Hello Group: Cheaply Valued, Impossible To Ignore

Summary

• Hello Group is a social network company based in China. The company operates a digital platform that enables users to socialize based location and interests.
• Down 44% YTD, MOMO is now trading at a P/E of below 5 and P/B of 0.65.
• The balance sheet is extremely healthy, profitability is attractive, shareholder distributions are best-in-class.
• Based on analyst consensus, MOMO will have amortized its current enterprise value as early as mid-2024.
• I conclude my article with a buy recommendation and set a target price at $8.68/share.

Hello Group’s valuation looks ridiculously cheap. Down 44% YTD, Momo is now trading at a P/E of below 5 and P/B of 0.65. Is the company the worst kind of value trap, or why else is MOMO trading so cheap? In this article I am looking at MOMO’s fundamentals and construct a valuation framework based on discounted future EPS, as estimated by analyst consensus. My analysis finds that MOMO is 68.6% undervalued, based on a price target of $8.86/share.

About Momo

Hello Group is a social network company based in China. The company operates a digital platform that enables users to socialize based location and interests. Hello Group owns two major apps: MOMO and Tantan. Momo is a social networking app based on social interactions and instant messaging. Tantan is a leading dating app in China, but also in broader Asia, very similar to Tinder. As of December 2021, MOMO recorded 114 million monthly active users and Tantan recorded 27 million. Like many social media companies in China, MOMO structured four major monetization sources: Live video services (1); Value-added service, which includes revenues from virtual gifting and membership subscription (2) Mobile games revenue (3); and Mobile marketing (4). However, live video services and value-added services together account for more than 90% of total revenues. MOMO first sold to the public in December 2014 at $15.15/share, which is more than x3 the company’s current valuation.

Financial Overview

MOMO hasn’t grown much in the recent past. The company’s revenues only kept pace with nominal GDP growth, recording a 3.6% CAGR from 2018 to 2021. MOMO’s path of profitability looks even less stellar. While the company recorded $430 million of net income (margin 21.2%) in 2018, the number decreased to $226 million in 2021 (margin 10%). Notably, this is a CAGR of -24%. However, investors should note that MOMO is still quite profitable as 10% net-income margin is quite attractive. Cash from operations has consistently been higher than net-income—supporting the strength of MOMO’s profitability metrics.

For sure MMOMO’s low valuation cannot be explained by financial worries. In fact, MOMO ended the financial year 2021 with $1.33 billion of cash and cash equivalents and total debt of $0.76 billion, which indicates a net cash position of $570 million. Notably, this is more than 50% of the company’s current valuation—referencing a market capitalization of 1.01 billion. I would also like to highlight that MOMO records a very clean balance sheet with almost no account-receivables, no inventories and no intangible assets. The company’s $2.85 billion asset strength is almost exclusively composed of investments and long-term assets such as property plant and equipment. That said, MOMO is in an excellent position to distribute wealth to shareholders. In 2021, MOMO distributed $275 million—or approximately 25% of the company’s valuation!

Looking forward: analyst consensus doesn’t expect that MOMO’s business will stagnate. In fact, revenues are expected to start growing again in late 2023/early 2024. Based on analyst consensus estimates, MOMO should record net income in 2023, 2024 and 2025 of $292 million $293 million and $190 million, respectively. If analysts are correct, MOMO would have amortized its current enterprise value as early as 2024. Based on a 2024 EPS estimate of $1.41/share, MOMO would trade at a 2024 forward P/E of 3.56.

Valuation

Given that MOMO is cheap at current levels, what could be a fair per-share value for MOMO? To answer the question, I believe a discounted earnings framework is the best valuation tool to assess a cash-cow asset such as MOMO. That said, I have constructed a Residual Earnings framework based on the EPS analyst consensus forecast until 2025, a conservative WACC of 10% and a TV growth rate equal to 0%. Based on my above assumptions, the calculation returns a fair share price of $8.68/share, which implies an undervaluation of 68.6%.

I also enclose a sensitivity analysis based on varying WACC and TV growth combination, so investors can value MOMO based on the scenario that best reflects their fundamental view on the company. For reference, red cells imply an overvaluation, while green cells imply an undervaluation as compared to MOMO’ current valuation. As you note, all tested combinations imply an undervaluation.

Investors might want to appreciate that the implied undervaluation is relatively low-risk, because most of the value is given by the current book value and earnings–not by any speculative future value based on long term earnings or growth.

 

Risk & Challenges

In my opinion, MOMO shares are significantly de-risked. However, investors should be aware of the following possible headwinds to the company and the stock: First, increased competition in the online dating market would pressure Hello Group’s market share and profit margins. Although currently no major tech/internet company in China Baidu, Tencent, Alibaba, JD has a focus on dating, this could of course change in the future. Second, shifting user behavior and demographics could cause Hello Group to lose interest and attention of its user base, thereby negatively impacting the company’s monetization opportunities. Third, a significant economic slowdown in China could negatively impact businesses advertising budget and users’ willingness to tip. Fourth, as a company based in China, Hello Group is exposed to significantly elevated regulatory pressure as compared to peers based in western economies. Fifth, much of MOMO’s share price is currently driven by investor sentiment towards risk assets, ADRs, and China equities. That said, investors might see significant price volatility in MOMO even though Hello Group’s fundamentals remain unchanged.

Conclusion

MOMO’s financials look amazing: The balance sheet is extremely healthy, profitability is attractive, shareholder distributions are best-in-class, and the valuation indicates strong undervaluation. Investors should note and monitor the challenges associated with buying equities based in China. But aside from any political and macro-economic challenges, MOMO stock looks like an obvious buying opportunity to me. I conclude my article with a buy recommendation and set a target price at $8.68/share.

Author: Cavenagh Research, Seeking Alpha