Tao Value recently released its Q1 2019 Investor Letter, in which its reported about its returns, portfolio update, and several stocks it holds. You can download a copy of its letter here. The fund posted gains of 14.03% for the first three months of 2019, outperforming its benchmark, and also shared its extensive analysis of the stock it purchased in this quarter – HUYA Inc. (NYSE:HUYA).
We purchased a small position of HUYA amid its price weakness at the beginning of the quarter. It is not really a new position, as we have owned it through YY for years. I was positive about its business prospect from early on and will summarize my latest thoughts as follows:
Tao: As we are entering an informational age, e-sports is more real than “real” sports ever before. I think the industry could mature just as how traditional sports value chain evolved. Streaming platform in this chain is very similar to content distributor (think of ESPN) in traditional chain and is poised to take a relatively big piece of the pie. I also think the virtual item tipping monetization, inherited from entertainment streaming, would be a great add to traditional ads-based monetization strategy.
Meteorology: The game streaming industry in China is perceived to a have a large addressable market and a long runway. Additionally, in early March, the once 3rd player, Panda TV declared bankruptcy. I believe this event increased the probability of the rest leading pack (including Huya) to win out.
Additionally, thanks to Twitch, global investors are well familiar with the gaming industry value chain, thus the value of game streaming platforms. It produces a smaller probability that Mr. Market (consists mostly of non-Chinese investors) would underappreciate, thus undervalue it, like in YY’s case.
Topography: One unique feature of game streaming in China is that top 2 platforms Huya and Douyu are both owned by Tencent, which means the cut-throat competition era is basically over. I believe the industry is more rational than many other TMT verticals, as Tencent has been “disciplining” both platforms to not bid away, with hefty bonuses, top streamers from each other. In other words, it is Tencent’s instruction to both platforms to not waste its own money (in form of big bonus and contracts to streamers) on moving streamers from its left hand to right hand. This means the platforms would more likely get a larger slice of the pie, as content producers are accustomed to rational contract sizes from early on. It thus leads to a higher probability and a shorter path to profitability for platforms.
Huya also demonstrated strong operating leverage. One thing different than general entertainment streaming is that game streaming absolutely requires high definition picture quality, thus high bandwidth. For this key cost component, we see the expense in percent of revenue has significantly decreased over years (from 42% of 2016, to 19% of 2017, then to 14% of 2018).
Commander: The CEO Rongjie Dong, a long-time lieutenant to YY CEO David Xueling Li, joined YY in 2006, and has been leading game streaming group since 2008. There has been very little media coverage for Dong until Huya’s IPO. Based on what I could find, Dong seems rational and not promotional. For example, as the top game streaming platform broadcasting the League of Legends World Championship S8 in November 2018, Huya gained significant new traffic (MAU grew 34.5% YoY, compared to high teens in past quarters) during the final where one Chinese team Invictus Gaming contended for and eventually won the title. When asked by an analyst about the spending pattern and value of such new traffics (whom the analyst attributed to PC end), Dong immediately discounted the PC end users spike as “one-time event”, and reiterated his long-time view on PC end users as “lower value” users due to its lack of interaction, compared to mobile users.
System: One key thing to evaluate System factor is to understand major owner Tencent’s incentive. Given Tencent’s history of letting multiple internal teams to compete in product development (dubbed as “horse racing mechanism”), one likely outcome could be that Tencent allows both Huya and Douyu to run by their courses and let evolution theory to play its role (i.e. the fittest survives). That means HUYA shareholders may not get any value accrued to them if it loses, in the worst-case scenario (call it scenario 1). There are also other more favorable possibilities (e.g. 2. the market ends with duopoly of Huya & Douyu or any others & 3. Huya wins out as the monopoly). In both scenarios, Tencent may buy out Huya from public at some stage with market premium. The risk is of course, the premium is to be applied to its future market price, which itself is unpredictable. History is not short of US listed Chinese companies got bought out by management when priced at significant discount to their intrinsic value. There is however a simple hedge to mitigate risks involved in all 3 scenarios, which is to buy Tencent. If Huya loses, we would own the winner through Tencent in scenario 1. We would also be on the same side with Tencent management if they decide to squeeze out Huya’s shareholders in buyout scenarios. Since we already own and like other businesses of Tencent, I do not intend to get too mathematical on determining a hedge ratio (i.e. how much Tencent exposure I need exactly). I believe that owning both companies would yield a high probability of getting the value when game streaming industry matures in China.
Valuation: What is a reasonable valuation multiple for a fast growing, profitable, strong network effect business in a large but rational competition market? It should worth above market average in my opinion. We think the price we paid for Huya (at about 5x TTM revenue) is not demanding compared to its similarly priced but money losing peers in other cut-throat battlefields2. I could not argue that we got it cheap, but I think with certain degree of higher estimated probabilities of below two outcomes (1. Gaming streaming industry meet and exceed the addressable market expectation; & 2. Huya being one of the winners of this market), it was a reasonable price to start owning this business directly.
HUYA Inc is a company that provides game live streaming services in China, operating through its subsidiaries. Year-to-date, the company is up 45.53%, and on April 24th it had a closing price of $22.95. Its market cap is of $5.0 billion. In its last financial report for the last quarter of 2018, HUYA reported revenue of RMB 1,504.9 million (US$218.9 million) representing an increase of an amazing 103.1% from the same quarter in 2017.
At the end of the fourth quarter, a total of 16 of the hedge funds tracked by Insider Monkey were bullish on this stock, a change of -6% from the second quarter of 2018. The graph below displays the number of hedge funds with bullish position in HUYA over the last 14 quarters. With hedgies’ capital changing hands, there exists an “upper tier”of notable hedge fund managers who were upping their stakes considerably (or already accumulated large positions).
The largest stake in HUYA Inc. (NYSE:HUYA) was held by Alkeon Capital Management, which reported holding $36.7 million worth of stock at the end of September. It was followed by D1 Capital Partners with a $32 million position. Other investors bullish on the company included Sylebra Capital Management, Kerrisdale Capital, and Jericho Capital Asset Management.
This article is originally published at Insider Monkey.