When Youku (NYSE: YOKU ) issued a press release over the weekend -- moving up its quarterly earnings release from Wednesday to Monday morning -- it was easy to get excited.
Was China's leading video-streaming website about to stun investors with a quarterly profit? Was it about to be acquired? Will shareholders be getting Youku.com-branded magical unicorns?
Well, there was no black ink posted, suitors knocking, or mythical creatures galloping about, but Youku shares are moving higher this morning after announcing the acquisition of smaller rival Tudou (Nasdaq: TUDO ) .
Youku will exchange 1.595 of its American depositary shares for every single share of Tudou. It's a ridiculous premium; given the pop in Youku's own shares on the news, we find Tudou roughly tripling in value today.
Let's take a closer look.
Youku oh no
Youku's growing quickly. Revenue soared 103% to $49.1 million in this morning's quarterly report. This would be awesome if serving online video in China was a scalable business, but this doesn't appear to be the case. Operating expenses soared 108% as bandwidth and content costs outpaced Youku's top-line burst.
The end result is that Youku's operating loss and net deficit widened substantially.
Tudou knows all about this. It was slammed after posting disappointing quarterly results two weeks ago.
Revenue soared 70% to $26.5 million, but revenue costs shot up by 119%. There's no applause for top-line growth when bandwidth, content, and mobile video service costs are each more than doubling. Scalable model? Bah!
Method to the madness
The good news for Tudou -- and clearly the catalyst behind the acquisition -- is that it appears to be gaining ground on Youku, according to market tracker comScore.
You couldn't tell that by last quarter's revenue gains, since Youku grew faster. However, Tudou has been gaining momentum since SINA (Nasdaq: SINA ) -- the parent company of the red-hot Weibo micro-blogging platform -- acquired a small stake in Tudou last summer. Tudou now lets Weibo visitors share videos using their Weibo usernames, resulting in 41% of the videos on "the Twitter of China" now hailing from Tudou. The visibility has been huge.
The comScore report showed that Tudou's share of video views rose in January to 13.8%, up nicely from its 11.9% slice in December. Youku slipped slightly, from 22% to 21.8% in that time.
This brings us to valuation. Why was Youku a nearly $3 billion company as of last week's close but Tudou -- with more than half of its trailing revenue and more than half of its gaining market share -- worth less than $500 million?
The math clearly works in Youku's favor here, even at this ridiculous buyout premium. However, investors shouldn't be cheering when a ridiculously overvalued company buys a merely overvalued rival. Two companies, each with costs of revenue growing faster than revenue, joining together won't make for a single profitable company overnight.
The future is buffering
Investors wanting some skin in China's booming online video scene don't need to settle for profitless specialists.
Sohu.com (Nasdaq: SOHU ) is reporting major traffic gains in its video business, but the portal's combination of its online advertising, search, and gaming pursuits offers a fast-growing company trading at just 13 times this year's projected profitability and a mere 10 times next year's bottom-line target.
Why pay up for a company that is so insanely mispriced that it has to pay three times market value for a busted IPO?
Yes, Tudou was trading well below last summer's IPO price of $29 before this morning's news.
Youku isn't a bad company. It's easy to appreciate the company's monetizing moves. It has used its market leadership position to woo Tinseltown powerhouses. DreamWorks Animation (Nasdaq: DWA ) and Warner Bros. have gotten behind the Youku Premium pay-per-stream initiative. Now it's using the disparity in valuation to make a deal that will be accretive -- at least on the top line.
Youku has fallen sharply since its peak, though it continues to trade above the $12.80 price it went public on toward the end of 2010.
It will be getting plenty of eyeballs in the Tudou deal. Internal data at Tudou shows 300 million monthly unique visitors consuming 5.2 billion monthly videos -- and that's the smaller of the two video sites. However, until profitability comes a-knocking, shareholders can forget about those magical unicorns.
There are currently about a dozen Chinese growth stocks recommended in the Rule Breakers newsletter service, and Youku or Todou aren't among them. If you want to discover the newsletter service's next Rule-Breaking multibagger -- even though it's not a Chinese growth stock -- a free report tells all. Check it out before it's gone.