Changyou.com's High Free Cash Flow Offers Attractive Yield Opportunities

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About: Changyou.com Limited (CYOU)
by: Investing Hobo
Summary

CYOU has paid over $1 billion in special dividends over the past two years.

CYOU's stable free cash flow should allow the company to continue to pay future dividends.

SOHU's 67% controlling majority stake in CYOU may be a driving factor for CYOU's cash management.

tlbb gameplay

(TLBB Gameplay; source: CYOU annual report)

After distributing a $503 million special dividend to its investors earlier this month, people may wonder how much more is left in Changyou.com (CYOU). After all this dividend represented more than half of CYOU's market cap the day prior to its disbursement. Investor skepticism has been further compounded by the company's inability to grow revenues in the past three years. While CYOU offers little value for growth investors, it is still a fairly safe income play at least for the next couple of years.

Despite operating in China where it derives all of its revenues, Changyou reports its results in USD. In the past few years, the exchange rate between China's RMB and the USD has ranged in a wide gap as large as 10%. For this reason, this article will examine CYOU's quarterly and annual results in RMB converted from its reported USD figures at the exchange rate used for that period. This gives a true constant currency analysis of the company's finances.

Cash and Cash Flow

Even after handing out $503 million to investors, CYOU still has approximately $175 million net cash balance based on figures in its first quarter 2019 earnings. At its current stock price ex-dividend, this net cash position makes up almost a third of its market cap. This cash position should help put a hard floor on CYOU's stock price given the company's willingness to pay large dividends.

While it's unlikely another large special dividend will be announced in the near term, smaller scale dividends could be announced perhaps a year from now. After all, the recent $503 million special dividend came exactly a year after CYOU's $500 million special dividend in 2018. Given the company's free cash flow averaged close to $200 million annually for the past three years, the next dividend could range around $200-300 million.

Operating Cash Flow Free Cash Flow
2016 $199.5 m $182.6 m
2017 $200.8 m $197.2 m
2018 $205.7 m $192.7 m

(Dollar amounts in millions of USD. Data taken from CYOU's 2018 annual report)

Recent trends in corporate cost cutting suggest CYOU is clearly trying to improve cash flow as it reduced its headcount by 13%, 13%, and 13.7% in 2016, 2017, and 2018 respectively. The following table shows the company's operating expenses for the past two years.

Q1 Q2 Q3 Q4 FY
2017 338.8 m 367.1 m 430.5 m 419.7 m 1556.1 m
2018 362 m 311 m 341.6 m 364.1 m 1378.7 m
2019 315.8 m

(Amounts in millions of RMB. Data taken from CYOU's quarterly earnings reports)

Revenue Stability

While Changyou does operate other businesses, all of its gross profits came from its online gaming revenues in 2018. The table below shows the percentage of gross profits came from its online gaming operations as the company slowly unwound its other businesses.

2016 2017 2018
Gaming Revenues 2703 m 3033 m 2575 m
% Of Gross Profit 83.30% 92.90% 101.20%

(Amounts in millions of RMB. Data taken from CYOU's 2018 annual report)

Thus for the foreseeable future, CYOU's fate solely relies on its online gaming segment. Most of CYOU's gaming revenues for the company's entire existence has come from Tian Long Ba Bu[TLBB] and its sequels. Despite its venerable franchise age, these games continue to generate a steady revenue stream as the table below shows.

Q1 Q2 Q3 Q4 FY
2017 587 m 839.7 m 883.3 m 723 m 3033 m
2018 670.7 m 601.3 m 652.6 m 650.3 m 2575 m
2019 667.6 m

(Amounts in millions of RMB. Data taken from CYOU's quarterly earnings reports)

The slight revenue bounce in the summer of 2017 was due to the mobile version release of TLBB. Outside of this mobile release bounce, CYOU's gaming revenues have been in a fairly steady range that only varied around 10%. The company's second quarter 2019 midpoint guidance of $95 million in gaming revenues (646 million RMB) actually calls for a 7-8% rise from last year's figures.

The big question is how much longer can this twelve year old game continue to generate revenues. TLBB's longevity has surprised many, including myself, and it is very hard to predict when the game will die out. As long as Changyou continues to provide updates, it's possible its current gaming base will continue to pay to play. For instance, Changyou's major competitor Netease (NTES) operates Fantasy Westward Journey and along its derivatives is approaching almost twenty years in age.

