The Limit of Fundamental Analysis: You

The other day, my friend Eddy Elfenbein wrote a post entitled “The Limits of Fundamental Analysis,” which made some good points (as he most always does), but in so doing, made far too broad and thus inaccurate a conclusion. The premise is (and I welcome Eddy to correct me if I’m off-base) that in some circumstances, fundamental analysis is inappropriate, such as when dealing with transformational businesses like Amazon was (is), cyclical firms, leveraged firms, firms with varying earnings quality, etc. The thing is, we can – and do (try to) – adjust for all of these things – and more – when performing a proper fundamental analysis! I’m going to attempt to show how, by making relatively small changes to a few key assumptions (sometimes even just one number will do!) in a simple DCF framework, we can grossly change not just how much we think a stock is worth, but why it’s worth that price, as well.

Fundamental analysis, by definition, involves examining the industry in which a firm competes, the regulatory/legal environment, the market for a firm’s goods/services, the goods/services themselves, the firm’s financial condition/performance, strategy, capital structure, reliability of financial statements/accounting controls, and several other factors, not only currently, but in the past and, more importantly, the future as well. Fundamental analysis isn’t just looking at a few ratios on Yahoo Finance or Finviz or whatever and concluding a company is a good (bad) investment based on valuation, liquidity, solvency, and/or other metrics. That can be the starting point for narrowing down firms which are more (less) likely to be worth investigating further, given a finite amount of time to allocate to identifying and researching ideas which we hope will help us invest wisely.

A quick tangent: If you’re not in the markets to invest, you are in the markets to gamble. This is not up for debate, it just is; if you find or fancy yourself a gambler, save the trouble and head to your closest casino where they’ll be more than happy to separate you from your presumably hard-earned money quite expeditiously (you may even get some “free” food and drink out of it). If you’re not sure whether you’re trying to invest or gamble, just put your money under your bed until you figure it out, you’ll be doing yourself a favor. If you’re interested in making good investment decisions, this is where the fun starts…

Continue reading

The Best Laid Plans of Mice & Men: YOKU Summary Thesis Update

A friend sent me an email about YOKU because he’d read my previous work, and I set out to respond quickly and concisely.  However long and about 1,200 words later, I realized I’d inadvertently (basically) summarized my outlook on YOKU in a kind of stream-of-consciousness style.  With the caveat that this is neither my full nor formal analysis, I’ve decided to publish my response to that email for those of you interested in my take on YOKU.

With all that being said, here goes:

Continue reading

Some Perspective on YOKU's Warner Brothers Deal

While something akin to Netflix is still a relatively new concept in China, I think we’re in serious need of taking a step back from today’s ridiculous reaction (judging by the stock rising 35% today) to YOKU’s new deal with Warner Brothers.

China’s Youku Inc (YOKU.N) has agreed with Warner Bros Entertainment’s local joint venture to offer pay per view movies on its newly launched online paid content platform, Youku said on Tuesday.

Under a three-year agreement with Warner Bros, Youku will add 400 to 450 Warner Bros movies to its Youku Premium library.

“People are increasingly willing to pay for high-quality content, and we take the growth of Youku Premium as a sign that the market is improving for paid services,” Dele Liu, Youku’s chief financial officer, said in a statement.

Great, so YOKU is paying (paid) a lot of money for content it now has to try to sell into a market that may or may not exist.  Let me rephrase that: In order for this deal to be break even (let alone be profitable), YOKU has to convince users not accustomed to paying for “premium” content to…pay for it.  Has this strategy worked anywhere in the world?  I can’t think of any examples of any similar size/scale.

Youku Premium, officially launched on Tuesday, began beta testing in October 2010. Since then, the service has processed 200,000 paid transactions for its library of more than 300 movies and 3,880 educational programs.

According to YOKU’s annual report, they had roughly 280 million monthly visitors.  In 8 (or 9) months then, assuming this number hasn’t changed, they’ve had 2,240,000,000 visits. Two point two BILLION.  In that time, their “beta” test of Youku Premium resulted in 200 thousand transactions.  I’m not entirely sure of the scale of the beta test, but only 0.009% of site visits resulted in a transaction. That’s only 8 or 9 out of every 100,000.

While this number will surely increase significantly when Youku Premium is rolled out across the site, I’m FAR less optimistic than other participants.  I’ve been privy to semi-confirmed reports of illegally-hosted copyrighted content not just on YOKU’s competitors’ sites (of which there are many), but on YOKU’s platform, too.  Ultimately, there are two questions investors must ask themselves:

  • Why would Chinese users accustomed to getting content for free pay for it, when it can still be accessed for free with minimal effort/inconvenience?
  • YOKU hasn’t filed a 6-k yet, but from the myriad of news reports I’ve read, this is NOT an exclusive deal, i.e. the content will still be available elsewhere and Warner Brothers is still free to strike similar deals with YOKU’s competitors.  This isn’t even the first such deal Warner Brothers has struck!  Is Youku’s brand strong enough to keep users coming back?

