Sohu Valuation enhanced by successful Sogou IPO and potential Changyou privatization

• Successful IPO of the Sogou search business clarifies the $1.5Bn value of Sohu’s retained 33% stake ($39/share of SOHU)
• Possible privatization of the Changyou gaming business would deliver $1.4Bn of net cash before tax ($35/share of SOHU) at the unfair preliminary offer price or $1.8-3.2Bn ($45-$82/Share of SOHU) at fair value
• Sohu has minimal debt, but its video business has been losing a lot of money ($60mm in 3Q17)

Sohu is one of China’s oldest internet companies and has been listed in the US since 7/12/00.  It has a significant presence in key industry segments (search, media, and games), but is not the leader in any of them.  Investors have valued Sohu based on the sum of the estimated values of its operating units and these two transactions (Sogou IPO and Changyou privatization) are providing greatly improved clarity that is not currently reflected in Sohu’s share price.  Sohu’s remaining businesses have been losing a significant amount of money, face intense competition, and their fair value may be negative.  If management can execute operational improvements or beneficial strategic transactions then it would be greatly beneficial.

The Sohu valuation thesis described here is not really original, but Sohu’s share price appeared to reflect excessive enthusiasm about the Sogou IPO which has recently led to excessive letdown.

Segment reporting in Sohu financial statements is a good introduction to the sum-of-parts analysis: (source 10-Q filed 11/03/17)

Key points:

• the “Sohu” segment comprising the internet portal (sohu.com), internet video (tv.sohu.com), and real estate information (focus.cn) is losing a lot of money, mostly in video.
• Sogou is profitable and growing rapidly
• Changyou is profitable, especially considering the non-recurring nature of the $87mm writedown

Looking at recent developments in each segment in more detail…

Sogou search – Sohu owns 127.2mm shares worth $1.55Bn ($39.79/SOHU)

Sogou’s business is documented in great detail in the F-1 filing for the its recently completed IPO.

• After the offering Sohu has retained a 33.4% ownership interest while Tencent holds 38.7%
• The company’s search business is #2 in China, well behind Baidu.  so.com (operated by Qihoo) is the only other significant competitor. (source Sogou prospectus)

• An excellent comparison of the functionality of Sogou and Baidu search in this article by Brian Lin.
• Strategic partnership with Tencent includes placement as the default search engine in the QQ Browser and at qq.com.  The prospectus also explains a very significant recent development: ” In October 2017, Tencent began testing, on a trial basis and for purposes of assessment, the integration of Sogou Search into Weixin/WeChat, whereby its users can use Sogou Search as a general search function from within Weixin/WeChat to access information outside Weixin/WeChat.”
• The company earns substantial profits:

Enhanced Tencent partnership and strong product create potential for expansion in market share in a sector with attractive profitability due to limited competition. Sogou is trading at 30X the average analyst 2018 forecast of $0.40 EPADS.

Changyou games – Sohu owns 35.875mm ADS

 

Changyou’s business, the privatization offer, and fair value are described in more detail in my companion article. Sohu owns 68% of Changyou shares so any significant Changyou corporate actions must serve the interests of Sohu which may be different from those of Changyou’s minority shareholders. In particular:

• Sohu may incur corporate tax liability on receipt of proceeds from sale of Changyou shares or dividends
• Sohu needs cash from Changyou in order to fund losses in its Media business (especially video). Sohu had borrowed $147mm from Changyou as of 9/30/17.
• Sohu would benefit if it were able to participate in some way in the privatization transaction. Sohu does not have the cash to conduct the privatization itself and I believe that as a foreign company it is unable to hold a controlling interest in a China-listed internet company. However it might be possible for Sohu to sell part of its shares to the buyer group for cash and roll over a non-controlling interest. This would facilitate a transaction by reducing the amount of cash needed by the Buyer Group and also allow Sohu to participate in the potential valuation upside created through a future China listing.
• Business Cooperation. Sohu would benefit from a continuing partnership with Changyou in use of Intellectual Property content (such as TLBB) for both video content and games.

Steps that Changyou could take to deliver greater value to shareholders may create tax liability for Sohu. Undoubtedly the Board of Directors and its financial advisors will consider ways to minimize this cost, but Changyou’s value has been discounted by 20% in the above table to reflect the possible impact.

Sohu Media – value unknown, possibly below zero

Sohu’s traditional internet business provides appealing information and services, but does not have any distinct advantages against intense competition.

Portal – the traditional role of the internet portal has been eclipsed in China by Wechat which now functions for many users as a primary gateway for communications, social networking, and entertainment.

News from third party sources is available through many different sites.  Recently Toutiao ( 今日头条) has enjoyed tremendous growth by offering personalized news using artificial intelligence and is reportedly seeking new financing at a $30Bn valuation.  Sohu is updating its own news service to provide enhanced personalization.  Tencent, Sina, Netease, and Phoenix/Yidian are also significant competitors.  Yidian recently raised money at a $1Bn valuation (as disclosed by Phoenix New Media).  Toutiao and Phoenix have just been hit by a regulatory crackdown on distribution of vulgar content.  It’s possible that an evolving environment will provide opportunities for Sohu to gain market share and clarify the value of this business.

Video services, including paid subscriptions, have been growing rapidly in China.  However intense competition among different providers has led to high fees for content licensed from third parties and heavy investment in original productions.  Sohu disclosed an operating loss of $233mm in 9M17 from video.  The company is not a market leader, but even the top company is losing a lot of money (Baidu 20-F disclosed a $398mm operating loss for iQiyi in 2016).

A year ago the company mentioned a goal of reaching breakeven profitability from video in 2019 and did not disclose any update since then. Sohu says that it is changing its business model and will cut losses by concentrating on its own video production and not renewing expensive licensing agreements.  The strategy was explained by Chairman Zhang during the 2Q17 conference call:

If Sohu is able to reduce quarterly losses from video then it would be hugely beneficial, but it’s unclear whether the new strategy will leave a viable stand-alone business or if Sohu would be better off in a partnership with one of its current competitors.

Sohu has covered the Sohu Media operating losses over the past year with loans from Changyou (secured by a pledge of Changyou shares).

Sohu’s video strategy will place greater emphasis on proprietary content. This can be complimentary to Changyou’s efforts to develop and maintain engaging game content. It Changyou were privatized then it might be beneficial for both parties to maintain some formal partnership.

Conclusions

Tencent’s ownership stake and business relationship with Sogou provide strong potential for profitable future growth. The successful IPO provides visibility into the value of Sohu’s stake.

Changyou’s successful TLBB franchise and high free cash flow have value that is not currently recognized in Changyou’s share price or the initial privatization offer. The higher market valuation of China-listed peers provides a strong incentive for  privatization, but Sohu must consider alternatives such as regular dividend payments from Changyou or joining the Buyer Group as one of the privatization backers. Fair value for a buyout probably cannot be determined until Changyou’s 1Q18 results demonstrate the success of current game launches.

The Media businesses provide valuable services to users, but intense competition makes these segments challenging for all participants. Investors will need to carefully monitor progress on the company’s current initiatives and potential strategic actions in video and news.

Chairman Zhang’s $42.10 privatization offer undervalues Changyou, but it appears that he believed the transaction would still be beneficial to Sohu because he purchased 25000 shares in May 10 days prior to submitting his offer. Sohu’s CEO Wang Xiaochuan then purchased 15000 shares in June.

Disclosures:

The author is a shareholder of Changyou and Sohu.  The author does not make any recommendation regarding investment in either company.  Investors should verify any facts in the article they deem relevant to their own decision about investment in either company.