By Zachary Scheidt on June 11, 2013
Shares of Youku Tudou (NYSE: YOKU) recently traded higher following a new deal that the company signed with SINA Corp. (NASDAQ: SINA).
If you're not familiar with either of these companies, don't worry. Both are high-growth Internet content companies operating in China. YOKU could be considered the YouTube of China, as it manages a video content platform that allows users to upload and share videos.
SINA, on the other hand, could be considered the Twitter of China. Its microblogging social media platform, Sina Weibo, has more functionality than Twitter and is rapidly expanding its user base. At last count, the service had more than 300 million registered users and generated $66 million in annual revenue last year.
The deal signed last week allows content sharing between Sina Weibo and Youku Toudu, giving both companies access to more eyeballs as users from both platforms cross-pollinate content.
Rapid Growth, Plenty of Cash
Youku Toudu has tremendous growth potential as its user base continues to grow and its ability to serve advertisements increases. Analysts expect revenue to increase by more than 75% this year, and then by another 50% in 2014.
Like many emerging Internet companies, Youku has yet to actually turn a profit. The company is estimated to see a loss of $2.83 per share this year, but is expected to turn a profit in 2014.
But unlike many of the U.S. Internet companies during the dot-com bubble, Youku is actually turning a profit on its underlying business. In 2012, the company generated revenue of $288 million, with costs of revenue at $241 million. So Youku is actually turning a gross profit, and then reinvesting cash into research and development, along with marketing expenses.
With all expenses included, Youku realized a loss of $68 million, and the company is still sitting on a cash balance of $563 million. This means Youku essentially has enough cash to burn through more than eight years like 2012. But when the company begins turning a profit next year, the cash balance should quickly expand, adding value for shareholders and helping to boost YOKU's stock price.
I share this fundamental information with you because I want to make it clear that Youku is not a fly-by-night Internet startup. This is a real company with real capital, inking real contracts with strong allies. That's why investors are buying the stock and pushing shares higher.
Shares of YOKU have already rallied sharply from their April lows, and I expect the stock to continue trading higher. In January, YOKU traded as high as $25.24 per share, and considering the long-term benefits of the new contract with SINA, I expect the stock to eclipse this price point rather quickly.
YOKU Covered Call Strategy
Rather than buying shares of YOKU outright, I want to set up a covered call trade for this stock. The broad Chinese economy is still challenged, and although YOKU should continue to grow its business, there is currently a bit more risk for all Chinese stocks right now.
The additional risk works in our favor though, because it increases the premium for the option contracts we are going to sell. Remember, the more volatility or uncertainty, the higher the option price. Since our covered call strategy includes selling option contracts against stock that we own, the higher option price creates more income (and more protection) for us.
Here's how we're going to set up our YOKU covered call trade:
-- Buy YOKU in 100-share lots for about $20.77
-- Sell YOKU July 20 Calls for about $1.65
-- Sell YOKU July 20 Calls for about $1.65
Remember, one call contract covers 100 shares, so only sell one contract for every 100 shares of stock that you buy.
Our net cost for the stock should be $19.12 per share. If the stock stays above $20, we will have an obligation to sell these shares at $20, netting us a profit of $0.88 in the next 37 days.
Based on our net cost of $19.12, this gain represents a 4.6% profit. That's a very attractive gain for such a short holding time. To put this in perspective, if you were able to generate 4.6% every 37 days for a year, your full-year return would be over 45%.
Another advantage of this approach is the protection that we receive by selling the calls. If YOKU trades lower and is below $20 when the calls expire, we will get to keep our stock, and we will also get to keep the money we received for selling the calls.
YOKU could drop all the way down to our net price of $19.12 (an 8% decline from the current price) and we still wouldn't recognize a loss. If YOKU does in fact trade below $20 and our calls expire, we will have the option of selling more calls against this position to generate additional income.
This is the power of the covered call strategy. In the best of circumstances, we get to realize a very attractive profit. And in the worst of circumstances, we are still protected against a significant portion of potential losses and have the opportunity to generate more income on our trade.
I'd love to hear what you think about this strategy. Please shoot me an email atEditors@ProfitableTrading.com and give me your perspective.
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