SOHU.COM(SOHU.US)INITIATEUW(V)：CHEAPBUTNOTCHEAPENOUGH1115.ppt
,37.00,-7.6,Bloomberg SOHU US,Company report,Telecoms,Media&TechnologyInternetEquity China,abcGlobal Research,Underweight(V)Target price(USD)Share price(USD)Forecast dividend yield(%)Potential return(%),40.030.0,S(SOHU US)Initiate UW(V):Cheap but not cheap enough,Note:Potential return equals the percentagedifference between the current share price andthe target price,plus the forecast dividend yieldDec 2011 a 2012 e 2013 e,Stock looks cheap but estimates at risk from ongoinginvestment phase,HSBC EPSHSBC PEPerformanceAbsolute(%)Relative(%),4.209.51M-0.30.8,2.3916.73M2.15.2,3.1212.812M-32.3-20.0,Aggressive moves to close gap with peers in video andsearch mean continued spending;Street sees marginrecovery next year whereas we see flat margins,Note:(V)=volatile(please see disclosure appendix)13 November 2012Chi Tsang*,CFAAnalystThe Hongkong and Shanghai BankingCorporation Limited+852 2822.hkTucker Grinnan*Regional Head of Telecoms ResearchThe Hongkong and Shanghai BankingCorporation Limited+852.hkPlease also refer to our accompanyinginitiation report on Changyou(InitiateOW(V):Cash cow with web gamekicker,13 November)This report replaces the one of thesame title and date to correct theoperating profit forecasts for 2013 and2014.View HSBC Global Research at:http:/*Employed by a non-US affiliate ofHSBC Securities(USA)Inc,and is notregistered/qualified pursuant to FINRAregulationsIssuer of report:The Hongkong andShanghai BankingCorporation LimitedDisclaimer&DisclosuresThis report must be readwith the disclosures andthe analyst certifications inthe Disclosure appendix,and with the Disclaimer,which forms part of it,Initiate at Underweight(V)with a USD37 target priceRisks to estimates outweigh value.We acknowledge that Sohu looks inexpensive withnearly 50%of its value in adjusted net cash.However,this substantial net cash position hasnot prevented a de-rating in the past few years,with the shares historical forward PE atjust 13x.Furthermore,its 5-year historical PEG is only 0.68.We believe this reflects theloss of momentum in the companys core portal business and margin deterioration onhigher costs.The stock is trading at 13x our 2013e EPS with a PEG of 0.73 on our forecast18%EPS CAGR from 2013-16.Investment spending threatens earnings.Sohu has adopted an aggressive strategy to tryto close the gap with its peers in online video and search,as well as position itself inmobile.In video,while Sohu is ranked second in daily unique visitors,its revenue shouldbe just a fifth of Youkus(YOKU US,USD18.87,N(V),TP USD20)this year.In search,while Sogou(Sohus browser and search engine)has an 8%traffic share,its search revenueis only equal to 4%of Baidus(BIDU US,USD103.73,OW(V),TP USD140).Addressingthese gaps requires continued high headcount growth,product development and sellingcosts.We expect surging expenses to lower operating margins by 13ppts in 2012 and seelimited operating leverage in 2013.Below consensus for 2013e and 2014e.We expect operating margins of 21.0%in 2013,compared to consensus of 22.5%.We expect 30%headcount growth next year,compared to50%growth for 2011 and 2012.We forecast 21.6%margins in 2014,versus the Street at25.1%.Our adjusted EPS estimate is 10%and 19%below consensus for 2013 and 2014.Initiate with an UW(V)rating and a USD37 target price.We value Internet stocks usingPEG as we believe it best captures earnings growth.We apply the companys 5-year meanPEG of 0.68 to our 2013e earnings per share of USD3.12 and CAGR of 18%for 2013-16e.Better-than-expected operating leverage is the key upside risk to our rating.The nextcatalyst will be when Sina(SINA US,USD53.42,UW(V),TP USD54)reports on 15November and provides comments on advertising.Index