Buy Renren: The Facebook Of China

| About: Renren Inc. (RENN)

Renren, the Chinese Social Networking Giant!

Renren (NYSE:RENN), with over 154 million users, is the largest online social network in China. Facebook (NASDAQ:FB), which boosts about 900 million users, is the largest social network outside China.

Facebook has an infinitesimal market share in China, as the Mountain View-based company's popular social network cannot be accessed within the country.

Beijing has imposed a great internet firewall in a move to censor and limit politically sensitive information being dispersed among the Chinese masses. Google (NASDAQ:GOOG), in a retaliatory move, backed out of China after the Chinese government tried to censor results and monitor internet traffic. The outcome was that other major players like Baidu (NASDAQ:BIDU), possessing an already significant market share, jumped in and took over Google's market share after its exit from the Chinese market. The Social Networking Industry is facing a similar situation in China, as other internet social networking companies like Renren (Chinese Facebook) and Sina (Chinese Twitter) are prospering in the absence of Facebook, Twitter and other popular social networking websites. Facebook currently has a Chinese user base of less than 0.5 million compared to Renren.

Renren went public last year with the listing of ADRs at the NYSE, and raised more than $800 million at shares priced at $14. At that time, investors demonstrated a strong interest in Renren owing to its bright growth prospects in China in the absence of Facebook. But, as of today, the stock has lost more than 68% of its IPO value since last year. Investors become cautious about Renren's sustainable growth, as the company's advertising revenue growth started declining. Furthermore, the slowing Chinese economic growth has further made investors wary of internet advertising budget cuts by corporations in China. Therefore, the shares of Renren are tumbling around $4.4, way below the $14 IPO price.

Overall, the company posted a 56% YOY growth in 1Q2012 revenues, owing to a strong growth from online gaming. The company posted $32.1 million 1Q2012 revenues with $9.3 million coming from online advertising, $17.5 million from online gaming, and the rest from other services. Advertising revenues grew by 14% YOY and gaming revenues grew by 90% YOY. Heavy human resource expenditures, and continued investment in selling and marketing resulted in an operating loss of $20 million for the recent quarter.

Over the years, the share of advertising revenues has decreased for the company, which now accounts for less than 39% of total revenues, compared to more than 50% two years ago. Advertising revenues are considered more sustainable than revenues from other services e.g. gaming, as advertising revenues are driven by stable customers and are considered long term. Gaming revenue on the other hand depends on the life of the game and active user engagement. Online games' lives are considered short term, ranging from 1-3 years. The primary source of revenue from these online games is through user purchase of virtual goods in the game. The purchase of these goods is directly proportional to user engagement, and since user engagement falls gradually owing to the short lives of the games, companies need to consistently develop new, engaging and better games for users. Therefore, gaming revenues have a high business risk compared to advertising revenues.

China currently has one of the lowest internet penetration ratios in the world, with only 0.12% of the total population accessing the internet. On top of that, even fewer Chinese people use social networks. Therefore, we see immense growth potential for companies involved in the Chinese Social Media Industry, as the number of internet users in China increases. Furthermore, we expect the companies to expand online marketing expenditures as online penetration widens in China.

Renren has shown a gradual increase in its user base over the past few years, but the declining advertising growth is a cause for concern. The decline in stock price is already reflecting concerns regarding advertisement growth. Improving growth in Renren's advertising business should be a buy trigger for investors seeking to take advantage of the social media boom in China. However, at the moment, one should be conscious until the management shows some improvement from the advertising revenue side, on top of gaming revenues. Furthermore, owing to rising mobile users of Renren (69% in 1Q2012), a prudent mobile monetization plan will definitely result in advertising revenues expansion.

Renren's shares are currently trading at 3.2x forward sales, at a 76% discount to Facebook's forward price to sales of 14x.

Boost in online advertising expenditures by Chinese corporations, and speeding online penetration in the Chinese population are some of the buy catalysts for Renren.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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