Youku's IPO: Could This Love Story Break Investors' Hearts?
American investors seem to be in love with Chinese Internet IPOs. This week, Chinese online-video site Youku (YOKU) had the strongest first-day rally of any company on a U.S. exchange since China's Baidu (BIDU) in 2005. Baidu went on to rise 40-fold over its offering price, and judging from the market's reception to Youku, hopes are high for a similar surge in time.
But the flip side to promise is risk -- and the risks of pinning big hopes on Youku are also big. The company has yet to post a profit, and the bandwidth-intensive nature of online video can weigh down margins. What's more, Baidu went public during a booming period in China's economy. It's not clear that the country's prospects are so bright in the next few years.
Those concerns haven't slowed Youku so far. The offering was initially priced between $9 per American Depository Share and $11, which would have put its market value between $922 million and $1.13 billion. Demand for the IPO quickly led underwriters to boost the offering price to $12.80 per ADS.
That put Youku's market value at the time of the IPO at $1.3 billion. But new investors were only getting started. By the end of its first day of trading, Youku's stock had risen 161%, and it rose another 9% on its second day, closing Thursday at $42.70 per ADS. At Thursday's close, Youku's market cap at just shy of $4.4 billion.
Another YouTube? Well, Maybe
The allure of owning shares in Youku are clear enough. It's being called the YouTube of China. YouTube is big in North America. China is potentially an even bigger market. So, the math goes, big plus bigger equals huge. How huge? As DailyFinance's Tom Taulli pointed out, to find a yardstick to measure Youku's valuation you might have to go back to the late 90s.
There's also reason to think the underwriters placed the offering price lower than demand dictated. Remember, Google (GOOG) paid $1.65 billion for YouTube in 2006, about 18 months after the video startup was founded. At the time of the deal, YouTube had 72 million monthly visitors. Youku, by contrast, was founded five years ago and has 264 million unique visitors per month, according to its prospectus.
By that measure, Youku was modestly priced at the opening, although it's starting to look pricey at its current level -- because one thing Youku does have in common with YouTube is a long history of losses. Four years after Google bought YouTube, its executives are still sheepish about answering questions about the unit's profitability.
Youku's losses have been growing smaller in proportion to revenue, but the black ink is still some ways away. In 2008, the company saw revenue of 33 million yuan ($5.1 million) and a net loss of $30.7 million. Last year, revenue grew to $23.1 million and the loss declined to $27.4 million.
All That Bandwidth Costs a Bundle
That trend is continuing this year, at least as far as revenue is concerned. In the first nine months of 2010, Youku's revenue increased to $35.3 million from $15 million for the same period a year earlier. But net loss grew to $25.1 million from $20.5 million, largely because of an increase in sales and marketing expenses. To bring in new ad revenue, the company is going to have to keep hiring sales representatives, which isn't unusual for a startup like Youku.
The problem is, as Google has learned from YouTube, Youku is also going to have to continue to spend on infrastructure as the amount of video content and the size of its audience grows. Youku has posted an aggregate loss of $53 million since 2006, about two-thirds of which came from cost -- primarily the cost of providing bandwidth to handle all the video traffic.
Youku plans to invest proceeds from the IPO in these areas, as well as video content that will help draw new audiences and perhaps subscribers. In time, investors will want to know that Youku can pay for its own costs through its operating activities, and that may take a while.
Cash flows from operations were a negative $25.6 million in 2008 and negative $20.4 million last year. Whatever revenue growth Youku is seeing is still being fueled by investments. In the first three months of this year, cash flow was a negative $17.5 million and is likely to top 2009's figure.
Thirty-Eight Pages of Risk Factors
What could hamper that growth? A few things. For one, Youku's market lead isn't as big as Baidu's was early on. Youku says it has a 40% share of the time spent watching online videos, and its closest competitor has 23%. But in terms of making money, the share is smaller: Youku controls only a 14% share of the online-video ad spending in China.
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Second, while all IPO candidates list risk factors in their prospectuses, Youku's is -- at 38 pages -- longer than most. Much of it centers on possible obstacles that could various Chinese agencies could present. Usually, most risks itemized are boilerplate text, but not all. And U.S. investors unfamiliar with Chinese commercial laws won't be able to know which risks are real.
Still, the biggest risk that Youku faces is plain enough. China has been pressuring interest rates higher to cool an overheating economy. Further moves to trim China's growth could put a speed bump on Youku's path to profits. Even worse would be the realization of fears now emerging that China's credit bubble could be the biggest bubble in history -- even larger than the U.S. housing boom.
Youku could overcome these obstacles and become an investment that, years from now, rewards early investors amply. But imagining the company as the next Baidu or even the next YouTube overlooks many risks that deserve some sober attention.
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