, meaning that they must appreciate relative to HUYA shares. E.g. if HUYA goes down 50% to 10 dollars a share, DouYu should remain priced at 10 dollars a share (a 0% price change). Conversely, if HUYA goes up 100% to 40 dollars a share, DouYu must go up 300% to get to a 1 to 1 ratio.
4. This means that provided that a merger actually happens, DouYu shares should outperform HUYA shares (regardless of if they both go up, down or sideways).
5. In order to take advantage of this without bearing the risk that HUYA goes down substantially (meaning DouYu would also go down, but by less), one could short HUYA shares and go long DouYu shares, with the same amount that they shorted HUYA.
6. This would result in a scenario where if HUYA went down a lot and DouYu went down a little, your net position would be profitable (a big gain from the short position and a small loss from the long position). Similarly, if HUYA went up and DouYu went up even more, you'd be profitable (a big gain from the long position and a small loss from the short position).

Because of the market-neutral nature of this strategy and the likelihood that it is the driving force behind HUYA's short interest (in order to profit off a merger), I believe that whilst short interest is high, it isn't necessarily indicative of a bearish stance on HUYA's valuation from the market, but more likely simply a belief that DouYu will outperform HUYA if the merger goes through.

The Bear Case For HUYA

Although a merged HUYA and DouYu would be a formidable business (if they could maneuver effectively through antitrust regulations), the major benefactors of this merge would be DouYu shareholders, not HUYA investors.

Perhaps more worryingly, the merger may attract unwanted attention from Chinese regulators, who have taken a hard stance on the tech industry ever since late 2020, when Alibaba Group Holding Limited (BABA) founder Jack Ma made negative comments regarding the country's regulatory policies.

This attention is especially concerning amidst allegations that DouYu may be breaking Chinese gambling laws, by allowing streamers to host online lotteries during their streams, allegations that could greatly harm HUYA if a merger goes through. If regulators determine that DouYu broke the law, allowing and possibly even encouraging users to take part, the ensuing punishment will be very harsh.

Considerations When Taking A Position In HUYA

HUYA is very much a tale of two stories: A thriving company with great future growth opportunities, but simultaneously a regulatory conundrum that may have overpaid for DouYu.

Anyone considering taking a position in HUYA at this point in time seriously needs to consider using some form of risk-management. Whilst options strategies such as long straddles (which are profitable if the stock moves up a lot or down a lot, but not if it holds steady) could allow investors to benefit if regulatory crackdowns are extremely harsh, or extremely mild, HUYA options have high bid-ask spreads and investors might struggle to squeeze out a satisfactory profit for the amount of risk taken in such a strategy.

Rather, I believe that the best way to benefit from HUYA's quantitatively outstanding valuation, would be to purchase long-dated calls on the company, with around a year till expiry, allowing for less capital to be allocated to the investment, whilst waiting for a rerating of its stock once regulatory fears subside. A rerating to a PEG of 1 would represent a significant positive movement in the company's stock, easily enough for the intrinsic value of calls bought slightly in the money to surpass the price paid for them (which is important in the case of a stock such as HUYA, as bid-ask spreads may be wide enough that exercising the option would grant a superior return to selling it.)

If the merger doesn't go through (as is quite likely amidst current government crackdowns), HUYA stock, should perform well, as long as regulatory concerns associated with Chinese tech companies do not persist. In my opinion, this is the most bullish scenario for HUYA, as it will no longer be dragged down by DouYu's online gambling concerns. Furthermore, HUYA's significant short interest should provide a great boost to the company's stock price, as those who were attempting to benefit from the merger buy back stock to exit their short positions, driving the price up.

If the merger goes through, the combined company would likely still offer decent investment prospects, due to its gigantic market share, even though DouYu shareholders would be the primary benefactors.

However, if regulatory concerns pile on too strongly, there's no telling the extent of a possible reaction from the Chinese government. In this case, investors would be especially happy that they opted to commit a smaller portion of their total capital to HUYA through the use of calls. I'm particularly concerned about regulatory retaliation post a merger, as the merged company may face retaliation for DouYu's actions, although HUYA was not involved in any wrongdoing.

Conclusion

HUYA's stock is valued cheaply relative to the business's future growth prospects. This cheap valuation is driven by increasing regulatory pressure on Chinese tech companies, concerns regarding DouYu's illegal gambling allegations and short sellers driving the price down in order to benefit from a potential merger.

Although HUYA's stock appears to be priced fairly reasonably given the potential issues associated with it, there may still be an opportunity for investors to take advantage of an asymmetric risk-reward profile offered by long-dated call options on the stock.

Analyst’s Disclosure: I am/we are long HUYA. 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.