The house rules are simple in this weekly column.

  • I bash a stock that I think is heading lower.
  • I offset the sting by recommending three stocks as portfolio replacements.

Who gets tossed out this week? Come on down, Youku.com (NYSE: YOKU).

Mandarin in motion  
China's largest video-streaming website posted some pretty impressive growth yesterday. Net revenue surged 178% to $30.6 million. Youku's deficit was more than halved to $0.04 a share. Analysts were betting on a loss of $0.05 a share on $26.5 million in revenue.

I'm always open to applauding market-thumping growth, but we're still dealing with a company that can't turn a profit on what should be a scalable model.

Let's be frank: It isn't easy turning a profit serving up licensed media files. Bandwidth costs alone ate up more than a third of Youku's revenue. Compare that with Baidu's (Nasdaq: BIDU), whose bandwidth during the same three months that consumed just 4% of revenue.

Content costs -- gobbling up another $7.7 million in overhead -- combine with Youku's bandwidth costs to account for nearly 59% of Youku's net revenue. Put another way, just $0.41 of every dollar in revenue is still around to pay company operating costs. Content costs may decline over time, and bandwidth will always be a bear to bear, but this is a company that will never approach Baidu's net margins of 48%.

It's not exactly fair to compare Youku with China's leading search engine, but the market certainly has a lofty opinion of Youku. The stock has shed 63% of its value since peaking earlier this year, but with the ADS equivalent of 109.3 million shares outstanding, we're still looking at a profitless company carrying a $2.5 billion market cap.

Is this company really worth nearly twice what Google (Nasdaq: GOOG) paid for YouTube? Before you answer, keep in mind that even though Youku is China's leading video-streaming site, but it's no YouTube or Hulu.

This remains a competitive and contested market in China. Its nearest rival, Todou, was set to go public late last week, but the market selloff got in the way. PPLive and even the smallish Ku6 (Nasdaq: KUTV) are aiming for eyeballs, and some of China's leading websites have hopped on the video-streaming bandwagon.

Youku popped higher earlier this summer, when it revealed that it will partner with Time Warner (NYSE: TWX) to sell hundreds of the studios flicks through the Youku Premium platform that's been available in beta since late last year. If you think there aren't a lot of people in the otherwise populous China open to paying for streams, you're right. All but $1.2 million of Youku's revenue this past quarter came from display advertising.

I think Youku is a quality company. It's growing at an impressive pace, and even though some analysts don't see it turning a profit until 2013, I can definitely see that happening next year.

However, this isn't a $2.5 billion company.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave ho. Let's go over the three fill-ins.

  • Sohu.com (Nasdaq: SOHU): One of the dot-com darlings making a strong push in video is Sohu. The company's online video channel saw a 150% pop in revenues, with a nearly 50% increase in advertisers. Sohu is a consistently profitable company that generated more in revenue this past quarter than Youku has over its entire three-year history. Sohu isn't growing as fast as Youku is, but it somehow has a smaller market cap, at $2.6 billion, than Youku does. That's just not right.
  • Netflix (Nasdaq: NFLX): This is the only company that's succeeding in getting folks to pay up for streaming video. No, it's not available in China. Its $7.99-a-month streaming plan is limited to Canada and the United States at the moment, though 43 countries through Latin America and the Caribbean will join the fun later this year. I'm not a fan of every move that Netflix has pulled lately, but the market selloff is doing wonders at adjusting its valuation. Is Netflix cheap at 33 times next year's projected profitability? If it's able to pull off its dual-plan pricing strategy and its overseas expansion, that valuation will be a bargain.
  • Baidu: I already argued about the merits of the Chinese search leader's model over Youku's chunky media-serving ways. The selloff has made Baidu's stock also reasonably priced relative to historical markups. Baidu is now trading for less than 30 times next year's targeted earnings. Baidu's revenue and profitability soared 78% and 95%, respectively, in its latest quarter. Any questions? 

I'm sorry, Youku. You're good, but you're not that good!