SSE COMPOSITE IDX Enterprise value(USDm)740Index level 2,069 Free float(%)100RIC SOHU.O Market cap(USDm)1,522Source:HSBCSource:HSBC,S(SOHU US)Internet13 November 2012Financials&valuationFinancial statements,Valuation data,abc,Year to,12/2011a,12/2012e,12/2013e,12/2014e,Year to,12/2011a,12/2012e,12/2013e,12/2014e,Profit&loss summary(USDm),EV/sales,0.9,0.7,0.4,0.2,RevenueEBITDADepreciation&amortisationOperating profit/EBITNet interestPBT,852309-5525416275,1,057263-4521826247,1,254322-5926327294,1,465388-7231633352,EV/EBITDAEV/ICPE*P/NAVFCF yield(%)Dividend yield(%),2.61.59.61.49.10.0,2.91.016.91.25.30.0,1.70.612.90.96.50.0,0.70.310.00.78.50.0,HSBC PBTTaxationNet profitHSBC net profit,275-47163163,247-757878,294-798585,352-87113113,Note:*=Based on HSBC EPS(fully diluted)Price relative,Cash flow summary(USDm),123,123,Cash flow from operationsCapexCash flow from investmentDividendsChange in net debtFCF equity,370-170-3060-54139,353-165-2030-5080,395-188-1880-21399,467-220-2200-254131,103836343,103836343,Balance sheet summary(USDm)Intangible fixed assetsTangible fixed assets,0663,0978,01,172,01,389,232010S Inc.,2011Rel to SSE COMPOSITE INDEX,2012,232013,Current assetsCash&othersTotal assetsOperating liabilitiesGross debtNet debtShareholders fundsInvested capital,9707331,6333570-7331,066544,1,1937832,1716530-7831,313736,1,4569962,6287330-9961,689899,1,7631,2493,1528190-1,2492,1281,084,Source:HSBCNote:price at close of 12 Nov 2012,Ratio,growth and per share analysis,Year to,12/2011a,12/2012e,12/2013e,12/2014e,Y-o-y%change,RevenueEBITDAOperating profitPBTHSBC EPS,39.122.810.317.48.6,24.1-15.0-14.2-10.1-43.1,18.622.520.718.830.5,16.820.519.919.929.5,Ratios(%),Revenue/IC(x)ROICROEROAEBITDA marginOperating profit margin,2.055.717.516.236.329.8,1.724.06.69.024.920.6,1.523.65.79.025.721.0,1.523.95.99.226.521.6,EBITDA/net interest(x),Net debt/equityNet debt/EBITDA(x),-57.4-2.4,-51.5-3.0,-52.5-3.1,-53.5-3.2,CF from operations/net debtPer share data(USD),EPS reported(fully diluted)HSBC EPS(fully diluted)DPSNAV,4.204.200.0027.89,2.022.390.0034.35,2.203.120.0044.20,2.924.040.0055.69,2,S(SOHU US)Internet13 November 2012Investment summary Cheap but not good value yet Earnings risk from spending to expand search and video;gamingbusiness is steady but investors can buy it separately Initiate coverage with UW(V)rating and a target price of USD37,abc,Diversified but under-scaleSohus three key businesses are:1)the SohuInternet portal;2)Changyou online gaming,and3)Sogou,which leverages a browser and Pinyinsoftware to market search engine advertising.We expect Sohu to generate USD1bn in revenuethis year,with USD238m of adjusted operatingprofits.Non-GAAP net income attributable toS on a fully diluted basis is estimated tocome to only USD95m with a 9%net margin.This is mainly a function of two factors.Firstly,all of its profits come from Changyou(CYOU,Cheap at face valueAbout 43%of market cap is net cashWe acknowledge that Sohu looks undervalued.The company has a market capitalization ofUSD1.5bn and net cash and equivalents ofUSD754m.Of this cash figure,its online gamesubsidiary,Changyou,contributes USD443m.Wenote that since Sohu owns 67%of Changyou,it isonly entitled to USD297m of its cash.Thus,on apro-rata basis,Sohus net cash position at the endof September was USD660m.This representsUSD17 per share or 43%of Sohus market cap.,US,OW(V),TP HKD31).But it only owns 67%of the company.Secondly,online video and itsSogou search business are currently losing moneybecause they are under-scale and remain in,Net cash vs.market cap(USD)Company Share price,Netcash/share,Newcash/shareprice,investment mode.Sohu vs.Baidu and Youku,NeteasePerfect WorldGiant Interactive,55.1611.595.24,2.684.940.65,4.9%42.6%12.4%,Revenue(USDm),2012e,Multiple,Shanda,3.58,0.27,7.6%,YoukuS,25354,4.7,Source:Bloomberg,company