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A Starring Role in China

By John Persinos on April 29, 2013

“To see things in the seed, that is genius.”

— Chinese philosopher Lao Tzu, circa 4th century BC

As the leading video-sharing website in the Middle Kingdom, Youku Tudou (NYSE: YOKU) enjoys star prospects as a small-cap growth stock.

Youku Tudou operates as an Internet television company in the People’s Republic of China. The company’s online platform allows users to search, view and share video content across different devices.

Dubbed the YouTube of China, Youku Tudou more accurately resembles a hybrid of Netflix (NASDAQ: NFLX) and Hulu, the joint venture of the ABC, Fox and NBC networks.

Youku Tudou is like YouTube, because advertising is its chief source of revenue, and it’s also like Hulu, because it offers professionally made movies and shows.

Youku Tudou is an early entrant in the field; the company only went public in November 2010. It remains a speculative Internet stock, but in the context of a changing television industry and China’s exponentially expanding middle class, it faces enormous growth prospects.

On-demand Internet TV is increasingly replacing the traditional channels of “linear TV.” Over the coming years, remote controls will be supplanted by new applications, for use on tablets and smartphones with touch screens.

Youku Tudou has a market cap of $2.8 billion and reasonable debt levels, giving it the wherewithal to be a serious player in this competitive landscape. The company is now forging direct-to-consumer services that are independent of the traditional pay TV bundle, to target China’s Internet-savvy and entertainment-hungry consumers.

According to Chinese government statistics, China’s Internet population reached 564 million in 2012, an increase of 10 percent compared to the previous year. This number is projected to exceed 718 million in 2013, accounting for 52.7 percent of all online users in the world.

The Youku Tudou platform already reaches a whopping 60 million Chinese viewers per day. Moreover, the company’s online programming is geared toward younger viewers, of which China is in plentiful supply. According to the World Bank, about 20 million people in China (roughly the population of Australia) turn 18 every year.

In March, Youku Tudou announced a partnership with Hong Kong Television Broadcasts Limited, or TVB (HKSE: 0511.HK) that will bring more than 2,500 hours of the broadcaster’s content to Youku Tudou’s streaming platform.

The two-year deal also makes Youku Tudou the exclusive venue to watch TVB’s popular dramas across several mobile devices. The two companies plan to soon start generating original content.

Youku Tudou is pursuing a three-pronged strategy for growth in 2013: 1) expand its advertiser base; 2) boost revenue per advertiser from existing clients; and 3) increase its footprint in second-tier cities in China, where the country shows particular room for growth.

These smaller but vibrant cities are home to younger, increasingly affluent consumers who clamor for Western-style programming, precisely the demographics that are in Youku Tudou’s favor.

China’s continuing rural-to-urban shift is one of the largest human migrations in history. City populations expanded by 20 million in 2012, mostly into the second-tier cities that Youku Tudo is emphasizing.

Moreover, China’s latest Five Year Plan is slated to spend huge sums to develop the country’s Internet infrastructure, which in turn will facilitate premium-streaming services. Not surprisingly, these services are undergoing rapid consolidation.

In March 2012, Youku paid USD1billion to acquire Tudou, which at the time was number two in the market and Youku’s biggest rival. The combination of Youku and Tudou created a market leader that now commands about a third of the online video market. (NASDAQ: BIDU), the world’s largest Chinese language Internet search company, offers an online streaming service called iQiyi that’s a direct competitor to Youku Tudou.

Last week, reports surfaced that iQiyi had purchased Shanghai-based video streaming platform PPStream for about USD400 million. To be sure, PPStream would increase iQiyi’s market share, but the latter still lags behind Youku Tudou.

Youku Tudou holds 32.4 percent of China’s online video market, while its nearest competitor (NASDAQ: SOHU) only has 10.9 percent. Baidu’s iQiyi currently holds just 6.7 percent of the market; the remaining field is fragmented with a smattering of weak competitors. In addition, Baidu has its hands full with fierce competition in its core business, as Chinese-based Internet searches increasingly migrate to various apps on mobile devices.

Another big advantage for Youku Tudou: Google’s (NASDAQ: GOOG) YouTube is banned from the Chinese market. China’s authoritarian government typically blocks access to websites it considers politically undesirable and YouTube made the blacklist.

Meanwhile, Netflix faces a problematic long-term future, as my colleague Chad Fraser makes clear in his April 24 article on Investing Daily.

As it grapples with its own challenges, Netflix has put expansion into China on the backburner, providing an opportunity for Youku Tudou to fill the void.

Much Tudou Over Nothing?

Investors concerned about Youku Tudou’s losses have been punishing the stock over the past year (see graph, below).

However, the stock recently ticked up, when Youku Tudou’s latest financials revealed soaring revenue and narrowing losses.

For the fourth quarter of 2012, Youku Tudou reported revenue of RMB635.8 million (USD102.1 million), a 30 percent increase from the fourth quarter of last year.

The company reported a fourth-quarter loss of RMB113.6 million (US18.2 million), a 43 percent decrease from the net loss in the same year-ago quarter.

Full-year revenue was RMB1.8 billion (USD288.2 million), for a loss of RMB424.0 million (USD68.1 million).

With a forward price-to-earnings (P/E) ratio of 14.38, the stock is reasonably priced, in light of its growth prospects and compared to the P/E of 25.5 for its sector of Internet information providers.

The combined company’s operating results are the first since Youku’s merger with Tudou. The losses reflect growing pains that are probably temporary, as Youku Tudou copes with the disruptions from integrating two operations.

Since the 2012 merger, Youku Tudo has been hitting its stride by reducing overlap and generating synergies. Many clients advertised on both Youku and Tudou; the combined company has streamlined its client base and raised prices.

The company expects between RMB480 million (USD76.5 million) and RMB520 million (USD82.8 million) in revenue for the first quarter of 2013.

For aggressive investors looking for a small-cap play on China’s Internet boom, Youku Tudou should get top billing.

John Persinos is managing director of Personal Finance and its parent website, Investing Daily.

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