YY reported after close Tuesday Q3 sales of $163.5M, and adjusted earnings of $0.87 per share, which beat analyst consensus sales estimate of $152.5M and earnings estimates of $0.76 by $11M in sales and $0.11 in EPS. Company guided Q4 sales above analyst consensus. Given leading China Internet firms like Baidu (NASDAQ:BIDU) and Alibaba (NYSE:BABA) are setting new highs, one would have expected YY to set new high as well with these excellent set of numbers. Yet, surprise! The share was down over 10% over two days following the report. So what's the matter? Anything going wrong? Should investors buy into this dip?
Investors appeared to have spooked by management comments in conference call. In the call, when asked about 2015 growth, the CFO said analyst consensus estimate of 45-50% yoy growth from 2014 is very challenging and said they like the challenges. Investors seem focused on this "very challenging" words, but forget this management is usually conservative with guidance. The following table shows management guidance and what they delivered and how much they beat from top of their guidance range:
Quarter Guided Reported Beat
Q1/13 280-290M 315M 25M
Q2/13 335-345M 409M 64M
Q3/13 430-440M 487M 37M
Q4/13 510-520M 612M 92M
Q1/14 625-635M 666M 31M
Q2/14 745-755M 841M 86M
Q3/14 925-935M 1000M 65M
This table indicated that the company beat its guidance every quarter since its IPO. This management is clearly conservative in its guidance. In other words, investors should not pay too much attention to the "very challenging" 45-50% growth estimate for 2015, and should pay some attention to the comments that "they like challenges". In retrospect, most Chinese Internet companies don't give out 2015 guidance. The stock would have reacted much better if management just followed other leaders like Baidu in its practice of guidance.
Investors could also have worried too much about competitions and margin pressure, as management indicated more spending on the call to fend off competitions in game broadcasting. In fact, management said Q4 margin would be in line with analyst consensus estimate even with the extra spending (33% excluding stock-based compensation expenses). Management also indicated that 2015 operating profit margin will be at least as high as that in 2014. Over the last 8 quarters as a public company, operating profit margin has improved from 23% in Q4/12 to 36% in Q4/13 and has been quite stable at 33-34% over last three quarters in 2014. This is remarkable in China Internet space as most companies are experiencing margin decreases such as leaders like BIDU, BABA, and NetEase (NASDAQ:NTES). Some companies like 58.com (NYSE:WUBA) had even shown a decrease in operating profits yoy as they really increased spending in Q3 to fend off heated competitions, but investors seem quite forgiving there: WUBA was up more than 10% after report, and pulled back less than YY did from Q2 report time. Compared with year ago quarter (based on quarterly reports of each of the mentioned companies, Sep/2014 quarter vs. Sep/2013 quarter):
YY operating margin decreased by 200 basis points,
BIDU decreased by 900 basis points,
BABA decreased by 930 basis points,
NTES decreased by 870 basis points, and
WUBA decreased by 1330 basis points.
Investors seem quite forgiving for all BIDU/BABA/NTES/WUBA with their shrinking margins (and sales beats), why they were so alarmed with YY's much better margin stability (also revenues beat)? It seems a clear mistake was made and the sharp stock price will make buyers richer, especially considering management guidance of stable and slightly higher margin for 2015.
Investors seem to forget as well that the founder Mr. David Li is a creative talent. My impression so far is that the company is like another Tencent in terms of business model, maybe a little bit more innovative than Tencent. David has worked at NetEase for many years and has ingrained in him the importance of quality product and the importance of creativity. When he teamed up with Xiaomi founder Mr. Lei Jun and started YY, one can see their creativities in clear display and a little Tencent in the making: they have a platform for game players, Duowan; they have a real-time messaging tool that connect users together; they have developed multiple revenue streams such as advertising, games, subscriptions, and the major one, what I called "appreciation". In its music business, users pay because they appreciate the performance by individual performers in YY's platform and YY has made such payment easy. Investors seem have not grasped the implications of this "appreciation" payment and don't seem to know how big it will be. I can see a lot of appreciation payment in this country as well: I am sure many of you paid $1 or 10 to subway performers in NYC. As a student, we sent gift cards to teachers each year as appreciations. We sometimes pay Wekipedia and sometimes pay PBS as appreciation as well. Hey, everyone in the heart wants some appreciation for some talents or hobbies or for a job well done, right? This world will be a much better place when everyone is being appreciated. What YY does in its music business is that it enabled the viewers on its platform a way to express their appreciation by sending the performers virtual gifts.
I'd venture here an estimate of how big YY's music business can be since such estimates seem missing in investor community. This is a rough estimate, and I believe it'll be a good starting point to get it more accurate. Let's assume about 1% of the 20-40 year olds have that desire to be a performer or an artist, this would be about 3 million people in China. Some of them will build a great audience and get a lot of appreciation and some of them will get little. In average, let's say they get 10% of what a salaried employee receives, or about 6000 RMB a year. So the revenue potential is RMB 18 billion a year. Alternatively, I believe people 20 or older could be the audience and that's over 900 million in China. Again let's assume 1% of them could be paying, so there will be 9 million payers. Based on annual ARPU of 2000 RMB, the revenue potential would be 18 billion RMB. I note here both this paying ratio 1% and ARPU 2000 RMB are not far away from what actually reported by YY: As of Q3 2014, YY had 105 million users, and 450K paying for music with ARPU annualized about 1800 RMB. In other words, I estimate the music business could reach 18 billion RMB in its full potential and the business still has ample room to grow. One can also imagine other businesses that can be monetized with the same "appreciation" model. The number and opportunities can be mind-boggling. This exercise makes me thinking of Tencent: over the last few years, many investors missed the huge run of Tencent, simply because they failed to grasp the market size for Tencent, so they either sold too early or they felt it's too expensive to get in.
YY this quarter had shown dramatic growth in game broadcasting (46% sequential growth from Q2) and online dating shows (119% sequential growth from Q2), and grew to over 10% of quarterly revenues. Analysts have yet to come up with sizing of these businesses potential yet. I am very encouraged with this result and I believe I am seeing another Tencent in the making: a platform, a real time product, and an innovative business model. The company Q3 sales reached 1/20 of Tencent, and its market cap roughly 1/40 of Tencent. The company was growing much faster at 100% yoy than 28% yoy at Tencent for the just reported quarter. I believe it is a great time to buy YY. At current price, YY share is priced at less than 20x 2015 earnings, while earnings growth will be at least 40% annualized rate for 2014-2016 in my estimates.
As of this writing, YY is rebounding. I believe the rebound has a long way to go: I believe YY is about to set new high just like BIDU/BABA/NTES have done after Q3 reports.
Disclosure: The author is long YY.