SOHU - Sohu.com: Overreliance On One Gaming Title

2023-03-27 06:42:28 ET

Summary

• Sohu.com has a gaming title that has the potential to be developed into a massive, sticky ecosystem of Chinese entertainment products, but this title is underutilized.
• Instead, the company focuses only on incremental growth plans that are not likely to be sustainable in the long run.
• Much of the company's revenue comes from the gaming segment, which is reliant on this title for its success which presents a significant concentration risk for investors.

Investment Thesis

In general, the financial position of Sohu.com (SOHU) does not appear impressive. The company is not making any profit and its cash flow is decreasing. However, its balance sheet has been stable and healthy for the past two years.

The company highly relies on its gaming sector to generate about 3 quarters of its revenue. The long-term success of this gaming sector is in turn reliant on the success of one main gaming title Tian Long Ba Bu ("TLBB").

TLBB has the potential to become a highly popular entertainment product if the company's management team has the long-term ambition of developing TLBB into an ecosystem of Wuxia-based entertainment products, similar to how Disney (DIS) did with Marvel's suite of superhero-themed entertainment products.

However, the company's current growth plans for TLBB appear to be more incremental, which means the potential of TLBB is not likely to be materialized in the near future.

Company Overview

SOHU is closely related to another company Changyou.com which was delisted and bought by SOHU. Wikipedia described how the 2 companies depended on each other which I summarised in chronological order:

• 2007 - Changyou.com ("Changyou") was founded as a division of the Chinese Internet company Sohu.com
• 2009 - Starting with just 2 MMORPGs , Changyou spun off from SOHU and went public through VIE, and developed its most popular game TLBB.
• 2011 - Changyou purchased nearly 70% of a browser games maker, 7Road
• 2014 - The gaming roster of Changyou's MMORPGs increased to 12
• 2020 - Changyou was acquired by Sohu and all Changyou stock was delisted from NASDAQ

Business Segments

From the company's latest annual report , we extracted the following information:

• "Through the operation of Sohu and Changyou, we generate brand advertising revenues, online games revenues, and other revenues."
• "Our brand advertising business generated revenues of $135.0 million, with an 8% annual decrease , representing 16% of total revenues."
• "Our online game business generated revenues of $638.2 million, with a 19% annual increase , representing 76% of total revenues."

From the above statements, we understand that while Sohu derives revenue from multiple sources, the lion's share is in gaming (76%). The gaming segment is also growing significantly, unlike its other smaller segments like advertising which is declining in revenue.

In my opinion, the future prospect of the company depends on SOHU's gaming segment, which is clearly the main strength of SOHU's business based on its current revenue trend.

Within the gaming segment, SOHU also heavily depended on the gaming title of TLBB for a significant part of its revenue, as inferred from the annual report:

We depend on revenues from Changyou's PC game TLBB and mobile game Legacy TLBB Mobile for a significant portion of our revenues, net income, and operating cash flow.

What is Tian Long Ba Bu ("TTLB")?

As mentioned earlier, the long-term prospect of SOHU is significantly tied to the ownership and success of the Tian Long Ba Bu ("TLBB") gaming franchise. As such it is necessary to understand the potential of this franchise.

TTLB is the title of a Chinese game that originated from a highly popular novel . The title can be directly translated to English as " Eight Books of the Heavenly Dragon " or more generally, "Demi-Gods and Semi-Devils".

The novel is set in the fictitious universe of " Wuxia ", which is effectively the Chinese version of historical fantasy , similar to the western " Lord of the Rings " trilogy.

Wuxia characters are often portrayed to possess exaggerated superhuman abilities through the practice of exotic/mystical Chinese martial arts and use these gifted abilities to embark on heroic adventures. The popularity of this genre of popular culture helps to spin off successful comics , movies , and other popular entertainment products among the Chinese community, including computer games .

This success of Wuxia-based entertainment products is similar to the genre of " Superhero fiction " in the west which created the highly successful Marvel superhero franchise. In my opinion, if the company can make full use of this key asset like how Disney benefitted from Marvel, SOHU has the potential to be the next success story in the Chinese entertainment industry.

The Potential Of Wuxia-Based Entertainment Products

When the movie of Ironman was released in 2008, it ushered in Phase One of the highly popular Marvel movie franchise developed with the backdrop of the Marvel Cinematic Universe ("MCU"). What follows is a long list of successful Marvel movies featuring different superhero characters with storylines that are interconnected through the MCU.

If each of these superhero themes is perceived as cash-generating entertainment "products", their successes can be attributed to the sticky network effect created by the MCU "ecosystem".

In my opinion, the Wuxia genre also has the potential to achieve similar success. Similar to the MCU, Wuxia can serve as the fictional "Universe" to bind all Chinese superhero themes together with a comparably strong network effect.

