Long SOHU Short SOGO

I was going to post this idea Friday morning, but then a Reuters scoop significantly affected the share prices. The trade is now slightly less attractive, but readers may still find the commentary useful

The current market price of SOGO implies a high likelihood that its $9/ADS acquisition by Tencent will be successful while the current market price of SOHU implies a very significant likelihood of failure. A hedged position has a high probability, but not a guarantee, of an attractive return regardless of the deal outcome.

If Sogou’s acquisition by Tencent goes through at the agreed price of $9/ADS then Sogou shareholders will receive $8.95/ADS (after $0.05 ADS cancellation fee) while Sohu will receive $1.179mm ($30/ADS) of cash proceeds that could be used for special dividends, share repurchase, and new investment. Sohu’s remaining operating businesses (consistently profitable Changyou games and consistently unprofitable Sohu Media) may be worth an additional $44/ADS.

THE SOGOU BUYOUT

Tencent formed a strategic partnership with Sohu in 2013 through which it invested US$448mm to acquire a 39% equity interest and a 52% voting interest in Sogou.  Sogou has become the default search engine for various Tencent products and on a trial basis Sogou is currently operating a search function within the wechat application.

Acquisition of Sogou provides these benefits to Tencent:

• High familiarity with the product – no further due diligence required
• Consolidates control over a core functionality of Tencent products
• Facilitates integration of Sogou’s artificial intelligence applications including speech recognition, language translation, and computer vision

The deal terms appear fair:

• The $9/ADS price is 39X 2019 earnings
• Sohu Chairman Charles Zhang negotiated on an arms-length basis and pledged his personal 6% stake in Sogou in favor of the transaction
• A competing bid is impossible due to Sogou’s strategic dependence on Tencent and Tencent’s 52% voting interest in Sogou.
• Analyst and investor reaction to the acquisition offer was positive.

Sogou signed a definitive agreement to proceed with the merger and a 13E Transaction Statement statement was filed. Public shareholders of Sogou control only 2% of the voting power so the acquisition can be completed without a shareholder vote. The termination date for the merger agreement was extended to June 2021 following media reports (example) about increased Chinese anti-trust scrutiny of Tencent and Alibaba.

A possible complication is that Sogou’s proxy explained that the merger would be completed without dissent rights based on an interpretation of Cayman Islands Companies Law. Sohu’s April 2020 privatization of Changyou followed the same process, however it was challenged in court and in January 2021 a judge ruled that minority shareholders should have been entitled to dissent rights. Sohu has appealed the ruling. Class action lawsuits have been filed claiming that Changyou’s 13E transaction statement failed to disclose that dissent rights were available. I don’t believe that any meaningful portion of Sogou shareholders are planning to dissent, however the company faces a dilemma in determining what to disclose about the availability of dissent rights. Should it adhere to the same legal argument used by Sohu in the Changyou merger, deny dissent rights, and risk class action lawsuits? Or should it offer dissent rights and possibly weaken Sohu’s argument in its Changyou appeal?

Chinese media have widely cited the Reuters story, but I have not seen any of them provide independent confirmation and none of the companies involved have made any official comment. However I believe the story will prove correct because I don’t think this merger created serious antitrust concerns. Sogou search is already used in Tencent applications so the merger will not result in any meaningful change in market concentration. It is unlikely to just be a coincidence that the Sogou/Tencent story leaked at nearly the same time as Alibaba’s 18Bn RMB fine and resolution of the regulatory status of Ant Financial. Weakness in Chinese equity markets (CSI300 is -14% since its February peak) probably created pressure to end the uncertainty created by the ongoing antitrust reviews.

SOGOU VALUATION

Sogou has significant market presence and top quality technology however the company reported a substantial loss of $108mm ($0.28/ADS) in 2020. Sogou had net cash and short-term investments of $1,062mm ($2.75/ADS) at 12/31/20.

Analysts were not optimistic about Sogou’s stock prior to the buyout offer. The company’s profitability is restrained by its distant #3 search market share and its most innovative AI technologies are not significant near-term revenue generators. The 13E included these financial projections:

If correct then Sogou would reach substantial profitability by 2024, but if the Tencent privatization fails to close I would still expect the ADS price to drop back to $4 or lower where it was trading prior to the offer.

