Description

To keep this brief, we all have World Cup matches to watch and fireworks to light after all.  We think this is a really interesting opportunity to purchase the second largest search engine in China at a silly low EV of $3.3B.  

What is the Opportunity: Own a leading Chinese search engine at a favorable entry price.  Sogou Inc. (SOGO) is the #2 search engine in China with 18.2% of mobile queries.  SOGO was spun out of its parent company SOHU in November 2017 at $13/share.  SOGO has performed poorly since IPO (see below for additional color) and now we have the chance to purchase a business that is growing rapidly, is under-monetized, and has a massive free call option via the WeChat partnership.  We think SOGO has a chance to make 2x+ from here.  

SOGO's secret sauce is its mobile keyboard (input method).  Because Chinese is a logographic language it creates huge QWERTY complexity. As a result lots of effort has been put into creating a method that maps a western style keyboard layout with 100k+ characters and 3,500+ commonly used words.  The SOGO input method searches 900,000 characters every second and has 400M+ MAUs.  SOGO's mobile keyboard currently accounts for ~50% penetration of the 750M China mobile internet users and this is expected to reach 70% over the next few years.  SOGO is using this Trojan horse (they keyboard everyone does everything on their phone with) to drive increasing share of search.  This has allowed them to increase their share of the search market by 200bps annually.  

The Chinese search market is a really good one to be in (talk about rising tides).  Currently the Chinese search market is something like $11.5B and it’s projected to grow to $31B by 2021.  The Chinese search market is under-penetrated compared with developed markets (0.1% of GDP is spent on search versus 0.2% of GDP in the US).  The US monetizes search with revenue per search user of $152.80 vs $19.10 in China - on a PPP basis China's revenue per search user should be 2.2x higher.  

Within the under-monetized Chinese search ecosystem, SOGO is particularly under monetized.  This is partially due to the fact that they historically have focused more on R&D and building out their input method and feeding their AI / audio search capabilities.  71% of SOGO's employees are in R&D and they have only 408 sales and marketing employees this compares with 12,392 sales and marketing employees at BIDU.  This then obviously translates to lower ARPA of $4,586 at SOGO versus $14,371 at BIDU - and this is in spite of the fact that SOGO's CTR is 90% of BIDU's - so ARPA should be dramatically closer.  Using similar math SOGO has lower ARPA than 360 and 360 is a piece of junk.  When speaking with advertisers it becomes clear they go to SOGO because it attracts a more mobile and youthful demographic than other search engines (IMO this is not a bad place to be).  SOGO has one of the more attractive ROIs right now - while advertisers aren't pulling spend from BIDU (they need the eyeballs after all) they are funneling incremental spend towards SOGO.

In October 2017 Tencent started to use SOGO as the default search engine for external searches within the WeChat app (Tencent for years tried to do this on their own but failed internally to create viable search functionality).  SOGO has been powering QQ for a while now.  SOGO has yet to monetize WeChat search at all as they are still perfecting usability.  While it’s unclear what this could ultimately mean - it has the potential for huge option value.  WeChat controls ~60% of Chinese mobile internet user’s time and has over 1B MAUs.  Suffice to say - having the de facto search for this funnel can be hugely valuable.   

Why Does it Exist: As mentioned SOGO is a broken IPO.  At IPO it sold off for four main reasons: 1) Who wants to own the #2 player in a winner take most market, 2) At year-end competing search engines became more aggressive in the OEM channel which resulted in an increase in TAC spend (as we know increase TAC = less profit and less profit = bad time), 3) overall China sell-off in 2018 has added fuel to the fire, and 4) the belief that search is less relevant going forward as all "discovery" will be done in apps.  

I can quickly go through why each of these are not big concerns today.  

#1 - Search is actually not a winner take most market - this is actually a western centric view.  Many markets have shown search to be a happy duopoly: Russia, South Korea, and Japan are just a few examples.  

#2 - This was a one of period where BIDU, Shenma, and 360 realized they could impact SOGO's listing and try to stem the market share SOGO has continued to take from them over the past few years.

#3 - N/A (rather, I have nothing intelligent to add)

#4 - While I don’t think search will become less relevant going forward if it does and more discovery occurs within dominant apps SOGO is well positioned for this given their partnership with WeChat as they are the engine that powers search within WeChat. Given that Tencent owns ~39% of SOGO and has 52% voting control there is pretty good alignment here.

How Much Can We Make: Simple math here - if the grow with the overall search market and increase their ARPA to less of a discount to BIDU (still a discount) it is easy to paint a path to $3.5B in 2021 revenue (~39% revenue CAGR) and naturally increase their EBIT margins as revenue expands esp. as organic traffic increases and TAC as a % of revenue drops (I still have EBIT margins at less than 20% by 2021) you can paint a path to $1.54 in earnings which implies the stock presently is trading at 7x 2021 earnings.  This just seems too low IMO.  I think there is easily a path to 2x+ from here with fairly minimal downside given SOGO is profitable (FCF and net income), has ~$2.70/share in cash and growing, and trades at 19x 2019 street EPS already.  

Catalyst

As SOGO starts to reduce the undermonetization gap and starts to monetize WeChat people will realize how silly it is to value the second largest search engine in China for next to nothing (esp as over time it continues to generate FCF and cotninues to aggressively grow topline and expand margins).