What’s next after the Changyou dividend and Sohu liquidation?

Changyou’s recently distributed special dividend and Sohu’s pending liquidation may be intended to facilitate a new buyout offer for Changyou.  Fair value for a transaction should be at least $29.74/ADS.

Some additional background was in my prior articles:

• Changyou’s Buyout Price Should be Raised to at least $53 
• Sohu Valuation enhanced by successful Sogou IPO and potential Changyou privatization

Any significant corporate actions undertaken by Changyou will be structured to benefit Sohu which owns 68% of the company.  Sohu’s liquidation will replace the current US holding company with a Cayman Islands parent and a primary goal of this change may be to avoid US tax liability on the gain that would result from privatization of Changyou.

STATUS OF THE CHANGYOU BUYOUT OFFER

On May 22, 2017, Group Chairman Charles Zhang offered to buy all shares of Changyou for $42.10/ADS (LINK).  The company formed a Special Committee and hired advisers but has not provided further updates.  On January 30, 2018, Chairman Zhang reiterated his desire to pursue a transaction (LINK), but suggested he might seek a lower price.

SOHU’S $210mm “TAX CUT” LIABILITY

Sohu was incorporated in Delaware in 1996 and had its Nasdaq IPO in July 2000.  The company has had no operations in the US and did not accrue any US tax liability based on the assumption that all of its earnings would be permanently reinvested outside the country.  The “Tax Cuts & Jobs Act” passed in December 2017 removed the option to make that permanent deferral and requires payment of a one-time “transition tax” on previously untaxed overseas earnings.  Sohu accrued a $210mm estimated liability in 2017, but the actual amount payable may be adjusted as the IRS issues guidance on implementation of the law.

Any significant corporate actions that Sohu might have taken in the future carried the risk of incurring new US tax.  Sohu’s 10-K explains:

SOHU’S LIQUIDATION PLAN

I believe the primary purpose of SOHU’s liquidation is to change the corporate structure in order to avoid US tax liability on the gain that would result from privatization of Changyou. Details of the change in corporate structure are shown on pages 6-7 of the proxy statement for the liquidation.  Following the liquidation of Delaware-incorporated Sohu.com Inc, public investors will own shares of Sohu.com Cayman which will continue to own all the existing operating businesses including the stakes in Changyou and Sogou.

The liquidation will require payment of the full “transition tax” liability this year.  The Sohu.com parent company had only $3mm of cash at 12/31/17 (see 10-K page F-76), but it can cover the tax expense with the $310mm it received from Changyou’s special dividend.

The liquidation plan will create a new tax liability to the extent that the “fair market value” of the Sohu Cayman shares distributed to shareholders exceeds the “adjusted basis” of Sohu’s investment in Sohu Cayman.   Unfortunately the “adjusted basis”is not disclosed.  It may be similar to $971mm of “Interests in Subsidiaries” shown on the Sohu parent company balance sheet (10-K page F-76).  The proxy explains that the “”adjusted basis” will increase by the amount of the “transition tax” which is estimated at $210mm.   The $1,181mm sum of these items is approximately equal to Sohu’s current market capitalization so the liquidation may not generate any new liability unless Sohu’s share price rises over the next month.  Investors should hope that does not happen.

Given the uncertainty over the final tax liability I expect Sohu Delaware to hold a cash reserve in a liquidating trust.  Any excess could be distributed to shareholders after tax returns have been filed and any subsequent audit has been closed.

A NEW OFFER FOR CHANGYOU

Privatization of Changyou could be beneficial to all interested parties:

• Sohu would receive a substantial cash infusion to invest in its media business which has been losing a lot of money, although the company recently reaffirmed guidance that it will reach break-even in 2019.
• Changyou public shareholders will receive a premium price for their shares.
• Chairman Zhang and the Changyou buyer group would benefit from eventually relisting Changyou’s business in China where competing companies trade at much higher valuations.

It could be beneficial to Sohu if it were able to roll over a portion of its shareholding as part of the Buyer Group.  There would be a strategic benefit to maintaining strong business cooperation such as complementary development of game and media IP.  There would also be a financial benefit if Changyou is able to list in China at a higher valuation in the future.

Changyou did not have any significant hits among recent game launches, but may have success late in 2018 or early 2019 with launch of a new Xuan Yuan Jian mobile game in cooperation with Tencent.  Adjusting the potential fair value for a Changyou buyout to reflect sharply lower consensus EPS forecasts and the reduced cash on hand after the dividend payment:

The value of Sohu using the adjusted Changyou value range:

On Sohu’s 1Q18 conference call group Chairman Charles Zhang reaffirmed guidance that Sohu media would reach breakeven in 2019.  If successful then at that point the fair value of the media units (news and video) would certainly be positive.

DISCLOSURES & NOTES:

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.

The author infers that Changyou’s dividend and Sohu’s liquidation are part of a well-thought out plan to facilitate the privatization of Changyou.  Neither company has made any public statement that would confirm this.

A lower fair market value for Sohu on the effective date of its liquidation (“shortly after May 31, 2018”) could minimize the potential for any additional US tax liability.  If this interpretation is correct then it is unlikely that either company will make any effort to release favorable news in May.