Flowing Cloud Technology Ltd., which bills itself as the biggest player in China’s augmented reality (AR)/ virtual reality (VR) space, has just signed up to list shares in Hong Kong. After Mark Zuckerberg made the metaverse a household word in 2021, and a McKinsey & Co. report estimated the metaverse could be worth $5 trillion by 2030, the IPO seems well timed. Despite humble beginnings, Flowing Cloud has become a major success story in China and is profitable. Whether it can remain successful and raise enough money to expand at a time when metaverse stocks have seen their profits and share prices swoon remains to be seen.

Flowing Cloud is in a head-to-head race with Tencent-backed (0700.HK) Soulgate, which filed for a Hong Kong listing in late June. Its Soul app, launched in 2016, is China’s first metaverse-based social networking platform, where all users interact via avatars with virtual identities. Flowing Cloud announced last year that it would build its own Feitian metaverse platform, which will also help facilitate business cooperation between clients and users. In its prospectus, however, it said that Feitian “is at a preliminary stage with no committed business model for monetization,” adding that the development and future of Feitian “is highly uncertain.”

The IPO comes at a time when metaverse companies are seeing record losses. U.S social media giant Meta’s (NASDAQ:FB) Reality Labs, which is its metaverse business, recorded a loss of nearly $3.0 billion in the first quarter of 2022. Soulgate’s loss ballooned to 1.32 billion yuan ($195.3 million) in 2021 from 353 million yuan in 2019. And the No. 1 metaverse stock globally – U.S. firm Roblox (NYSE:RBLX) – reported a loss of $160 million in the first quarter of 2022. Meta’s shares closed at $164.70 on July 16, down from $314 in July 2021. Roblox shares have fallen from around $98 at the start of this year to close at $39.77 on July 16.

Flowing Cloud’s revenue and profit have been on the rise in recent years, reflecting success in a market that is fragmented, with more than 5,000 players and its strategy of targeting business customers rather than consumers. According to its preliminary prospectus, revenue surged 137% to 595 million yuan in 2021 from 251 million yuan in 2019. Net profit climbed to 71.7 million yuan from 41.9 million during the year-ago quarter. And the top and bottom lines further improved in 2022. First-quarter net profit shot up 315% year-on-year to 38.20 million yuan. Sales rose 65% to 228.9 million yuan.

According to research firm iResearch, which Flowing Cloud quoted in its prospectus, the company ranked No. 1 in terms of revenue in the AR/VR content and services market in China, with a market share of 2.6% in 2021. It also ranked first in terms of revenue in the AR/VR services market last year, with a market share of 13.5%. iResearch estimates that the AR/VR content and services market will grow to 130.2 billion yuan in 2026 from 35.7 billion yuan in 2022, a compound annual growth rate of 38.2%.

Despite the rosy outlook, it is worth noting the relatively low gross margin of the AR/VR marketing services division at Flowing Cloud, which has ranged between 19.4% and 21.7% during the past three years. That is significantly lower than gross margins between 40% and 50% for the other two divisions. The overall margin of the company may continue to decline with the rising revenue share of the AR/VR marketing services division. In addition, Flowing Cloud garnered 30.7% of its revenue in the first quarter from five customers.

Although Flowing Cloud has not yet released full details of its offering, we can still estimate its valuation based on peers like BlueFocus Intelligent Communications (300058.SZ), Hubei Century Network Technology (300494.SZ) and Zhejiang Jinke Tom Culture (300459.SZ), which had 2021 price-to-earnings (P/E) ratios of 89.4, 24.7 and 18.7 respectively. With an average P/E ratio of 44.2 times, Flowing Cloud Technology could expect a valuation of HK$3.7 billion ($474 million). That valuation is much smaller than an estimated valuation of HK$11.2 billion for Soulgate, which is calculated based on an industry average price-to-sales (P/S) ratio of about 7.5.