Sohu: Privatization Is The Better Option For Both Sides

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Investment Thesis

Sohu (SOHU) reported Q2 results for 2019, leading to a 26% drop on Monday, Aug 5th. Overall, we are passive on SOHU’s future business growth. However, given the low share price and sizable cash position, we do expect a privatization deal to come, which may present some room for share price appreciation.

Disastrous Q2 Earnings Results for SOHU

SOHU released their Q2 earnings on Aug 5th. Here are some of the key highlights:

  • Total revenues for the second quarter of 2019 were US$475 million, down 2% year-over-year
    • Online game revenues for the second quarter of 2019 were US$102 million, up 8% year-over-year
    • Total online advertising revenues were US$320 million, down 4% year-over-year
    • Brand advertising revenues totaled US$44 million, down 29% year-over-year
    • Search and search-related advertising revenues were US$276 million, up 2% year-over-year
  • GAAP net loss attributable to Sohu for the quarter was US$53 million or US$1.35 loss per fully-diluted ADS compared with a net loss of US$48 million in the second quarter of 2018 and a net loss of US$57 million in the first quarter of 2019

The market was so disappointed by the results that the share price dropped more than 26% on Monday, Aug 5th:

Source: Google Finance

The current market cap of the company stands right above $350 MM. According to the earnings release, SOHU has a net cash position (defined as cash and cash equivalents plus short-term investments, minus short-term bank loans) of US$1.56 billion, which is more than 4x its market cap. Although the company has been trading below its net cash position for years, investors should find the current price surprisingly low.

And, in case you are not aware, SOHU’s most valuable assets are actually the properties they own in Beijing:

Sohu Internet Plaza SOHU bought this building back in 2006 with about $277 MM, which is worth close to $500 MM now
Sohu Media Plaza SOHU built this property in 2010, which is worth close to $300 MM now
Sohu Changyou Plaza SOHU bought this building for $130 MM in 2010, which is worth about $200 MM now

Source: Author’s Summary

For SOHU’s management, the low market cap is indeed “humiliating”, which makes privatization a very natural choice. In fact, we have seen Charles Zhang, the president and CEO of SOHU, buying back shares in the past few quarters. According to SOHU’s annual report, Mr. Zhang added about 220k shares sometime between December 15, 2018, and March 15, 2019, after he purchased 1.53 million shares between April 2018 and December 2018. This increased his position to 24.83% of the company’s outstanding shares.

If SOHU ends up going private, we think it will be good news for SOHU investors, as we do expect the offering price to be good. The reason being that SOHU has so much hidden value, and, most importantly, Mr. Zhang still values the company at a pretty high level (it was reported that Charles Zhang paid on average $27.40 and even as high as $41.30 for some of the shares he bought back).

But if Mr. Zhang still insists on keeping SOHU as a public company, for example, Changyou.com (CYOU), the subsidiary of SOHU has issued two large special cash dividends in the past two years, literally passing cash to its parent company SOHU), let’s take a look at whether SOHU is able to make its way back.

Business Sector Analysis: Online Gaming

Online game revenue is still a big part of SOHU’s total revenues, which come primarily from its controlling subsidiary Changyou.com. CYOU sees quarterly revenue of $119 million for 2019 Q2, up 5% year-over-year with a net income of $40 million compared with net income of $28 million in the same quarter of 2018.

The most interesting part of CYOU’s revenue is that the majority of it comes from a single game that existed for over 12 years. The game was called Dragon Oath or Tian Long Ba Bu (TLBB) in Chinese:

Source

The game was originated from a famous Chinese novel with the same name written by Jin Yong. The novel was so popular that CYOU lived on this game (both PC and Mobile) for many years. Other than this game (and its extensions), CYOU hasn’t developed any meaningful new game in the past few years. That’s why when talking about future guidance, SOHU’s plan is essentially just to rely on monetizing from TLBB’s current players:

In the third quarter 2019, Changyou will launch a new expansion pack and introduce more in-game content to sustain user interest. Going forward for PC games, Changyou’s key strategy is to maintain player engagement and maximize the longevity of legacy PC games such as TLBB.

The Q3 outlook on revenues from online gaming is between $80 million and $90 million, which implies annual decrease of 6% to 17% and a QoQ decrease of 12% to 22%. Overall, we expect the online gaming business for SOHU to be struggling in the future.

Business Sector Analysis: Video Streaming

In Q2 2019, operating losses for Sohu Video was $23 million compared with a loss of $35 million in the second quarter of 2018. Sohu Video has been losing money for years, and the fact is there is no outlook of generating profit in the near future.

Sohu Video’s main competitors in this market are all backed by tech giants in China, as mentioned in our previous article. These include iQiyi (IQ, backed by Baidu Inc. (NASDAQ:BIDU)), Tencent (OTCPK:TCEHY) Video, and Alibaba’s (BABA) Youku Tudou.

China’s online video market is really capital/investment intensive. The three large platforms above all have to spend billions of dollars in purchasing popular video content (like TV series) in order to maintain user base growth, and they have to do so for a long time before they can even think about profitability.

According to SOHU’s Q2 earnings call, they “continued 2-engine strategy with a balanced mix of original long-form content and short clips user-generated content”. Apparently, SOHU doesn’t want to compete directly with the other three main video platforms in long-form contents, which is a wise choice since they won’t have that much cash to burn. Their short clips user-generated content strategy, on the other hand, will have to face even more competition, from some well-known unicorns in this field such as Kuaishou and Douyin (Chinese version of TikTok).

With these being said, we find it hard for SOHU to even survive in the video business. The best option for SOHU is to sell off the video business (if it still has a value) or simply shut it down.

Business Sector Analysis: The New Social Network App

In June 2019, SOHU formally launched a new social networking app named Huyou to target China’s younger users. Huyou offers typical tools such as blogs, photo-sharing features, and online games:

Source: w.sohu.com

Mr. Zhang was quite optimistic about Huyou that he immediately became a heavy user of it. In fact, all registered users will automatically become followers of him. His page shows that there are about 2.5 MM users now on the app:

Source: Charles Zhang’s Huyou page

Although Charles puts Huyou as “the future of SOHU”, the truth is China’s social networking market is already so crowded, with WeChat, Weibo (WB), and Momo (MOMO) dominating each sub-area. We haven’t seen any uniqueness in terms of product feature from Huyou, which is why we think Mr. Zhang is likely to be disappointed.

Conclusion

SOHU’s weak financial performance leads to major sell-off. The market cap of the company sits at only 25% of the net cash position based on current share price. We find all of SOHU’s business segments in trouble with little chance of making a success or even surviving. The only upside potential on the share price would be from a privatization deal.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.