Following Tencent’s buyout of their jointly controlled Sogou search business, Sohu has:
- US$1.57Bn ($40/ADS) of cash equivalents and short term investments. The company recently announced a $100mm share repurchase program.
- Consistently profitable Changyou games business which will earn net income of approximately $228mm in 2021 and Sohu could retain a stake worth $56/ADS following a successful HK/China IPO.
- Sohu Media (news+video) which has reduced losses in recent years, but has an uncertain outlook.
Sohu’s cash position and gaming profitability provide a large margin of safety at the current ADS price under $20. The risk is that business deteriorates and gradually erodes the cash reserve. Sohu management has not described any long-term strategic plan to investors. Without a plan, it’s impossible to assess the probability of success and the potential returns.
- Key Financial Data – Gaming Gross Profit at Multi-year High
- Investor Concerns – Competition, Economy, Regulation, Use of Cash
- Potential IPO Valuation of Changyou
- What Is The Plan?
- Share Ownership – Potential for Activist Involvement
Key Financial Data – Gaming Gross Profit at Multi-year High
Sohu reported a Net Loss every year from 2016-2020, but trends in Sohu’s business have been obscured by accounting changes caused by corporate developments and non-recurring expenses:
- Change of corporate domicile from the US to Cayman Islands in 2018 should result in substantial long-term benefit (e.g. the capital gain on the Sogou privatization in 2021 was tax free), but quarterly reporting now provides much less disclosure than was previously available in 10-Q filings.
- Privatization of Sogou by Tencent in 2021 resulted in the business being treated as a “Discontinued Operation” in 2020 and 2021.
- Impairment charges and asset writedowns totaled $300mm from 2016-20. Changyou wrote off the value of failed acquisitions. Sohu Media wrote off the value of acquired content licenses. Following these charges Sohu’s balance sheet is clean with only $48mm of remaining goodwill, $46mm of long-term equity investments, and no debt.
- Tax accruals totaled $440mm from 2016-2020, but actual tax payments were only $179mm. In 2017 Sohu estimated US$219mm of repatriation tax liability associated with the Tax Cuts and Jobs Act, but in 2018 management concluded that it was likely to have zero liability so US$77mm of the expense was reversed and at 12/31/20 an accrued balance of $142mm remained (plus interest of US$14mm) which will be reversed into income if the company’s tax position is not challenged by the IRS. In 2018 Changyou recorded tax expense of US$47mm payable on remittance of a funds from China in order to pay a special dividend. In 2020 Changyou changed its accounting policy and accrued $88mm of expense for potential remittance tax on all Chinese earnings even if it has no plan to remit the funds. Sohu received the Sogou proceeds offshore so there is no corporate need for Changyou to remit funds for the forseeable future. Sohu’s 3Q21 financial statement showed consolidated “Long-Term Tax Liabilities” of US$430mm at 9/30/21, however it’s likely that very little of this will ever be paid.
- Privatization of Changyou by Sohu in 2020 eliminated the additional disclosure from independent reporting of Sohu’s most valuable business segment.
Sohu’s reporting of revenues and cost of revenue from Brand Advertising (Sohu Media) and Online Gaming (Changyou) have been consistent so their long-term trends provides helpful insights:
- Changyou has performed very well and it’s evident the 2020 buyout occurred immediately prior to an improved release schedule for new games.
- Sohu Media has struggled as the benefit of cost containment initiatives begun in 2017 was substantially offset by falling revenues due to industry conditions (intense competition and weak economy). TTM revenues were just US$143mm at 9/30/21 compared to US$577mm at 12/31/15, a drop of 75%.
- Intense competition in China has pressured margins for all advertising supported businesses such as Sohu Media. For example, video industry leader Iqiyi has lost US$936mm in the last 12M and has cumulative losses of US$7.1Bn. IQ appears to be insolvent (11Bn RMB of cash, 25Bn RMB of debt, and 2Bn RMB/qtr cash outflow), is rumored to have just laid off 20-40% of its staff, and will have to be rescued in one way or another by Baidu (its controlling shareholder). Competition for content creation will inevitably decline while customer subscription pricing will rise.
- Key industries responsible for online advertising spending are struggling. Auto sales are down due to supply chain bottlenecks (chip shortage). Real estate sales are down due to the credit squeeze on developers. After-school tutoring was banned by regulation. Travel is down due to COVID restrictions. These macro factors are far beyond the control of company management.
- Online gaming is subject to regulatory uncertainty with approvals for new games currently suspended due to government reviews of data privacy, usage by minors, and content. Changyou is less affected by these rules than some peers because the TLBB franchise has a limited number of games with a loyal (and aging) user base.