reports,share price based on November 7,2012,net cash asof 31 December 2011.,BaiduSogouSource:HSBC estimates,3,540122,29.0,Fully valued based onhistorical PE,Sohu currently trades at a PE of 17x 2012e EPSand 13x 2013e EPS.We note Sohus averageforward PE has been 13.6x and its PEG has been0.68 over the previous five years.Moreover,Sohu3,9-Nov-07,30-Mar-07,30-Mar-08,30-Mar-09,30-Mar-10,30-Mar-11,30-Mar-12,9-Nov-08,9-Nov-09,9-Nov-10,9-Nov-11,9-Nov-12,S(SOHU US)Internet13 November 2012Sohu historical 1-year forward PE4035302520151050Source:Bloomberghas had a very high cash balance over the pastseveral years.It had USD17 per share of net cashin 2010 and USD19 per share in 2011.This hasnot prevented the stock from getting continuallyde-rated.High spending to continueMargins have been under pressure,as managementhas stepped up investment in each of Sohusbusiness segments.We expect spending to remainhigh as the company continues to strengthen inonline video,search and online gaming.Sohus profitability has declined consistentlysince 2009,with its adjusted gross margin downfrom 76.1%to an estimated 64%in 2012e.Itsadjusted operating margin has declined from 43%in 2000 to an expected 21%in 2012e.Its gross margin has declined due to thesignificant investments made in online videocontent(both rising costs and acceleratedamortization),as well as rising bandwidth costs inonline gaming.While its search gross margin hasexpanded during this period,it only contributes8%of gross profits.Operating profitability has been severely impactedby sizable increases in product developmentspending(engineering headcount and wages)and,recently,increased sales and marketingexpenditures.Total employee headcount increased4,Sohu historical 5-year PEG21.510.50Source:Bloomberg56%in 2011 and should be up another 50%thisyear.Of particular note,product developmentcosts have risen from USD57m in 2009 to anestimated USD177m this year.This represents a48%CAGR.As a percent of revenue,it hasincreased from 11%in 2009 to an estimated 17%this year.For reference,total revenue grew at a27%CAGR from 2009 to 2012.Sales andmarketing costs grew 52%in 2011 and weestimate 31%this year.Portal under pressure fromweak macro outlookSohus core portal advertising business has beenvery sluggish in recent quarters.It grew 5%y-o-y in3Q12 after posting four consecutive quarters of y-o-y declines.This represents weakness in its two keycategories,auto(25-30%of revenue)and property(15%of revenue).While the property categorypicked up in 3Q,management continues to take acautious approach to accounting for revenue.We believe continued economic weakness inChina will hurt advertising budgets for 2013.Weak demand is forcing large brand advertisers tofocus on cost cutting,with advertising spend a keyemphasis.We are cautious on the Chinaadvertising market and expect overall growth todecelerate from 23%this year to 10%in 2013.,abc,S(SOHU US)Internet13 November 2012Video:two years away fromprofitsSohus online video business reached the numbertwo spot in China in September in terms of dailyunique visitors.The company has been able todifferentiate itself from the market by offeringmany of the most popular TV dramas.While Sohu has spent a significant amount ofcapital on content to attract a large user base,ithas been less successful in monetizing its traffic.Indeed,we estimate video revenue was onlyUSD23m in 2010 and USD50m in 2011.Incontext,Youku generated USD143m in revenuein 2011,threefold that of Sohu.In terms ofmonthly unique viewers,Youku was only 1.4xbigger than Sohu by December 2011.In 1Q,management restructured its online videosales force.Sohu set up a dedicated selling team,hiring 150 new sales people.We