XNET - Xunlei: An Update And A Special Situation

2023-06-12 03:59:55 ET

Summary

• Xunlei, a Chinese digital services company, has reported a 25% YoY increase in revenue and a marginal profit of $1.1m in its latest quarterly earnings.
• The company has a negative enterprise value of $125m, but its recent $20m share buyback authorization could lead to a significant re-rating of its share price.
• Were the stock to simply trade at a price that produced a positive enterprise value that implies a $3.50 price target.

In today's article, I quickly update my coverage of Xunlei ( XNET ), including reviewing the latest earnings figures, but my biggest reason for writing today is to discuss a special situation / catalyst that comes with a new share buyback authorization. For readers new to the company, I suggest reading my previous article for more background on the company.

Xunlei

XNET is a Chinese company operating in the digital space with service offerings including cloud acceleration, shared cloud computing, subscriptions and live streaming.

It reported its most recent quarterly earnings on May 16th, 2023, growing revenues by 25% year over year (from $79M to $99M) and eked out a marginal profit of $1.1M. As a foreign filer, XNET doesn't report quarterly cash flows but it did have this to say regarding the change in cash position over the quarter (with my emphasis):

As of March 31, 2023, the Company had cash, cash equivalents and short-term investments of US$258.3 million, compared with US$260.8 million as of December 31, 2022. The decrease in cash, cash equivalents and short-term investments was mainly due to repayment of a bank loan and spending on share buybacks .

Thus the slight reduction in cash wasn't due to cash burn from operations, instead, as discussed below, it was actually anti-dilutive.

The company also provided helpful color commentary on its business lines during the earnings call .

Cloud/Edge Computing

The cloud computing segment performed well with growing revenues and new products (with my emphasis):

Despite the fierce competition in the industry, our cloud computing business leveraged its competitive edge in shared cloud and technology to provide reliable, scalable and cost-effective services to our clients, and achieved an 8.2% year-over-year growth and generated $32.7 million in revenue in the first quarter of 2023.

We are continuously conducting proactive research and development of Edge computing applications to effectively compete in the industry and mitigate pricing pressure on the CDN business.

As you may already have known, OneThing recently launched 2 hardware product lines, OES and OEC aiming to construct an autonomous and controllable cloud computing infrastructure through technical improvement to support a broader range of Edge application scenarios for both corporate clients and ourselves. We're glad that user feedbacks are encouraging, and we expect the demand will continue to grow as the industry evolves .

Subscription

Likewise for the subscription business in which upselling to existing customers has been successful. With my emphasis:

Now turning to our subscription business. Benefiting from the demand from our loyal users [Technical Difficulty] revenue in the first quarter of 2023, representing a year-over-year increase of 15.8%. Furthermore, we are delighted to observe a growing propensity among subscribers to pay for the quality of services, as evidenced by the increase in the average revenue per subscriber from RMB 34.9 to RMB 41 in the first quarter of 2023 as compared with the same period last year. This is a testament of the effectiveness of our efforts to create a more engaging member community and enhanced user experience.

Live Streaming

Unfortunately, the live streaming business, while growing revenues, was challenged by various operating headwinds (with my emphasis).

As our growth driver, live streaming and other international value-added services generated $37.2 million in revenue in the first quarter of this year with an increase of 58.4% year-over-year, driven by the high demand of our diverse products in our product portfolio, both domestically and internationally. Our efforts to continuously refine product functions and iterate features enhanced our product synergies and improve user experience. However, conducting business operations across different countries and regions is always challenging due to volatile geopolitical factors as well as varying compliance and regulatory policies. It's especially so for us as it's one of our newly developing businesses. We're mindful of potential headwinds and even setbacks during the course of our business development. We will closely monitor the evolving regulatory and operating environment as well as changing industry trends, while focusing on improving localized operational efficiency and maintaining regulatory compliance.

Indeed, subsequent to the quarter's end, XNET announced that it was drastically reducing the size of its live streaming offerings.

