Why Did Investors Dump Momo After Its Earnings Beat?

Shares of Momo (NASDAQ: MOMO) are down over 20% this week after the Chinese social media company reported its third-quarter earnings. That decline is surprising, given Momo easily beat top-and bottom-line estimates.

Revenue rose 126% annually to $354.5 million, beating expectations by $15 million. Its non-GAAP net income rose 89% to $93.8 million, or $0.45 per share, surpassing expectations by $0.07. Its GAAP net income roughly doubled to $79.1 million.

Moreover, Momo still trades at about 13 times forward earnings estimates -- making the stock look like a deeply undervalued growth play on the red-hot Chinese tech market. So why were investors so eager to sell the stock, which remains up nearly 40% for the year, even after its recent drop? Let's take a closer look at the good and bad news from the quarterly report to decide.

First, the good news ...

During the quarter, Momo's live video revenue rose 179% annually to $302.6 million, as its value-added service revenue rose 45% to $26.3 million. Revenue from mobile marketing, mobile games, and other services (a combined 7% of sales) all declined, but the company is intentionally pivoting away from those legacy businesses to focus on its live-streaming platform.

Monthly active users (MAUs) grew 22% to 94.4 million. Average revenue per paying user also increased, thanks to the introduction of new virtual gifts and value-added services. Paid users of its value-added services climbed 41% to 4.8 million, while paid live video users grew 58% to 4.1 million.

Momo finished the quarter with $949.7 million in cash and equivalents -- that strong cash position should give the company plenty of flexibility to invest in new initiatives like "Momo 8.0", which adds new chat experiences, a "discovery" page for browsing user profiles, and faster ad delivery to the platform.

Now, the bad news ...

The bad news is that Momo's 126% sales growth during the quarter marked its slowest growth in six quarters. Its guidance for 50% to 56% growth to close out the year also strongly indicates that its growth has peaked.

That slowdown is worrisome, because much of Momo's triple-digit growth was driven by the introduction of its live video platform in early 2017. Prior to that shift, Momo was usually dubbed "China's Tinder" due to its reputation as a location-based dating app.

Looking ahead, the live video business faces an uncertain future, as the market is crowded with similar apps from YY, Weibo, Yingke, and Xiandanjia. Many of these rivals are either growing at faster or more sustainable rates than Momo. YY, for example, reported its highest revenue growth rate in seven quarters in mid-November.

Momo's results also only look impressive on a year-over-year basis. On a sequential basis, growth appears much weaker. MAUs were up just 3% sequentially during the third quarter, while its paying users for value-added services increased 7%. Most troubling of all, its paying live video users stayed flat sequentially, from both the first and second quarters.

As Momo struggles to convert its MAUs to paid live video users, it needs to develop and promote additional value-added services to generate more revenue per user. That's problematic, because its total costs and expenses already jumped 130% on a non-GAAP basis to $251.7 million during the quarter.

We should also remember that Chinese regulators have been aggressively cracking down on live-streaming apps -- Momo was previously slammed as a "prostitution" app by the state media three years ago. If regulators turn up the heat again, Momo's user growth will only get worse.

Three members of Momo's board abruptly resigned just days ahead of its earnings report for "personal reasons", leaving the board with six members. The company named COO Li Wang as a seventh board member, but those resignations raised some serious concerns about the company's long-term prospects.

The market loves high-growth companies when their that growth is accelerating, but the tables can turn quickly once momentum is lost. That's what's happening here. But Momo stock won't truly bottom out until the company can demonstrate that its growth is more sustainable than it currently appears.

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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.