Video games have always been a passion of mine. I have played some games semi-professionally in the last fifteen years and experienced how competitive my generation is. However, for many people, it is rather strange to watch how other people play. But isn't that what we have been doing for centuries, even millennia? Already the Romans organized gladiator fights with thousands of spectators. Nowadays, soccer is the most-watched sport, so it is definitely not new to watch others playing. Now, there are just other games. The basic requirement to enjoy these is a deep understanding of the games to appreciate the players' performance.

I have this understanding and the necessary insights into many different games. As of today, I am more fascinated when watching eSports compared to typical sports. In the long run, eSports are likely to have higher viewer numbers than physical sports. Hence, there are many years of high growth ahead of us.

For this reason, I have been looking for a suitable investment in this industry for years. I contemplated many game manufacturers, but they are too dependent on the success of individual titles. Therefore they have very volatile sales numbers because it is tough to predict which game will be the next big hit. Hence, these companies are out of the question.

$HUYA & $DOYU Merger proposed by Tencent

During my search for mid- and small cap companies among the holdings of ARK Invest, I came across DouYu (DOYU) and Huya (HUYA). These companies are the Chinese counterparts of the AMZN-owned Twitch. Which is banned in China and is, therefore, not a competitor in the Chinese market. HUYA & DOYU are the two largest streaming platforms and have long been fierce competitors fighting for the best content creators. However, this will now change. Tencent (TCEHY) has decisive power over both companies, as it holds a majority of both firms' shares.

A few weeks ago, it was announced that DOYU would become a subsidiary of HUYA. The result of this merger is a new and strengthened HUYA. And it will thus be the sole market leader in China. Another significant advantage coming out of this is the networks of TCEHY. HUYA already benefits from them. DOYU does not yet. In the future, both companies will be strongly supported by TCEHY; this is possible through the large number of games TCEHY owns and its reach to potential customers. Two of these games are League of Legends and Fortnite.

In the Asian market, the movement from physical sports to esports is even faster than in Europe and the USA. The fascination for video games is enormous. The growth potential is, therefore, given. It remains to be seen whether the companies are currently undervalued. 

Revenue & Margins

All numbers I mention below are a combination of both companies. I have summed up the sales and costs of HUYA and DOYU. Due to the merger, both companies' performances have to be considered; hence, this approach gives us a good perspective.

Revenues have increased from $306M in Q2 2018 to $736M in Q2 2020. This is more than a doubling in two years. Companies with such strong growth are often not yet profitable, and the margins are often just constant during the growth phase. However, this is not the case here. While HUYA has been profitable since the second half of 2018, DOYU has been profitable since early 2019.

Figure 1: Combined Quarterly Figures of HUYA & DOYU

Source: Created by author

This makes HUYA and DOYU extraordinary investment opportunities. Both firms were able to improve their margins during their hyper-growth years significantly. In 2018 the combined gross margin was below 10%; in 2020, it exceeded 20% for the first time. This trend has been slowing down. However, this could change due to possible synergies from the merger and thus accelerate margin growth. It is particularly noticeable that the net margin is higher than the operating margin. This is since both companies have almost no long-term liabilities and extensive cash positions. Leading to no interest costs but profits from interest and long-term investments.

Figure 2: Combined Margins Development of $HUYA & $DOYU

Source: Created by author

In conclusion, the development of sales and margins is exceptionally favorable. Is this similar for the customer base?

Yes, the number of users of both companies have skyrocketed to between 160M and 170M MAU (monthly active users). The majority of these come from China. Only a fraction of the users is from outside China. These are on the platform Nimo TV, which is owned by HUYA. At the end of 2018, Nimo TV had roughly 11.5M MAU in South East Asia and Latin America. For comparison, Twitch, the American counterpart, has about 150M MAU. Thus HUYA and DOYU have by far the largest market share and are continuing to grow.

Risks

I was extremely surprised by the companies' promising fundamentals, so I spent most of my time looking for possible risks.

Potential Delisting from the NYSE - Trump threatened China to delist its firms from American stock exchanges. In my opinion, this is most-likely solely a negotiation tactic.

Inflated User Numbers - When it gets to the numbers provided by Chinese firms, there is always a bit of doubt regarding their truth. E.g., just lately faked $LK its revenues numbers by roughly $300M.

Censored content by the Chinese government - China is famous for censoring content on the internet. Due to this, almost no websites of the western world are accessible in China.

These risks at least partly explain the low price. However, TCEHY has a majority stake and is very interested in taking over the streaming market. Therefore, one can assume that TCEHY has done thorough research and is sure about both companies' seriousness. In addition, Tencent has bought a large share of HUYA for $27. This symbolizes that Tencent believes that this price reflects a fair price.

When to buy?

Generally, I do not invest the biggest chunk of money right away. Most often, I buy in six to nine tranches. However, with HUYA and DOYU, this will be different. Tencent has set an anchor at $27. Furthermore, there was no talk of synergies when the merger was announced. This is very unusual. Could this be because TCEHY wants to buy HUYA after the merger? I hope that this is not the case because I would not be able to invest directly in HUYA anymore, and consequently, I would not participate in long-term growth. The fact that HUYA is a candidate for an acquisition makes the stock even more attractive in the short term. In addition to TCEHY, ARK Invest has also increasingly bought DOYU in recent weeks. This also indicates that it might be a good time to buy.

What should one buy? HUYA or DOYU?

A DOYU share is converted to 0.73 HUYA shares. Additionally, DOYU pays a dividend of $60M, while HUYA pays a dividend of $200M. By buying DOYU shares, you indirectly buy HUYA shares. With the current prices (HUYA $22.07, DOYU $15.11), it is cheaper to buy DOYU, dividends included.

Conclusion

HUYA and DOYU show extraordinary growth in both sales and margins. Additionally, both companies are already well established in the market and have over 160M MAU each.

My fair value for HUYA is $50. This makes HUYA and DOYU excellent opportunities for betting on the eSports and streaming trends. As always, there are also significant risks involved. The fact that both are Chinese companies has deterred me for a long time from taking a closer look at them. However, I consider the risks, in this case, to be manageable. I have already bought 60% of my targeted DOYU position and will continue to do so in the coming weeks. I intend to keep the company in my portfolio for at least five years, if not much longer.