By Perry Wu
The big news of the last week was Sohu's (NASDAQ: SOHU) troubles with China Mobile. From a mere peccadillo, China Mobile reminded Sohu who its Daddy is in the Chinese online world. And it reminded investors that no matter how polished and transparent a corporation functioning in China appears to be, that company must still operate in the muddy waters of Chinese business and bureaucracy.
According to China Mobile, Sohu sent out 1374 messages in Sichuan without getting prior approval from China Mobile's Sichuan-based subsidiary. As a result, Sohu will need to issue refunds to a handful of mobile phone users, and will be barred from applying for new business with China Mobile for one year. But the real bombshell is that China Mobile decided to suspend Sohu's multimedia messaging services business (MMS) for a whole year.
All this because of a mere 1374 messages? Yes, Sohu was technically in violation, but violations like this have been going on for years with many different wireless service providers. 1374 messages is but a rounding error compared to the millions of messages sent out each day in China. In fact, wireless consumers have been complaining for years of wireless spam from the portals, but the public relations mavens at these portals shove those Chinese-language complaints under the rug during the quarterly English-language investor briefings.
Something is not right in the relationship with China Mobile.
This incident is larger than just the slide in quarterly profits that Sohu is now forecasting due to China Mobile's decision. Even with the recent slide in Sohu's stock price, its market valuation is still around US$550 million. With Sohu's revised guidance, we can assume that Sohu is forecasted to have net income around US$35 million (just a rough estimate) for the full year 2004. That would make its price-earnings ratio around 16. Adding to this, there is the US$90 million of convertible debt that sits and rots on Sohu's balance sheet–everyone in the accounting department should be fired for pushing this through.
Now, 16 is not an outrageous p/e ratio for a growing company, but it does take some explaining. First, we have to assume that its strong growth can continue. Second, we have to assume that the company is more than just the sum of its numbers, that it has certain intangibles that are not in its financials, that it has, say, good relationships with its partners.
A business is more than the sum of the numbers in its financial statements. If a company's true value were the same as its book value, than an investor's job would be much simpler. But it is not. Companies like Sohu that trade at substantial multiples to their book values better have something else.
And that something else is largely the value of a company's relationships, both with customers and other businesses. With the news on Sohu's troubles with China Mobile, investors can justifiably question a large part of the premium that the market is assigning to Sohu's shares. Sohu no longer has bragging rights to investors about its great relationships in China. And this is not the first time relationships with mobile partners have been strained: Sohu's VP Elaine Feng was sacked last year after failing to maintain potentially lucrative relationships with mobile entertainment and gaming vendors.
So this incident with China Mobile casts doubt on previous valuation assumptions. First, much of Sohu's recent business growth has come from growth in its wireless service business, but that is now in jeopardy. Second, this incident demonstrates that the company is sorely lacking in its relationships. And this is not just any relationship, this is THE relationship, China Mobile. China Mobile holds the purse strings for mobile revenue in China.
So soon after its press release on the China Mobile troubles, Sohu hastily arranged a conference call to soothe investors. For some background on the conference call, remember that last year when Sohu's wireless services business was growing by leaps and bounds the company wasted no time in emphasizing its wireless business. Now, with the same business in trouble, Charles Zhang, the CEO, has gone to his fallback position. He said during the conference call that Sohu has "diversified business lines" and that revenues from other businesses are "very secure". So what'll it be, Charlie?
And how does Sohu explain this obviously deficient relationship with China Mobile? When asked directly during the conference call if China Mobile's sanctions against Sohu were indicative of broader problems in the relationship, Mr. Zhang fell silent. Finally, Carol Yu, Sohu's new CFO, blurted out "definitely not."
In response to a different question, Mr. Zhang claimed that China Mobile had been on a campaign to target unauthorized message-sending and it had nothing to do with Sohu itself. But why, in the first place, was Sohu breaking relevant regulations? And what about all those other spam wireless messages myself and other Sohu users have received over the last few years?
Alright then, so we're supposed to believe that of the countless minor violations that happen all the time in China, China Mobile's decision to penalize Sohu (as well as other companies) was just bad luck? There was nothing wrong with this relationship that precipitated such sanctions?
All this begs the question: is China ready for investors' money to roll in? Of course it's ready, but should investors continue to believe the hype that their money won't be swiped away by the muddled vagaries of enforcement agencies? In many ways, China is still a very irrational place to do business. Motorola, Siemens, Ericsson, Microsoft, and many others still stumble. Domestic companies also stumble. For a company to prosper in the Chinese hinterlands, it takes greased palms and a ridiculous amount of cajoling to local authorities to get things done. Companies have always complained, or boasted, that they had to go through these motions to build decent returns on their investments. But if a powerhouse like Sohu can be humbled, what about other investments?
Chinese normally pride themselves on good "guanxi" with business partners. But Mr. Zhang has now wholly downplayed this importance. Or it's just too painful to talk about. And if he has no "guanxi", than investors might as well pull out their money and go invest somewhere else–Sohu, Sina, Netease and other Chinese Web companies are hard enough stocks to swallow because none of these companies hold any advantage over each other. Now we're being told that Sohu even lacks "guanxi". Maybe Chinadotcom, with all of its cash reserves, should come out of the closet and purchase the three portals for cheap. Chinadotcom should also pick up mobile-only companies like Linktone and KongZhong since those companies have limited life-spans unless they massively diversify and stop relying on China Mobile for most of their revenue.
Last week, the day after Sohu's mobile relationship problems were aired, the public relations mavens for Charles Zhang announced Zhang had been awarded a "Best Manager" citation by a US-based management association. Talk about damage control. What has Sohu and Zhang done to deserve this?
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.