Sohu.com (SOHU) today announced a $100m share repurchase of its own stock and/or shares of its majority owned Changyou.com (CYOU) subsidiary. CYOU is an online game developer and operator in China which was spun off in a U.S. IPO in mid-2009. Sohu collected $72.5m in proceeds for the portion the company divested. It now appears Sohu may be willing to repurchase portions of Changyou for a sum larger than it collected in the spin off two years ago.
This recent repurchase announcement by Sohu is not a big surprise given the history of its industry. Online gaming is a very big business in China and operators of hit titles can generate substantial profits as well as cash flow from operations. CYOU earned $175m in net income in 2010 and $107m in the first half of 2011 alone. Fellow U.S. listed peer Perfect World (PWRD) also earlier this year announced its own $100m share repurchase program, adding to a string of buybacks which has reduced its diluted share count by almost 20% in the past 3 years.
Sohu itself has repurchased a significant portion of its share base since becoming public over a decade ago, with the most recent being a $150m share repurchase program announced in late 2008. As of the end of the second quarter, Sohu held $718m in cash, excluding marketable investments without any debt, while Changyou ended the first half of this year with $398m in cash and no debt on its balance sheet.
Although the official announcement includes Sohu’s own shares as part of its potential repurchase, buying back shares in Changyou would be more accretive to the company’s shareholders. Sohu’s trailing 12 month earnings per share (“EPS”) of 4.19 is very comparable to Changyou’s 3.77 trailing EPS. However, at roughly $75 currently, Sohu trades at almost double the earnings premium as CYOU at its recent $37 share price. Annual earnings at first half’s run rate, Changyou is on track to earn slightly over $4.00 in 2011 EPS which values its shares at approximately 9x earnings. Excluding Changyou’s cash balance, CYOU trades at only 7x 2011 earnings. Since the earnings of online gaming operators in China typically trickle almost entirely into cash flow, Changyou also trades at a very attractive valuation based on its free cash flow.
Currently, Sohu still owns approximately 67% of Changyou. At recent share prices and assuming Sohu dedicated its repurchase towards Changyou shares, it could buy back about 15% of the shares it doesn’t already own. While concentrating its repurchase program on Changyou may benefit CYOU shareholders more in the short term, CYOU’s discounted valuations relative to Sohu shares makes it a better deal for SOHU shareholders in the long term.