Qihoo360 (QIHU) has become the No.2 search engine in China growing at a fast pace over the last few years and is now starting to pressure the market leader Baidu (BIDU). The company started out by selling a mobile browser and leveraged its market lead in the mobile browser space to become a top search engine provider. The search engine market in China is quite large and both domestic and foreign companies such as Google (GOOG), Sohu (SOHU), NetEase (NTES) and Tencent Holdings (TCEHY.PK) have been trying to break into the lucrative Internet segment. Google was forced out of the Chinese market, as the government was not too comfortable with Google becoming a leading information provider in the closely controlled society. The other top Chinese Internet companies have not been too successful in carving out a marketshare. Qihoo has made a big impact in a short time as it could show its search tab in its mobile browser. The company has taken the fight to Google and is now in talks to acquire Sohu's search engine division to gain scale. The stock is not cheap and the market capitalization is already $8 billion. The company also has been caught in the past for some unethical practices. So while I think that the company has done a good job in the search engine, the corporate governance standards and the high valuation makes this stock avoidable.
1) Unethical Practices - All companies have been caught in the past for aggressive business practices. Google , Microsoft (MSFT), Apple (AAPL) etc. are no strangers to large fines due to wrong practices such as price-fixing, monopolistic behavior etc. But Qihoo 360 has crossed the line a few too many times for comfort. They started selling anti-virus software to uninstall the pesky toolbars that come with free software/browsers, even as they were following the same practice with their mobile browsers. They have been warned by the China's State Administration for Industry and Commerce (SAIC) for unfair competition and practices. The company also tried to install its own software by incorrectly informing internet users that it was a Microsoft patch.
2) Google entry could be damaging - The Chinese market is dominated by local companies as foreign companies have exited the business or are insignificant in size. However, Google's search engine technology is miles ahead of Qihoo and if they manage to strike a deal with the Chinese government in the future, Qihoo prospects would turn quite bad overnight. Google dominates the search engine market in most of the global markets. Even though Microsoft and Yahoo (YHOO) have managed to garner a combined 20-30% marketshare in the U.S. market, Google completely dominates Europe and countries such as India with a ~90% marketshare. QHOO has almost no chance of expanding into foreign markets and it will remain a China centric company.
3) Geographical Risk - Qihoo depends on the Chinese market for most of its revenues and profits and internationalization looks remote for the company. The Chinese economy is slowing down and there are even some risks that the economy might face a hard landing. Qihoo's super charged growth may fizzle out very quickly in such a scenario, as advertisers pull back on their spending. In contrast, big U.S. Internet players like Amazon (AMZN), Google and Microsoft have a large part of their income being generated from non-U.S. operations.
4) Chinese ADR Risks - The Chinese companies listed in the U.S. have come under sharp attack for accounting problems if not outright fraud. Qihoo has also been criticized for its aggressive accounting practices and some numbers which do not look right. Many big Chinese companies such as Sino-Forest have crashed as they were proven to be frauds. Top investors with huge stakes in these companies have been found wanting in their due diligence. This risk has to be kept in mind while investing. SEC is taking action against the Chinese subsidiaries of big audit firms for not providing adequate disclosure.
5) Valuation is very Expensive - Qihoo is priced to perfection with a P/B of 14.8x and a P/S ratio of 20x. The company already supports a market capitalization of more than $7 billion with just $47 million in annual 2012 revenues. There is little prospect of upside given these kind of valuations.
6) Stock Price has Increased too much for comfort - Qihoo's stock price has increased by more than 100% year to date and is currently near its all time highs of $60. The company's stock took a bit of a hit when the merger talks were announced but shrugged that news off and have continued on their exponential trend. I think the stock price has overshot its fundamentals by a wide margin.
QIHU Total Return Price data by YCharts
Risks to the Upside
a) Sohu Merger - Qihoo is reportedly in talks to buy China's No.3 search engine Sogou. This would give Qihoo a ~24% market share of the Chinese search engine market and give it a critical scale. The Chinese search engine market is not just about technology but more of a sales and marketing game. You need a huge sales force to sell advertisements to thousands of SMEs. It is about establishing relationships and gaining scale. However, the downside is that Qihoo might have to pay a large amount for Sogou.
b) Fast growth and large market - China's huge search engine market has made Baidu's investors fabulously wealthy as the company grew by more than 50% CAGR for a long time. Qihoo operates in the same market as Baidu and has grown rapidly in the last few years. Revenues and net profits have increased by more than 100% in the last few years. If the company manages to keep up the pace, then its bubble like stock valuation may not be unjustified. However I don't think that will be the case, as the search engine market is more competitive and the market leader Baidu would fight Qihoo tooth and nail for additional marketshare.
Baidu remains a formidable Internet force in China due to its dominant search engine. Qihoo has managed to capture a 10% plus marketshare as it started to install its own search bar on its popular mobile browser which is used by millions of Chinese users. The company's next growth phase will be very tough as it has to use different levers to gain more marketshare. The company's valuation is already reflecting exponential growth in the future with the trailing P/E of almost 200x. If the growth does not come about, then expect a very sharp fall in stock price. Qihoo is not a technology leader so the company is unlikely to grow in foreign markets. So it has only the Chinese market from which to derive its growth. The Chinese market is not a small one, however the competition is rising and Internet penetration has already increased to a high level in the past few years. I think investors should avoid Qihoo as the risks do not seem to be adequately reflected in the current stock price.