IPO Pick of the Week: Qihoo 360 Tech

| About: QIHOO 360 (QIHU)

Qihoo 360 Tech (NYSE:QIHU) is scheduling a $139 million IPO with a market capitalization of $1.348 billion at the ADR price range mid-point of $11.5, for Wednesday March 30, 2011. QIHU is based in Beijing, China.

As the No. 3 internet company in China, QIHU offers a way to participate in the growth of the internet in China. QIHU itself is on a rapid growth path.

  • Sales were up 82% in 2010 to $58 million from $32 million in 2009
  • Gross margin increased to 88% from 74%
  • Net income increased 125% to $9 million from $4 million

In the December 2010 quarter the annualized sales rate was $80 million, with 71% of revenue generated from advertising. The December quarter profits of $4 million equaled all the profits generated in 2009.

Reasonable Price: Annualizing December quarter's profits, a QIHU IPO at the price range mid-point of $11.50 has a P/E of 84, which is reasonable for a fast growth company with a high gross margin in a rapidly growing segment in China. Look here for QIHU valuation metrics.

Yes, it's true, there has been a downdraft in Chinese stocks and there have been accounting problems, etc. Therefore, investors are not as interested as before. QIHU, however, generated very good recent sequential quarterly results and seems to have good growth momemtum.

Business: QIHU is the No. 3 Internet company in China as measured by user base, according to a report QIHU commissioned from iResearch. In January 2011, QIHU had 339 million monthly active Internet users, representing a user penetration rate of 85.8% in China, according to iResearch.

Chinese Market: According to iResearch, the number of internet users in China grew from 137 million in 2006 to 457 million in 2010, representing a CAGR of 35.2%, and is expected to grow to 667 million in 2013.

China users are also increasingly conducting internet activities through mobile devices, including mobile-banking, mobile-commerce, mobile-gaming and mobile social networking, among others. According to iResearch, the number of mobile Internet users in China increased from 17 million in 2006 to 303 million in 2010, representing a CAGR of 105.3%, and is expected to grow further to reach 658 million by the end of 2013.

Primary Product and Users: QIHU recenty had 172 million monthly active users with the No. 2 web browser in China (360 Safe Browser). Microsoft (NASDAQ:MSFT) Internet Explorer is the No 1 browser. QIHU’s browser has a user penetration rate of 44.1% in China in January 2011, according to iResearch.

QIHU recently had 98 million monthly active users of the 360 Personal Start-up Page, the default homepage of 360 Safe Browser and a key access point to popular and preferred information and applications.

QIHU's No. 1 mobile security product in China (360 Mobile Safe) has a market share of 58.2% as measured by the number of active users in January 2011, according to iResearch. QIHU is also the No. 1 provider of internet and mobile security products in China as measured by user base, according to iReseach.

Other products include 360 Application Store, a key access point to securely obtain and manage software and applications; and 360 Safebox, a solution that protects users against thefts of personal account information.

Business Model: QIHU charges customers advertising fees for providing links to their websites or online applications in prominent positions on QIHU websites and secure platform products.

QIHU generally charges customers a fixed fee for an agreed contract period and occasionally also charges customers on a cost-per-sale or cost-per-action basis. QIHU began offering web games developed by third parties in 2009 under revenue sharing arrangements with the game developers.

In 2010 QIHU began to offer Internet security services such as remote technical support to paying customers. When computer users encounter security issues, they can request QIHU’s staff for live technical assistance and remote troubleshooting for a service fee on a per-case basis. QIHU also provides monthly and annual subscription for this service.

QIHU offers web games developed by third parties and generate revenue from selling in-game items online. All of the web games are developed by third-party game developers and can be accessed and played by end users on QIHU’s website without downloading separate software. QIHU collects payments for the sold items from end users and remits certain percentages of the proceeds to the game developers. QIHU recognizes revenue from these sales primarily on a net basis since because QIHU acts as an agent in the transactions.

Competition: The primary competitor in this market is Tencent (OTCPK:TCEHY), the largest Internet value-added services provider in China. In January 2011, Tencent's QQ instant messaging software had a monthly active user penetration rate in China of 89.3%, while QIHI’s 360 Safe Guard had a monthly active user penetration rate in China of 76.9%, according to iResearch.

According to page 14 of the S-1 filing:

Tencent tried to reduce QIHU’s market share

On November 3, 2010, Tencent issued a letter to users of Tencent QQ, Tencent's popular instant message software, announcing its decision to disable the widely used Tencent QQ on computers that had installed our security products, effectively requiring users to either stop using Tencent QQ or uninstall QIHU’s internet security products.

As a result, a significant number of users stopped using Tencent QQ, or QIHU’s Internet security products, or both. Due to the large number of internet users that were affected, this incident was extensively reported in the media and attracted government scrutiny.

On November 21, 2010, the Ministry of Industry and Information Technology, or the MIIT, ordered that Tencent and QIHU end the dispute, apologize to affected users and ensure the compatibility of products concerned.

Use of Proceeds: $172.8 million from this offering and from the concurrent private placement. $51.8 million for development of new Internet and mobile security products and services; $51.8 million for enhancement of our research and development capabilities to further develop technologies; $25.9 million for investment in and acquisition of technologies, products or businesses; balance for general corporate purposes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.