Related topics: China, Google, Yahoo, investing strategy, Jim Jubak
Last week was a great week for Chinese Internet stocks.
Oh, not for their share prices. Last week was grim on that front.
Baidu (BIDU, news), the operator of China's most popular search engine, was down 7.1% for the week. And that's about as good as it got in the sector. Sohu.com (SOHU, news), which runs an Internet portal, fell 11.3% for the week. Sina (SINA, news), an operator of online content sites, dropped 14.6% for the week. Renren (RENN, news), the hot recent initial public offering for the Facebook of China, plunged 21.7% in the week.
But for investors hoping to figure out if there is a fundamental case for investing in this sector -- and in specific stocks -- it was a super week. The Chinese Internet stocks that plunged did so based on fundamentals that we know and understand from the history of the U.S. companies in the sector (although valuations for U.S. Internet companies don't always reflect these fundamentals). The drop, painful as it was, demonstrated that China's Internet stocks aren't just playthings of momentum, where nothing counts but the enthusiasm of the moment. After the plunge I think you could feel a whole lot more confident about investing in the sector -- and not just because the stocks had become 10% cheaper.
What happened last week
The key event of the week was the May 11 announcement from Sina, owner of China's third-most-visited website and the Weibo social messaging service, that it had missed first-quarter earnings estimates. Earnings fell by 39% from the first quarter of 2010 to $15 million. That was below the $15.4 million consensus among analysts who follow the stock. The shortfall was a result of increased spending on the Weibo service, the company said. Total investment in Weibo, which claims 140 million users, may reach $100 million.
Jim Jubak
So what's the big deal about Sina's quarter? It was a simple reminder that attracting eyeballs isn't the end of the story but just the beginning. Once a company attracts the eyeballs, it has to extract actual revenue and profits from those visitors. It has to sell them something at a price that results in a decent profit margin. (It's not enough to say, "We lose money on every sale but make it up on volume.") Developing things to sell, marketing them and constructing the infrastructure to collect payment and deliver them can be expensive.
Sina isn't alone in facing this problem. You can see the same dynamic at work at Sohu, the owner of China's fourth-most-visited website. On April 25, the company announced a 48% increase in first-quarter profit. Net income came to $45 million, or $1.01 a share, up from 73 cents a share in the first quarter of 2010. Sales climbed by 35% on a 45% year-over-year increase in ad revenue.
A big part of the company's growth is projected to come from its Changyou.com (CYOU, news) game unit, which showed a first-quarter increase in profit of 33% to $53 million.
But that growth will cost money. Changyou is set to introduce a game called "Duke of Mount Deer," and that will mean an increase in marketing costs. That will shrink profit margin in the second quarter, the company noted in its post-earnings conference call. In addition, Changyou will spend as much as $101 million, according to Sohu, to buy a majority stake in Shenzhen 7Road Technology, a developer of Internet games..
Spending on marketing increases
Of course, when one Chinese Internet company ramps up spending on marketing and product development, cutting into its margins, it raises the bar for its competitors. You can see this at Baidu, for example.
Baidu dominates the paid search ad market in China. That dominance produced 88% year-over-year revenue growth in the first quarter of 2011 and a doubling of net profits. But, as you'd expect, that growth has attracted competition in paid search from Tencent (TCEHY, news) and Sohu -- to name just two of Baidu's competitors -- with noticeable consequences for Baidu's bottom line.
Baidu's costs for acquiring traffic as a percentage of sales climbed in the first quarter to 8.2% from 8.1% in the fourth quarter. That may not seem like much of an increase, but it reverses the downward trend of 2010. Rising traffic acquisition costs added to higher research and development costs (as the company expands its platforms to offer new services). Higher market costs have started to show up in the company's overall operating margins. Operating margin of 49% in the first quarter of 2011 was up from 41% in the first quarter of 2010 but down from 52% in the fourth quarter of 2010.
