Focus Article: Sohu.com (SOHU)

Sohu.com, Inc. (SOHU) $53.88

The Company:

Founded in 1996, by Dr. Charles Zhang, Sohu.com is a Chinese online media, search, gaming, community and mobile service group. After completing his Ph.D at MIT, Dr. Zhang joined Internet Securities (ISI) before relocating to China and starting Sohu.com. The company primarily operates in the search engine, online gaming, entertainment and information spaces. Sohu’s group of Chinese language web properties consists of:

1. Mass portal and online media destination www.sohu.com
2. Interactive search engine www.sogou.com
3. Games information portal www.17173.com
4. Real estate website www.focus.cn
5. Online alumni club www.chinaren.com
6. Wireless value-added services provider www.goodfeel.com.cn
7. Online mapping service provider www.go2map.com
8. Online games www.changyou.com/en/

The company, which has been growing rapidly, saw its stock hit an all time high of over $109 last Spring before losing more than half of its value and hitting a 52 week low of $45.40 last December. Sohu’s Chief Operating Officer made a large open market purchase of 60,000 shares at an average price of $49.43 last Monday. The stock was slow to react to this purchase and also did not post much of a gain after widely followed Citron Research (formerly known as the controversial Stock Lemon) came out with an article claiming a “sum of parts” analysis puts the value of Sohu.com at $93/share. Sohu.com did see some momentum on Friday with a gain of $2.83 or 5.54% to $53.88.

Sum of Parts Valuation:

We decided to verify Citron’s sum of parts analysis by doing our own sum of parts valuation and the results are given below.

Sohu owns a 66% stake in gaming website Changyou.com (CYOU), which spun out of Sohu in 2007 and listed on the Nasdaq in 2009. The company operates massively multi-player online games (MMOG) based on its own games as well as by licensing third-party games. Another Chinese company that operates on a similar model is NetEase.com (NTES), which brings Activision Blizzard’s (ATVI) popular World of Warcraft to Chinese gamers. The company currently has a market cap of $1.46 billion and posted annual revenue of $484.6 million. Sohu’s 66% stake is currently worth $964 million.

Sohu also owns a 53% stake in the search engine Sogou.com. While Sogou is a distant second to Chinese search engine Baidu (BIDU), its new browser already has a 26% penetration rate. Sogou’s Pinyin software, a Chinese character input method software, is estimated to be on 70% of Chinese desktops. Sohu sold 32% of Sogou to Alibaba and another investment company owned by Dr. Charles Zhang in 2010 for $48 million. Sogou’s revenue jumped 238% to $63 million in 2011 and gross margins more than doubled to 58%. Even if we assume Sogou’s value has only doubled since that 2010 sale to Alibaba, we get a value of approximately $160 million for the remaining 53% stake.

Leading Chinese video site Youku (YOKU) recently made a bid for smaller rival Tudou (TUDO) in an all-stock deal for $39.89 or over $1 billion, agreeing to pay an astounding premium of nearly 160% over Tudou’s closing price on March 9th. Traders not only bid up Tudou’s stock, they also bid up Youku by 27% following the announcement. Sohu has one of the largest Chinese video properties that streams 21 out of the top 30 prime time dramas and is estimated to have generated approximately the same number of page views as Youku and Tudou in December 2011.

Sohu ended the year 2011 with $826 million in net cash and investments on its balance sheet. Backing out the $345 million in net cash Changyou.com has on its balance sheet and that is also included in Sohu’s balance sheet, we get a net cash position of $481 million. Adding the $964 million from the Changyou.com stake and the $160 million from the Sogou.com stake to this cash position, we get $1.6 billion. Sohu’s market cap is currently $2.05 billion, implying the market is valuing Sohu’s video and web portal business at less than $450 million, which is less than half Tudou’s market cap of $1.07 billion. Citron Research’s sum of parts numbers are given below and they have assigned a value to Sohu’s video and web portal business to come up with their $93/share number.

Business Statistics and Financials:

Online advertising and online gaming are Sohu’s core businesses. For the year ended December 31, 2011, Sohu.com’s online advertising services, which includes both brand advertising and search engine advertising, generated $342.2 million or 40% of total revenues of $852.1 million and it’s online game business generated $435.5 million or 51% of total revenues.

Sohu.com reported strong fourth quarter results that helped the company finish a solid year for 2011. Total revenue for the fourth quarter were $246 million, up 42% year-over-year and 6% quarter-over-quarter. For the full year 2011, total revenues of the company were $852 million, up 39% year-over-year.

I have broken down the revenue and growth numbers for each of Sohu’s four divisions in the table below.

The company has a cash rich balance sheet, sports operating margins of 33% and yet trades for just 3.5 times EBITDA. Besides a general aversion to Chinese stocks due to all the reverse merger frauds that were unearthed over the last year, another concern specific to Sohu is a drop in operating and net income in the fourth quarter. Part of this drop was on account of non-cash charges related to write-offs for goodwill and intangible assets and part of it was higher operating expenses.

Competitors:

Insider Buying:

One insider purchased stock on the open market over the last six months as listed below. You can view a list of all insider transactions for Sohu.com here.

Risk Factors:

There are three main risks that are likely to weigh Sohu down in the intermediate-term unless the company can proactively addresses some of these concerns.

1. The macroeconomic environment in China is of concern especially since Sohu relies on advertising for nearly half its revenue. It is not just Jim Chanos, president and founder of the $6 billion hedge fund Kynikos Associates, who is concerned about the Chinese economy but management at Sohu also mentioned on the last conference call that “we are not so optimistic about macroeconomy”.

2. Operating expenses are rising at Sohu and the company gave a weak forecast for the first quarter of 2011. While the first quarter is traditionally weak for the company and the timing of the Chinese New Year was not favorable this year, expectations of non-GAAP earnings of 50 to 55 cents per share represents a drop of nearly 50% from Q1 2011.

3. With a highly competitive and fragmented market for online video, Sohu is attempting to stand out with premium content and in the process is also paying higher prices to acquire this content from TV networks.

Conclusion:

Despite some of the challenges Sohu faces in the near future, the stock is trading at a discount to peers and these concerns appear to be reflected in the current stock price and then some. With a strong management team and several lines of businesses that are growing rapidly, the company fits the GARP (Growth At a Reasonable Price) bill very well.