The company is growing revenues at an incredible rate (so they claim), and the market is growing.  But in evaluating how much to pay for the stock, we have to consider more than just headlines.  Is a company worth 35% more because they signed a non-exclusive to sell content into a market not accustomed to paying for it?  I highly doubt it.

At Goldman Sachs, Chinese Tech Companies Apparently Have the Same Risk As U.S. Ones

I’ve been analyzing YouKu.com (YOKU) for the past three weeks, and as I said most recently, I can’t possibly see how the stock could be worth more than about $21/share, using what I think are pretty optimistic assumptions.  I read Goldman Sachs’ – YOKU’s lead cheerleader underwriter – report before I published, and I’m still going through it and finding data, figures, conclusions and other “analysis” I find very puzzling, to put it nicely.  I’d made a note to myself during my first read-through to go back and check GS’s WACC calculation, since their Cost of Capital was only 12%, which seemed pretty low to me considering we’re trying to value a high-growth, relatively high-risk company in China.

Today, I finally went back and checked GS’ work, and what I found is at the very least EXTREMELY confusing, and at worst, deeply, deeply troubling.

Here’s why:

Continue reading

Project YOKU-zuna: Downgrading to Conviction Sell (Again)

Last week Goldman Sachs (Asia) LLC (YouKu.com’s lead cheerleader underwriter) upgraded YOKU to a buy with a $55 12-month target price.  I’ve read the report, and I think the GS analysts are even more bullish than some of the silliest blind China bulls I’ve encountered.  The report is also riddled with non sequitur, stating, for example, that smaller competitors must be profitable in order to continue operating and that firms are under U.S. sort of obligations to pay for content (like TV shows and movies).  Such naivete aside, I’ve re-worked much of my model and assumptions, in many cases giving the company significant benefit of the doubt, but I still can’t rationalize the current stock price (~$29).  My analysis suggests the stock is STILL significantly over-valued, even after declining ~45% since my initial report.

Continue reading

Project YOKU-zuna: Failure to Execute

While his legacy is still being written, YouKu CEO Victor Koo has achieved success seen only by a very select group of revered business leaders, visionary CEOs with an ability to not just dream it, but do it.  His previous effort, Sohu, is one of the most successful internet firms in China, and if the past few years are any indication, he’s well on the road to a repeat performance with YOKU.

I’ve been analyzing this company (stock) for the past two weeks or so trying desperately to essentially over- value the firm.  When I started, the stock was trading around $43/share, and even with aggressive assumptions for revenue growth, margin expansion, and other measures of management effectiveness, I couldn’t figure out how the company could be worth more than mid $20′s/share (for whatever its worth, the stock closed yesterday at $29).  Investors should make no mistake: Just because a firm operates in a major growth sector in a major growth market, profits are far from guaranteed.  Running a several billion dollar company is NOT an easy task, and while some have been able to handle it (and then some), the path to sustainable success is littered with the carcases of corporate failure.  Many and myriad are the chances to slip-up, while those to achieve lasting prosperity are fewer and farther between.

That being the case (like it or not), this week I’m playing around with my original assumptions to see how the valuation changes if the company – led by Victor Koo – fails to attain the lofty goals I set with my assumptions.  I’ve made some relatively small changes/fixes/improvements to my model and its assumptions too nuanced and numerous to mention here (those with financial modeling experience should understand, model is now more consistent/accurate/flexible, formulas less clunky, etc), but the cumulative result is that the DCF value is now higher -  17% higher in fact or $27.77 – than the $23.76 from my initial effort.  Using this new, higher value and the assumptions driving it, let’s see what happens when we make some changes.

Here is the income statement along with growth rates and margins:

As you can see, that $27.77 valuation is predicated on some serious revenue growth – 58.1% CAGR – and gross margin expansion – 75.5% CAGR -  over the next decade.  It is these two assumptions that I want to address today, to see what happens if YOKU fails to grow as fast as projected.  We should be publishing more in-depth report on YOKU’s operating costs soon.

I use comps (SOHU, Tudou, etc) and industry reports (e.g. the iResearch data cited by both YOKU & Tudou) to help generate my assumptions for revenue growth and gross margin expansion/contraction, which is what I’ve done here (see my last post on revenue growth assumptions).  I then use a multi-step approach – to reflect the business (growth) cycle – et voila, an oversimplified explanation of where these numbers come from.  For YOKU’s top-line growth and gross margins, though, I focused primarily on the rates for the next year or two and assumed those rates degrade constantly over time, i.e. for 2011, I assumed a 110% growth rate, which decreases 10% each year, and cost of goods (services) of 75%, which similarly declines 10%/year.  While this is not very likely to reflect the firm’s actual performance over time, it makes it far easier to sensitize the valuation to changes in growth rates.

I think using 10% decay for both of these figures is fairly generous; I’d be surprised if YOKU management can get costs in line that well, even as the business scales and matures, considering significant wage growth and inflation in China.  If we adjust the decay rate for cogs to -7.5%/year from -10%/year, all else being equal, the valuation drops from $27.77 all the way down to $19.37!

