Changyou Will Deliver Strong Results For Sohu In 2020

• Sohu offered $10/ADS to buy out the 33% public stake in its Changyou gaming business
• Release of a new mobile game from its hit TLBB series could boost Changyou’s 2020 earnings to $150mm (about $3/ADS)
• Sohu should report a substantial 2020 profit after 8 years of losses.  Changyou will be strong, Sogou will continue to grow.  Sohu Media losses will narrow.
• Owning both stocks provides a near-term opportunity to enjoy a bump in the Changyou buyout price, and a long term opportunity to benefit from improved 2020 earnings.

Completion of a Changyou (CYOU) buyout is highly likely and the only question is how the value will be shared between Sohu (SOHU) and the public shareholders of Changyou.  I believe a $15/ADS price would provide a fair return to Changyou shareholders while providing Sohu with the opportunity to profit from Changyou’s improving outlook.

Topics:

• Changyou’s games business has been consistently profitable
• Changyou’s peers listed in Hong Kong and China trade at average P/E over 20
• Changyou’s business depends heavily on its TLBB franchise
• Changyou has a new TLBB mobile game under development
• Changyou privatization considerations
• Sohu’s valuation

Changyou’s games business has been consistently profitable

• Game revenues and income fell sharply in 2016 due to a market shift away from PC games to mobile.
• Game revenue and income rose in 2017 due to introduction of a new TLBB mobile game
• Game revenue and income dipped in 2018 due to the absence of new hits and maturing of older games.
• Game revenue and income have risen slightly in 2019 despite the absence of new hits
• Non-game segments (cinema advertising and online portal/platform) have generated significant losses due to impairments of amounts spent on acquisitions.

Remaining exposure to non-game segments is minimal. Changyou shut its cinema advertising business in 2Q19 and the 17173.com portal business is likely to operate at breakeven now that acquisition costs have all been written off.  Future company earnings should be approximately equal to net income from the Online Game segment.

Changyou’s peers listed in Hong Kong and China trade at average P/E over 20

It will be hard for Changyou’s independent Directors to accept a fairness opinion that would justify a buyout price of $10/ADS (a P/E of about 5X estimated 2019 earnings).

Changyou’s business depends heavily on its TLBB franchise

Games based on Tian Long Ba Bu (Demi-Gods and Semi-Devils), a novel by Louis Cha that has been the source for multiple TV and film adaptations, provided 78% of Changyou’s 2018 revenue. The TLBB PC game which was first introduced in 2007 earned $201mm in 2018 and the Legacy TLBB mobile game introduced in 2017 earned $103mm. Reliance on the strength of the TLBB franchise provides stability but also suggests that Changyou has limited growth potential.

App Annie data show that Changyou’s other games have not achieved comparable success. Note that daily ranks change every day and Apple/IOS has a minor position in the Chinese market so these numbers provide only a general indication of the relative popularity of different games.

TLBB’s daily rank fluctuates depending on release of new features that stimulate player engagement.

Pessimists about Changyou’s earnings suggest that revenues from current games will steadily decline, however the company has been able to sustain customer interest in the TLBB mobile game introduced in May 2017.

Changyou has a new TLBB mobile game under development

Changyou introduced its first TLBB mobile game (TLBB 3D) in 2014, followed by Legacy TLBB in 2017, and a new game began limited public testing early this year which would put it on track for general release in 2020. I have not seen any analyst mention of this game or the positive implications it will have for Changyou’s 2020 earnings. Changyou has not mentioned it in any investor communications.  Authors of two recent Seeking Alpha articles seem to have been unaware of it.  Sohu’s offer to privatize Changyou appears to be timed to capture the full benefit of the profits from the new game.

A very limited number of TLBB players had the opportunity in May 2019 to participate in a test round of a new game with the temporary name “代号TL” or “Code TL” (LINK). The game has a web page describing it as “Coming Soon” (LINK). This website suggests that the game will be distributed by Tencent (the same arrangement as Legacy TLBB mobile) with a tentative release in February 2020.  On 10/14/19 a new game called 天龙八部·归来 (Tian Long Babu – Return) was approved by China’s State Administration of Press Publication Radio Film and Television (SAPPRFT).  Commentators have assumed  that 天龙八部·归来 must be the release name of 代号TL, but Changyou has not yet made any comment.  The important information for investors is that it looks like a new TLBB game will be out before long.

“Code TL” Screenshot

The new game should boost earnings in a manner similar to the 2017 release of Legacy TLBB mobile. Changyou’s 2020 net income could easily exceed $150mm or $3/ADS. Privatization of Changyou at $10/ADS would be an incredible bargain, but I believe Sohu should feel motivated to pay a higher price if that would enable a transaction to be completed quickly and before release of the new game.

