Changyou: Is The Dividend A Catalyst For A Buyout?

Summary

• Plenty of cash and low valuation.
• Special dividend of $9.4/ADS announced on 4/5/2018 could be a hint of a coming buyout.
• Even without a buyout, post-dividend P/E will be very low compared to peers.

Changyou (NASDAQ:CYOU) is a Chinese game company with a relatively low valuation, a lot of cash, and a potential buyout from the chairman, Charles Zhang. The chairman, who is also in charge of Chinese internet company Sohu (SOHU), has sent a letter on 2/1/2018 reaffirming his desire to buy the company at $42.10/ADS following his original letter on 5/22/2017. After missing guidance in the Q4 2017 earnings release, the stock sold off and languished in a range between about $27 and $29 per ADS until 4/5/2018, when the announcement of a special dividend of $9.4/ADS pushed it out of the range to about $30/ADS.

Such a large special dividend is a bit unusual. I can think of three reasons for it (all of which are bullish):

1. The controlling shareholder, SOHU, needs cash.
2. Taking out excess cash makes the valuation look more attractive to Wall Street.
3. The buyout of CYOU is coming soon.

For more background, readers might want to read some of the recent articles by Seeking Alpha contributor John Sheehy.

Risks

Before getting excited, it's worth outlining some potential risks:

1. Concentration risk - CYOU is a Chinese company majority owned by SOHU, with Charles Zhang as the controlling shareholder of both.
2. Complexity risk - Due to Chinese laws about ownership of media companies, CYOU doesn't technically own its subsidiaries but has a complicated legal arrangement which gives it "effective control." See the section on "VIE-Related Risks" in SOHU's 2017 10-K.

So we are talking about investing in a company where one person has majority control via a complicated legal arrangement in China and may be planning to take the company private with a low-ball offer. This should worry you. It worries me.

On the other hand, if you are trying to buy stocks for less than they are worth, there are often risks you need to worry about.

Special Dividend Analysis

Next, we discuss possible reasons for the recently announced special dividend and why it may be important.

Possibility 1: SOHU Needs Cash?

It is possible that as controlling shareholder, SOHU needs cash and is orchestrating the dividend for that reason. This seems unlikely, as the company's 2017 10-K indicates total current assets of $2.6 billion versus total liabilities of $1.57 billion.

Then again, as noted in CYOU's Q4 2017 earnings release, SOHU has an arrangement where it can borrow from CYOU for 6% and is currently doing so. I find it odd that SOHU seems cash-rich but is borrowing from CYOU. Then again, CYOU is also cash-rich, so perhaps there are tax reasons, liquidity reasons, or other explanations for why SOHU is borrowing from it.

The amount which SOHU borrowed from CYOU is RMB 1 billion (about $160 million). SOHU will receive about $340 million from its portion of the dividend. Since SOHU is the controlling shareholder of CYOU, it is possible that it is forcing CYOU to pay a special dividend so that SOHU can use the portion of the dividend it receives to pay down that loan. Since the dividend is much more than the loan, and since SOHU does not seem to need a lot more cash, it seems like paying down the loan is not the primary motivation for the special dividend.

Another possibility is not so much that SOHU needs cash but that the liquidation plan it filed on 4/2/2018 makes it a good time to get cash out. After all, if the company is liquidated, then getting cash out now may be cheaper than doing it later.

The liquidation itself is a bit strange and not discussed much by SOHU. Based on other sources (including an article by John Sheehy) it seems like the liquidation of SOHU would have benefits for a Cayman Islands holding company and potentially reduce taxes if CYOU is liquidated (more on this below).

Possibility 2: Valuation Improvement

Another possibility is that CYOU would like to get a better valuation from Wall Street. Currently, the forward P/E for CYOU is about 14, according to various sources implying forward annualized earnings of about $110 million. This sounds about right considering that the Q4 2017 earnings release estimates Q1 2018 guidance of $23-28 MM of GAAP income and Q1 is expected to be a seasonally slow quarter.

Distributing about one-third of the company's price in cash would lower the forward P/E by one-third to about 9.3, much less than typical P/Es for similar companies. See John Sheehy's article on CYOU for some valuation comparisons, or see the NYU valuation ratio list to see that typical forward P/Es are in the range of 20-30. Given that it seems like CYOU doesn't need the cash, it certainly appears that giving it out as a dividend to improve the valuation multiple would be reasonable. At half to a third of the typical valuation of similar companies, one could really pound the table that a post-dividend CYOU is cheap.

It is worth remembering that CYOU paid a special dividend in 2012, and the stock rallied significantly afterward.

Although this would be a good reason, I don't actually think this is why CYOU is distributing the special dividend. Charles Zhang has no incentive to raise the price if he is serious about a buyout. Although, if for some reason Zhang is now more interested in selling his stake than buying out the company, this would be a reasonable plan.

Possibility 3: Buyout

The best reason I can think of for the special dividend is to facilitate Zhang's buyout of CYOU.

Perhaps Zhang has enough spare cash to simply buy CYOU, but if he isn't that liquid, he would have to take out a loan for the deal. To the extent that the special dividend cash makes its way to Zhang, he can then use it to buy CYOU. This is easier than borrowing money to buy CYOU and then paying off the buyout loan.

Another reason for the dividend in supporting the buyout is to optically improve the valuation. Some have noted that Zhang's $42.10 bid for CYOU was too low. Compared to the roughly $28/ADS the stock was trading at recently, that is a 50% premium (although on a depressed price). If the special dividend drops the stock price to, say, $19/ADS and Zhang reduces his bid by $9.40 to $32.70 post dividend, then Zhang is instead paying more than a 70% premium to the stock price. That should give him plenty of cover if people want to challenge the buyout price.

Now technically, the CYOU dividend is partly going to people besides Zhang, so there is a "cost" in giving out a dividend before the buyout instead of doing the buyout and then taking the cash. Given that Zhang is one of the controlling shareholders, though, that cost is somewhat mitigated.

Concluding Remarks

CYOU is murky, and that introduces some risks. It's particularly uncomfortable to be long a stock where the controlling shareholder may be actively working to take the value for himself. That said, there seem to be some significant signs that the company is planning to go private relatively soon.

If you imagine that buying the stock here at around $30 would net you about $40 after the dividend and buyout, you stand to gain around $10/ADS. If you bought the ADS directly, you are probably risking around $2-3, provided you sell if/when the stock goes back into the middle of the recent price range. That gives a reward/risk between 3-to-1 and 5-to-1 on a buyout, which is not bad. If the buyout thesis is completely wrong, you may also do well as CYOU starts to screen better on valuation metrics and quant funds or fundamental investors get interested.

If you are more aggressive, you could try to get some of the out-of-the-money calls either soon or perhaps after the ex-dividend date. For example, if you could get the July 35 calls for about 40 cents, then you can get a 10-to-1 reward/risk if the buyout happens in time.

Finally, I would welcome readers to comment on their thoughts about this unusual special dividend.

Analyst’s Disclosure: I am/we are long CYOU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.