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ChangYou (NASDAQ:CYOU) is a company that I recently became aware of through screening. I identified that the current valuation clearly didn't reflect the company's past remarkable performance, and then delved deeper in an attempt to determine whether the current market skepticism is completely justified. Past articles do a good job explaining the company's business model and that information is easy to obtain, so I will not focus there. My focus is the current health of the business - where it will go from here and what it deserves to sell at given those conclusions.

Business Overview

Changyou.com Ltd. is a former wholly-owned subsidiary of Sohu Group (NASDAQ:SOHU). It began operations in 2003 as Sohu's MMORPG (online game) business unit, was carved out as a stand-alone company in December 2007, and IPOed in April 2009. It is a Chinese company that develops, licenses, and operates online games and a popular gaming website. The games are free to play. The company makes money through discretionary in-game purchases and advertising.

Management

The company is led by CEO Tao Wang, a 15 year veteran gaming executive in the Chinese MMO industry. He's been at Sohu/ChangYou since December 2004 and worked in gaming at Sina (NASDAQ:SINA) before that.

$100mm in share repurchases were authorized in July and $9mm has been used as of Q3 at about $30 per share.

Health of the Business

CYOU is an immensely profitable enterprise, but profitability has steadily deteriorated since the company's IPO. At the time of the IPO in late 2009, the company was doing 90% in ROE; now ROE is roughly half that, but still impressive at 43.5%.

The company has steadily grown revenues at a CAGR of 30% since the IPO but the current trend is less impressive as well. In Q3, revenue was flat QoQ and up 10% YoY. The guidance for Q4 of $193-199mm implies 13% growth YoY and +7% QoQ.

Gross profit increased 1% QoQ and 13% YoY in Q3, and gross margin remains very high at 84%.

Net Income has increased at a clip of 22% since the IPO.

And now the bad: In Q3, Net Income decreased 3% QoQ and 4% YoY, driven by OpEx up 23% QoQ and 69% YoY. The increase in OpEx is attributable to the hiring of new engineers and higher wages, but mainly the marketing of games. Q4 guidance is for Net Income of $18-22mm, down 73% QoQ and YoY. The company specified that it would be adding an incremental $53mm to market 8-12 new game roll-outs. This is why the earnings guidance is so bad. It was a controversial topic in the conference call. Nearly every analyst asked the company whether the marketing expenses would be recurring or more of a one or two quarter thing. The company described the advertising plan as 'strategic' and 'aggressive.' Tao essentially said that they want 2014 to be a year of investments that will drive 5 years of profitability from a stronger, larger portfolio of games. He said that depending on the effectiveness of the ad dollars, they may continue to spend a similar amount in Q1 and Q2 of 2014. He and his team described the spending at length in this way, painting a picture of the money being strategic and a non-necessity. More of an investment than an expense.

Sell-side analysts seem to think differently, though. The company received 4 downgrades after the Q3 release and price targets got moved down, in general to about $30. Analysts cited that they believe the marketing expense ramp-up to be the new normal for ChangYou in terms of OpEx, margins, and profitability.

My view is mixed. Though my knowledge of the industry is limited, it seems to me that the Chinese gaming industry is experiencing a major change. Things are getting more competitive. The industry is shifting toward mobile games, which are a much lower margin business and where ChangYou will face competition from independent developers. On the other hand, I don't think all expenses are created equal and it does seem like there is a lot of discretion behind these expenditures. The aggressive advertising will definitely aid in the success of the new games. The real question is: to what extent? I'll address that in the Valuation section.

In Q3, Monthly Active Users (MAU) in games decreased 14% QoQ and -21% YoY, driven by decisions unpopular with gamers, like holding back expansion content for the big TLBB expansion that released just prior to the Q3 release. This downtrend came pretty suddenly. In Q2, MAU came in stable, -2% QoQ and +4% YoY. In the call, the company said it opened new servers on the opening weekend of the new TLBB expansion that were operating near capacity and that they expect a rebound in Q4. I don't know if the rebound will be complete, but given the new games that are being rolled out and the TLBB expansion, I think it is reasonable to expect at least a partial rebound. If there is no rebound, then this is a serious issue. The uncertainty surrounding the Games MAU makes ChangYou a very speculative investment right now.

MAU in platform channels (encompasses web games and 17173.com, the company's gaming site) is looking very different. MAU went from being flat QoQ and +4% YoY in Q2 to +16% QoQ and +15% YoY in Q3. The improvements are impressive, but while there is about 3x as much traffic in platform channels compared to games, games contribute far more to the company's financials.

Important to note: Unlike some disturbing companies that I've analyzed, just about all of ChangYou's Net Income translates into Free Cash Flow. The business is still generating significant cash and sits on $525mm of net cash.

Valuation

Based on the current trend, Q4 guidance, past performance, and analyst estimates, I expect $800mm in 2014 revenue and see that as a sustainable base. If the company were to continue on with a 40% margin, the company could rake in $320+mm annually and would currently be selling for just 3.3x that. Clearly the market is pricing in a decline in profitability. I agree that this is warranted, but it is unclear at this point exactly how much of a decline in profitability should be considered. I don't see things getting worse than 10% or better than 30%, so I created the following graphic to illustrate how cheap the stock is now relative to a variety of scenarios within that range.

For a company with ChangYou's track record, the headwinds it faces, and the uncertainty surrounding MAU on existing games and how well its new games will be received, I think a multiple of 10 is what shares 'deserve' to be at now. With that in mind, there is a clear bias to the upside in the various scenarios. If I had to pick a margin level that I see as probable, it'd be somewhere between 15% and 20%. From this, it seems that shares are about 30% undervalued.

Price-to-book analysis also indicates shares may be cheap. Shares currently sit near the lowest P/B level they have since the IPO at 1.85.

Considering that P/B should correlate with ROE and ROE has been cut in half since the IPO, much of the P/B contraction is deserved, but I don't think all of it is. As a general rule, I've found that stocks typically have a P/B multiple that is 11x ROE. So, a company that earns 20% ROE should trade at 2.2x book. That 20% ROE is what I expect ChangYou to earn going forward. That's half of what they've done most recently. I think 2.2x book is reasonable and that would mean shares are 19% undervalued now.

Conclusion

ChangYou.com has a history of strong profitability and growth, but the Q3 numbers and guidance foreshadow a dangerous trend of much lower margins. The company is dismissive of this, but analysts seem convinced that margins will be much lower for much longer. At this point, investors must choose a stance and the company's current valuation indicates that the market is siding with the analysts. Personally, I think shares are pretty cheap here. I see 20%-30% upside, but would like to see a little more before I buy because of all the uncertainty. I'll definitely be watching when the Q4 results come out in a week or so.

Source: ChangYou: Management Vs. The Sell-Side