Youku, Tudou Shares Surge on $1.1B Merger (Update 1)

Updated to include analyst note, CEO comments and earnings estimates.

NEW YORK (TheStreet) -- The top Chinese video Web site Youku (YOKU) is merging with competitor Tudou (TUDO) in a rare merger among U.S.-listed Chinese companies that will create a dominant Web presence.

The two merged online video competitors will create the largest Chinese Web video presence with control of about a third of the overall market, in a move that may cut at a glut of competitive local players. The companies, analogous to Comcast (CMCSA)-owned Hulu and Google (GOOG)-owned Youtube, have turned $100 million-plus annual losses on their free streaming video services prior to merger announcement that's valued at $1.1 billion. The tie-up may help both sites achieve profitability in the future, leading to a share surge in Monday trading.

"Overall, we view the Youku/Tudou acquisition as a net positive for the company as we believe it eliminates a significant competitor in content acquisition and will make Youku far and away the largest online video company in China," wrote Piper Jaffray analyst Gene Munster in a Monday note to clients. He rates Youku shares "neutral" with a price target of $27 a share based on a valuation of 10 times the company's expected 2012 revenue and cash flow.

In the deal, Tudou shareholders will swap their shares for those of Youku at a value of roughly $39.88, forming a combined company called Youku Tudou that will continue to trade as an American depository receipt on the New York Stock Exchange under the ticker "YOKU." Youku and Tudou shareholders will hold roughly 71.5% and 28.5% of the combined entity, respectively, according to a press release.

"We intend to lead the next phase of online video development in China. Youku Tudou Inc. will represent a differentiated leader in the online video market in China with the largest user base, most comprehensive content library, most advanced bandwidth infrastructure and strongest monetization capability within the sector," said Victor Koo, founder, chairman and chief executive officer of Youku.

The move is also expected to create significant cost synergies when the companies rationalize their overlapping Web capabilities. "This transaction would also lead to improvement in the industry structure and the underlying economics of the online video sector in China," said Koo. In a Monday conference call, Tudou executive Michael Xu estimated that the deal could create $60 million in cost savings.

Tudou shares rose nearly 150% to $38.34 in early Monday trading, while Youku shares swung from losses to a nearly 13% gain putting shares at nearly $29. Shares of both companies are up over 40% year to date prior to Monday's merger announcement.

There are drawbacks to the deal among two of China's Web leaders. The New York Times reports that prior to the announcement, a surge in Tudou shares has analysts questioning whether investors had advanced word of the merger, which may be scrutinized by regulators. Tudou was the largest share gainer in the Bloomberg China-US 55 Index Friday. The index tracks Chinese companies trading on U.S. markets.

According to Thomson Reuters data, the merger is China's largest Internet stock-swap deal on record.

In addition, both Youku and Tudou have struggled to turn a profit from their business of streaming Web video's for free to Chinese content consumers. Earlier in March, Youku reported a wider fourth-quarter net loss of RMB49.61 million or $7.9 million versus RMB37.72 million loss in the previous year. The company has lost roughly $200 million in the last three years, while its competitor Tudou saw its losses double to $350 million in 2010.

Youku is expected to post a $168 million 2012 loss on a more than doubling of revenue to $1.7 billion, according to consensus estimates of analysts polled by Bloomberg prior to news of a deal. Those analysts gave Youku a price target of $27.20, with 3 "buy" ratings, 5 "holds" and a "sell" rating.

While the deal is a consolidation of two Chinese Web competitors, others like Google-analog Baidu (BIDU), Sohu.com (SOHU) and Tencent may continue to present a glut of competition that may depress margins.

Goldman Sachs and Allen & Co. advised Youku on the merger, while Morgan Stanley and Credit Suisse advised Tudou.

-- Written by Antoine Gara in New York