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, (NYSE: YOKU).

Game over?
Shares of China's popular video-sharing website went public this morning. Youku was initially expecting to price its shares between $9 and $11 apiece. They were priced last night at $12.80, and the company still left a lot of money on the table when the stock more than doubled to open at $27 this morning.


Youku's appeal as a story stock is obvious. It attracts well more than 200 million unique visitors a month. It commands 40% of the market share in China in terms of time spent watching clips, with its nearest competitor amassing a mere 23% stake.

Youku collects only 14% of the money being spent in online video advertising. Bulls may argue that this creates an opportunity for upside, but I suggest that Youku's popularity is largely related to its restraint when it comes to monetization.

Is this China's YouTube? No. It doesn't have the kind of undisputable market share that YouTube commands. The majority of Youku's content is also professionally produced video. In other words, it's more like China's Hulu.

This is an important distinction, because it means that Youku has to pay up to license most of its enticing video content. Between the chunky bandwidth costs and necessary licensing payments, this has never been a very profitable niche. Matters are made worse in China, since Youku's 343 brand advertisers aren't likely to be paying much to reach a video-happy audience that has historically been a tough crowd to monetize.

Youku has been growing quickly since its debut four years ago. Through the first nine months of 2010, net revenue soared 135% to $35.1 million. Unfortunately, cost of revenue alone -- at $37.2 million -- more than swallows up the money going in. In other words, Youku is sporting negative gross margins before we even get to its actual operating costs.

This isn't a blip. Youku delivered negative gross margins in 2007, 2008, and 2009 as well. Even if this company could be run by a single person watching over its 5,500 servers, it'd still be losing gobs of money.

Margins are improving, but this company's still far away from outright profitability -- and toiling away in a market that regulators govern with a tight fist.

Youku's not alone here. Its closest rival, Tudou, recently filed to go public, and it's also a bleeder. The same goes for the smaller and already public Ku6 (Nasdaq: KUTV).

China is going to create some of the market's biggest winners over the next few years, but investors need to dig beneath the story-stock veneer of some of its latest debutantes. Mecox Lane (Nasdaq: MCOX) went public less than two months ago, with some calling it China's The stock has since shed nearly two-thirds of its opening day pop as reality sets in.

I don't think Youku will crash that hard. It's a legitimate leader in its niche. However, the stock's ridiculous pop, for a model that will requires patience on its long road to profitability, will shake out today's speculators in the coming weeks.

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.

  • Baidu (Nasdaq: BIDU): If you're going to buy into a company cashing in on China's online advertising boom, go for the best. China's leading search engine has always been profitable, largely because paid search is a high-margin feast compared with web-based video. Revenue soared 86% in its latest quarter, and earnings more than doubled. Trading at 46 times next year's projected profitability isn't cheap, but at least it has positive earnings to create that multiple in the first place.
  • Google (Nasdaq: GOOG): If any company can make data-hogging video files work in an ad-supported model, it's going to be YouTube parent Google. The world's top video-sharing site, owned by the world's top online advertising company, makes for a perfect match. Google also trades at a reasonable year-ahead earnings multiple in the high teens.
  • (Nasdaq: SOHU): I was torn between SINA (Nasdaq: SINA) and Sohu for the final slot this week. Both companies have been new-media darlings in China for a long time. They have also been consistently profitable. I'm going with Sohu because of its more attractive valuation, but investors should still keep an eye on SINA, since it's the company behind Weibo, a Twitter-esque microblogging site that's been on fire this year.

I'm sorry, Youku. I'll take a closer look when you're nearing profitability.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.