Jiayuan.com Flirting With Disaster

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) -- Jiayuan.com ( DATE) is a very popular online dating site in China with over 40 million users. However, like most of the Chinese Internet space, the shares have been pummeled recently, falling by more than 70% from 2011 highs. I believe that shares have at least 50% more downside, with limited catalysts for any upside movement. As a result I am short the stock.

A good comparison is RenRen ( RENN), which many investors felt would bottom out at around $5.00. Despite having over $1.2 billion in cash, RENN now trades at just over $3.00, with a market cap roughly equal to the cash it has on its balance sheet. Effectively, investors are valuing the entire business of RENN at roughly zero.

On Dec. 21, DATE hit an all-time low of $5.50, prompting management to announce a share buyback program of up to $10 million. The share price immediately jumped as much as 20% to over $6.50. However, the initial enthusiasm has proven to be short lived and the share price has drifted back down to the $5 to $6 range once again.

Buybacks in the China space have a mixed track record, although companies continue to announce them whenever their stock hits a significant low. The most recent example is Qihu360 ( QIHU). The company announced a $50 million buyback program once its stock broke below its 2011 IPO price. QIHU's stock rose 4%.

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After a company announces a buyback program, there are still several uncertainties. Will the company actually go ahead and buy back stock under the program? How will investors perceive the buyback as a use of cash? Will the added buying prove to provide more than just a temporary bump up in the share price? So far I have yet to see a buyback of shares provide long-lasting benefit to the share price once negative sentiment has already set in. As a result, in my opinion, a buyback is typically a poor use of the company's precious cash.

Like many Chinese Internet stocks, DATE is being weighed down by the realization that the Internet space in China is no different than in the U.S., even though there are more Internet users and a much higher growth potential in China. What matters in the long run is actual financial results, and those companies which do not deliver see their share prices plunge.

Good examples include YOKU, which was once a $70.00 stock and now trades at $16.00 (down almost 80%) and DANG which was once at $36.00 and now trades at $5.00 (down almost 90%). Each of these companies once had astronomical valuations based on the seemingly unlimited potential for Internet revenues in China. Now, the valuations have contracted enormously as investors realize that actual profits are not materializing.

Fallen Low

Shortly after its IPO, and at the peak of the China Internet bubble, DATE rose to a high of $16.12. Sentiment was driven by DATE's high growth rates for users and revenues, despite the fact that the company was not yet profitable in terms of income available to common shareholders. In the third quarter, when DATE did finally turn profitable, the share price was already down 50% to below $8.00.

The question now becomes, where does DATE bottom out? I am highly confidant that (similar to RENN) the answer is somewhere in the $2 to $3 range, implying a market cap of around $200 million or less. That represents a drop of at least 50% from the current price. The two potential catalysts for an upward move (i.e. the swing to profitability and the announcement of a buyback) are now factored in by the market and won't cause a pop in the stock going forward.

The key reasons why I think DATE is headed for a very significant drop are there are minimal earnings, no projected growth and only a limited cushion of cash on the balance sheet. These factors combined with the strong negative sentiment toward Chinese Internet stocks make DATE a very attractive short play.

The recent swing to profitability was in reality a wake-up call to shareholders showing just how little DATE is actually capable of earning. DATE only made $3.9 million for the quarter, and this was only achieved by slashing selling expenses by over 20%.

This model is clearly not sustainable over several quarters as selling expenses are crucial to any further growth in revenue. So either expenses need to increase, hurting the bottom line, or revenue will suffer, also hurting the bottom line. Even at a share price of $6.00, DATE still has a market cap of close to $500 million, which implies a sky-high valuation vs. earnings.

In addition, not only are earnings negligible, but there is expected to be little or no growth going forward. DATE saw 10% growth in revenue between the second and third quarters, however the company has already given guidance that Q4 will show no growth and revenue will be flat at around RMB 90 million (about $14 million). If growth is already beginning to flatten out for DATE, the valuation will obviously need to contract considerably as the current valuation still suggests a fast growing internet company.

Buyback Option

DATE only has around $90 million of cash on its balance sheet compared to its market cap of nearly $500 million, leaving a long way to fall before the cash starts acting as a safety net. The company obviously has more than enough cash to buy back $10 million in shares. However, I suspect that, similar to many other smaller cap Chinese companies, the buyback could actually be counterproductive as a means of supporting the share price.

Buying back only $10 million of stock for a $500 million company is clearly not enough to provide a permanent boost in the share price. Also, for a company with minimal earnings the effect of the buyback on EPS would not be substantial. Furthermore, the buy back would result in DATE consuming a meaningful percentage of cash on hand, much needed by the business to operate.

In short, I would not expect the buyback to provide much help for the share price, and depending on how investors view the consumption of cash, it could actually put more downward pressure on the share price.

Over the longer term, the big problem for DATE, is that the online dating business model is competitive to the extreme, even moreso than most other Internet businesses. In China, there are literally hundreds of "major" online dating sites, some of which even offer free access in an attempt to maximize traffic and boost ad revenue. Even Internet heavyweights such as Baidu ( BIDU) and QQ have gotten into this business and are offering online dating services. So have many smaller local sites that are tailored to specific areas in China.

Given the headwinds facing all Chinese Internet stocks and those specific to DATE, it is hard to see who will have appetite for the stock. For the same reasons, I don't expect that existing holders will show much patience for a company with minimal revenue and no growth operating in an intensely competitive environment. This will become even more of an issue once the stock breaks through the key $5.00 level, which can often be a trigger for institutional holders to sell.

In short, there may be some bumps along the way, but I expect that DATE will largely be a one-way street to $3.00 or less.
At the time of publication the author was short DATE, QIHU and YOKU.
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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