Why YY Inc's Stock Growth is No Sure Thing

Shares of YY (NASDAQ: YY) recently surged to historic highs after the Chinese live streaming company's third quarter numbers crushed analyst expectations. Its revenue rose 48% annually, marking its strongest growth in seven quarters and topping expectations by $42 million. Its non-GAAP net income rose 47% to $96.1 million, or $1.59 per ADS, beating estimates by $0.14, and its GAAP net income climbed 59% to $95.6 million.

YY also provided rosy guidance for 37%-41% sales growth in the fourth quarter. Analysts expect its revenue and non-GAAP earnings to respectively rise 38% and 41% this year. But despite all those positive numbers, YY's stock trades at just 15 times next year's earnings -- making it seem like an undervalued hidden gem.

But if we take a closer look at YY, we'll see some clear reasons to be cautious. Let's examine the potential pitfalls investors should be aware of.

It's an all-in bet on live video

93% of YY's revenue came from its live video streaming platform (and related value-added services) during the quarter. That ecosystem includes YY Live, which features music, entertainment, sports, and e-learning videos; and Huya, which features video gameplay streams.

YY monetizes those videos by selling virtual items, which can unlock more features, and virtual gifts, which are given to popular broadcasters. The company splits that revenue with the broadcasters. YY's live streaming rivals -- like Momo (NASDAQ: MOMO) and Weibo -- also use the same business model.

YY's live streaming revenues rose 60% annually to $432 million last quarter, but revenue from its three other business units -- online games, membership fees, and "other" (primarily online advertising) -- respectively fell 18%, 28%, and 39%. YY attributed those declines to its "strategic shift toward its live streaming business", but it also makes it a poorly diversified "all-in" bet on live video streaming.

Its percentage of paid users is low

The biggest flaw in YY's business model is that it relies on a relatively small number of higher-paying users to keep growing. YY's mobile live streaming monthly active users (MAUs) rose 37% annually to 73 million last quarter, while its paid live streaming users grew 47% to 6.3 million.

This tells us that the average paying user spent about $23 per month on their favorite broadcasters. That's a very high number compared to other streaming platforms in China. Tencent's (NASDAQOTH: TCEHY) QQ Music, for example, costs just $1 to $2 per month. Premium subscriptions for online video sites like Tencent Video generally cost between $2 to $4 each month.

However, the abrupt decline of YY's rival Momo shows how fickle these paid users can be. Last quarter, Momo's MAUs rose 7% sequentially to 91.3 million, but its number of paying users stayed flat at 4.1 million. YY's number of paying users rose 11% sequentially last quarter, but that still marks a major slowdown from its 47% sequential growth in the second quarter.

An increasingly crowded and regulated market

YY has a first mover's advantage in the live video streaming space, but there are now hundreds of rivals offering similar platforms, including Momo, Weibo, Yingke, and Xiandanjia. These growing ecosystems could lure broadcasters and viewers away from YY.

To make matters worse, Chinese regulators are aggressively cracking down on these live streaming apps. Last year, regulators required YY's broadcasters to register their real names. It then introduced a new broadcasting license (which YY obtained) and subsequently suspended, fined, or shut down non-compliant platforms.

The government also cracked down on live streaming platforms on a case-by-case basis if they were found to "harm national security, damage social stability, disturb societal order, violate the rights of others, or broadcast obscene or erotic activities." If the regulators keep turning up the heat, the growth of China's live streaming market -- which Jefferies analysts see becoming a $6.4 billion industry by 2020 -- could grind to a halt.

So is YY worth the risk?

At first glance, YY looks like an undervalued growth play on the red-hot Chinese internet market. But if we dig deeper, we'll notice that it has a risky business model which faces slowing sequential growth in paid users, tougher competition, and tighter regulations in the near future.

That's why the stock is trading at such low multiples. I'm not saying that YY is a bad investment, but I think investors would be better off sticking with established Chinese tech names like Tencent, which offers a well-diversified business model, a wide moat, and consistently stellar growth.

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Leo Sun owns shares of Tencent Holdings. The Motley Fool recommends Momo and Weibo. The Motley Fool has a disclosure policy.