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I think there are some amazing opportunities for China-based small/mid-cap ADR stocks, as many stocks are down between 70% – 90% and trade at highly attractive multiples. I understand that this sector comes at high risk as there is not much coverage in US media. That said, I’m planning to launch a series of articles where I present multiple China-based high risk/high reward opportunities. Today I initiate my first pick Youdao (NYSE:DAO) with a buy recommendation. In this article, I look at the company’s business model and fundamentals, and I value the stock based on a residual earnings framework. My target price is $6.71/share.
Youdao is a leading digital education provider in China, and a subsidiary holding of the internet giant NetEase (NTES). As of December 2021, Youdao boasted a monthly active user base of >100 million and a rich portfolio of online learning products. Specifically, Youdao operates three segments: 1) learning services which are approximately 55% of revenues; 1) marketing services which are about 40%; and 3) smart devices which are about 5%. For reference, learning services include mostly AI-powered learning content based on various media and interactive tools and smart devices include products such as a smart pocket translator for language learning. For most of Youdao’s learning platform the company operates a studio model, where professionals record their teaching and Youdao software engineers translate the content in a digitized learning experience. Based on user experience and feedback, the content is the continuously refined, expanded and optimized. Notably, Youdao also operates Youdao Dictionary, which is China’s leading online language learning application with a MAU > 50 million.
There are multiple reasons, why investors might like Youdao’s business model and market potential. First, the online education market in China is truly enormous and growing rapidly as education becomes one of the most important success-factors for Chinese citizens. Frost & Sullivan expect the online education market in China to grow at >40% CAGR until at least 2025 and thus likely to reach a cumulative market size of greater than $85 billion. Second, Youdao is in the prime position to capture this growing market opportunity as the company’s scale and massive user base support network effects. Youdao has also managed to build strong engagement scores as socialization and gamification features provide a fun and interactive education experience. Third, Youdao’s value proposition stands out based on leading technological capabilities and content comprehensiveness. Supported by NetEase’s software engineering skills, Youdao managed to build leading AI-algorithms and build a competitive edge in voice-/speech-based learning. Finally, Youdao’s business model is scalable, as the company is pushing into almost all education verticals and age-classes.
As the market opportunity indicates, Youdao has enjoyed supercharged growth in the past few years. Revenues grew from $189 million in 2019 to $622 million in 2021, reflecting a 2-year CAGR of approximately 80%. Respectively, over the same period gross margin increased from $53 million to $308 million, indicating a margin increase from 28% to 49.5%. However, Youdao is not profitable net of business expenses. In 2021 the company recorded a $122 million net-loss and cash from operations was negative $208 million. Youdao closed the year 2021 with $130 million of cash and cash equivalents and $197 million of financial debt.
Youdao’s recent Q1 2022 was very much in line with analyst expectations and key metrics show that the company is still in high-growth mode:
Going forward, analysts expect Youdao will generate revenues of $724 million in 2022, $934 million in 2023 and $1.14 million in 2024, indicating a 3-year CAGR of approximately 17%. EPS is expected to be -$0.63, -$0.07 and $0.12 respectively (Source: Bloomberg Terminal). Thus, analysts see Youdao achieving profitability by 2024. If this profitability would be sustained, or slightly increase, then investors might find a value thesis in Youdao.
What if Youdao would achieve sustained profitability? How much should the stock be worth? To value DAO, I use the Residual Earnings Framework. I believe the Residual Earnings framework is the best tool to value DAO, because: firstly, free cash flows are distorted due to growth-investments; secondly, multiples do not reflect business value; thirdly, the company is paying no dividends. My key assumptions are as follows:
Based on the above assumptions, my calculation returns a base-case target price for DAO of $6.71/share, implying that DAO appears approximately 35% undervalued.
Analyst Consensus; Author’s Calculation
I would like to highlight the following downside risks that could cause Youdao stock to materially differ from my price-target of $6.71/share:
First, as Youdao is based and operating in China, the company is exposed to heightened political risks as the CCP aims to regulate tech/internet companies. And in fact, education is one sector that has seen especially strong regulatory pressure in 2021.
Second, much of Youdao’s share price volatility is currently driven by investor sentiment towards Chinese ADRs and risk assets. Thus, Youdao stock price might show strong price volatility even though the company’s business fundamentals remain unchanged.
Third, Youdao has a history of writing losses and there guarantee that the company will ever enjoy sustained profitability.
Finally, the economy in China is currently pressured by multiple headwinds including inflation, real-estate crisis and COVID-19 lockdowns. If the Chinese economy would slow more than what is expected and priced in, investors should adjust expectations for Youdao’s short/mid-term business monetization accordingly.
Reflecting on Youdao’s business model and growth potential, I assign a Buy recommendation to DAO stock. I like that the stock is down >80% from ATH and might be poised to bounce sharply once negative sentiment towards risk assets and ADR’s fades. Moreover, visibility for profitability gives the stock a speculative fundamental anchor. However, given the regulators pressure in China with regards to the online education industry, I note the need to remain cautious and not to place a big bet. My target price per share is $6.71, supported by a residual earnings valuation.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: not financial advise