Such Wuxia-based Chinese entertainment products already exist as movies and games, including SOHU's TLBB game titles. Another example is the "Legend Of The Condor Heroes" by Yoozoo Games. Unfortunately, they were released in silos by different organizations and do not capture enough attention and momentum in the market to become a runaway success.

Disney has demonstrated how it developed Marvel's MCU into a successful cash cow. In my opinion, by owning TLBB, SOHU has the potential to achieve similar success if it decides to emulate Disney's successful playbook.

Income Statement

We infer to Seeking Alpha's income statement to get more insights on the company's profitability:

We can observe that within the last 5 years:

• SOHU's top-line growth has been largely stagnant since 2018.
• The cost of revenue has been kept low enough to allow the benefits from the rising top line to trickle down to the gross margins. SOHU has consistently maintained a decent gross margin in the range of 50% to 75%.
• The operating costs, while not visibly increasing, are mostly on par with its gross margins, resulting in SOHU barely being able to achieve profitability over the last 5 years. The company was only profitable in 2020 and 2021 (2 out of the last 5 years).
• If we drill down to the net income, the company is also not profitable in most years. The only exception was in 2021 when the company records a profit of $927.7M. But this is due to the discontinuation of one of its business units, which is expected to be a one-off event. In the subsequent year of 2022, the company's net income is once again negative.

Overall, SOHU remains a loss-making company and it is unclear whether the company will attain profitability in the long run.

Balance Sheet

Let's move on to the balance sheet :

Here are some observations:

• SOHU has consistently maintained a positive amount of liquid assets (Cash and ST investment) since 2018.
• SOHU's current ratio is consistently greater than 1, meaning that over the years, the company has accumulated more assets than liabilities to maintain positive working capital.
• The company's debt has fluctuated greatly. From the table, I consider a Debt/ EBITDA ratio lower than 30% to be 'low' (highlighted in green). We can see that from 2018 to 2020, the debt level was very high, with an EBITDA of much more than 30%. Fortunately, it managed to pay off most of its debt in the last 2 years.

In my opinion, overall, the company's balance sheet is healthy only for the last 2 years.

Cash Flow

Now, we shall check on the company's cash flow profile:

• SOHU has been able to generate positive cash flow from its operations in most years since 2018, except for 2021.
• The company's spending on CAPEX is relatively low, resulting in an FCF that does not deviate too much from its cash flow from operations.
• In 2021, when the FCF was negative, the company is able to offset it with cash generated by investing, resulting in an overall positive net change in cash flow.

Overall, the cash profile of SOHU, as represented by its FCF is consistently decreasing. It turned negative in the last reported year of 2021. Investors should observe whether this decreasing trend in FCF will turn around and reverse back into positive territory.

Valuation

How does the company fare in terms of valuation with respect to its competitors? According to Finviz , it competes with a few other Chinese companies in the gaming industry:

Specifically, we will compare SOHU's valuation with NetEase ( NTES ) and Bilibili ( BILI ):

Looking at the valuation criteria of P/S and P/B, SOHU appears significantly undervalued compared to its peers.

Risks

I explained earlier why leveraging on its gaming title of TLBB, "SOHU has the potential to be the next success story in the Chinese entertainment industry". Unfortunately, to achieve that, SOHU needs to ensure it can even own the license of TLBB in the long run.

According to the company's latest annual report, right now, the company is still pending the renewal of these license agreements. Investors should watch closely whether the renewals are successful eventually.

Conclusion

Overall, the company has a financial profile that is mediocre at best. The company is not profitable and has a declining cash flow profile. Its balance sheet is still healthy over the last 2 years.

In my opinion, SOHU owns a key asset of the TLBB gaming title that has the potential to become a runaway success, but only if the company has a long-term execution plan similar to Disney's playbook with Marvel's MCU.

Unfortunately, right now, there were no concrete plans for such an ambitious long-term vision. According to the latest earnings call , as of now, the current plans were all "incremental" improvements of the same gaming title:

• "In our business line for PC games, we adjusted the battlefield map and the gameplay of regular TLBB PC's [cross-server clan] [ph] or system."
• "We launched a new expansion pack for TLBB Vintage to celebrate its anniversary with the tradition of its first new clan."
• "we will launch expansion packs to celebrate Chinese New Year and serious holiday events for TLBB PC Legacy, Legacy TLBB mobile, and other games."

Without any tangible plan to secure TLBB into a larger Wuxia-based entertainment "ecosystem" (similar to the MCU), with a sticky network effect, TLBB is likely to be just another "silo" product that will eventually fade away in the long run. By relying heavily on TLBB, SOHU possessed a potentially valuable entertainment asset that can make or break the company in the long run.

If TLBB becomes highly successful, it can propel SOHU to stratospheric financial success. Else, the product will fade and be replaced by newer entertainment products, meaning SOHU has almost no other major revenue streams to fall back on, presenting a significant concentration risk.

Until the long-term prospect of the company's gaming segment becomes clear, my rating for SOHU remains on 'hold'.

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