[T]he Company is downsizing its domestic audio live streaming operations due to lower gross margin of such business and the rapidly evolving and challenging industry environment.

Guidance

Prior to the downsizing, the company had forecast increasing revenues, but this guidance has now been withdrawn until the details of the live streaming downsizing are fully worked out.

Turning to our revenue guidance for the second quarter 2023, Xunlei estimates total revenues to be between $111 million and $117 million and the midpoint of range represents a quarter-over-quarter increase of approximately 14.9%. This estimate represents management's preliminary view as of the date of this press release, which is subject to change and any change could be material.

Annual Financial Performance

As a foreign filer, XNET only fully updates financial numbers annually, so here is that latest data. As can be seen, the company has been generally growing revenues and cash flow from operations has now trended positively.

Valuation

With the stock trading at $1.59, the valuation metrics are quite compelling, in particular the price to sales, price to book and price to cash flow ratios.

With this quick update complete, let's now consider the special situation I mentioned at the outset.

Share Buybacks as a Catalyst

XNET generates cash from operations and now has a stellar balance sheet. In particular it has $258M in cash and short term investments on hand, with only $136M in current liabilities and $162M in total liabilities.

With 64.76M shares currently outstanding and the stock trading at $1.59, the market cap is $103M. More importantly, because of its substantial net cash holdings, the company trades at an astounding negative enterprise value of $125M. That's about negative $1.93 per share.

One excellent way for a company to take advantage of trading at a negative enterprise value is to use some of the cash on the balance sheet to buy back shares, since doing so is highly anti-dilutive.

In fact, the company has previously bought back shares, such that the share count has been declining recently. But importantly, that trend should continue with the company announcing another buyback authorization for up to $20M.

To understand the opportunity, let's consider what would happen if the company could buy back the full $20M in shares trading at $1.59 per share. This would total 12.57M shares to be bought back. After such a transaction, cash on the balance sheet would be reduced by $20M while the number of shares outstanding would decline by 12.57M, to result in 52.18M shares outstanding. The market cap would then have reduced to $83M (where we assume the stock price remains unchanged) and the enterprise value would still be negative $125M. But the key is that the negative EV per share would be even more negative ($125M/52.18 = $2.39), i.e. the surplus value per share would increase by $0.46. Thus these buybacks would be highly accretive and with the balance sheet still having substantial room, additional buybacks are certainly a possibility.

It is my strong belief that when the market understands this dynamic, XNET's share price will re-rate substantially. For example, if we take an extremely conservative approach and say that the EV for XNET should be zero, then that implies a market cap of $226.5M (MC + $31.8 - $258.3M = 0, or MC = $226.5M). With the current number of shares outstanding, that translates to a share price of $3.50 per share!

Quant Ratings

Seeking Alpha doesn't provide quant or factor ratings for XNET, probably because there is no Wall St coverage of the stock. Indeed, this latter point is likely an important part of the reason the stock trades at such a negative enterprise value (i.e. without coverage investors simply aren't aware of the situation).

Options

XNET has options, but they are lightly traded. However, if the market begins to re-rate the stock, options volume may increase, and in fact keeping an eye on the volumes might be one way to diagnose if the stock is about to come into play.

Risks

There are three main risks with holding XNET:

First, that the company fails to execute and that what are currently positive trends in revenue growth, earnings and cash from operations become negative.

Second, that the company is a VIE and thus shareholders don't actually own the company. Here is a good link describing this risk.

And third, that the market continues to overlook this special situation indefinitely and thus the share price never re-rates.

Given these risks, in particular the second one, I have taken a much smaller position in this name than I would were it based in the US.

Summary

XNET is generating cash from operations and has substantial cash on its balance sheet, yet it currently trades at a substantial negative enterprise value. I believe that a recent additional stock buyback authorization is a catalyst that will raise the stock price such that the EV becomes positive, which implies a share price of $3.50 per share or higher. I am long a speculative sized position as a result.

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