“China’s Facebook” is Finally a Bargain

Preparing a company for its public debut on the stock market is a long and arduous process. The numbers need to be checked and checked again, dozens of meetings with potential investors need to be arranged, and a virtual mountain of paperwork needs to be reviewed by regulators. So when major last-minute changes were announced just days ahead of the initial public offering (IPO) for RenRen (Nasdaq: RENN), “China’s Facebook,” it was pretty clear the company and its bankers had bungled what could have been a huge deal. But as it turns out, what was a bad deal for RenRen and its early investors could turn out to be a real coup for investors who get in now…

#-ad_banner-#Just days before the deal was priced, management admitted to miscalculating the size of its user base, which grew 19% in the first quarter, and not 29%, as had been stated in a previous recent filing. It didn’t help that the head of the board of directors’ audit committee abruptly resigned after being accused of fraud at another company.

Nevertheless, on its first day of trading on May 4, 2011, investors’ enthusiasm for social networking stocks in general led them to overlook the sloppy last-minute scramble. RenRen,  which had been priced at $14, opened at $19.50, then hit an intra-day high of $24 and finished the day at a still-respectable $18.

That would be the last bit of respect RenRen would get from investors as concerns grew that the company was just another fraudulent Chinese company that had absconded with investors’ money. Shares finished the week at $16.80. Two weeks later, they had dropped to $13, and three weeks later the stock was down to $9. Shares appear to have finally found a floor in the $7 to $7.50 range.

But the damage has been done. Shares are off more than two-thirds from that intra-day high seen at the debut. Yet at the current price, it’s increasingly looking as if the reward now outweighs the risk.

The best social media play in China?
The very notion of a social media play in China is a bit murky. After all, the Chinese government goes to great lengths to restrict forums that can be used for unwanted social commentary and dissent. As a result, RenRen has been heavily monitored by authorities and must be very careful to avoid running afoul of censors. Despite that, this is clearly a business in high-growth mode. Sales rose 64% in 2010 to $77 million, and are likely to top $100 million this year.

More important, that kind of growth can be sustained as Chinese Internet penetration expands and companies like RenRen figure out more ways to monetize their rising user bases. The whole point of social media business models thus far has been to build user bases and worry about revenue extraction once the user base is truly sticky. So social media companies like RenRen may see the number of users eventually rise at a moderating pace, but revenue growth could actually accelerate down the road.

To be sure, we’re in uncharted territory. We really can’t be sure how each of these business models will play out. Will LinkedIn (Nasdaq: LNKD) justify its huge market value by stealing classified job listings from Monster.com (NYSE: MWW) as some suspect? Will Facebook start offering more Google-like (Nasdaq: GOOG) features and services such as e-mail and calendars? Will some of these companies flame out like MySpace.com did a few years ago? We don’t have the answers, so trying to figure out where RenRen will be in two to three years is an inexact science.

In addition, RenRen doesn’t have the field to itself in China as Facebook does in the United States. Kaixin001 was a first mover, and though currently smaller than RenRen, could garner some buzz with an IPO rumored to be held later this year. And the Chinese web portals such as Baidu.com (Nasdaq: BIDU), and Sina Corp’s (Nasdaq: SINA) short messaging site known as Weibo, and Taobao.com are all gaining traction. Still, RenRen’s 122 million registered users makes the company the largest player in the space. (Only a fourth of those log in at least once a month and only 18.5 million log on daily, however.)

So what do Wall Street analysts think of RenRen? The initial response has been somewhat tepid. Deutsche Bank analyst Alan Hellawell (whose firm was the lead underwriter), has a “Hold” rating and a $8.42 price target. Oppenheimer’s Andy Yeung who rates shares “Outperform” and thinks they’re worth about a $12 target, noting that the “long-term strategy to create an integrated platform for [social networking], web gaming, and social commerce should enable RENN to further monetize its large and growing user base.”

RenRen’s just-released first-quarter results were luckily devoid of any bombshells. Sales rose 47% from a year ago to $20.6 million, and as noted earlier, sales will likely top $100 million this year. On the conference call, management noted that the recent IPO proceeds will be used to step up the development of more services and features and perhaps be used for acquisitions that help broaden the platform.

Action to Take –> As mentioned by the previous analyst statement, RenRen is also trying to capture the “Groupon” buzz with its Nuomi site, which helps generate local deals. The company is also actively pursuing the online gaming space. As these efforts play out, the company will start to look a little less like Facebook and a little more like a portal like Sina.com. This is not necessarily a bad thing, but it’s hard to model from a future sales and profits perspective. So buying shares now, after they’ve been crushed, is taking a stab that part or all of the components of RenRen’s business model will succeed. It’s a speculative approach, but at least you’re speculating after shares have lost two-thirds of their value.

It’s important to see this company for what it is: a good company facing a large opportunity with sketchy communication skills (as seen in the botched IPO) that is operating in a somewhat crowded field. Despite the sharp pullback, shares are expensive on just about any metric. But that’s the nature of “story stocks” that hold tremendous potential. Adding it all up, you can make the case that all of the bad news is now priced into the stock, the sellers have been flushed out (shares have shown real support around $7 in recent sessions), and a few solid quarters to come could push this stock back into favor. RenRen isn’t a “bet the ranch” stock but looks to be worth a small part of the speculative end of your portfolio.