Sohu (SOHU) – Net Net – 45% Upside

Current Price: $20.00

Target Price: $29.00

Upside: 45%

Expiration Date: TBD

This idea was hinted by Tan.

 

Chinese brand advertising and online gaming company Sohu will be a major beneficiary of Sogou/Tencent (see SOGO write-up here) merger and will receive $1.18bn for its 45% stake in SOGO. That should net SOHU $24/share in cash after taxes vs its current price of $20/share. Following this SOHU stock is likely to re-rate closer to its net cash ($29/share) position once it gets reflected in financials and the market starts to notice.

Just today regulators have approved the merger between Tencent and Sogou. Closing was expected by the end of July (unless amended).

Aside from the large expected cash infusion, SOHU also owns:

  • Around $6.46/share in net cash on its balance sheet (restricted cash, liquid investments and less all long term and short term bank debts)
  • 4 office buildings in Beijing (131k sq. m combined) with a cost basis of $10/share. The buildings were acquired prior to 2010 and in that time the average property price in Beijing has almost tripled. Thus, I think the buildings are worth at least $15/share today.
  • Online games development business Changyou (ref. CYOU). The business is in decline and is still milking its old flagship franchise TLBB (launched in 2007), while all other new releases have basically failed. CYOU was re-acquired by SOHU in April'20 for a total valuation of around $582m (SOHU owned 68% before privatization). Prior to that CYOU has been generating stable FCF close to $200m. In the last 2 quarters, the business saw a likely temporary revenue spike due to a new TLBB version release ("TLBB Vintage"). This has put the whole company in a positive cashflow position. Even with a gradually shrinking topline, the business should be able to generate substantial FCF for several more quarters (or even years). Peging CYOU valuation at $15 per SOHU share (same as reacquisition at covid lows), can easily be argued as being conservative, given the historical cash flows and recent positive developments.
  • Legacy operating business assets - SOHU Video (streaming), SOHU Media (news aggregator) and Focus (real estate information and services). These businesses are struggling heavily due to competition from large players and have been burning cash big time historically. On a quick glance, legacy assets together with corporate overhead generated operating losses of $240m in 2019 and $150m in 2020.  Assuming management will continue pouring cash into these businesses and create no value (management argues the opposite) I deduct a further $800m or $20 per SOHU share for expected future cash burn.

So at the current price, SOHU trades at 30% discount to net cash including the merger proceeds and 50% discount to this conservative back on the envelope sum of the parts valuation of c. $40/share (keep in mind that this assumes a negative $20/share for the operating businesses outside of CYOU due to current cash burn)

This discount seems too wide. At the moment the price is likely depressed as the expected cash infusion has not yet been reflected on the balance sheet and due to market overhang due to the prolonged timeline of the merger. But this is in the past with today's announcement.

Another risk is that management could waste cash - so far the company has not clarified how it intends to use the proceeds:

Unidentified Analyst

Yes. Thank you. I was referring more to the incoming cash with a potential merger the $1 billion plus in cash.

Charles Zhang

Okay. So that as we said, we don't talk about this because it's still – I mean, we don't speculate what we'll do with more cash because the deal is still not done.

Charles Zhang, founder and CEO, owns 26% of the stock. Zhang is regarded as one of China's internet pioneers and at one time used to be one of the richest people in China. His track record is quite fragmented - aside from the very poor dives in saturated streaming and news markets, he has managed to launch two large and successful "billion-dollar" businesses (CYOU and SOGO) inside SOHU. The cheap and timely reacquisition of CYOU last year was also a pretty good move in my opinion. So far, not many details were given for the capital allocation plans, except that some of the cash will clearly go towards the growth of SOHU Media and SOHU video (Q1'20 conf. call):

So that's why as I said that I would need to explore and to do it, especially to build this social network platform to the distribute content and to develop social networks with our current APPs – apps and to grow user base to a much larger scale in a matter of fact, larger user base. So that we can get more market share of advertising brand, advertising market share and also to market our own products like market our TV, our dramas, right. And also even, if Sohu build our own platform with large – much larger user base. I think Changyou can also benefit because we will sell Changyou and promote Changyou winning our own matrix using the costs [Audio Dip] have any costs [Audio Dip] expensive.

So on until we approve that we can build our social network successfully and have its exponential growth. Social networks are basically grows exponentially. But it's like a building a chain reaction and also kind of giving a atomic bomb neither chain reaction. So until we do that and then grow our user base exponentially, we are – so our growth financial will remain at the current pace. So that events are not excited. So in other word, basically the score of our stock price, we need to demonstrate a hyper growth, right. And then the stock price will improve.

Despite that, I still don' believe that management will just waste $1bn+ in cash with no positive results on the business. A substantial portion of Zhang's net worth and reputation is in SOHU, so shareholder interests seem to be well aligned here (albeit that didn't help that much in the past).

13 COMMENTS

  1. dt

    We intended to post this yesterday (just had to dot the i’s and cross the t’s) when SOHU was trading at $18.60, but got a bit delayed. And then this morning regulators gave the green light for Sogou/Tencent merger the stock shot up by 8% in pre-market session ($20.1 at the time of this comment)

    While obviously, it would have been nice to post this yesterday, the situation is now also materially derisked as the cash proceeds from Sogou stake sale are almost in the pocket.

    1
  2. snowball

    For what it’s worth, there is a well-tested “rule of thumb” among Chinese local investors:

    (1) that every time the “cigar butt” value of SOHU is “re-discovered”, stock prices of Chinese internet sector will soon crumble. This happed again in February this year, when there was much discussion among on local online forum about this trade;

    (2) and that subsequently when the “cigar butt” value of SOHU is “re-discovered” again by non-Chinese investors (in Seeking Alpha or twitter), we usually have not reached the bottom of the sector’s bear market yet.

    The logic behind it, I think, is that, historically, SOHU is usually not on the radar screen of investors until the last leg of a bull market in that sector.

    So, better hedge the trade by shorting KWEB (Chinese internet stock ETF).

    2
  3. Tan

    Charles Zhang has previously said relisting Changyou in Hong Kong or China is under consideration . I think this will a bonus and massively accretive to Sohu, as the bad co (Sohu media/video) separates from the good co (Changyou). The former cannot be negative as separate entities, which the market is pricing now.

    1
  4. g4734g

    Been interesting how SOGO has held its value fairly well thru all the China nastiness…..assume the market still feels this deal is solid….given a large portion of SOHU’s value is attributable to SOHU, the SOHU price action has been disappointing. Wondering if anyone has an update on this opportunity.

    1
  5. dt

    Sogou/Tencent merger has closed and Sohu received $1.18bn in gross proceeds. With the latest Q2 numbers, the net cash position should stand at around $32/share. Obviously, the closing of the merger did not act as a sufficient catalyst and shares are back at write-up levels. This might be related to the overall sell-off in Chinese stocks. The next catalyst could be the publication of financial results making companies’ net-net position evident for everyone or announcement of some capital return to shareholders (probably unlikely). The relisting of Changyou should help the stock rerate as well, however, the timeline for that is not clear. We are tempted to wait for Q3 results before taking money off the table. The downside is very well protected at these levels.

  6. g4734g

    I did sell some 20’s which expired……now doing November 17.5 and actually picked up some decent change few days ago for Nov 15

  7. WeagleWeagle123

    Am I missing something or does it seem to be that public shareholders only own 1/3 of the equity.

    1. Lukas

      Yes, you are right. Excluding management and large shareholders, the “free float” is ~32%.

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