2023-08-05 11:57:33 ET
Summary
- The stock delivered a massive above a 100% rally in the last twelve months, and my valuation analysis suggests it is still massively undervalued.
- But I think the discount is fair given the company is facing secular demographic headwinds.
- Substantial political and geopolitical risks are also inherent to Chinese companies.
Investment thesis
Based on my valuation analysis, Hello Group's ( MOMO ) stock is massively undervalued. But the substantial discount is fair given the secular demographic headwinds the business is facing. The management is doing well in cost control and delivers profitability metrics expansion amid consistent revenue decrease in the last five quarters, which is impressive. But the topline growth sustainability is the major factor investors are seeking in growth companies, and MOMO has problems here. All in all, I assign MOMO a "Hold" rating.
Company information
Hello Group is a holding company incorporated in Cayman Islands conducting operations through its Chinese subsidiaries. Activities of subsidiaries are related to online social networking space. Momo is a mobile application that connects people and facilitates social interactions based on location, interests and a variety of online recreational activities. Tantan, the company's second major offering, is a dating application.
The company's fiscal year ends on December 31. Hello Group's applications give the company multiple monetization opportunities, out of which Live video services represent roughly a half of the total sales. Value added service is close to live video services, representing 47% of the total. Value added services include membership subscriptions and virtual gift services.
Financials
The company demonstrated a stellar revenue growth between 2013 and 2019, but COVID-19 pandemic was a big disruption for the business, and the adverse effect lasted until FY 2022. The change in strategy regarding the marketing spending and experiments with monetization approached also adversely affected the top line in the recent years.
Despite challenges related to the revenue growth, the company still generates double digits in operating margin and a positive free cash flow [FCF] ex-stock-based compensation [ex-SBC] margin. Though, the FCF margin was razor thin in FY 2022. MOMO's substantial FCF margin generated before the pandemic enabled the company to build a solid balance sheet with a substantial net cash position and high liquidity ratios.
Seeking Alpha
Despite a strong balance sheet and almost no CAPEX, the company does not pay quarterly dividends, only special dividends. Apart from special dividends, MOMO also exercises stock buybacks.
The latest quarter's earnings were released on June 6, when the company topped consensus estimates both on revenue and the EPS. Sales declined YoY in a fifth straight quarter with a 16% drop. Despite the revenue decrease, the company managed to expand the adjusted EPS from $0.29 to $0.33. This was possible due to the optimization in SG&A costs. The substantial decrease in the SG&A to revenue ratio ensured the operating margin expansion from 11% to 15.5%, which is impressive.
The upcoming quarter's earnings are scheduled on August 30 and the revenue is expected to demonstrate a YoY decline again, though the decrease pace will decelerate to -5%. It is also important to emphasize that the adjusted EPS is expected to expand YoY despite the revenue decline.
I like the company's strong cost-control performance amid the revenue decrease. It is not frequent to see when companies demonstrate solid profitability expansion during decreases in revenue. That said, once MOMO returns to the revenue growth path, it will have more upside potential to profitability metrics. During the latest earnings call , the management reiterated its commitment to the improvement of internal processes which will ultimately help in cost savings.
Valuation
The stock rallied about 11% year-to-date, notably underperforming the broader market. On the other hand, during the past twelve months, the stock price more than doubled. Seeking Alpha Quant assigns the stock the highest possible "A+" valuation grade due to low multiples compared to the sector median and the company's historical averages. Though, the important price-to-FCF ratio does not look low at almost 8.4.
Despite most of the multiples might look convicting that the stock is substantially undervalued, I want to simulate the discounted cash flow [DCF] model. I use a 10% discount rate for MOMO. I have revenue consensus estimates for the upcoming three fiscal years and I expect for the years beyond a 3% CAGR. I use the FY 2022 FCF margin ex-SBC at 4.1% and expect it to expand by 50 basis points yearly.
As you can see, the stock is still substantially undervalued even after the past twelve months' massive rally. If we add up the above $1 billion net cash position as of the latest reporting date, the stock has the potential to double. Please also note that the assumptions I use are very conservative, meaning there is a large room for the upside in case positive catalysts pop up.
Risks to consider
I consider political risk as the most substantial one when we speak about investing in Chinese businesses. Especially if it relates to businesses possessing sensitive information related to personal data. In authoritarian regimes like in China, the government's control policies might change suddenly, and this might significantly disrupt MOMO's operations and financial performance.
Geopolitical tension between China and the U.S. is also a substantial risk. In recent years there was a big threat related to the potential delisting of Chinese companies from U.S. stock exchanges. While this risk eased in late 2022 , there is still no guarantee that a new potential wave of tensions between the world's two superpowers might make the delisting risks emerge again.
I also think that the company has the limited growth potential because the applications are aimed on Chinese market and it is a very specific culture and market. That said, I do not think that the company has significant international expansion opportunities. Apart from it, we should also keep in mind the demographic challenges China is facing. Apart from the secular population shrinking trend, there is a big issue related to the target audience - the Chinese young people. The country has a vast problem of unemployment among youths , where one of five people aged between 16 and 24 is unemployed. MOMO's revenue streams are discretionary for users and the youths unemployment problem is a big secular headwind for MOMO.
Bottom line
To conclude, MOMO is a "Hold". While the upside potential is vast, the massive discount looks fair to me. The upside potential does not outweigh the risks and uncertainties. I like the management's ability to deliver margins expansion amid revenue decrease, but the topline potential matters the most for me when I analyze growth companies. MOMO is facing significant secular headwinds to revenue growth, and it is the major reason why I do not invest.
For further details see:
Hello Group: Secular Headwinds Outweigh The Massive Upside Potential