What to Keep as China's Net Bubble Bursts

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- Every investment bubble shares a common theme, namely that investors come to adopt a mentality that "this time things are different." As a result, they make investment decisions that justify valuations that are fundamentally unjustifiable. In early 2000, the Nasdaq briefly rose above 5,000. Now, almost 12 years later, the Nasdaq is still hovering at roughly one half of that level. So much for "buy and hold," "wait it out" or "buy on the dips" investment strategies.

Back in the heyday of the U.S. Internet bubble, analysts adopted new metrics to justify the sky-high valuations of Internet companies. P/E ratios didn't work because most of these companies were not profitable, so in some cases analysts simply used price-sales ratios. But in some cases, companies were coming public without even having meaningful sales, so analysts used odd metrics such as "price to eyeballs" ratios, comparing companies based on number of page views regardless of their potential for profitability.

The market for Chinese Internet stocks was an obvious bubble over the past year, with multibillion-dollar companies more than doubling in value on their first day of public trading. The element that was "different" this time was that China has more Internet users than the U.S. has people (over 350 million) and the rate of Internet penetration continues to increase rapidly. Combine this with China's rapidly growing per capita income, and things certainly do look "different this time." However, we can see just as clearly that the bubble is now in the process of bursting, as these share prices come crashing down.

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Some of the more prominent examples include:
Ticker 52-Week High Current Price % Change
DANG 36.40 6.43 -82%
RENN 24.00 5.74 -76%
YOKU 69.95 20.35 -71%
LONG 29.60 13.62 -54%
QIHU 36.21 16.69 -54%
SINA 147.12 82.26 -44%
SOHU 109.37 61.65 -44%
CTRP 52.32 35.60 -32%

Given the selloff in many Chinese Internet names many investors have been tempted to go bargain hunting. But just as with the U.S. tech bubble and crash of 2000, there will be far more long-term losers than long-term winners in the China Internet space. As a result, investors who jump in now should take extra care in making their selections.

Baidu vs. YouKu

Goldman Sachs recently recommended that investors take profits on Baidu ( BIDU), and issued a "Conviction Buy" on YouKu ( YOKU). I strongly disagree with both of those investment calls. Many of the Chinese Internet names will continue to tumble and many inevitably disappear altogether. However BIDU is a company that, like Apple ( AAPL) or Google ( GOOG) can seemingly do no wrong. BIDU will continue to be a money machine for years to come. As I come across various computers in China, in offices, classrooms, airports or coffee shops, it is almost invariably the case that Baidu is the homepage for every browser I see. Every time someone logs on, the first thing the see and use is Baidu. In addition, Baidu has been even more aggressive is monetizing search results than Google. BIDU is a stock I own and plan on holding for years.

YOKU is indisputably the best online video site in China. I use it often and absolutely love it. However from numbers standpoint there is going to be near-term financial strain at YOKU. From a balance sheet perspective, YOKU is obviously quite strong and the company should certainly be commended for taking raising $400 million when the price was at $50. However among media circles in China, it is widely known that YOKU is single handedly driving up the price of online content in China by a factor of three to four times.

This is a deliberate effort to corner the market on premium content which will attract visitors to YOKU's site rather than their competitors. YOKU has enough cash on hand to price its competition out of the market. Goldman has suggested that they expect YOKU to be profitable in 2012. However, given YOKU's obvious strategy of blatantly overpaying for content, I am highly skeptical that this will happen. As a result, I chose to go short YOKU at 22 to 23.

Ctrip and Qihoo

As a company, I am a big fan of Ctrip ( CTRP). The company consistently exceeds customer expectations in all areas of service and price whether online, by phone or in person at their various airport service counters. I use CTRP every time I travel and I love it. It is easy to see it will be a long-term winner in the Internet space, however I do not own the stock because I am concerned the slowing growth in the Chinese economy could have a negative impact on travel and hotel revenues. It is a stock I continue to watch, and one I expect to go long if the price comes off substantially.

Qihoo 360 ( QIHU) was recently the subject of a negative report by Citron Research. The company quickly issued a rebuttal. For anyone choosing to go long or short QIHU, I would strongly recommend reading both pieces and drawing a conclusion accordingly.

From my on-the-ground perspective, QIHU faces several significant issues. First, unlike BIDU or YOKU or CTRP, QIHU's product is just not commonly found in China at all. QIHU is the equivalent of the Gateway computer; most people have heard of it and many people might even know someone who has owned one in the past, but it is not something that people currently use. Problem number two is that QIHU does not even sell software, but rather it gives the software away for free and attempts to generate advertising revenue from its Web page. Last quarter (its best quarter ever), the company only generated $11 million in net income, while the previous quarter QIHU posted a $21 million loss. Despite this, the company boasts a lofty valuation of $2 billion in market cap.

Even if one assumes that the company can continue to generate $11 million per quarter, that is a P/E ratio of nearly 50 times for what is very much a tier-three or tier-four company. In comparison to names such as BIDU, SINA, and SOHU which have very high nominal share prices, it is easy to see QIHU trading at $16 and view it as a cheap stock. At $2 billion in market cap QIHU is definitely overvalued by at least 50%. As a result, I am heavily short QIHU and I expect it to be trading in the single digits by the fourth quarter. The company's quarterly earnings announcement is in eight more trading days; I believe that this will be the catalyst that drives the stock sharply lower.

RenRen and QQ

Finally, there's RenRen ( RENN). RENN has been mislabeled as the "Facebook of China," but history will prove RENN to be the "Friendster of China." Unlike Facebook, RENN is primarily used by college students while in college. However they quickly drop off after entering the workplace. RENN has failed to attract any meaningful non-college demographic, in contrast to Facebook which is used by students, grandparents, grandchildren and just about everyone else. The real "Facebook of China" is actually the service QQ (operated by TenCent) which is seemingly used by virtually everyone online in China. When meeting a new acquaintance in the U.S., people are often heard saying "look me up on Facebook", in China people invariable say "QQ me." Noone says "RenRen me."

Ultimately RENN will not survive the Internet bubble deflation and will almost certainly become a $1 to $2 stock. However, in the meantime it makes little sense to go short RENN because it still has over $1.2 billion in cash on its balance sheet and no debt. However, as its cash burn picks up, RENN will likely be trending lower unless they make a meaningful acquisition that can change their business.
At the time of publication, the author was long BIDU, short YOKU and short QIHU.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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