If we assume cost of goods decreases 10%/year, but that revenue growth will come up a little short of my initial estimates, say this year will still be 110% growth, but that will decay by 12.5%/year thereafter, the value drops all the way down to $19.02!

If we assume that both revenue growth and gross margins will be strong this year, but will be increasingly less so going forward, lower than my initial assumptions (of -10% sequential decay), say -12.5% for revenue growth and -7.5% for cost of goods, the value goes all the way down to $13.14!

Continue reading

Project YOKU-zuna: Deconstructing Questionable Revenue Growth Assumptions

I don’t like stating the obvious, except when it seems many if not most are seemingly oblivious to it.  Such, I believe, is the case with the stock price of Youku.com (YOKU).  As I shared last week, I believe the firm is grossly over-valued even when assuming amazing revenue growth and margin expansion over the next decade.  We’re talking 70% average revenue growth for the next 10 years.  Off the top of my head, I’m not sure any firm of this size has achieved a decade-long run that impressive in the history of the corporation!

This should be obvious, but firms can only grow so much, so fast.  YOKU makes substantially all of its money from online advertising, which means its revenue growth is bounded by two factors: the growth rate of the Chinese internet advertising market, and its share of said market.  The very-same “independent” research firm YOKU cites in its regulatory filings – iResearch – says the market only (yes, only) grew 54% last year, yet YOKU’s revenues grow three times as fast (152%)!

The only way for this to happen (and continue to happen) is for the market to grow faster than estimated, the sub-market in which YOKU operates – online video advertising – grew (and will continue to grow) faster than the broader internet advertising market as a whole, and/or YOKU made (and will continue to make) HUGE market share gains last year.  (YOKU could also expand into new markets, but for our purposes, we’ll assume the company invests most of its capital in the internet video space.)  Of course there is another way – falsifying revenue – but as I have done in my financial analysis, I’m working on the (very possibly unrealistic) assumption that YOKU’s financials are fraud-free.

In order to rationalize YOKU’s current (at the time of my analysis last week, around $42/share) price, not only did YOKU’s revenue growth rate have to significantly outpace that of the industry rate, but going forward, it will have to continue to do so for years to come!  Even if Victor Koo is the most brilliant CEO the World has ever seen, he is still (using our no fraud assumption) faces real-world constraints in how fast he can grow the company.

If we take a deeper look at the industry and YOKU’s position within it, I think it will become even more crystal clear that YOKU’s share price – driven largely by unrealistic revenue growth assumptions – is grossly over-valued.

Continue reading

Project YOKU-zuna Update: 10-Year Projected Income Statement

I’m still not done modeling YOKU‘s projected financial performance, but so-far I think I’ve done enough research to put together a preliminary (set of) income statement(s).  The image below shows an income statement which combines generous revenue growth and margin assumptions, each semi-possible – although by no means probable – if we look at those of YOKU’s “comps” over the past 5-10 years.

I haven’t finished the model yet so I don’t have accurate cash flows, but even using these very bullish assumptions I’m extremely skeptical I can get to the current valuation (~$4.5 BILLION).  The stock price has dropped significantly following the (announcement of) the secondary offering, but it looks like its still over-valued by about 15-20%, at the very least…

Continue reading

Explaining the Lack of Posts This Week: Project YOKUzuna

If you read the site but don’t follow me on Twitter, you’re very likely wondering why I’ve gone from at least one post/day to zero over the past week.  The simple reason is because I’ve decided to undertake a much larger, more time-consuming project of attempting to value Chinese “internet television” high-flyer Youku, in response to challengers who think $4.5 billion is an entirely reasonable valuation for a company with increasingly tough competition from new and incumbent services that’s bleeding cash and losing money every year for the foreseeable future.  Did I mention its a high-flying Chinese internet company, susceptible to what readers should immediately recognize is a non-zero probability of being an accounting and/or other type of fraud?

Preliminary results (read: NON CONCLUSIVE) indicate that if we assume the Youku’s financial statements are accurate – which I consider to be a bit of a leap of faith – the firm would have to grow revenues about 50% per year for the next decade while driving their costs down by about the same % to rationalize its current valuation.  Is this possible?  Sure, but is it likely?  Most certainly not.  Again, this is to say nothing of the (not unsubstantial in my opinion) discount we should apply considering the legal structure and financial/etc opacity involved.

If you want to see some of my preliminary thoughts, you can check out the Stocktwits stream and/or follow it on Market Pulse.

If you’ve been following this company and/or cover it, feel free to get in touch and we can discuss the assumptions/inputs.

What Chinese Company is Worth 60% More Than Sohu With 1/10th the Revenue?

The company is actually worth ~57% more than Sohu with 1/9th the revenue, but rounding made for a better title.  Know what company I’m thinking of?

No?
Here’s a few more hints:

  • It’s currently trading at about 60x annualized 2011 sales (4x as rich as Linkedin’s valuation)
  • Has about 1/10th as many employees as Sohu
  • Claims to be engaged in significant research & development, but only spends 8.2% of revenue on R&D while Sohu spends 12.6%

Any guesses?

Continue reading