Is Momo an Undervalued Growth Stock?

Shares of Momo (MOMO +0.17%) surged 9% on Aug. 22 after the Chinese social app company posted solid second quarter numbers that topped analyst expectations. Revenue surged 58% year over year to $494.3 million, beating estimates by $14.5 million.

Its non-GAAP net income rose 90% to $140.2 million, or $0.66 per American Depositary Share (ADS). On a GAAP basis, its net income rose 94% to $117.8 million, or $0.56 per ADS. For the third quarter, Momo expects its revenue to rise 51% to 55% annually.

Image source: Getty Images.

While those growth figures look incredible, its stock trades at just over 17x forward earnings following its post-earnings rally. Is Momo an undervalued growth stock, or are there hidden risks investors should be wary of?

Understanding Momo's business

Momo's core app allows users to connect to each other via social profiles and shared locations. It's often called the "Tinder of China" since it's widely used as a dating app. However, Momo's growth kicked into overdrive last year when it launched a live video streaming platform for the app. That feature allowed Momo to monetize users' video broadcasts with virtual gifts. To expand its reach in the video market, it co-produced and sponsored a new reality show, Phanta City, in July. The company also launched a premium subscription service earlier this year that offers better AI-powered matches, higher search exposure (via its "Super Exposure" feature), and a new "See Who Likes Me" feature.

To expand its reach in online dating, Momo acquired Tantan -- another dating app also referred to as the "Tinder of China" -- earlier this year in a deal worth nearly $800 million. Unlike Momo, Tantan directly clones Tinder's swiping mechanisms and other features. In fact, the resemblance was so close that Tinder's parent company Match Group sued Tantan for IP violations, and Tantan agreed to pay Match royalties and redesign its U.S. app.

Image source: Getty Images.

Momo's third quarter revenue guidance assumes that Tantan's average monthly revenue run rate will rise 60% to 70% year over year. It also assumes that Phanta City will contribute "at least" 100 million RMB ($14.6 million) in revenue.

How fast is Momo growing?

Momo's monthly active users (MAUs) on its core app rose 18% annually and 5% sequentially to 108 million during the quarter. Its total number of paying users rose 63% year over year to 11.6 million, but that growth was inflated by its inclusion of 3.1 million paying users from Tantan. Excluding Tantan, its paid users would have gone up 20%.

Over the past year, Momo has pivoted away from its smaller mobile marketing and gaming businesses to focus on online dating and live video streaming. During the second quarter, the company's live video and value-added services accounted for 83% and 11% of its top line, respectively. Mobile marketing and gaming revenues accounted for the remaining 6%. Here's how growth for each of those businesses has panned out over the past year

YOY sales growth. Source: Momo quarterly reports.

Momo's live video growth is gradually decelerating, but it hopes that the acquisition of Tantan will offset that slowdown and boost the results of its value-added services unit instead.

How profitable is Momo?

Momo's total non-GAAP cost and expenses rose 49% annually to $346.5 million during the quarter, mainly due to higher revenue sharing with video broadcasters, production costs related to Phanta City, and higher personnel costs.

However, Momo still grew its adjusted operating income by 88% to $163.4 million for the quarter, which gave it a non-GAAP operating margin of 33%. That's up from 28% in the prior year quarter. On a GAAP basis, its operating margin expanded from 24% to 28%.

Momo didn't provide any bottom line guidance, but analysts expect its non-GAAP earnings to rise 27% during the third quarter and 42% for the full year.

So is this an undervalued growth stock?

Those growth rates seem high relative to the company's valuations, but investors are concerned about the ongoing deceleration of Momo's top line growth. Total MAU growth could peak in the near future, and its future relies heavily on its ability to sell more virtual goods, convert more users to paid subscriptions, and bolster its value-added services revenue with Tantan.

I personally think Momo is an undervalued growth stock, but investors should be aware of the ongoing shift toward high-growth platforms like streaming video and Tantan. If that strategy pays off, its stock could soar. But if those plans fall short of expectations, growth-oriented investors are even more likely to abandon the stock.