Shares of YY (NASDAQ:YY) recently rallied after the Chinese live video provider's first-quarter numbers crushed analysts' expectations. Its revenue surged 47% annually to 4.78 billion RMB ($705 million), beating estimates by $80 million.

YY's reported net income, which includes its recent acquisition of the short and streaming video company Bigo, more than tripled to 3.12 billion RMB ($460 million). On an adjusted basis, which excludes that acquisition and other one-time benefits, its net income dipped 10% to 654 million RMB ($96 million), or $1.38 per ADS, but still beat expectations by $0.20.

A young woman streams a live video on her smartphone.

Image source: Getty Images.

YY's post-earnings pop erased some of its recent losses, but the stock remains down nearly 40% over the past 12 months and trades at just 17 times forward earnings. Does that low valuation indicate that YY is an undervalued growth stock?

Understanding YY's business

YY's core platform, YY Live, hosts entertainment, music, sports, and e-learning videos. Most of that content is created by its users, who earn money when viewers buy them virtual gifts. YY's smaller platform, Hago, is a social network for casual gamers, and the company owns a controlling stake in the video game streaming site Huya (NYSE:HUYA), which it spun off in an IPO last year.

YY also owns Bigo, a Singapore-based company that provides its Bigo Live streaming app, LIKE short video app, and IMO video chat app to Gen Z users across China, South and Southeast Asia, the Middle East, and America.

During the first quarter, YY generated 94% of its revenue from its live streaming segment. Its entire live streaming ecosystem reaches over 400 million mobile monthly active users (MAUs) worldwide, and only about a quarter of those users are in China thanks to its takeover of Bigo. However, the segment's revenue still primarily comes from YY Live and Huya.

The rest of YY's revenue comes from its "other" businesses, which mainly include ad revenue from Huya and Bigo. Here's how those two core businesses fared over the past year:

YOY revenue growth

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Live streaming

47%

50%

36%

30%

48%

Others

4%

(9%)

(7%)

(3%)

36%

Total

43%

45%

33%

28%

47%

YOY = Year-over-year. RMB terms. Source: YY quarterly reports.

YY's growth decelerated throughout 2018, but its acquisition of Bigo, which closed in early March, clearly lifted its first quarter sales.

YY's average mobile MAUs (which include Hago but exclude Huya and Bigo) rose 66% annually to 59.8 million, marking a significant acceleration from its previous quarters. YY's services grew its paid users 17% annually to 4.1 million, or 7% of its mobile MAUs.

Huya's average mobile MAUs rose 30% to 53.9 million as the platform's number of paid users surged 57% to 5.4 million, or 10% of its active user base. YY didn't offer any financial metrics for Bigo, but it stated that Bigo's mobile MAUs surged 161% to 78.7 million, while mobile MAUs for IMO (which is separate from Bigo's main apps) reached 211.8 million.

A gamer plays a PC game.

Image source: Getty Images.

But mind the margins

YY's growth in revenue and users is impressive, but its gross margin of 33.9% marked a steep decline from 38% a year earlier. It attributed the drop to higher revenue-sharing fees with broadcasters, other content costs, a higher contribution from Huya's lower-margin revenue, and ongoing losses at Bigo, which is expected to remain in the red for the year.

YY's operating margin also plunged from 18.4% to 9.9% due to lower gross margins, higher sales and marketing expenses, and acquisition costs related to Bigo.

YY expects its second quarter revenue to rise 59%-64% annually, but it didn't provide any guidance for its margins or earnings. This makes it tough to determine if YY's aggressive expansion will sacrifice earnings in favor of stronger sales growth. Analysts expect YY's earnings to tumble 11% this year, but they also anticipate a 22% rebound next year if the company's investments pay off.

The bottom line

YY has four core strengths: its robust revenue growth, its expanding ecosystem, its waning dependence on China, and its exposure to the live streaming market, which seems less vulnerable to China's economic downturn than online ads.

However, its margins are contracting as it generates more revenue from lower-margin businesses, and the stock doesn't seem that cheap relative to its near-term earnings growth. I think YY still has upside potential, but it probably won't revisit its 52-week high until some positive news about the trade war whets investors' appetite for Chinese stocks again.