To understand the game's longevity, we need to understand its gamers. One likely explanation is as the game ages, its gamers also age and have more money to spend. TLBB is a fantasy role playing game and like most games of this genre require a lot of grinding to get experience, money, and equipment. Perhaps a decade ago, most of TLBB's player base were teenagers or young adults who made up for the lack of money by putting vast amounts to time into building their characters. As they aged and got jobs, less time is available to play but the same gamers could achieve the same in game results by spending a little money. This aspect is what drives most free to play games and the massively multiplayer online role playing [MMORPG] experience builds online communities that keeps gamers coming back.

Of course, the company is still actively developing new games but the chances of a new game becoming a commercial hit is very low in an extremely competitive Chinese gaming market. Thus while investors shouldn't expect large jumps in gaming revenue, it would be premature to predict CYOU's gaming demise until there is a clear downward trend from their reported results.

Dividend Driver

I'm sure nearly all investors didn't mind huge special dividends CYOU has handed out in the past five quarters, but it's important to try to understand why and if it's going to continue. I believe the answer is Sohu's (SOHU) 67% majority stake in the company. Because SOHU has controlling voting power, major corporate decisions like these special dividends probably originated directly from SOHU. In a recent article I explained how SOHU's intrinsic undervaluation might have played a part in CYOU's dividends which in effect transferred money from CYOU to SOHU; SOHU received $337 million of CYOU's $503 million special dividend.

As a controlling majority parent, SOHU appears to be using CYOU essentially as a cash cow. As shown above through CYOU's cost cutting measures, the company is clearly hunkering down instead of trying to spend its way through revenue droughts. I do not know for certain but from my understanding of how Chinese businesses are run, I believe SOHU is guiding CYOU strategically to maximize cash flow and thus CYOU's ability to continue issuing special dividends in the future.

Trading Strategy

CYOU's downside risk should be fairly limited at current valuations. Not only is a third of its market cap in net cash, but it is trading at around 3x free cash flow which is crazy low. On an earnings basis, CYOU is currently trading around 5x 2019 estimated EPS of $2.09 per share. If you believe its revenue stream is stable at least for the foreseeable future, CYOU is cheap and can be an income stream through the following three trading strategies:

  • Buy the stock: At 3x free cash flow, there's minimal risk especially considering the likelihood CYOU will continue to issue special dividends. Even if CYOU pays much smaller dividends such as half of its free cash flow, yields would be 15-20%. Obviously, this is the best strategy if you believe the market will grant higher valuations on the stock. Keep in mind unless revenues clearly show an upward trend, CYOU may be stuck in a low valuation range indefinitely. Thus capital gains should only be viewed as an unplanned bonus to potential dividends.
  • Selling puts: You can collect roughly 1% premiums on 10% out of the money or 2-3% premiums on 5% out of the money puts, for the forward month expiration. If CYOU doesn't drop, you can collect a nice premium monthly with minimal risk as long as the stock doesn't trade much higher than $14 or about 4x free cash flow. If the stock drops and you end up owning it, start selling covered calls. This is the best strategy if CYOU remains in a low free cash flow multiple, or stock prices around $10-12.
  • Selling covered calls: Similar to selling puts, the premium isn't too great since CYOU isn't very volatile outside of periods around earnings. Again, as long as you don't end up owning CYOU at over 4x free cash flow, the risk should be very minimal so any monthly premium collected is a nice bonus. Covered calls should be avoided through Q1 2020 earnings in case CYOU decides to announce another dividend as they did in the prior two Q1 earnings announcements. If the stock rallies and you get called out of owning it, just go back to selling puts and repeat the process.

A key metric to keep an eye on are CYOU's online gaming revenues which should stay around 600-660m RMB ($87-96m USD) on a quarterly basis. As long as CYOU maintains a stable gaming segment, it should be able to generate close to $200 million in annual free cash flow and thus allow for 10-20% annual returns using the methods listed above.

Lastly because I know some investors may wonder, I do not believe CYOU will get bought out. SOHU's controlling stake won't allow it unless the premium is huge. If SOHU wanted to buy back CYOU itself, it would have already in my opinion prior to its special dividends to ordinary shareholders.

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