Description

Idea: VK Company has a vast portfolio of digital assets, most valuable of which is VK, the leading social network in Russia. Given its national favoritism and growing ecosystem effects, we are confident VK will grow its share of the online advertising market. I believe today’s estimates overstate the competitive risk of Facebook/Instagram and thus understate the durability of growth. While VK Company has multiple exciting assets, I believe the best way to frame an investment is upside on the core business (social plus games) and value-add on the rest of the business. I think there’s a 34% IRR and a long recommendation.

Reasons Mispriced:

• Overstated risk of Facebook/Instagram – VK wins on every user and engagement metric we can find

•  Difficult to value new business segments – worsened by complex economic and voting shareholder rights

• Russia Ukraine

Business Overview

Founded in 2005, Mail.ru Group (MRG) is one of the largest internet businesses in Russia and the CIS. MRG’s business segments include:

1)    Social and Communication: Mail.ru, VKontakte (VK), and Odnoklassniki (OK)

2)    MMO Games: a portfolio of mobile, desktop, and console games

3)    New Initiatives: includes Youla (#2 online classified) and a cluster of EdTech businesses

4)    Joint-Ventures: includes O2O (food delivery, taxi, mobility) and AliExpress Russia

VK is the leading social network in Russia with est. 100mn MAUs (73mn of which are in Russia). On average, VK users spend 35 min/day on the platform – more than Facebook, Instagram, and TikTok in the US (according to eMarketer). In addition to its core social and content features, MRG is rapidly expanding the number of Mini Apps on the platform (currently, 34K apps with 38mn MAUs, 74% and 28% y/y growth, respectively). These include apps like VK Connect, Pay, Taxi, Food, Clips, and Games. Of the RUB $53 social network business, I believe VK is RUB 26bn, growing 30-40% y/y at 45-50% EBITDA margins.

MMO Games is a top 50 gaming company growing 3x the global games market since 2016. Originally a Russian PC gaming business, MMO Games transitioned into a global mobile-first one  (70%+ international and mobile). Its top 5 and 10 “franchises” account for 68% and 80% of revenue (most notably, Warface, War Robots, and Hustle Castle) and should remain the bulk of revenues going forward. Games is a RUB $41 bn business growing 25-30% y/y at 15% EBITDA margins

Online Advertising

The online advertising market is extremely lucrative. In steady-state, the industry is dominated by a few key players, with search and social networks taking ~60% share and earning at high margins. In Russia:

1)    Digital is still taking share – in mature markets, digital typically represents 60-70% of total ad spend, but online was just 53% in Russia last year

2)    Ad budgets are still low – consequently, digital ad spend/internet user is just RUB 2k – 3x and 17x less than China and the US, respectively.

3)    Market share is still in flux – ecosystem and network effects are still developing. The relevant competitors are Yandex and Google (search) as well as Facebook, Instagram, and TikTok (social networks)

As more advertisers shift online and ad spend/user grows, TAM should follow. However, ad spend/user growth is tied to economic growth and consumer spending (budgets grow when businesses see high engagement, conversion, and ROIs).

Thesis:

1)    The online ad market in Russia will grow at a 17% CAGR through 2025

2)    With the most MAUs and highest engagement, VK will capture outsized share, primarily via ARPU expansion but also via MAU growth

Thesis 1: the online ad market in Russia will grow at a 17% CAGR through 2025

The 16% CAGR mostly comes from a 16% CAGR on digital ad spend/user, but it also benefits from internet penetration growth from 83% in 2020 to 86% in 2025. As just discussed, market growth will ultimately higher advertising budgets (with online capturing a higher and higher share). Ultimately, assigning any number to CAGR digital ad spend/user is difficult, but I decided 15% was fair, because:

1)    16% y/y is in line with pre-COVID digital ad spend/user growth. On this front, we think 15% might even be too conservative given the infancy of the Russian market and the trajectory markets like the US have experienced (concave). We think an inflecting market makes a lot of sense, because advertisers continue to double and triple down when they have strong returns on ad spend.

2)    The US grew at a 16% CAGR between 2003 and 2020. We recognize comparing Russian economic growth to the US is far from perfect, but we felt it was a worthwhile guide nonetheless.

3)    As a testament to the early stages of the Russian market, our growth estimates still imply 8x less digital ad spend/user in Russia in 2025 compared to the US today.

Thesis 2: with the most MAUs and highest engagement, VK will capture outsized share, primarily via ARPU expansion but also via MAU growth

VK is the dominant social network in Russia. The terminal fear is VK being usurped or at least ceding share to Facebook, Instagram, or TikTok (i.e., Myspace in the US). We believe that possibility is extremely unlikely, because VK wins on both users and engagement at the moment:

1)    Users: VK has the 73 mn MAUs in Russia – more than Facebook (est. 66 mn), Instagram (est. 35mn), and TikTok (est. 15mn). Moreover, according to a 2017 MMG report, 50% of Facebook users in Russia lived in Moscow (the city is just 8% of the country’s population). This isn’t the case anymore, but the point likely stands that Facebook is bigger among urban/more Western audiences than the typical internet user.