Changyou privatization considerations

• No Shareholder Vote: Sohu has a 67% economic interest in Changyou, but 95% of the voting power due to ownership through Class B shares with preferential rights.  Holding over 90% of the votes will enable Sohu to complete the merger in accordance with section 233(7) of the Cayman Islands Companies Law which means that if Changyou’s Board of Directors approves a transaction then no shareholder vote will be required.
• Prior Offer: Sohu group chairman Charles Zhang previously offered to privatize Changyou for US$42.10/ADS in May 2017. That price would be equivalent to $23.30 after subtracting the two special cash dividends paid by Changyou in 2018 and 2019. That offer was subsequently withdrawn and Changyou earnings dipped in 2018 due to impairment charges and the natural decline of Legacy TLBB mobile after the initial launch enthusiasm in 2017. I believe the current privatization offer is much more likely to be successful for these reasons:
  • The offer is timed when business is on the verge of improving (new TLBB game launch in 2020) rather than fading as happened in 2018.
  • The buyout offer from Sohu presents less of a conflict of interest than an offer made personally by the Chairman.
  • The buyout offer from Sohu can be completed through an easy squeeze out process under section 233(7) of the Cayman Islands Companies Law.
  • Sohu reorganized its corporate structure in 2018. Moving the holding company from Delaware to the Cayman Islands means no corporate tax will apply to any gains or deemed gains in transactions involving Changyou equity.
  • Acquisition by Sohu preserves and improves business and financial synergies. The value of IP content can be maximized across different segments (games, video, other media). Surplus cash flow from Changyou games can be allocated to new business segments without the complication of intragroup loans.
• Easily Financed: The US$174mm cost of buying out public shareholders in Changyou at $10/ADS is covered by Changyou’s US$212mm of cash and short-term investments at 6/30/19. Changyou has consistently generated positive operating cash flow and does not have significant working capital requirements. Access to financing should not present an obstacle to completion of a privatization at a price above $10/ADS.

The “fair value” of Changyou’s business should be at least $20/share and possibly over $30/share, but investors and analysts lost interest even as the company delivered significant value through payment of special cash dividends of $9.40/ADS in 2018 and 2019. Changyou competitors previously listed in the US were all privatized and most relisted in Hong Kong or China (Perfect World, Giant, Shanda, Idreamsky, China Mobile Games). It’s likely that Changyou would remain chronically undervalued if it continued to trade by itself in the US.

The current $10 offer price provides only a 4% premium to the average closing price of Changyou ADS (adjusted for dividends) over the past 3 years.  The price also does not compensate Changyou shareholders for the $153mm ($2.87/CYOU) intragroup loan currently outstanding from Changyou to Sohu.  A revised buyout price of $15 would be an outstanding bargain for Sohu (net of the intragroup loan the price would be about 4X 2020 EPS), but would provide all Changyou investors with an attractive return which is possibly greater than they would be able to earn if the company remained publicly listed in the US.

Changyou investors would have the opportunity to continue participating in the company’s success by buying shares in Sohu.

Sohu’s valuation

Sohu ADS are currently trading at a large discount to the value of its public stakes in Changyou and Sogou:

Release of a new TLBB game is likely to boost Changyou’s 2020 earnings to at least $150mm. At a low P/E multiple of 10X that business would be worth $1500mm or $38 per Sohu ADS. It’s possible that Sohu could seek to relist Changyou in Hong Kong or China to provide visibility into that value and possibly even much greater value if it trades at average multiples of locally listed peers.

Sohu’s valuation has been depressed by the weak media advertising market described in my Phoenix New Media article and especially by losses in its streaming video business.

Video losses have been shrinking as Sohu shifted its focus to internal development rather than renewing expensive licenses for external content. The company believes video will be breakeven by the end of this year. When Sohu shares dropped after 2Q results Chairman Charles Zhang told Chinese media that investors were failing to understand the improvements under way. He expected a consolidated net loss for 3Q19 of $22-32mm and a breakeven result in 4Q19.

I believe Sohu will report a consolidated profit in 2020 of about $70mm ($1.80/ADS) for the first time since 2012:

• 100% owned Changyou (following privatization) should earn at least $150mm due to the new TLBB game.
• 33% owned Sogou search will earn about $120mm based on current analyst estimates ($40mm attributable to SOHU). Sogou announced a US$50mm share buyback plan with 2Q19 earnings.
• Sohu Media, including news and video, will lose less than $120mm

The biggest uncertainty in estimating consolidated earnings is the rate of losses in the media business which will be sensitive to advertising spending dependent on economic conditions.  Sohu has been trying differentiate itself by creating newsworthy events like a 5G Summit and drone photography/video competition.

If privatization of Changyou is not successful then Sohu 2020 earnings will be closer to $20mm because it will own only 67% of Changyou.  I believe Sohu is highly motivated to complete the privatization as quickly as possible.

Sohu has significant hidden value in Beijing real estate that it acquired in 2006-2010 as detailed in this article. These office buildings are currently used for Sohu, Changyou, and Sogou operations so they cannot be considered surplus financial assets, but they should provide some valuation support if operations were to deteriorate.

In the past 2 years Sohu Chairman Charles Zhang has acquired 2.0mm SOHU shares in open market purchases at prices up to $40.06.

Disclosures and Notes

At the time of publication the author was a shareholder of Sohu and Changyou.  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’s optimistic expectations for Changyou’s 2020 earnings are based on 1) testing fo the “Code TL” game, 2) SAPPRFT approval of “TLBB Return”, and 3) the strong performance of the current TLBB mobile game in 2017 (the first year was released).   Changyou has not made any official comment about release of a new TLBB game.  There is no certainty that a game will be released and if released there is no certainty that it will be successful.