One to Buy and One to Short
Thus far in our Global Gains CAPS Champion of the World Contest we’ve you advised to go long some stocks and short some other stocks -- and our results have been quite good. This week, however, I’m recommending you go long and short two stocks together at the same time. That’s because it’s arbitrage, and while a 50% accuracy score may drag on your rating, you have the potential to rack up some big points.
But before I get to the idea, allow me to plug our Global Gains 2009 research trip to China. This is an annual event for our service and each year we've gone, we've discovered a stock that went on to more than double for us (CFSG in 2007 and CGA in 2008). Given that the broader market has done over that same period of time, we're quite proud of that fact.
As always, we'll be sending dispatches back from the road on what we find free to anyone who signs up. If you'd like to sign up to receive those dispatches, simply enter your email address in the box on this page.
And if you know people who are looking to learn more about investing in China, please send them the link and encourage them to sign up as well. The content should provide to be both interesting and valuable. And if you're into Twitter, you can also find us there, where we'll be providing real-time tweets from China. Should be interesting.
And now, this week’s contest idea…
Long Sohu.com (SOHU) and Short Changyou.com (CYOU)
Thesis: Sohu.com and Changyou.com are two significant Internet plays in China. Sohu.com is a popular news and communication portal that owns a hive of websites relating to various interests. Changyou.com is a large online gaming company that specializes in massively multiplayer online role playing games (MMORPGs, for short). And while it’s very difficult given Internet growth rates in China to calculate the value of either of these companies individually, it’s easier to figure out what their value should be relative to one another. That’s because SOHU recently spun-off CYOU and continues to own 70% of the company’s shares. Today, there’s a discrepancy in that valuation (either CYOU is overvalued or SOHU is undervalued) and you can make money by arbitraging it out.
Valuation; Following its IPO, CYOU shares have been on a tear. The company is now worth $1.95 billion dollars and trades for 9x revenue and 14x EBITDA. While that looks really expensive, these Chinese gaming stocks are notorious fast growers with lots of potential customers. So let’s assume CYOU is fairly valued. If that’s true, then SOHU’s stake in the company is worth $1.37b dollars. Yet SOHU’s stand alone market cap is just $2.47b. So if we net out the value of the CYOU investment, then you can buy SOHU’s entire business for $1.1b. But SOHU also has $178mm in net cash on its balance sheet. If we take that out, then SOHU’s operations are selling for just $922 mm.
So what do you get for $922mm? Roughly $250mm in annual sales, $152mm in annual gross profit, $50mm in annual EBIT, and $44mm in annual earnings. Do the math and net of CYOU, SOHU is selling for 3.6x sales and 20x earnings. That doesn’t scream cheap, but this is a business that grew its top line 20% year-over-year and its operating line more than 40% year-over-year. Further, the average Asian emerging markets Internet services peer today sells for 8.4x sales and 31x earnings.
Takeaway: If we assume CYOU is fairly valued and the sector is rising, then SOHU stock stands to appreciate much more than CYOU stock, and you’ll earn more points on the SOHU long than you will on the CYOU short.
If, however, you believe that CYOU is dramatically overvalued and SOHU fairly valued, then reverse everything I wrote above and you’ll earn more points on the CYOU short if the sector is falling than you’ll lose on the SOHU long.
Either way, the value of the two companies should converge over time and by going long SOHU and shorting CYOU you will earn a nice dose of points on that convergence.