2)    Engagement: while we can’t pinpoint the exact difference in engagement between VK and Facebook/Instagram, we are confident we are directionally correct.

a)     According to Brand Analytics, VK is the most used social media platform in Russia, with 496 mn monthly posts compared to 265 mn and 56 mn for Instagram and Facebook, respectively.

b)    VK reports users spend 37 minutes per day (53 minutes for ages 12-24) on the platform. According to eMarketer, this is higher than Facebook (33 minutes in the US), Instagram (29 minutes), and TikTok (32 minutes). The comparison isn’t perfect, but Facebook Social + Watch + Marketplace, Instagram + Store, and VK + Mini Apps feel comparable.

c)     Every Quora and Reddit forum comparing the two has reported the same thing: VK has better UI/UX, more capabilities/services, and their friends (see exhibits for quotes).

d)    Looking at Google Trends (40% search), we see search traffic is very similar between VK and Facebook. Essentially, VK wins in every region besides Moscow and is more dominant in Central/Eastern Russia. This makes sense, because the user base on Google is more likely to use Facebook. However, when looking at Yandex (60% search), we see VK gets 5x more impressions than Facebook, which again, makes sense when thinking about the type of user on Yandex vs Google.

Ultimately, we are confident VK is the preferred and dominant platform in Russia and should remain so.

Because VK has the most users and highest engagement, we’re confident it will grow faster than the market. Specifically, we think MAU’s can continue growing 2% y/y (below historical growth) and ARPU can grow 20% y/y (below historical growth which has been ~2x digital ad spend/user growth). This implies market share increasing from 10% in 2020 to 13% in 2025. We think 13% in the medium to long-term is fair:

1)    Essentially, it comes down to believing VK can grow ARPU 20% y/y. Our assumptions imply VK is going to capture 15% of incremental ad spend/user – less than it has been capturing from 2017-2020.

2)    Another way to frame it, VK has been growing share north of 100bps/year. Our assumptions imply half that, growing share at just 50bps/year.

3)    Facebook (ex-Instagram and WhatsApp) has 13% share of the US online ad market – an imperfect but realistic outcome in our opinion.

4)    We think Mini Apps are an additional lever for ARPU growth. Currently, penetration of Mini Apps is just 25-30%, less than half and a third of AliPay and WeChat, respectively.

Risks

1)    Online ad market develops much differently than the US – we ultimately feel comfortable flexing Russia to the US, because average time spent on social media is more in Russia. Moreover, if a super app does become dominant, we feel that app is equally if not more likely to be VK than Yandex (social + messaging + apps vs search + taxi + apps)

2)    Facebook

3)    Russia-/Ukraine risk

Catalyst

1)    Divorce with Sberbank in the O2O JV –  the media  speculates of a potential separation between Mail and Sberbank (where Mail gets food delivery and Sberbank gets mobility). Both sides denied these rumors, but a split would likely lead investors to begin valuing the JV assets.

Valuation

The key assumptions to this investment include:

-       Growing internet users 50 bps/y and digital ad spend/user 16% y/y, implying a 17% CAGR for TAM

-       Growing VK MAUs 2% y/y and ARPU 20% y/y, implying a 22% revenue CAGR and 13% market share in 2025

-       The remainder of Social and Communication grows mid-single digits (below historical)

-       Growing games below historical numbers, converging to global games market growth

-       Not valuing New Initiatives or JVs, because the revenue contribution is so small today, and any projections would be extremely difficult

-       8x exit EV/EBITDA (additionally optionality)

-       This arrives at a 34% IRR (20% ex-FCF IRR)

Exhibit A: Super App in the Making

Exhibit B: Penetration of Additional Services/Features

Exhibit C: Facebook ARPU Across Geographies

Exhibit D: User Comparisons between VK and Facebook

Reddit (r/AskARussian): How does VK compare to Facebook?

-       “The design seems more intuitive and less cluttered than Facebook, more free music and films until recently, also the major difference in audiences.”

-       “It's a copy of some old FB design, when it was much more usable than now. Its feed is also much better than FB one without FB Purity.”

-       “It's much better in terms of design and functionality. Facebook still feels like it’s a website from 2007. Also no censorship.”

-       “It's better. Facebook UX is fucking terrible on desktop and mobile and I don't understand why so much people use so uncomfortable site.”

-       “The thing that wasn’t mentioned here is that VK is an important platform for artists, writers and musicians, like Tumblr and SoundCloud combined. Also, podcasts…  Basically, it’s trying to be a combination of every social media service there is, but the interface is still easy to navigate. Maybe that’s why it’s still popular despite all of the recent issues with censorship.”

-       “I use both frequently. VK is everything and more. I just watched the Superbowl in 4k via VK the morning following the game. Amazing. Communities are better.”

-       “There's basically free music and videos (including most films, series etc.)… You don't have to install another app to be able to chat, you can send any media or file via messages.. also you can edit and delete your messages… You can turn the smart feed off and everything will show up chronologically… The only downside in the interface I found is that everyone can see my comments, etc. in a special tab… the app supports Russian and English only… VK has a music subscription which is $2/month… The audience. Nearly everyone’s on VK, and most people I know use it every day, while Facebook got basically two types of community: politicians… and people who post their dogs morning meal…”

Quora Inquiry:

-       TLDR: VK is extremely popular in its national market

Catalyst

MAU and ARPU growth