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Misinterpreted News Leads To >100% Annualized Return Potential In QIHU

|Includes: JASO, KZ, MOMO, QIHOO 360 Technology Co. Ltd. (QIHU), TSL, VNET, YY

Executive summary:

  • A definitive agreement is in place for a MBO of Qihoo 360 at $77
  • After coasting at $76 for several weeks in anticipation of the deal closing, QIHU stock plunged over the last 2 days.
  • The plunge was caused by rumours that China's securities regulator, the CSRC, would delay a re-listing in China subsequent to the MBO.
  • However the MBO definitive agreement is signed and it does not allow the deal to be terminated due to CSRC issue.
  • Management involved in the buyout have a big carrot and a big stick to encourage them to close the deal: they get c. US $1 billion in stock if the deal closes and face a c. US $440 million termination fee if they walk away from the deal.
  • The deal is at a late stage (shareholders have already approved it) and should close within a month.
  • The truth seems to be getting out - the stock has rebounded a little from its plunge but this isn't fully priced in yet.
  • With the stock at $70.95 as of today's close, the annualized return from here is over 100% if the deal closes in the next month which I expect it will.
  • Qihoo issued a press release to deny market rumors about the cancellation of the deal.
  • A senior Qihoo executive involved in the privatization planning told local Chinese media that the CSRC rumors are false.
  • False rumors have created a buying opportunity in QIHU before: last year rumours that the buyout price would be cut or that a deal would not be reached caused the stock to plunge. Qihoo denied those rumors. Investors who paid attention at that time enjoyed quick gains in the run up to the announcement of a definitive agreement at the originally agreed price of $77 last December

Why the market is wrong again:

Before getting into the background to the Qihoo 360 privatization offer, I will first outline why the market is wrong here.

Last Thursday, rumors surfaced that China's securities regulator, the CSRC, was discussing a regulatory clampdown on backdoor listings, or reverse mergers. As is customary for these Chinese stocks when negative rumors surface, the stock dropped on huge volume. It was rumoured in Chinese media that the CSRC told Qihoo that the MBO party would have to accept a 6-year lockup if they wanted to return to China's A-share market by backdoor listing. Qihoo 360 issued a press release on Friday evening to deny this rumor. A senior Qihoo executive who is overseeing the privatization process also told local Chinese media that the rumor is false. For readers that don't speak Chinese, the relevant paragraph of that article says: "One senior manager of 360 said, many people have asked with me about the rumor, I am in charge of the 360's privatization project, I restate our company's announcement here, the rumor is untrue."

While it is highly unlikely that Qihoo investor relations and a senior executive would lie about this, to gain confidence that the deal will go ahead it helps to review the merger agreement that has been signed between the buying parties (including management) and Qihoo 360. The latest version can be found in Qihoo's SC 13E3/A filing with the SEC on Edgar.

Since the agreement has been signed, the only way that the buyers could walk away from the deal without incurring the > US $440 million termination fee is if there was an escape clause in the conditions to the merger that would allow them to walk away without penalty.

The relevant section which discusses this starts on page 107. It sets out the various approvals from Chinese regulators (called 'PRC Required Approvals' in the document) which are required for the deal to close. It also lists the Chinese regulators that have to approve the privatization. If one of these was the regulator which opposed the deal, then the market concerns would be valid. However, the CSRC, which is the regulator the market grew concerned about last Thursday and Friday, is not on the list. Here is the relevant paragraph (bullet points added for ease of reading):

For purposes of the Merger Agreement, "PRC Required Approvals" mean the filings and/or registrations with

  • the Ministry of Commerce of the PRC,
  • the National Development and Reform Commission of the PRC and/or
  • the State Administration of Foreign Exchange of the PRC or
  • the designated banks, and other procedures required by
  • the State-Owned Assets Supervision and Administration Commission of the State Council of the PRC or
  • other competent regulatory authorities (where applicable) to the extent required with respect to the transactions contemplated by the Merger Agreement and the other agreements entered into in connection with the Merger Agreement, other than the consents, approvals, authorizations or permits of, or filings with or notifications to, the governmental entities with authority over the enforcement of applicable antitrust or competition laws in any jurisdiction that is material to the business of the Company or any Parent Party.

