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Foreign "Magic Formula" Stock? Sohu.com (SOHU)

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February 20, 2009 – Comments (0) | RELATED TICKERS: SOHU , BIDU , SINA

Note: Sohu.com is not an official Magic Formula stock, but a foreign stock with Magic Formula characteristics as identified by Magic Formula Investing Europe.

Sohu.com is one of China's largest Internet companies, with 7 major websites, 5 of which rank among the top 50 most trafficked in the country. The namesake Sohu.com is a web portal similar to Yahoo! (YHOO), Sogou.com is the company's search engine, Chinaren.com is somewhat similar to Classmates.com in the U.S., Focus.cn is a real estate site, and the company also operates an online gaming network. In fact, Sohu.com's one and only multiplayer online game, Tian Long Ba Bu (or TLBB), has exploded as the primary source of revenue, contributing almost 45% over the past 12 months. Brand (or banner) advertising contributes about 42%, while the remainder is filled out by wireless services and a small sponsored search operation.

Sohu is not as cheap as the usual Magic Formula stock, but the current 8.6% earnings yield should be put into the context of the company's growth prospects, which are substantial. Sohu has grown revenues at over 20% annually over the past 5 years, but that growth has really taken off recently, averaging over 50% over the past 3 years and set to rise nearly 100% (!) for fiscal 2008. The online ad market, young even in the U.S., is embryonic in China. Organically, the ad market is expected to grow there 25% annually for the next 5 years, and Sohu is set to benefit proportionally. More impressive has been the explosive growth in online gaming, which is huge in Asia. TLBB has become Sohu's best revenue source in a little more than a year - to $167 million in sales from less than $9 million just 2 years ago. With several more games in the pipeline, this high margin residual business is management's main focus.

The company is also in great financial shape, as with most solid Internet firms. Sohu carries the equivalent of $280 million in cash, with no debt. Free cash flow margins have come in at a staggering 52% so far this year, but long term should settle into the high 20% range (which is still outstanding). MFI return on capital is strong absolutely at 43%, but low compared to more established Internet players in the U.S. Since Sohu is still in the growth stage of the business lifespan, I expect this figure to work up as long as management avoids value destroying acquisitions.

There are risks here, of course. Any investment in China faces political risks, and in Sohu's case an example of this is the deal competitor Baidu (BIDU) struck to report state news, giving that company significant competitive advantages. While Baidu is by far the most trafficked site in China, Sohu and web portal Sina (SINA) are neck and neck for #2. This strong competition will probably erode advertising margins over the long run. Probably Sohu's biggest risk is the concentration of revenues in their only game - TLBB. TLBB's growth will moderate as it matures, and there is no guarantee Sohu's new games will be as popular. It's next game, The Duke of Mount Deer, is not scheduled until the 4th quarter.

In all, I believe Sohu.com will be a market beating investment from current price levels. While again I want to stress that this is not an "official" Magic Formula stock, it is a good choice for those looking to get some exposure to China's growth story into their portfolio.

Steve owns no position in any stocks discussed in this article.

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