By Perry Wu
Over the last few months, share prices for Chinese overseas-listed Internet companies have become noticeably cheaper. In full view among these companies is Sohu.com, listed on NASDAQ, which peaked at around $43 last year. Sohu's share price closed on Friday, May 7 at $16.65. So is it time to go buy Sohu's shares and take advantage of a much reduced market valuation?
In 2003, Sohu finally turned the corner and made a profit of US$26 million after only losses since its inception. Even with the Severe Acute Respiratory Syndrome in 2003 that brought down many Chinese businesses, Sohu did well. Much of Sohu's profit turnaround was attributable to strong growth in its "e-subscription" services. E-subscription includes such services as wireless short messaging (SMS) and other second generation technology (2.5G) wireless services. Revenues from such services grew from US$10 million in 2002 to US$47 million in 2003.
This growth also appeared to coincide with the departure of Vice-President Elaine Feng and Sohu's subsequent cleaning house in her Marketing and SMS departments. Prior to Ms. Feng's departure, some of Sohu's partners had complained that Sohu was mismanaging their marketing accounts and not fulfilling their contractual duties–at least one mobile partner cancelled a potentially lucrative contract with Sohu after being lost in the many folds of the Sohu operations. But Sohu re-engineered itself after Feng's departure, rose to the surface, and seemed to have found a niche for itself in providing seemingly-profitable wireless services. And even now as Sohu's stock goes down, its business seems to be growing. Sounds like a buying opportunity? Not quite.
Right off the top, we can compare Sohu's $26 million of revenue to its current market value (based on a share price of $16.65) of US$600 million. That is still a multiple of 24, which is not cheap. Then look at Sohu's book value of US$91 million at year end 2003 and compare that to its market cap of US$600 million, which gives Sohu a price to book ratio of almost 7. Still, it is far from a bargain.
Drill further into Sohu's financials and other interesting items appear. It seems that though Sohu had this phenomenal growth in its e-subscription business, more than 40% of this revenue ($19.7 million out of $47 million) came from related parties. It is not clear from exactly which companies this revenue derives but what is clear is that Dr. Charles Zhang, the CEO of Sohu, is not shy about getting his family and friends involved with his business.
Sohu's related party disclosures in its financials run to two and a half pages and are too many to list here but we learn, among other things, that Dr. Zhang paid out US$1.9 million to his brother's company for "e-commerce" services. The good doctor also booked revenues of $1 million from an unidentified investee in Sohu. Behavior like this makes me suspect about whether Dr. Zhang is working for his family or Sohu's shareholders.
And just like its competitor Sina.com, which issued $100 million of debt last year, Sohu has done almost the same thing. Like a lemming, Sohu issued $90 million of convertible debt which fundamentally changes its financial picture. The accounting wizards who threw this at Sohu's officers and board must have done some magic to make the company believe that the convertible debt was truly good for long-term growth. Unlike 2002 when its debt to equity ratio was less than 15%, this $90 million of debt skyrockets Sohu's debt to equity ratio to more than 125%!
Aside from this picture that the current financial data presents, there is a deep structural problem with Sohu. Sohu is incorporated in Delaware. But Sohu has virtually no business in the U.S. so this hardly seems to make sense. Of all places, why would Sohu decide to incorporate in virtually the only country in the world which taxes a company even if it does no business in that country? The U.S. is not a tax haven.
The only possible answer is Sohu figured back in 2000 that it would have a better shot at doing a successful IPO in America if it were a U.S. company. So by gaining a little benefit up front, the company has now permanently cursed itself. Of course, this won't matter much if Sohu goes back to its money-losing ways, then the U.S. will have little to tax. But if Sohu is ever able to establish itself as a perennial money-maker, its American tax curse will do permanent damage to Sohu's valuation.
As if this is not enough, a main contributor to Sohu's phenomenal stock climb was Sohu's revenue from value-added mobile services, which will prove to be unstable. Yes, the company has popular mobile products. Yes, the company has millions of users potentially using those mobile products. No, the company does not have an easy path in collecting those monies on the mobile products from the millions of users. China Mobile and China Unicom hold those purse strings and in recent months they have threatened Sohu and its competitors with tightened reins as the government presses for greater monitoring of mobile content. And whereas the Chinese telecom companies normally have receivable cycles running a year or more, it is difficult to predict the amount of available cash Sohu can retain from these products. Sohu must rely on other revenue streams, but as it broadens its base of products it also encounters more entrenched competitors.
So Sohu's stock is cheaper than before, but it is far from being cheap. But even if the stock dropped to almost nothing, its fundamental organization coupled with its ever-growing list of competitors and ever-changing shaky product offerings make it difficult to swallow. The market is still giving Sohu an appraisal that is beyond what it deserves. But over time, the efficient hand of the market will reflect Sohu's true worth which is far less than its current US$600 million.
About the author:
Perry Wu is a writer and correspondent for ChinaTechNews.com and can be reached here at the site. Perry Wu does not hold any positions, long or short, on any of the Chinese or American company securities mentioned in this article.