Some readers might think that the last bullet point above leaves scope for a CSRC objection to a backdoor listing in China to scuttle the privatization. However, one must remember that the buying party's future plans for Qihoo 360 are not contemplated by this Merger Agreement. This merger agreement deals with only the current step in the buying party's plans: that is the privatization. Management's subsequent plans are separate and are not dealt with in the merger agreement. CSRC approval for any subsequent listing in China is not required with respect to the transactions contemplated by the Merger Agreement. Therefore the last bullet point does not apply to what the market is concerned about.

As an aside, this is why it is beneficial that the Special Committee representing Qihoo in the negotiations with the buyers retained Skadden, Arps, Slate, Meagher & Flom as its legal counsel. Skadden Arps know how to draw up an agreement that the buyers can't wiggle free from if the change their minds.

Background information and why I expect the deal to close very soon:

Qihoo's management teamed up with private equity to make an offer for the business in June of last year.

Since management are part of the buying party, a Special Committee of independent directors was formed to negotiate the deal on behalf of Qihoo 360 shareholders.

In December, the buyers reached a definitive merger agreement and announced that they had committed equity and debt facilities.

Debt facilities were quickly raised with syndication for a $3.4 billion syndicated loan facility completed within 3 weeks and oversubscribed.

The required equity was also quickly raised with local Chinese private equity firms promising tremendous returns for Chinese investors. As an aside, if management's financial projections outlined in the SEC filings related to the merger are accurate, equity returns for the buyers will be tremendous. They are paying a P/E of less than 10 based on management's 2018 expected net income.

A timeline from a local pitchbook indicated that funds for the privatization had to be in place by the end of March 2016. This timeline for financing coincides with several announcements from various investors in the deal.

At Qihoo 360's AGM, the CEO announced that the buying parties are granting 10% of the firm to management if the privatization closes. That is worth c. US $1 billion.

Proving that Qihoo 360 is not short of cash, the company offered to buy Norwegian company Opera for US $ 1.2 billion in cash in February.

On 19th April the National Development and Reform Commission approved the privatization. This is a key step and an approval for the required currency conversion by SAFE is usually a formality that occurs a few weeks later.

Other similar deals to privatize US-listed Chinese firms have recently closed after receiving SAFE approval. The privatizations of HMIN and BONA closed in early April. Like QIHU, both deals involve Sequoia and top-tier law firms.

Another indicator that the deal will close soon is that Sequoia, which is heavily involved in the QIHU deal as one of the buying parties and financiers, joined the MBO of ZPIN last Thursday. These are extremely well-connected financiers in China. There is no way they would have joined the deal if they thought that the CSRC clampdown was a legitimate risk.

Furthermore, on Friday the CEO of ATHM which is also subject to a privatization offer commented in an interview with the Singapore Business Times that he is very keen to close the deal. He would not have said this if he viewed the CSRC threat as realistic to these types of privatizations.

The share prices of several other stocks including VNET, MOMO, YY, TSL, JASO and DANG have gotten slammed along with Qihu's over the last few days. None of these have a definitive agreement in place like QIHU has so the risk is greater in those situations. Further analysis may be worthwhile however.

Summary:

The market appears to be wrong in its concern regarding the Qihoo 360 privatization. CSRC approval is not a condition to the definitive merger agreement that Qihoo 360 has signed with the buying parties. The company's assertion that the rumors are false in its press release and in the comments of a senior company executive are likely accurate. Since NDRC approval was obtained on April 19th, SAFE approval is likely to happen very soon. Since shareholder approval is already in place, the deal will close shortly after. Given where QIHU is trading, the annualized IRR from an investment today will be north of 100% if the deal closes within the next month, which I expect it will.

Disclosure: I am/we are long QIHU.