Qihoo 360 Technology Co. Ltd. (QIHU:NYSE) - Case Study in Valuation

Qihoo 360 Technology Co. Ltd. (QIHU:NYSE) - Case Study in Valuation

First ....back to basics...... "Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life." Warren Buffett annual letter to Shareholders - 1993

All citations refer to the SEC document links below. Here are the bullet points:

1.)QIHU went public in 2010 - US$60 million in revenues & $8mm profits.  Prior to the IPO there were really no assets (US$87 million), common equity (US$$2 million) or book value (US 89 cents per share) to speak of in relation to the size of the US$230 million IPO. (424(b)4 filed 3/29/2011, p 41-43)

2.) The disclosures in the same prospectus: They are the 3rd largest "Internet Company" in China with 339 million Monthly Active Users (MAU) (p51) with an 85% market penetration.  (iResearch)  Apparently, the two companies ahead of them split up the other 15% of the market and somehow became much larger than OIHU?  

3.) Business structure is a Cayman Islands VIE with 3 Hong Kong subs, and a PRC (Peoples Republic of China) sub (Qizhi Software).  Qizhi has contractual relationships with seven (7) other VIE's which conduct substantially all of the company's business in the PRC.  These VIE's are owned by Mr. Hongyi Zhou, chairman & CEO and Mr. Xiangdong Qi, director and president & other key employees and investors. (p 79)

4.) At the time of the IPO cash infusion of $230 million......to facilitate the IPO, QIHU made an immediate 10 year loan loan to the officers of the company  for US$12.1 million (p81) terms were not disclosed.

5.) After the IPO, the Stock price has gone from from US$30 per ADS to US$120 in March 2014 back to US$58 today.....i.e mkt cap of US$5B to US$19B back to US$9B

6.)Now, lets fast forward to the 9/30/14 quarterly numbers/balance sheet. (6K filing 11/24/14) Huge revenues (US$960 million in 9 months)  But unfortunately, they've made relatively little money since the IPO; US$147 million over the 3 years through the (audited) 12/31/13 numbers and another US$150 million in the (un-audited) 9 months ended 9/30/14. Total - US$300 Million.

7.) The 9/30/14 numbers have a few odd ratios:

• Revenue per MAU grew to an annualized rate of $2.50/MAU in September of 2014, from $1.40/MAU in 2013 and only 17 cents/MAU at the time of the 2010 IPO.  This is a significant, unexplained increase in revenue per MAU.
• Cost of Revenues held relatively constant at about 12% from 2010 through 2013.  COR ballooned to 21% for the 9 month period ended 9/30/14.  There was no explanation offered.
• Revenue more than doubled year over year (US$960 Million v US$450 Million), yet the company's operating metrics remained (with the exception of SmartSafe) relatively flat.  Revenue and profit margins by product line were not disclosed.  

Total monthly active users of Qihoo 360’s PC-based products reached 495 million in Sept.of 2014, vs. 465 million in Sept. of  2013.  User penetration of Qihoo 360’s PC-based products was 94% in September 2014, compared to 94% in September 2013.  Total smartphone users of SmartSafe reached a record of 673 million in September 2014, compared to 408 million in September 2013.  Monthly active users of Qihoo 360’s PC browsers were 357 million in September 2014, compared to 342 million in September 2013.  User penetration of Qihoo 360’s PC browsers was 68% in September 2014, compared to 69% in September 2013.  Average daily unique visitors to the 360 Personal Start-up Page and its sub-pages were 129 million in the third quarter of 2014, compared to 126 million in the third quarter of 2013.  Average daily clicks on Qihoo 360’s Personal Start-up Page and its sub-pages were approximately 723 million in the third quarter of 2014, compared to 681 million in the third quarter of 2013.

•  The flat Metrics simply do not reflect a doubling in Revenue.

8.) The balance sheet also ballooned since the IPO.  As of 9/30/14 total assets were US$3.1 Billion.  There are two main reasons for this increase. 1.) The company had two bond issues; US$600 million in September of 2013 and a second  issue of US$1 billion in September of 2014 (Total US$1.6 Billion) AND 2.) The company "wrote up" intangible assets by more than US$500 million in the un-audited 9 month period ending 9/30/14.  There were no acquisitions disclosed.

