How High Can YY Soar After Its 190% Rally?

YY (NASDAQ: YY) was one of the best performing tech stocks of the year. The Chinese live streaming company rallied nearly 190% this year, fueled by a streak of double-digit sales and earnings growth.

But after that big run, investors might be wondering if it's time to take profits. Let's check the fundamentals to see if YY still has room to run in 2018.

What does YY do?

YY generates most of its revenue from its live video streaming ecosystem, which includes YY Live for music, entertainment, sports, and e-learning videos; and Huya, which mostly showcases gaming streams.

YY monetizes these videos by selling virtual items for unlocking premium features, or virtual gifts for broadcasters. YY splits those revenues with its broadcasters. Many of its live streaming rivals -- including Momo (NASDAQ: MOMO) and Weibo (NASDAQ: WB) -- use similar business models.

A smaller portion of its revenue comes from its legacy online gaming, membership, and advertising revenues. YY is intentionally pivoting away from those businesses to focus more heavily on its live streaming business.

Why is YY on fire?

Last quarter, YY's revenue rose 48% annually, marking its highest growth rate in seven quarters. That growth was fueled by its 60% growth in live streaming revenues. Its mobile live streaming monthly active users (MAUs) rose 37% annually to 73 million, while its paid live streaming users (who buy virtual products) rose 47% to 6.3 million.

YY is also highly profitable. Its non-GAAP net income jumped 47% during the quarter, as its GAAP net income rose 59%. Wall Street expects its revenue and non-GAAP earnings to respectively rise 40% and 42% this year.

What headwinds does YY face?

YY's growth figures are impressive, but it has some flaws. First, its 11% sequential growth in paid users last quarter marks a steep slowdown from its 47% sequential growth in the second quarter.

That's troubling when we compare YY to Momo, which saw its paid user growth stay sequentially flat at 4.1 million last quarter. Momo's stock initially plunged after that report, but rebounded over the following weeks.

YY's 6.3 million paid users represents just 9% of its mobile live streaming MAUs. If YY's growth in paid users slows down as its total MAUs rise, it will become difficult to balance hosting fees and revenue sharing deals with broadcasters -- which would weigh down its margins.

Meanwhile, the live streaming market in China is getting increasingly crowded, which could force YY to invest more heavily in marketing or increase incentives for broadcasters to stay competitive. Bigger competitors like Weibo could also run their live streaming businesses at a loss to gain market share. To make matters worse, tighter censorship laws regarding live streaming could throttle the growth of all these platforms.

What do the valuations tell us?

YY currently trades at 19 times earnings, which is just half the industry average P/E of 38 for internet information providers. Its forward P/E of 16 also looks surprisingly cheap relative to its projected earnings growth.

However, investors should notice that Momo looks similarly "cheap," with a trailing P/E of 17 and a forward P/E of 12. Those multiples indicate that investors are still wary of high-growth live streaming companies in China, since any of the aforementioned headwinds could blow the stock off course.

So how much higher could YY soar?

In a best case scenario, YY's paid user growth wouldn't stall out, it could maintain its first mover's advantage in the live streaming market, and Chinese regulators would back off.

If those things happen and Momo keeps beating analyst expectations, the stock could easily double from these levels, as its P/E ratio narrows the gap with its actual earnings growth rate. But if YY fails to meet any of those expectations, its stock could either stagnate or plunge -- so it's clearly a high-risk play with potentially high rewards.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends Momo and Weibo. The Motley Fool has a disclosure policy.