Hello Group: Free Cash Flow Generating Business Remains Too Cheap To Pass Up

• The market does not like the negative growth trend.
• Tantan´s performance to date has been disappointing, to say the least.
• Don´t overlook this company´s high return on capital.
• If ROC returns anywhere near to its long-term mean, shares will rally hard.

If we look at the long-term chart of Hello Group Inc., we can see that shares remain heavily oversold. The question now is whether shares indeed bottomed out on the 29th of last month or is there more carnage on the cards here. The MACD technical indicator has never been this oversold but we may be beginning to see green shoots with respect to the histogram, which is very close to entering positive territory. Suffice it to say, the longer shares can remain above those December lows, the more possibilities of a turn-up in the 10-month moving average, which would definitely be an encouraging sign.

 

The market remains unconvinced though and from a pure fundamental standpoint, there is certainly merit to this viewpoint. Tantan, for example, which has been built up for a while now to take over the mantle for the company has disappointed so far. However, the company´s overall results are actually not that bad as the core Momo segment has actually been overachieving in recent quarters.

The market as mentioned remains unconvinced and the fact that Tantan did not really take center stage on the recent third-quarter earnings call may lead investors to believe that its hype, in the end, may not live up to expectations. Irrespective of the top line performance in Tantan, which was down considerably in the third quarter, what upset the market in earnest was the paying user count tally which dropped by 200k to come in at 2.9 million.

Overall, in the Hello Group in the latest third quarter, sales came in basically flat compared with the same period of 12 months prior and net income came in at RMB403 million (12% drop over Q3 last year). Wall Street will always bemoan negative earnings growth but despite the company’s growth problems at present, its net income margin remains healthy in double-digit territory.

Wall Street will lead you to believe that high-growth companies are always the best investments but this is not always true. For one, the company´s valuation remains extremely attractive in the Hello Group. Another reason why growth is not always the answer is the scale of the company´s profitability and here is where we really want you to see the strength of the Hello Group´s business.

For example, even if a strong equally cheap competitor emerges which manages to grow its earnings much faster than the Hello Group (as the sector is doing), investors should always investigate how much capital it costs the competitor to generate this growth. This is a very overlooked area in that if a competing company for example has to retain a high portion of its earnings to generate its growth, then what happens to this company when its earnings do not meet expectations? The sector´s return on invested capital currently comes in at roughly 5%.

On the contrary, the Hello Group´s return on invested capital currently surpasses 9% over a trailing twelve-month average. The return on invested capital metric basically is a solid read on how efficiently capital is invested in a business or sector. Sustainable business models always generate high returns on capital which makes us believe that sooner rather than later, the Hello Group´s valuation will change for the better. Essentially by not having to invest the lion’s share of the firm´s earnings, more of the Hello Group´s cash flow can then become available to return to shareholders.

We can see exactly what I mean by looking at the Hello Group´s cash flow numbers over the past four quarters. RMB 1.933 billion of operating cash flow was generated over the past four quarters. Furthermore, due to investment maturities exceeding investment purchases over the same time frame, a further RMB 301 million was generated by the Hello Group from investing activities. With this war chest of cash flow (remember – off negative bottom line growth), management was able to return RMB 853 million to shareholders by means of the annual dividend as well as RMB 1.061 billion by means of share buybacks. Suffice it to say, many “growth” companies come nowhere near the same level of compensation we see from the Hello Group at present.

Therefore, to sum up, in a company such as the Hello Group, the cash flow statement demonstrates clearly what high margins and limited interest expense can do for a business even in a negative earnings cycle. Even if shares remain where they are for a sustained period of time, we suspect that shareholders will continue to get rewarded handsomely through buybacks and the dividend and shareholder equity (net worth) will continue to increase. These are reasons enough to stand pat on our position and continue to get paid while we wait. Remaining long. We look forward to continued coverage.

Author: Individual Trader, Seeking Alpha