Yandex: We Have Seen This Before
Recency bias is a strong force. When investors start associating a country, sector or stock with negative thoughts, undervaluation is likely to be the result.
That is one of the reasons I believe there to be decent value in Russian technology stocks at the moment.
Russia has been hit hard by falling commodity prices, and in particular in 2014 when oil prices fell sharply. An invasion of Crimea and EU-US-imposed economic sanctions did not help. The Russian central bank was forced to raise interest rates to 17%, and is still well above historical standards. These factors led to a recession and a rise in non-performing loans.
So with this backdrop there are plenty of reasons not to invest in Russian stocks. I believe however that if you find a great growth stock with excellent management, market sentiment is a secondary concern. Russia’s largest search engine operator Yandex (NASDAQ:YNDX) may be one of those great growth stocks.
The Yandex story
Yandex can be viewed as a Russian version of Google. The company was founded in 1997 by entrepreneurs Ilya Segalovich and Arkady Volozh. The latter ran a computer trading business in the 1980s, which later branched out into data analysis software. All other search engines at the time were based on the rules of English grammar, and Yandex’s idea was to develop a search engine that takes into account the peculiarities of the Russian language. Just like in German, the nouns and adjectives used in Russian change depending on the case. And Russian verbs have a lot more conjugation forms than English ones. That means that Yandex can find better gauge the user’s intention from his or her syntax than foreign search engines such as Google or Bing. Yandex now has a close to 60% market share and its dominance mirrors that of Naver in South Korea, Seznam in Czech Republic, Yahoo in Japan and Baidu in China.
Yandex has also expanded into other fields. Other than its search engine, Yandex runs an advertising network similar to Google AdWords. It has a photosharing service similar to Flickr. A social networking service similar to Linkedin. It has its own browser similar to Google Chrome. It recently launched a travel website aggregating packaged tours. And it has a price-comparison website that has the potential to become a smaller version of Alibaba. For this you are paying less than $5 billion.
Google has been making inroads into Russia lately. This is a chart of the online search engine market share by company. Google has increased its share from 11% in 2007 to 34% today. Google has gained mostly at the expense of other competitors, but Yandex has not been immune to its growth either.
In 2014, Google attacked by shutting down the Yandex search option in the top toolbar. It also launched three advertising campaigns of its Chrome browser, which enabled it to take market share in early 2014. Google also prevented local smartphone manufacturers to install Yandex as the default search engine on their devices. Yandex has asked Russia’s competition watchdog to investigate whether Google is abusing its dominance of its Android mobile operating system. The case is still ongoing.
Yandex revenue in 1Q15 was up just 13% YoY due to the recession. Profits are likely to be down over 50% in 2015 as office rents are denominated in US Dollar and the company has certain operating leverage. It recently launched a new version of its Yandex browser and in March 2015 became the default search engine option for the Mozilla Firefox browser. This may help Yandex recover some of its lost market share.
Why Yandex is a buy
Yandex is operating in a duopology. Yandex is dominant in Russian-language search and Google is dominant in English-language search. Yandex’s search results are said to be better as the search engine is able to parse synonyms and user intent regardless of exact spelling.
The company is unlikely to be displaced. It is extremely unusual that a local search engine is overtaken: Not in South Korea, not in China and not in Japan. I doubt that Russia will be an exception. The key reason is economies of scale: the more users a search engine has, the more data it has to analyse and the better the search algorithms are likely to become. Websites in Russia are already optimised for Yandex’s search algorithms (a.k.a. “SEO”), which increases their willingness to pay advertising dollar to Yandex. It may improve the relevance of search results as well.
Another reason why Yandex is unlikely to be displaced: the Russian government’s control over the Internet. In late 2014, Russia stepped up a new law to control foreign Internet companies. According to the new law, foreign Internet companies are required to store their data within the country’s borders. It has also implemented a law requiring bloggers with more than 3000 readers to register with state authorities, and a law prohibiting foreign companies owning more than 20% of media outlets. The message is clear: the Russian Internet should not be controlled by foreign companies. It is not unthinkable that the Russian Internet will go the path of China, where Google’s domestic website was blocked in 2010 and Google’s market share subsequently fell from 36% to 2%. If the Russian government chooses to close down parts of the Internet from foreign influences, Yandex would be the natural beneficiary.
There is a precedent for Google’s recent market share trends in Russia. When Qihoo (NASDAQ:QIHU) entered the Chinese search engine market in 2012, it managed to install software in users’ Internet browsers that routed search queries to their own search engine instead of Baidu’s. Qihoo increased its market share quickly, but it was not the end of the world. Baidu still holds the vast majority of the online advertising market and has a market share of 80% in mobile.
There are a number of secular growth tailwinds for Yandex’s business:
- The transfer of advertising dollars to the Internet: Digital advertising is now 28% of the total market, compared to 40% in developed markets. The digital advertising market is $1.8 billion per year compared to $60 billion in the United States. Adjusted for population, the digital ad spend in the US is still 15x higher than in Russia while GDP/capita is about 3x higher. It is not hard to see a lot of potential for the Russian digital advertising market. The market has grown 30-40% per year over the past 5 years and brokers expect growth to continue at 20% per year going forward.
- Higher Internet penetration: now 53% in Russia vs 80-90% in most other European countries. Query volume is growing at 12% per year.
E-commerce is a wildcard in company’s valuation. Yandex has a plan to remake its price comparison website Yandex.Market into a full-fledged e-commerce platform. This would enable Yandex to receive a commission on every purchase. The business model would then become similar to eBay in the US and Alibaba in China. The e-commerce market in Russia is fragmented and not very developed: Online is less than 4% of total retail sales, compared to over 10% in China and the US. Yandex is by no means the only company in the market, but it has a decent chance of succeeding. Its price comparison website currently has 20 million users per month. There are no figures on the gross market value that goes through the Yandex.Market as the company only gets paid on a cost-per-click basis. But if you compare the number of users, German e-commerce website Zalando may be a telling example. Zalando has 14 million active users and is valued at €7.7 billion. The potential is obviously huge.
Yandex’s share price has come down a fair bit: from $42 in early 2014 to just below $15 today.
Yandex is a long-term bet on the Russian advertising market. It has a strong franchise, and is likely to remain in a duopoly with Google for the foreseeable future. Meanwhile, the market is likely to grow at least 20% per year, if not more. Yandex’s revenues are up 6-fold the last five years (42% per year) and even though growth should slow down, it is not inconceivable that Yandex will have tripled its revenue over the next five years to at least RUB 170 billion. Margins should come back to their historical average of around 30% as revenue growth recovers. Add to this yearly buybacks of 12-15 million shares (4-5% of market cap), a conservative 20x EV/EBIT ratio two years out and you end up with $30/share target price. The main attraction of Yandex is that the company’s development mirrors that of Google, Naver and Baidu in the past. Long-term visibility is therefore very high. It is just a matter of managing short-term volatility.
Fundamentals are still deteriorating in the short-term, given gently dropping market share figures and a deepening recession. The ideal approach in my view is therefore to buy a small stake now and increase exposure as we see further evidence of a turnaround.