The Cheapest Chinese Internet Stock

The words "cheap," "Chinese," "Internet," and "stock" don't belong together -- at least not until the current bubble bursts. In the wake of raging returns from Baidu.com (Nasdaq: BIDU  ) , a recent spate of Chinese Internet IPOs has demonstrated beyond a doubt that U.S. investors are willing to pay a pretty penny for a piece of China's Internet growth story.

This does make some sense. China is a market of 1.4 billion with an Internet-using population that already tops that of the entire United States. If an investor wants to find the next [insert name of wildly successful Internet company here], he or she should undoubtedly be looking in China.

Don't forget the lessons of the first Internet bubble
While there have been a number of wildly successful Internet investments, there are two enduring lessons from 1999 worth remembering if you're looking to replicate those experiences. First, remember that successful investments were the exception, not the rule. For every Amazon.com, which is up more than 12,000% since IPO, there were many more Pets.coms, which liquidated just two years after its founding.

Second, remember that the price you pay to own a stock does matter. Amazon, for example, is up just 100% since the end of 1999 -- a measly 6% annual return -- and has had to expand from selling books to selling everything, venture into cloud computing, and launch a music service, video-on-demand, and more. That's a lot of execution risk -- and the stock still looks expensive. If you bought in as the stock cratered in 2000 and 2001, then you've obviously done much better. Yet Amazon is not the only example. Intel and Akamai are two other successful tech businesses that still trade well below their peaks.

What this means for China
With that in mind, take a look at this list of Chinese Internet opportunities that was recently printed in The Economist as part of an article titled "Another digital gold rush."

Company

Market Cap

TTM EBITDA

EV/EBITDA Ratio

Baidu $47 billion $784 million 58.5
Tencent $51 billion $1.7 billion 28.2
Alibaba.com $8.6 billion $293 million 24.7
SINA (Nasdaq: SINA  ) $7.1 billion $108 million 55.6
Ctrip (Nasdaq: CTRP  ) $6.4 billion $184 million 30.7
NetEase (Nasdaq: NTES  ) $6 billion $450 million 9.8
Youku (NYSE: YOKU  ) $5.1 billion ($6 million) N/A
Renren $5.1 billion $15 million 373.9
Sohu (Nasdaq: SOHU  ) $3.2 billion $274 million 9.4
Qihoo 360 $3.4 billion $10 million 327.8
Dangdang $1.6 billion $5 million 298.8

Data from Capital IQ. 


Stare at this table long enough and a few things start to jump out at you. The first is just how ridiculous valuations across the sector are. Broadly speaking, the best bet is probably to stay away.

If you wish to live dangerously
That said, there are levels of ridiculousness. For example, paying less than 30 times EBITDA for a profitable market leader like Tencent, which operates two of China's 10 most popular websites as well as a messaging platform, sure looks to make a lot more sense than paying almost 300 times for a lesser operator and one-trick pony like e-commerce company Dangdang.

Ctrip also jumps out as a relative "bargain," given its leadership in the online travel space and the fact that rising incomes in China mean travel will be increasing alongside Internet usage in the country.

Finally, there are Sohu and Netease, which at less than 10 times EBITDA could be considered attractively priced by any standard. The story with Netease is that it's an online gaming company in China, a space that carries significant regulatory risk. As for Sohu, it's a portal, but not a top portal. If experience in the U.S. applies, then Internet companies tend to benefit from compounding leverage and network effects -- making it essential to be the top dog. Sohu is not quite that, even though it is a respectable business.

The cheapest Chinese Internet stock
Leaving aside closely held Alibaba Group, whose investment case I argued not long ago, the cheapest -- and again that's a relative term -- looks to me to be Tencent. It's the largest company in the sector, with several established businesses and revenue streams, and continues to grow operating earnings at a near-40% clip -- positive characteristics that will only strengthen as more and more people in China move online.

Yet just as the bursting of the Internet bubble created incredible opportunity for savvy, long-term investors amid the carnage, so, too, will a sell-off of Chinese Internet stocks. That's why one of our charges on this year's Motley Fool Global Gains research trip to China is to get a better sense of the competitive landscape in the sector, including meetings with the biggest players.

Get all of our dispatches in real time from the field by signing up with your email address in the box below.

Tim Hanson does not own shares of any company mentioned. Sohu, Baidu, Amazon.com, and Netease are Motley Fool Rule Breakers recommendations. The Fool has bought shares of Intel and call options as well. SINA is a Stock Advisor pick. Ctrip is a Motley Fool Hidden Gems selection. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2011, at 6:14 PM, BabyBeluga2 wrote:

    I look forward to further research in the next year. It seems to me that development of the sector is in its infancy and that the bursting of a "bubble" is many years away, as the internet market has achieved about 40 percent penetration now. As in all new industries, growth potential can be weighed as heavily as current revenue and profits, and those such as myself who are long in the sector are looking ahead and hoping to buy and hold before the predictable results come in. Those companies with a lower EV/EBIDTA ratio have the most to lose in this competitive (though protectionist via censorship and other laws) arena. Another wrinkle (and one that makes things less predictable) is that nearly all of these companies are multiplying services and trying to compete outside of their original niches as well as in their established ones.

  • Report this Comment On June 02, 2011, at 6:30 PM, StoneStAdvisors wrote:

    I spent the past week analyzing YOKU, and I can't - even when trying to overstate the firm's prospects - rationalize the current valuation. So far, it seems the stock is anywhere from about 20-50% over-valued, and that's giving YOKU management an enormous amount of credit and assigning a very, very (almost zero) probability of no fraud in their financial statements now or in the future.

    I've gone into much, much further detail here http://stonestreetadvisors.com/2011/06/01/project-yoku-zuna-...

  • Report this Comment On June 02, 2011, at 7:54 PM, TMFMmbop wrote:

    YOKU does look wildly overvalued. It is a top 10 website in the country, so there is some chance at monetization, but I agree with you StoneSt.

    Tim

  • Report this Comment On June 03, 2011, at 11:24 AM, RobMonaco wrote:

    My favorite is CYOU, no debt high growth and extremely cheap.

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