Value Play or Dog With Fleas?

by: Alex Morris

Yesterday, while I was searching the internet and avoiding my school work at all costs, I came across a potential value play in Inc (NASDAQ:SOHU). For those of you (like myself) who are not familiar with the name, here is the description from the 10-K:

Our company, Sohu, is a leading Internet company in China providing hundreds of millions of Chinese Internet users with news, information, video content, entertainment and communication. We operate one of the most comprehensive matrices of Chinese language Web properties and one of the most popular online games in China. Substantially all of our operations are conducted through our indirect wholly and majority-owned China-based subsidiaries and variable interest entities (collectively the “Sohu Group”).

Let’s start by taking a look at the financial statements. As of March 31, 2010, the company had $599 million in cash, and zero debt. In that same three month period, net income was $41 million; for 2007, 2008, and 2009, net income was equal to $34.9 million, $158.6 million, and $147.4 million, respectively. Things look pretty good here (as far as growth), and when you take out the cash from the current market cap of $1.57B, the company is trading at only 6.65x trailing 2009 earnings. A strong balance sheet and consistent earnings throughout a tough economic environment is a good start.

The thing that stands out is a stake that Sohu has in another company, called Changyou. Since 2003, the company has become one of the top massively multi-player online role-playing game (MMORPG) operators in China. In 2009, Sohu split off their MMORPG subsidiary (Changyou) in an IPO, which currently trades publically under the ticker CYOU.

After the IPO, the company retained ownership of 66% of the economic interest in Changyou, and, as stated in the quarterly filing, “we do not expect the percentage of Sohu’s economic interest in Changyou to fluctuate significantly, given that Sohu does not have any plan to sell any additional shares in Changyou in the foreseeable future.

From looking at CYOU, the company had net income of $144 million last year (compared to $107M in 2008), and has a market cap of $1.37B; this means that if they sold it today, SOHU’s stake is currently worth $900 million. When you add this to the cash figure from before ($599 million), this means you can essentially buy a company for $71M that made $147M last year, or .48x trailing 2009 earnings. ($1.57B (SOHU market cap) - $900 million (CYOU stake) - $599 million (cash) = $71M/$147M)

This seems too good to be true, and likely is, which is why I wrote this article. From looking at the 10-K, one big problem is a current legal issue: “In March 2008, the Sohu Group was sued by four major record companies, Sony BMG, Warner, Universal and Gold Label, which alleged that the Sohu Group provided music search links and download services that violated copyrights they owned. As of December 31, 2009, the lawsuits with these four record companies were still in process.”

I have no idea what the legal implications for this might be, and would not be willing to invest a penny until I had a better idea of what this could mean to Sohu. Another issue is the company itself; from what I have read, it appears to be a mash-up of Google (NASDAQ:GOOG), Yahoo (YHOO), Activision-Blizzard (NASDAQ:ATVI), and Facebook, quite an interesting mix. If anyone has any insight on the company’s main websites and their acceptance among Chinese users, it would be greatly appreciated. While the price looks cheap, I bet people were saying the same thing at $60/share in January as well.

For the time being, I will be avoiding this company due to my lack of understanding in this particular business, but figured I would talk about it to spread the word for those with a better understanding of this industry. Best of luck everyone.

Disclosure: No position