Sohu Stock Undervalued Based On Sum-Of-The-Parts Analysis

Introduction

Sohu(SOHU) generated a meager 5% return over the past 12 months, vastly underperforming many other Chinese technology stocks. Yet there are two catalysts in store for Sohu in the near term and the stock’s performance may finally be able to catch up. Sum-of-the-parts analysis on Sohu’s valuation shows very favorable risk/return at current price point. In an optimistic scenario, Sohu’s stock could return over 170%.

Catalysts

One of the catalysts is the continued price appreciation of Changyou(CYOU), Sohu’s gaming subsidiary. On May 22, Sohu’s Chairman and CEO Charles Zhang sent Changyou’s board a proposal to privatize Changyou at the price of 42.10 per ADS. Since Sohu owns about 68.5% of Changyou, Sohu will be able to monetize the Changyou stake at a decent price, given the fact that Changyou’s stock has appreciated over 100% in the last twelve months and Zhang’s offer suggests a further 6-7% upside at the current price(June 9, 2017). However, Changyou might appreciate even more if the board actually rejects the privatization. TLBB Mobile, a mobile game developed by Changyou and distributed by Tencent, has been on fire since its May 16 debut. This game, based on AppAnnie’s data, has been consistently ranked second or third in China App Store’s daily grossing. Changyou has lifted Q2’s guidance because of TLBB Mobile’s outstanding performance. If TLBB can keep maintaining its popularity, Changyou’s will vastly exceed market’s current expectation and Changyou’s stock can go even higher. In turn, Sohu should enjoy a nice stock price boost as well.

*TLBB mobile performance since release as of June 9

The other catalyst comes from Sogou, another subsidiary of Sohu. In Jan 2017, Bloomberg reported that Sogou is targeting an IPO this year potentially valuing the company at 5 billion. Sohu controls over 50% voting rights and 36% economic interests in Sogou. Sohu’s stake in Sogou alone could be worth 1.8 billion, roughly the entire market cap of Sohu.

Sogou Input method is the most popular Chinese input tool with a 95% penetration among PC users. According to Sohu’s 2016 10-K, as of December 2016, “Sogou Mobile Keyboard remained the third largest mobile application in China in terms of daily active users.” Sogou Input is very sticky because it “uses search engine technology to capture and generate vocabularies and language models and can present the latest trends in words used by Internet users.” While typing, user can directly search typed words via Sogou’s search engine without going to a search bar. Additionally, Sogou encourages its royal users to install Sogou browser and use Sogou’s search engine embedded in the browser. After Tencent bought 40% of Sogou in 2013, Tencent granted Sogou exclusive rights to search content appeared on Tencent’s WeChat social platform.

The competition is fierce in China’s search engine market: the dominant player Baidu will use all the resources to defend its market share; Shenma Search is a subsidiary of the deep-pocketed Alibaba; Qihu 360 completed its privatization and will soon gather a big round of fresh funding through an IPO in China at high valuation. Facing formidable competitors in the Chinese search engine war, Sogou knows that it must also bulk up financially as soon as possible. In addition, the year 2017 has proved so far to be a decent year especially for U.S. tech stocks, boosting Sogou’s chance of a successful IPO in the U.S.

Sohu’s Core Business

Compared to its rising subsidiaries, Sohu’s core media business is suffering. Its online video media business suffered heavy losses and its advertising business was not profitable in 2016 either. The company sees a similar level of losses for the video business this year but believes that the segment will be profitable in 2019.

Valuation

Based on sum-of-the-parts analysis (detailed in the appendix), even after factoring the expected losses from Sohu’s core business this year, the stock is still highly attractive. A conservative valuation suggests the stock could go up 40% while bull case points to a 170% return, if the catalysts play out. Sohu’s chairman holds 20% of the stock and I believe that his Changyou privatization proposal is a good way to boost Sohu’s stock.

Risk

The biggest risk for this thesis is that neither of the catalysts play out and the conglomerate discount persists. Specifically, if Changyou’s independent directors reject the going-private proposal and TLBB mobile’s revenue starts to decline rapidly, Changyou’s valuation would decline. The other concern is that Sogou might fail its IPO. However, given the risk and reward scenario, I still feel Sohu is a compelling buy at the current level.

Summary

Buying Sohu at current price is a good arbitrage trade, a bet that the gap between the underlying assets’ aggregated value and Sohu’s market cap will shrink. The catalysts for the gap to close are Sogou’s IPO and Changyou’s value appreciation. However, I personally view this strictly as a trade, not a long-term holding.

