Why SINA Is Reducing its Stake in Weibo

Back in 2014, Chinese internet company SINA (SINA) spun off its social network Weibo (WB 0.91%) as a publicly traded company. SINA retained 56% of the outstanding shares of Weibo after the IPO. But over the past two years, SINA reduced its stake in Weibo with two share distributions.

The latest distribution, which will be completed on July 10, will reduce SINA's stake from 49% to 46%. However, SINA will still retain 72% voting power at Weibo. E-commerce giant Alibaba (BABA -1.14%), Weibo's second largest shareholder, reportedly holds a 31.5% stake.

SINA's mobile news app. Source: Google Play.

This means that investors who owned SINA shares on June 7 will receive one extra share of Weibo for every ten shares of SINA on July 10. That move might seem confusing to investors, so let's explain what SINA is actually doing.

Why is SINA doing this?

Weibo went public on April 17, 2014 at $17 per share, and rallied over 320% since then. During the same period, shares of SINA rose just over 60%. That disparity occurred because SINA was weighed down by a slower-growth portal business, while Weibo was considered a streamlined "pure play" on Chinese social networks. The difference is apparent in their annual sales growth over the past three years.

Annual revenue growth. Source: Company quarterly reports, Yahoo Finance.

Due to the performance and growth gap between the two companies, SINA started distributing its own Weibo shares to its shareholders to more accurately reflect the growth of the social network.

After the two 1-for-10 distributions, an investor who initially held 100 shares of SINA will own 20 additional shares of Weibo after July. SINA likely believes that the rally in Weibo shares will offset the perceived lack of enthusiasm for its older portal businesses.

What does this mean for SINA and Weibo investors?

As SINA reduces its stake in Weibo, the growing social network's revenue will account for a slightly smaller percentage of its top line. Last quarter, SINA's revenue from Weibo rose 67% to account for 72% of its top line. The portal business, which accounted for the rest, grew its revenues by less than 1%. Despite that drag, SINA's total revenues still grew 40%.

The portal business' gross margin of 50% last quarter was also much lower than Weibo's 77%. Therefore, reducing its stake in Weibo would likely impact SINA's margins and earnings growth. But analysts don't seem too worried -- they still expect SINA's earnings to rise 86% this year.

For Weibo, SINA's reduced stake isn't that meaningful, since its parent company still retains a clear voting majority. This means that if any potential suitor wants to acquire Weibo, it would need SINA's approval. That's why there's been speculation that Alibaba could buy SINA to gain control of Weibo.

Does this make one stock a smarter play than the other?

The distribution strategy creates an interesting opportunity for investors, since it currently appears that the market undervalues SINA's stake in Weibo. As of this writing, Weibo shares trade at about $72, which gives it a market cap of $15.6 billion. A 46% stake in that company would be worth $7.2 billion. SINA has a market cap of just $6.1 billion.

That disparity makes SINA look like an oddly undervalued play on Weibo. But we should also consider the valuation gap: SINA trades at just 26 times earnings, while Weibo trades at 112 times earnings. The industry average for internet information providers is 37.

If we value both SINA and Weibo with a P/E of 37, SINA's market cap rises to $8.5 billion, while Weibo's market cap falls to $2.7 billion -- which more accurately reflects the relationship between the two companies. However, it also tells us that SINA is a much safer way to invest in Weibo than Weibo itself, which is trading at lofty valuations in a frothy market.