S&P Downgrades YY, Inc. (YY) to 'BB'; Profitability Expected to Continue Weakening

Standard & Poor's Ratings Services said that it had lowered its long-term corporate credit rating on China-based online entertainment company YY Inc. (Nasdaq: YY) to 'BB' from 'BB+'. The outlook is stable. We also lowered our long-term Greater China regional scale rating on YY Inc. to 'cnBBB-' from 'cnBBB+'.

"We lowered the rating on YY Inc. because we expect the company's profitability to further weaken over the next 24 months following a significant margin dip in 2015," said Standard & Poor's credit analyst Tony Tang. "We believe the company's aggressive business expansion in the online real-time entertainment industry will squeeze the company's EBITDA margin. We don't anticipate any material improvement in business conditions and the company's profitability over the next 24 months."

The competition landscape and user preference in the online entertainment industry have been changing rapidly over the past six months. The growing size of the market and high user engagement are attracting new and well-funded competitors. We see YY Inc. has been passive in mobile application development and lagging behind by 8-9 months in terms of expanding its business footprint from core music to other social interactive business. We also view that small players have taken the first-mover advantage in the new business sub-segments. As a result, YY Inc.'s business profitability has worsened, especially its newly developing business including online game broadcasting, online education, and mobile application.

We believe YY Inc. will aggressively expand to gain market share at the expense of smaller players. Such expansion will enable the company to maintain high growth and improve user engagement and experience with its newly developing platforms. We expect YY Inc. to prioritize top-line growth and market share gain instead of business profitability. In addition, its earnings visibility for the coming 12 to 24 months will be lower.

We remain cautious on the revenue growth and profitability of YY Inc.'s newly developing platforms. We believe the sub-segment will continue to be highly fragmented with no clear market leader. And there is limited track record of monetization of user traffic, which will take time to build up. We project that the company's online game broadcasting, online education, and mobile application 'ME' will continue to operate at a loss. We estimate the company will further increase its marketing and advertising costs to 8% of total revenue in 2016 from 3% in 2014. Also, we project the EBITDA margin to drop further, to about 20%-25% in 2016 from 25% in 2015.

We forecast YY Inc.'s debt leverage will increase slightly in the next 24 months. However, we expect its ratio of debt to EBITDA to remain slightly below 1.5x. We project that the operating cash flow generated from YY Inc.'s core business to be sufficient to cover the higher-than-expected marketing expenditure, costs of acquiring user traffic from third-party platforms, and higher revenue-sharing costs with online performers for its developing businesses.

"The stable outlook on YY Inc. reflects our expectation that the company will maintain its positive operating cash flows and niche market leadership in the online real-time entertainment industry in China over the next 12 months," said Mr. Tang. In our base-case scenario, we expect market competition to intensify, YY Inc.'s EBITDA margin to decline due to further investment in its newly developing online game broadcasting platform, online education business, and mobile app platform. However, we also expect the company could generate sufficient operating cash flow to fund the business expansion without compromising materially its debt leverage position.

We could lower the rating if YY Inc.'s debt-to-EBITDA exceeds 2.0x, or the company's market share shrinks materially for a sustained period. This could happen if YY Inc.: (1) fails to manage the sign-up fee or revenue-sharing costs with the hosts or performers on its platform; (2) incurs substantially higher expenditure on newly developed businesses; (3) fails to turn around its loss-making businesses, such that the overall profitability is dragged down; or (4) adopts a more aggressive acquisition strategy or share buyback program than we expect.

We could also lower the rating if the regulatory risk relating to the company's online platform and related business increases.

We could also downgrade YY Inc. if the company accepts and completes the proposed privatization. We believe the cancellation of YY's listing status will weaken the company's management and governance.

The potential for an upgrade is limited for the next 12 months. We could raise the rating if YY Inc. can improve its market position by increasing user "stickiness" and expanding its business scale and revenue base; and strengthens its geographic and business diversity. At the same time, we would expect the company to maintain its revenue growth across different sub-segments and improve its EBITDA margin to be substantially higher than 30% for an upgrade to occur.

We could also raise the rating if the regulatory risk associated with YY Inc.'s variable interest entity (VIE) structure reduces, either through an official endorsement by the Chinese government and legal system, a waiver of restrictions on foreign investments in the Internet industry in China, or if the company is privatized with no VIE structure.

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