estimate Sohusonline video business will generate USD54m inrevenue this year but lose around USD80m this year.Management is aggressively expanding its videobusiness and we expect its content budget to increaseby 40%from an estimated USD50m this year toUSD70m in 2013.We do not expect the videobusiness to reach breakeven for another two years.Sogou:profitable in 2014eWe believe Sogou will lose USD4m on revenueof USD129m this year.This business generatedprofits in 4Q11 but management stepped upinvestments in mobile and search related products.We do not expect Sogou to return to profitabilityuntil 2014.Changyou is key value driverChangyou has been able to leverage a few hitgames into a reliable earnings and cash flowgenerator for Sohu.Changyou represents 72%ofSohus gross profits and over 100%of itsoperating profits.,Changyou has 5.8%market share in onlinegaming in China in terms of revenue in 2011.Over 75%of its revenue is from the massivemulti-player online role playing game(MMORPG)called Tian Long Ba Bu(TLBB)launched in 2007.TLBB is a self-developed gamebased on a classic Chinese novel called“Novel ofthe Demi-gods”.It is one of the most popularMMORPG games in China.Changyou has expanded from the slower growthMMO segment into the fast-growing web gamessegment.We expect the web/social/mini gamemarket to grow about 40%this year.In May 2011,Changyou acquired control of7Road,a leading developer of web games.7Roadhas two of the top five web games in Chinacurrently.Its top game is DDTank,a web-basedshooting game.DDTank is the number threeranked web game in China and has been exportedto Malaysia,Vietnam and other countries.As a standalone business,Changyou(including itsonline gaming and a small advertising business)hasan 84%gross margin,58%adjusted operatingmargin and 49%adjusted net margin.Its onlinegaming business contributed 63%of Sohus grossprofits in 2011 and is estimated to be 72%in 2012.Changyou trades publiclySohus biggest value driver also trades publicly.Sohu spun out Changyou in 2009,retaining a 67%stake.Its current market cap is USD1.5bn.Investors have the option of owning only thegaming business.One issue is liquidity,as it hasan average daily turnover of approximatelyUSD2m.Changyou trades at 5x 2012e and 4x2013e PE,based on our estimates.Earnings riskOur adjusted EPS estimate of USD3.12 for 2013is 10%below consensus of USD3.46.For 2013,we expect operating margins of 21.0%,compared,abc5,S(SOHU US)Internet13 November 2012to consensus of 22.5%.We expect 30%headcount growth next year,compared to 50%growth for 2011 and 2012.We expect totalrevenue to increase 19%next year.Total brandadvertising should grow 13%,boosted by videoand its online gaming portal but we expect thecore portal business to be negatively impacted bya slowdown in display advertising from multi-national companies(MNCs).Video revenue willlikely grow 49%,as the new sales team increasesmonetization.We expect search revenue to grow50%while online games grow 17%.For 2014,our EPS estimate of USD4.04 is 19%below consensus of USD5.00.We expect a 17%increase in revenue,with 13%growth in total brandadvertising grows and 40%growth in search.Weexpect online gaming revenue to increase by 14%.For 2014,we forecast 21.6%margins,versus theStreet at 25.1%.We see 60bps improvement in2014,whereas the Street expects 190bps.Sohu is in an investment phase,critical tomaximizing the potential of its still-nascent videoand search businesses.We expect total headcountto increase by 30%in 2014.In our model,productdevelopment grows by 58%in 2012e and 21%in2013e.Sales and marketing costs increase by 31%in 2012e and 26%in 2014e.Unlikely to unlock sum ofparts valueWe acknowledge that Sohu looks undervalued ona sum-of-the-part basis.We derive a valuationrange of
