Description

QIHU is richly valued with an outdated business model that is likely to be a fraud. Many of you may be familiar with QIHU through Citron’s excellent research on the company. They have written up several compelling articles on QIHU that you can find at http://citronresearch.com/ that describe the short case much better than I can.  With the stock rising on another quarter of literally unbelievable results that were just announced, I think now is a good time to enter a short or put position in QIHU.

QIHU is “a leading internet company in China” that offers internet browser and anti-virus software products. QIHU used to sell its security software but now offers it for free along with its 360 Safe browser. QIHU monetizes its user base from selling ads on its web directory hao.360.cn (72% of revenues) and other “value-added services”, primarily from an online game directory, along with some search referral business. QIHU has a reported user base of over 400M, or 94% of the Chinese internet market.

There are three ways to potentially win with this short.

1. The valuation is expensive. With a market value close to $2.1B and an EV of $1.75B, QIHU is trading with a EV/NOPAT multiple of over 35x if you annualize the most recent quarter.
2. The company’s business model is outdated and is not likely to succeed over time. Providing a web directory service is not a viable business. Companies like Lycos and Excite were not able to succeed in the U.S. in the 90’s and Qihoo is unlikely to succeed in China in the 10’s.
3. The reported financials are likely to be materially overstated.

In regards to 1, QIHU trades at an expensive valuation any way you look at it: 35x EV/NOPAT, 7x EV/S, and 5.6x P/B. With revenue growth of 191% and earnings growth of 83% just reported for 2011, if you believe the reported financials and QIHU continues to grow at such a rapid pace, this valuation might be justified. But any change in sentiment for the company or the general market could send the shares tumbling down. It is worth noting that QIHU also trades at much higher multiple than most of its Chinese internet company comparables.

2. In my opinion, generating sales revenue by providing a web-directory is not going to be an enduring successful business. As web users in China become more sophisticated, I think they will stop using web directories just like U.S. users have. Within the next several years, QIHU’s business will likely be declining, not growing. It is hard to see how meaningful growth could continue with the current business model. Their main page is already cluttered and full of links, so it will be hard to add additional revenue generating links. And competition from other web directories should prevent QIHU from continuing to raise ad rates after already passing through triple digit price increases in 2011.

3. There is a high probability that QIHU’s reported financials are likely to be fraudulent. Instead of going into much detail on why I think QIHU’s numbers are misstated, I will go over some of the highlights. For a much more substantial discussion, please refer to Citron’s website. Other resources that lay out the fraud case pretty clearly are http://deloitte-watch.com/ or http://www.thestreet.com/story/11399949/1/fraud-claims-dog-qihu.html.

Signs of a possible fraud:

• It is hard to get reconcile to the ~$45M reported revenue from advertising by multiplying the number of paid links on the website by the ad rate per paid link. In their refutation of Citron’s claims, QIHU gave some of the following figures: 130 links on its web page, ad rate of 335,000RMB per month and 75% of add revenues from the hao.360 front page. Even assuming that QIHU’s dubious claims are true that duplicate links and links that are not tracked are both paid, you still come materially short of QIHU’s reported revenue: 130 links x 335,000RMB rate x 3 months x .16 USD exchange rate /75% of revenue from front page = $27.6M.

        In order to believe QIHU’s 4^th Quarter ad revenues, you have to believe QIHU increased paid links by 10% and increased add rates by 50% in one quarter.  

• The monthly ARPU for its games  in 3Q was 380RMB ($60 US). It is simply nonsensical to think that Qihoo would be able to get this high of a monthly revenue per user rate for its Chinese consumers when the most successful online game, World of Warcraft, charges $15/month.
• Growth Rates that are simply too good to be true (214% 4^th qtr yoy growth in revenue), an order of magnitude beyond competitor’s growth rates.
• Other Chinese internet companies not listing QIHU as a major competitor.
• A CEO/Company with a history of aggressive/deceptive business practices

So what is QIHU worth?

I don’t know exactly, but a lot less than the current price. Assuming the financials are presented fairly, valuing the business at 2x sales plus cash would result in a share price of $7.30. If there is some type of fraud, it will probably trade down to a couple of bucks a share.

Risks:

• QIHU finds some transformative way to monetize its large user base
• Stock keeps going up as earnings are continually misstated higher
• All fraud accusations are disproven
• Short position is called, stock holds up until after your puts expire
• Extended trading halt

Catalyst

Catalysts:

• General market downturn/Chinese economic slowdown causes optimistic sentiment in QIHU to subside
• Auditor resigns before April 30^th deadline for 20-F