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Momo Stock Is Too Cheap to Ignore, but Consider the Headwinds

Chinese digital company Momo (NASDAQ:MOMO) recently reported Q3 numbers which beat on top and bottom line expectations and included a strong fourth quarter revenue guide. Yet, in response to the report, MOMO stock dropped more than 15%.

Why? Because despite the double-beat-and-raise report, growth at Momo is slowing and margins are falling. With trade war headwinds still as prevalent as ever, no one wants to buy into a company with slowing revenue growth and falling margins against a trade war clouded backdrop.

Is this a dip worth buying? Yes, but patience is key. At current levels, MOMO stock is simply too cheap to ignore. If this company can simply maintain a digital-average growth rate and stabilize margins, upside in a long term window is compelling. But, near term headwinds from slowing growth and trade war noise will keep this stock weaker for longer.

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As such, you have a classic case of near term pain, long term gain. If you can stomach the near term pain, this is an attractive “buy the dip” candidate. If not, then wait for trade war headwinds to clear up.

Momo’s Quarter Was a Mixed Bag

From head to toe, there were a lot of things to like about MOMO’s third quarter earnings report.

Not only did revenues top expectations, but revenue growth stayed above 50%, continuing a multi-quarter streak of impressive 50%-plus revenue growth. Also, earnings topped expectations, and operating profits rose more than 20% year-over-year. The monthly active user base expanded by 17%, while the paying user base grew by over 70%.

Overall, the quarter affirmed that Momo’s growth narrative remains on tack. This is still a company morphing into an increasingly popular social media, live-streaming, and dating app in China’s rapidly growing digital economy.

There also were some things not to like. Revenue growth continued its multi-quarter deceleration trend, dropping from 64% at the beginning of the year, to 58% in Q2, to 51% in Q3.

This trend is expected to persist in Q4, with revenue growth projected at 45% next quarter. User growth, while still near 20%, has also been decelerating for several quarters now. Also, margins dropped in a big way during the quarter due to bigger marketing investments.

In the big picture, Momo’s quarter was a mixed bag. You had strong numbers, but those strong numbers were less strong than they were last quarter, and those were less strong than they were the previous quarter. Thus, Momo is a slowing growth company with building trade war headwinds, and this combination clearly has investors spooked.

Stock Is Too Cheap to Ignore

This company is projected to do about $2.50 in EPS this fiscal year. MOMO stock trades at $26. Thus, this stock is trading at just over 10X forward earnings. That multiple seems rather anemic next to what was 50%-plus revenue growth and 20%-plus profit growth last quarter.

The big concern here is that revenue growth will continue to slow, margins will continue to fall, and profit growth will fall flat, so the 10 forward multiple makes sense, but those concerns seem overstated.

Revenue growth will continue to slow, but the rate of deceleration thus far has been moderate (64% to 45% in 2018), and should remain moderate in the foreseeable future given digital economy tailwinds throughout China and still near-20% user growth.

Meanwhile, margins are dropping. But, in the big picture, they have been largely stable, and the big drop last quarter was from higher marketing expenses. These expenses aren’t a structural concern, and should be phased out in the long run. Thus, today’s margin compression is a near term phenomena.

With revenue growth projected to remain healthy and margins projected to remain stable, Momo projects as a big profit growth company for the next several years. The Street is looking at $2.50 in EPS this year, and over $3 next year. From this perspective, $4 in EPS in five years seems very doable.

A market average 16 multiple on that implies a four to five year forward price target of $64. That is more than double the current price.

Thus, in the big picture, MOMO stock has doubling potential in the long run from current levels. The stock may not realize that long term potential right away thanks to persistent headwinds. But, this stock is way undervalued, and once those headwinds clear, you could see a rocket ship rally.

Bottom Line on MOMO Stock

Near term trade war headwinds will keep MOMO stock weaker for longer. But, the long term bull thesis remains in tact, and seems especially compelling at current levels. Thus, with MOMO stock at current levels, you have a classic situation of near term pain, long term gain.

As of this writing, Luke Lango was long MOMO. 

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