SOHU VALUATION

If the Sogou privatization is completed then Sohu will receive $1.179Bn in cash proceeds ($30/SOHU). Sohu will continue to own the Changyou games business which has been consistently profitable and the Sohu Media Portal business which has been consistently unprofitable.

Sohu reported an operating profit in 2020 for the first time since 2015 due to strong results from Changyou and narrowing losses in other segments. If one sets aside losses from discontinued operations and non-recurring tax expenses then the improvement is more clear.

Changyou Gaming Segment

Changyou 2020 results were the best it has reported in 5 years

Sohu Chairman Charles Zhang has been cited repeatedly in Chinese media as saying that Changyou will relist in Asia (example). If Changyou went public through an IPO in Hong Kong or China then peer valuations suggest that Sohu could retain a stake that might be valued at US$2,250mm ($57/SOHU).

The estimate of $150mm in earnings is below the 2020 actual and the estimate of 20 P/E is below most peers so significant upside potential remains, however forecasting is difficult because Changyou has not given guidance about its pipeline of games under development. Management provided this useless commentary in the 4Q20 conference call:

“Currently, several key games are being developed, and we look forward to introducing them to players soon. Looking ahead, Changyou will further execute its core strategy of top games. Changyou’s strategic focus will continue to be MMORPG mobile game, while we’re also developing and looking to roll out games across various genres.”

At the 2020 Chinajoy convention Changyou previewed an ambitious MMORPG under development called Sea Of Dawn which appears to be a potential hit, but it is still in beta testing. The nautical themes and global historical scope are beyond the Chinese legendary settings for so many well established games.

Media Segment

Sohu Media has endured 8 years of losses due to intense competition in its news and video operations. Over the past 2 years Sohu has reduced media losses by concentrating on lower cost production of proprietary content and not renewing expensive external licenses.

Sohu’s video business is a distant fourth behind industry leaders iQiyi, Tencent, and Youku.  Losing less money is certainly progress, but it’s difficult to see whether Sohu will be able to find a market niche offering potential for long-term stability and profitability.  Charles Zhang promised in 2019 that video was on the verge of breakeven, but the COVID epidemic was highly disruptive to advertising revenues despite increased user engagement. Nevertheless, the business made impressive progress at reducing losses in 2020.

The Media segment would have a negative value of $674mm ($17/SOHU) based on these assumptions

• Unallocated Corporate Expense and new business initiatives continue to consume $50mm/year
• Sohu Media (excluding corporate) reaches breakeven in 2025
• Future losses are discounted at a rate of 10%

Corporate Outlook

Sohu has not provided any meaningful commentary about what it would do with proceeds from the Sogou privatization. Past actions by Sohu group companies give hope that a portion of the cash could be allocated to dividends or share repurchase:

• Changyou paid a series of special cash dividends: $3.80 in 2012, $9.40 in 2018, and another $9.40 in 2019 totalling over $1.2Bn
• Sogou authorized a US$50mm share repurchase plan in August 2019 and utilized the full amount.

Sohu generated “Net Cash from Continuing Operations” of $163mm in 2020 and held $141mm of Cash net of short and long term loans at 12/31/20. The business does not need to retain the full Sogou proceeds and I would be disappointed if Sohu did not use at least US$100mm ($2.56/ADS) for dividends or repurchase. The company could afford to do substantially more.

Price Potential

Sohu traded at a discounted valuation for several years due to heavy losses in video and declining games revenue. The company demonstrated dramatic improvement in both areas in 2020 and the risk that value would continuously erode has been greatly reduced. However investors are likely to remain cautious until the company articulates a clearer vision of its place in the internet, media, and consumer landscape.

The stock price will be determined by investor perceptions. I believe $10 would be a conservative expectation if the Sogou privatization does not close and $30 if it does. There is even considerable upside potential to the bull case if Changyou earnings are higher, if it is able to list at a higher valuation in line with peers, and if Sohu is able to make good use of the Sogou proceeds.

While I expect that Sohu will trade around $30 following a successful Sogou privatization, the breakeven for a hedged position is only $19.83. Sohu traded up to $25.71 following the initial Sogou buyout announcement so this seems easily achievable.

Disclosures and Notes

At the time of publication the author held a long position in Sohu and a short position in Sogou.  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.

While the position described in this article is “hedged”, it’s not a strict arbitrage because the price of Sohu shares will depend entirely on investor sentiment following a positive or negative outcome for the Sogou privatization.