- Changyou has relied on its hit TLBB franchise launched in 2007 for the bulk of its profits. Investors feared that revenues would gradually erode, but in the past 2 years the company successfully launched TLBB Honor (a reduced version of the game optimized for budget phones) and TLBB Vintage (a nostalgia version recreating aspects of the visual style and gameplay of the original TLBB game).
- Sohu might not use its cash for the benefit of shareholders. During Sohu’s 3Q21 conference call Charles Zhang suggested that the company would increase investment in user acquisition and R&D. Without more detail about how much money could be used, how it will be spent, and what management hopes to achieve, investors fear the money could simply be lost.
Some investors were disappointed that only US$100mm would be used for share repurchase. While Sohu could have promised more, $100mm equals 21% of the value of shares not held by insiders (based on a $16.50 ADS price) and would generate substantial accretion (cash/ADS would rise from $39.64 to $43.83).
Potential IPO Valuation of Changyou
Changyou’s peer companies that were previously listed in New York all privatized and then relisted at higher valuations in Hong Kong or China so observers have expected a relisting of Changyou. Charles Zhang has mentioned it several times in media interviews and most recently on the 3Q21 conference call.
Changyou has performed well relative to the industry this year. While Sohu no longer provides detailed segment results with its quarterly reporting, I estimate Changyou will be responsible for $228mm of after-tax income.
Peer valuations reflect the different business mix of each company:
Gaming companies with high margins and consistent profits are valued at least 15X Earnings and 4X Revenues. The average of these multiples would value Changyou at US$56.19/Sohu.
There’s no certainty that Sohu will pursue a Changyou IPO, no certainty that regulators would approve it, and no certainty what valuation it will trade at, however I believe a valuation of US$2-3Bn is very reasonable for the segment. An IPO would provide improved transparency for investors and enable the business to raise additional capital for growth.
What Is The Plan?
Chinese financial media loves telling the story of Sohu’s tragic decline from its position as an internet leader 20 years ago that lost its way while Tencent, Netease, and Sina/Weibo thrived. However I think this unfairly overlooks Sohu’s successes:
- Changyou games was founded by Sohu in 2003 and launched its TLBB game in 2007. The company has grown to a current value of US$2-3Bn and also paid over US$1Bn in dividends to shareholders including Sohu.
- Sogou search business was established as an operating unit within Sohu in 2006. Sohu realized a profit of over US$800mm as a result of the acquisition of Sogou by Tencent.
- Sohu Media has struggled, as have most news and portal peer businesses, but Sohu took proactive action in 2017 to cut costs.
Despite considerable uncertainty in the Chinese internet sector, Sohu is currently in a comfortable position with a large cash reserve and a valuable gaming business anchored by a long-lived franchise. The problem for investors is that the most important issues affecting Sohu are not addressed in any organized manner, but left to chance comments by CEO Charles Zhang in response to analyst conference call questions. Some analysts show little interest in Sohu as a company and only ask questions about general industry conditions. Investors cannot assess the probability of Sohu’s future success and potential shareholder returns without more information. The only significant change on Sohu’s investor relations website in the past 8 years has been that the ADS price fell 72%.
Share Ownership – Potential for Activist Involvement
Sohu appears to be an attractive target for activist shareholders:
- Chairman/CEO/Founder Charles Zhang owns 26% of the company, but has no preferential voting rights.
- Institutional investors reporting on US disclosure forms 13F and 13 D/G held 38% of the shares at 9/30/21. These firms are all independent and have no business relationship with Sohu or board representation.
- Proceeds of US$1.2Bn ($29.77/Sohu) from Tencent’s privatization of Sogou were received by the Sohu parent company in the Cayman Islands so they are free to be used for any corporate purpose including special dividends and share repurchase.
- Changyou depends on its management team led by Dewen Chen and the license from the estate of Louis Cha for adaptation of his TLBB novel. Changyou does not appear to depend heavily on Charles Zhang who involves himself much more closely in the media segment.
- Management has not articulated any long-term vision or strategy for Sohu Media. Sohu continues to be one the most frequently visited websites in China. In 2015 Verizon paid US$4.4Bn for AOL and then in 2016 paid US$4.5Bn for Yahoo. This year the combined Verizon Media business was sold to Apollo Global for US$5Bn in May 2021. If Charles Zhang can’t figure out what to do with Sohu Media then it’s very likely that it could be sold at a valuation that balanced its weak operating results against its large user base.
- Sohu purchased Beijing office buildings in 2006 and 2010 for its own use. These are currently operating assets rather than investment properties, but sale or liquidation of Sohu’s businesses might allow $500mm ($12.62/ADS) of value to realized from these assets.
Sohu has a Shareholders’ Rights Agreement (poison pill) that would slow down any effort to take control of the company.
Disclosures and Notes:
At the time of publication the author owned shares of Sohu. This position should not be interpreted as a recommendation of any type of investment in Sohu.