Investment Thesis

Sohu is a low leverage, profitable, high quality and growing business trading at a distressed level.  My long thesis is based on

• Overall cheap valuation.  3x EBITDA according to Bloomberg
• A conservative sums-of–parts valuation that provide 45% upside
• Management with a track record of utilizing spin-offs to monetize hidden value
• The upcoming spinoff of Sogou would act as catalyst

Business Description

Sohu is a Chinese internet-search company.  It has 4 main lines of business.

• Brand advertising which allows companies to build campaigns on Sohu’s portals and websites.  Sohu.com, Sohu Video, Focus.cn ( a very useful real estate site), 17173.com (online game information site) and other various Sohu-owned websites provides free of charge content, interactive community to users and provide advertising during the browsing experience.

• The search business is offered through Sogou.com.  It provides pay-for–click, priority ad placements for customers within its search directory.

• The online game business was partially spun-off in April 2009 as Changyou.com (ticker: CYOU).  All games are free.  Revenue is generated when players purchase virtual items to enhance game play.

• The wireless business offers sms, ring tones, interactive voice response and mobile games through telecom operators.  Wireless represented 6% of Sohu’s 2011 revenue.

Business Quality

Sohu/Sogou

I find that the best way to describe Sohu.com and Sogou is Yahoo.com and Google respectively.  Sohu/Yahoo are web portals with media contents that drive traffic.  Sogou/Google’s traffic depend on the relevancy and accuracy of their search technology.  The business model is simple - monetize the traffic by selling advertisement.  The moat depends on the network effect.  As long as the media contents and the search engine can attract high volume of eyeballs, companies will pay to advertise.

According to Alexa, Sohu.com’s traffic ranking is 8^th  and 45^th in China and the world respectively.  Sogou is 22^nd in China and 111^th globally.  Additionally, as part of my research, I have asked dozens of people who are born in mainland China and identify simplified chinese text as their preference ( I find that Chinese outside of mainland China, such as those in HK, Taiwan and those who cannot read simplified chinese text prefer other search engines) to rank how often they use Sohu and its competitors.

In general, the results from my informal survey corresponds with Alexa rankings.

• For web portals, Sohu ranks behind QQ, Sina, and 163.com
• For search, Sogou ranks behind Baidu, Soso and Google. 

As a side note, I find that Baidu leads by a wide margin over the search engines.  Also all chinese search sites suffer a credibility problem.  I cannot confirm this but numerous respondents mention that they believe supposedly neutral “search results” are actually “paid ads”.  This shows there are market shares available for a trusted western brand to take.

Online game/Changyou

The online game business relies on 2 games, TLBB and DDTank, and the gaming portal 17173.com for all its revenue.  The risk is obvious.  CYOU needs another another game to replace TLBB which is launced in May 2007.  Management knows this and is actively developing its pipeline.  The market knows this too and that’s why CYOU is trading at less than 3x EBITDA.

The Youtube link below contains a video of TLBB gameplay.  The second link is DDTank.

http://www.youtube.com/watch?v=B9P2iSCnJLk

http://www.youtube.com/watch?v=NW9LNgT72VM

Full disclosure: I am not an avid gamer.  I cannot comprehend why players would pay for virtual items to “enhance” gameplay.  However, the frequencies of TLBB being discussed on several Chinese online gaming forums indicate that it remains popular.  After talking to several game players,  I find that the continuous expansion packs update is the reason to TLBB’s longevity.  The packs often refresh the game experience and keep the players engaged.  TLBB is similiar to World of Warcraft or Counter Strike.  People will play as long as there are updates or if their friends are still playing the game.  The same dynamics apply to DDTank as well.  The players do concede that both games have likely matured and peaked.  Without a new hit revenue will probably decline in the next few years.

Wireless

The wireless business is in terminal decline, similar to the pager or the phone directory business.  As the world migrates to smartphones, sms and ringtones will become obsolete.  The mobile game business is the only bright spot.

The service is billed and revenue is collected by the telecom operators.  Sohu has no bargaining power against the operators.  Also, smartphones can perform the same service/function without additional charges.  Therefore, Sohu has no pricing power against the end users.

Valuation

The brand advertising/internet search business is valued at 10x EBITDA.  This is very conservative because

• The CAGR of revenue  from 2005 – 2011 , adjusted for currency effects is 23%. 
• During the same period, the lowest yoy revenue growth was 7% in FY2007.
• Sohu/Sogou is the 4^th  most popular web portal search engine in a country with 8% GDP growth and the biggest online population in the world.

The game business is valued at 6x EBITDA – the same multiple the newspaper industry is trading.  This is conservative because

• adjusting for currency effects, year over year growth for the game business was 23%, 22%, and 31% in FY2009, 2010, and 2011 respectively.  This is not a dying business.
• Embedded call option in the game pipeline.  If one of the game works, investors will reprice this business.

For margin of safety and the poor economics and fundamentals of the wireless business, I assume the wireless business to be worth zero.

After adjusting for the publicly float of CYOU, contingent acquisition payments, unvested options/shares, operating lease and other off balance sheet liabilities, the equity is worth about ¥405 rmb/share.  Assuming a 6.3 cny/usd exchange rate, Sohu is worth about $64/share USD, representing about 46% upside.

Risks

Online Game - the biggest risk is if CYOU cannot come up with new games to replace the inevitable decline of TLBB and DDTank.  This is why I recommend SOHU instead of CYOU.  With Sohu if the online game segment does not work out, you still own the web portal and search engine, and the equity will still have some value left.  CYOU has a remote possibility that it can go to zero.

Corporate Structure – this is not a Sohu-specific risk.  It applies to all Chinese companies listed outside of China.  Sohu enters into contractual agreements with the VIEs to perform substantial portion of its operations across all its business segments because the Chinese Government (PRC) restricts foreign direct investments in businesses.  The VIE is structured to get around the restriction.

Here’s how it works.  Sohu provides interest-free loans to the individual shareholders of the VIEs to fund the latter’s investment in the VIE.  The loans are secured by pledges of the shareholders’ shares in the VIEs.  They can only be repaid by the shares and cannot settled by cash.  Therefore, the lender effectively becomes the equity owner.

• The shareholders have the incentive and the leverage to squeeze Sohu.  They could force Sohu to buy them out at an inflated price, threaten Sohu by ruining the operations, or at worst confiscate the business without compensation.  (This kind of happened to Yahoo)

• Most of the VIE is owned by the CEO and individual executives of Sohu.  Personal enrichment through salaries, kickbacks, and providing service through affiliated entites are too easy and hard to detect.

Related Party Transaction - in October 2010, Sohu issued and sold Sogou preferred shares to 3 parties for $48mm USD.

• Alibaba (owns by the famous Jack Ma),
• China Web (Yunfeng Capital, a private equity firm founded by Jack Ma and a who’s who in the Chinese corporate world.  Bios can be found at the website below.  http://www.yfc.cn/en/founders&partners.html
• Photon Group, owned by none other than the Chairman and CEO of Sohu, Dr. Charles Zhang.

So how did they come up with the $48mm number?  I am not here to point fingers but this transaction just does not pass the smell test.  One thing I am sure is that the buyers certainly got a good bargain.

Catalysts

The company indicated the Sogou preferred shares issuance is part of the restructuring of the search business in preparation for an eventual sale.  Sohu has previously spun-off CYOU.  An eventual IPO of Sogou will unlock hidden value.