China Internet Stock Picks for 2012

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.

BEIJING ( TheStreet) -- Over the past month, the U.S.-listed Chinese Internet space has continued its slow meltdown. As expected, the weaker names in the space have been pummeled quite badly. However, now even the marquee names such as Baidu ( BIDU), SINA ( SINA) and Sohu.com ( SOHU) are being dragged down by negative sentiment even despite a recent rebound in the NASDAQ.

I still generally like names such as SINA and BIDU, but I sold my BIDU because I expect I will have the opportunity to buy it back at a lower price in coming weeks. In the low $50's SINA is also looking quite cheap and is probably being overly punished for losses due to its investments in Mecox Lane and China Real Estate Information which are already reflected in SINA's share price. If either SINA or BIDU drift much lower, I will be tempted to jump back with a longer buy and hold mentality.

On the short side, it is arguably too late to go short the weakest names in the space such as RENN ( RENN) and E-Commerce China Dangdang ( DANG). In addition, shorting either of these names has become very expensive. However, Youku.com ( YOKU) and Qihuoo 360 ( QIHU) both remain very attractive shorts, each with share prices hovering around $18 and market caps of about $2 billion. I am quite certain that both of these stocks will join the rest of the herd of China Internet stocks and see single-digit share prices in the near future, which is a drop of 50% or more from current prices. My best guess is somewhere in the range of $5 to $8 for each of these stocks.

In the case of YOKU, the company has seen losses accelerate due to increased content costs. Despite what Wall Street analysts had been saying, this should have come as no surprise to anyone as it is widely known that YOKU continues to single-handedly bid up the price of premium online content in China by a factor of several hundred percent. Over the past 12 months, YOKU has lost roughly 160 million RMB, despite very rapid growth in revenues. Cash flow has continued to be negative. The company has just over $500 million in cash compared to its market cap of over $2 billion, leaving plenty of room for the stock to drop.

By comparison, RENN has cash of $1.2 billion and a market cap of $1.4 billion. Effectively, money-losing RENN is valued at a tiny premium to its cash, while YOKU (which loses more money than RENN) is valued at four times cash. RENN currently trades below $4 but previously traded at $24 (a $9.4 billion market cap!) showing just how overvalued a stock can get, and just how far it can fall when investors tire of holding a "story stock" which continues to lose money.

In short, YOKU could have quite a long ways to fall. If there is upside in YOKU, it will only happen when the company announces a surprise swing to profitability and positive cash flow. Given the missed expectations that have become consistent in the past, it is unlikely that we see this in the next 2 quarters. YOKU's clear strategy is to price its competitors out of the market with respect to content and over the long term that may prove to be a successful strategy. But over the short term, I suspect that investors will lose patience with companies that continue to lose money and burn cash at an excessive rate (even when their platform is exceptional such as YOKU's).

Because it is a money-losing, cash-burning Internet company with a $2 billion market cap, YOKU is arguably the best short pick in the China space. QIHU is either tied for first place or a close second.

QIHU is also a $2 billion market cap company, but by contrast one which is just slightly profitable. QIHU makes all of its money by selling ads on its website and through revenue sharing with game developers on its website. As a result, from a financial standpoint, QIHU is directly comparable to ad giants SINA and SOHU. QIHU has reported a market share as high as 90% for its anti-virus software and over 50% for its Internet browser, but it should be kept in mind that these products are given away for free and the only benefit derived from them is the increased traffic they can direct to QIHU's website. In comparison to advertising competitors SINA and SOHU, QIHU is dramatically overvalued, as shown below.

I focus here on price-to-sales because both SINA and QIHU have recently posted one-time losses that make earnings not meaningful. But looking at it a different way, QIHU posted net income of just over $10 million in the third quarter, down from $11 million in the second quarter. Revenues are expected to increase by around 20% in the fourth quarter, so if earnings stay in line, that would give us about $12 million in fourth-quarter earnings.

Even if QIHU meets or beats these numbers, the current market cap of $2 billion still places the company on a PE of nearly 50 times earnings which compares to SOHU which trades at of around 11 times earnings. And in fact, this ignores the fact that SOHU owns 68.5% of Changyou.com ( CYOU). That stake is worth nearly $500 million at current prices, making the effective PE for SOHU roughly 8 times earnings. Clearly SOHU and QIHU are not owned by the same investors. In fact, a long SOHU short QIHU trade is starting to look quite compelling.

Similar to YOKU, the long thesis is that QIHU may actually start making real money in the future, either through the Internet search business or through monetization of its mobile strategy. However, unlike QIHU, management has already indicated that this is likely to be as much as two years away. Given the difficulties in the current environment for Chinese Internet stocks, I see it as being highly unlikely that investors will give any company a two-year grace period and similar to YOKU, I expect the Chinese Internet downdraft will take QIHU down to the $5 to $8 level in coming weeks.

Overall, I believe that the easiest way to grasp the valuations in the Chinese Internet space is to focus on market caps. As shown in the table below, QIHU is the fifth-largest U.S.-listed internet company in China by market cap. However, QIHU is still only earning about $10 million per quarter, dramatically less than any of its market cap peers. In addition, within the Internet space, fully ½ of the names are trading at below $1 billion in market cap, less than half of where QIHU is. Like YOKU, QIHU has a long ways to fall.

Disclosure: The author is short YOKU and QIHU.

The author can be reached at comments@pearsoninvestment.com.

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.