Appendix:

I. Sogou valuation

Comp Analysis using Baidu’s current valuation

Baidu Sogou
2016 Sales 10374.85 660.4
2014-2016 3 yr Sales CAGR 12.80% 19.57%
Net Income 1628.53 60
Diluted Shares 348.7
Price 185.75
Market Cap 64771.025
Net Cash 11755.87 303
P/S net Cash 5.11
P/E net Cash 32.55

*Based on Baidu and Sohu’s 10K. Chinese Yuan to USD exchange rate is set at 6.8:1. Sogou’s Net Cash includes 17million long-term investment of Zhihu recorded at cost.

Comp Analysis using Qihu 360’s going-private valuation

Qihu
2015 Sales 1680.4
Net Income 307
Market Cap 11040.58
Net Cash 484
P/S net Cash 6.282185
P/E net Cash 34.38627

*Data from Qihu 2015 10-K

Other valuation methods:

  1. In Sep 2013, Tencent invested 448 million in Sogou for an equity stake of 36.5%, valuing Sogou at 1.22 billion. Since then, Sogou has grown nicely. Applying a 50% appreciation based on Tencent’s original valuation, I value Sogou at 1.8 billion.
  2. Aforementioned Bloomberg news reports that Sogou is seeking 5 billion valuation.

Sohu’s Sogou stake valuation:

 Sogou Valuation Sohu Stake 36%
Based on Baidu P/S 3677.62 1323.94
Based on Baidu P/E 2256.24 812.25
Tencent Valuation 1800 648
Based on QIHU P/S 4451.76 1602.63
Based on QIHU P/E 2366.18 851.82
Based on Bloomberg 5000 1800

II. Changyou Valuation

Changyou at a glance

Diluted Shares 53.4
Price 39.37
Market Cap 2102.358
Net Cash 836.4

*Stock price as of 6/09/2017

I devised two scenarios-base case and bull case-for Changyou’s 2017 P/E multiple depending on TLBB mobile is future performance. The bull case assumes that TLBB mobile can firmly sit among top five in term of grossing throughout the rest of the year while the base case assumes TLBB mobile starts losing momentum quickly somewhere in Q3.

2017 P/E Forecast Base Case Q1 Q2 Q3 Q4 Total
30 53 70.5 50 203.5
2017 P/E Forecast Bull Case Q1 Q2 Q3 Q4
30 53 88 70 241

*Q1 actual earnings and Q2 estimates are from Changyou’s filing. Q2 earnings will only include half-quarter earnings contribution from TLBB mobile

*Q3 and Q4 earnings estimates factor in full-quarter TLBB mobile revenue contribution and natural monetization erosion

Changyou’s valuation will also be based on a range of scenarios:

SOHU Stake 68.5%
Privatization 2248.14 1539.98
2016 Net Income 10X 2286.4 1566.18
2017 Net Income 10X Base Case 2871.4 1966.91
2017 Net Income 12X Bull Case 3728.4 2553.95

*Net Income valuation estimates include net cash

III. Assumption on Sohu’s loss in 2017

I estimate Sohu’s total loss this year to be similar compared to last year, with bigger losses from Sohu’s core businesses offset by growing income contribution from Sogou and Changyou. Per Sohu’s 2016 10-K, Sohu’s loss is about 224 million.

IV. Valuation on Sohu’s core businesses

Although the company is in clear decline, Sohu is still a household brand and its portals still attract a big audience. Since the core businesses are losing money, we have to estimate its value based on its revenue. As a reference point, Verizon paid about one-time sales multiple for Yahoo!’s portal business. To value Sohu’s core businesses, I use 1-time sales for the bull case and 0.5 times sale for the base case.

2016 Sohu Sales 468
1 time sales 468
0.5 times sales 234

Valuation Summary

Base Case Bull Case
Sohu Core business 234 468
Sohu Net Cash 113.5 113.5
Sohu NOL 200 200
2017 Loss -224 -224
Sogou 648 1800
CYOU 1539.9759 2553.954
Sohu SOTP Value 2511.4759 4911.454
Diluted Shares 38.8 38.8
Market Price(06/13/2017) 46.54 46.54
Market Cap 1805.752 1805.752
Upside 39.08% 171.99%

*Sohu Net Cash excludes cash, short-term investment, and long-term investment that are held in Changyou and Sogou but consolidated on Sohu’s balance sheet

*Base case valuations for Sogou and CYOU refer to the lowest valuation among different valuation methods. Bull case valuations for Sogou and CYOU refer to the highest valuation among different valuation methods.

*All data are based on Changyou and Sohu’s 10-K and latest 10-Q.

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