Macro Tsimmis

intelligently hedged investment

BUY Sohu.com (SOHU)

Posted by intelledgement on Thu, 18 Dec 08

Sohu.com (SOHU) is China’s leading internet portal, and as such, it fills a hole in our portfolio which, heretofore, has lacked a China growth play. Sohu.com is one of the premier Internet media companies in China, providing millions of Chinese consumers with information, entertainment and communication services—and advertisers with the opportunity to make their pitch to these consumers. The company has a family of websites, some developed internally and many adopted via acquistion:

  • sohu.com—internet portal and online media destination
  • sogou.com—interactive proprietary search engine
  • chinaren.com—online alumni club (acquired October 2000)
  • 17173.com—gaming site (acquired November 2003)
  • focus.cn—real estate site (also acquired November 2003)
  • goodfeel.com.cn—wireless value-added services provider (acquired May 2004)
  • go2map.com—online mapping service providers (acquired May 2005)

Sohu.com derives revenue from consumers and from advertisers. Consumer services include online games, wireless, and a panoply of value-added services such as news, information, music, ringtone and picture content delivered to cell phones. (More Chinese internet consumers access the web via cell phones than computers.) Corporate services consist of brand advertising on their matrix of websites as well as paid listing and bid listing on their search engine.

The company operates two massively multi-player online role-playing games (or MMORPG games)—Tian Long Ba Bu (or TLBB) and Blade Online (or BO)—plus a casual game platform. The pricing model for the MMORPG games is different from the standard USA model in that you can play for free…but to progress satisfactorily, you need to acquire virtual objects, which are available for sale from Sohu.com. This is a much more flexible—not to mention, insidious—arrangement than the model that is typical with USA gaming companies, where you need to pay an upfront licensing fee—for downloadable software which you need to install on your computer—and then a monthly subscription fee to afford you access to the game server.

Gaming is huge, accounting for 45% of revenues in Sohu.com’s latest quarter (3Q08) as compared to 41% for brand advertising, 14% for wireless services, and 1% for search ads (a weak point). The ash and trash (ringtone downloads and the like) accounts for the other 1%.

We are buying Sohu.com because of the growth potential, and growth is most definitely their calling card; check out their revenues:

And, it isn’t just unmanaged growth. The company turned profitable in 2002, and while the growth in profits lagged the growth in revenues—in the sense that the ratio of profits to revenues was stagnant to down from 2004 to 2007—they have strung together 28 consecutive profitable quarters and appear to be back on a healthy growth track now:

The company had an IPO on the NASDAQ in July 2000, raising $52 million. Since then, their growth has been pretty much self-funded. The $25 million loss blip in 3Q01 was due to a adjustment of the valuation of goodwill and “identifiable intangibles” in connection with the Chinaren acquisition from the prior year, not any sort of problem with ongoing operations…in other words, a one-time paper loss. They did issue $90 million of notes in 2003, but by the end of 2007, those had all been paid back and the company has no long-term debt and—as of 30 Sep 08—$279 million of cash ($7/share!).

Speaking of share price, the best time to buy Sohu.com was probably September 2002…they turned profitable that quarter for the first time, and the shares were going for $2 each. Of course Intelledgement was not around then. But when we launched in January 2007—and purchased the China equities ETF FXI for the IMSIP—we could (and should) have bought SOHU shares for the ISOP for $20 each.

Yesterday the shares closed at $45.50. <sigh>

Still, that is down from a high of $91/share in June. And taking into account the $7/share of cash (and no debt), the P/E is around 13, and that is dirt cheap for a company that has increased quarterly revs from $39 million to $120 million in the space of five quarters, and whose y-o-y quarterly earnings growth for those five quarters has been 45%-148%-383%-604%-316%, respectively! Plus, the company is shareholder friendly—excellent and timely reporting (in fact, they just won an award for it!) and minimal dilution. (Since their IPO in 2000, the share count is up from 30.4 million to 39.3 million, which amounts to a modest 3% annual increase.)

The one remaining question is…why Sohu.com instead of (BIDU)? If Sohu.com is akin to Yahoo! (YHOO) in China, then Baidu—with the leading search engine—is akin to Google (GOOG)…and we all know how that has played out. While we haven’t looked that closely at Baidu, we expect that it is a perfectly legitimate way to play the China growth story, and in the long run, may be an even better choice than Sohu.com. But the latter is not just another Yahoo! Sohu.com derives nearly half their revenue from their online games. Think about a combination of Yahoo! and Activision Blizzard (ATVI), the publisher of the World of Warcraft online gaming franchise. As the number of internet users ramps up in China, the pie is plenty big enough for Sohu.com to prosper, even if Baidu ultimately wins the search engine war decisively.

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