9.) The bonds were issued at terms that IMO were a dream come true for the company......Notes due in 2020 and 2021 with .5% and 1.75% interest payable semi annually in arrears (lower interest rates than US Treasuries) with a conversion price at the equivalent of $120/ADS (at a current ADS price of $58/share this conversion option is relatively worthless).  I would be less than thrilled if I were an investor that purchased these bonds at face.  These were private issue sec 144 securities issued to qualified institutional buyers.

10.) Here are the write-ups of the Intangibles (12/31/13 v 9/30/14).  Land Use Rights (US$75 Million v US$140 Million); Goodwill (US$26 Million v US$203 Million); Intangible Assets (US$93 million v US$180 Million);  Long Term Investments (US$84 Million v US$290 Million) Other Long Term Assets (US$41 Million v US$47 Million)  Total (US$319 Million v $860 Million) or a total write up of US$540 million increase in 9 months.  These items were "relatively" unchanged and immaterial prior to the 9/30/14.   Rapidly increasing Intangible Assets are a red flag indicating inflated earnings.  i.e. funds spent that should have been recorded as an expense are carried on the balance as an asset to "manage/improve" profits..

11.) So let's do an exercise I always find extremely valuable.  It involves "top side what if's" and usually gives a nice view of the Intrinsic Value of a business.  Total Assets on the Balance Sheet of QIHU as of September 2014 were $3.1 Billion.  Let's give management the financial benefit of having all of that capital without any of the cost, and we can see what the balance sheet would look like under ideal circumstances. We'll start with the $3.1 Billion in assets and reverse the cash proceeds from the bond issue (US$1.6 Billion) and the IPO (US$230 million) and write off the magically increasing "intangibles" (US$860 million). That gives us Adjusted/Real Assets of US$410 Million.  Since QIHU didn't pay any dividends, we should have about US$410 million in Cash/assets left for shareholders......makes sense?....now we look at the remaining liabilities on the balance sheet (after removing the $1.6B in bonds)....these are roughly is $500 million.  The company actually has a negative net worth of about US$100 Million. So after 4 years, without all of these capital transactions, this company would be insolvent, didn't flow a dime of cash to it's shareholders and the reported $300 million income number ($150 million of this income occurred in the un-audited 9 months ending 9/30/14) is actually due solely to the US$860 million write up of intangible assets.

12.) On 10/3/14 the Company has also authorized US$200 Million share buyback. The details re: which shares would be purchased and the per share purchase amount(s) were not disclosed.

13.) the coup de grâce is that last week QIHU announced a joint venture with Cool Pad (2369:HK) a relatively small mobile device company bumping along with earnings of US$50 million a year and a market CAP of  US$800 million according to Bloomberg & Yahoo Finance.  QIHU will  contribute US$409 Million for a 49% stake in the Joint Venture.

http://finance.yahoo.com/q?uhb=uh3_finance_vert&fr=&type=2button&s=2369.hk

http://www.bloomberg.com/quote/2369:HK

14.) So, even though QIHU has never created any value for ADS Shareholders, they are spending US$600 Million in the relatively near future on a share repurchase (probably designed to benefit insiders) and a "surprise" Joint Venture, betting half of the company's current (overstated) equity, not contemplated or discussed in any prior filings.

15.) Management's new end-game seems to be to pile as much US cash into the company as quickly as possible and spend it on Chinese Joint Ventures/acquisitions and insider compensation.  I'd fully expect this business to "go dark" or be taken private at a substantial discount , like so many of these VIE's  have done in the past, now that they've got their hands on all of this cash.  (e.g.China Sky One Medical Inc., AutoChina, SinoTech Energy Limited and China MediaExpress, etc.)

Given the above, let's get back to the initial question....."What is the Intrinsic Value of QIHU?" 

After reviewing the filings, there seems to be little, if any, possibility that any cash will ever be made available to Common/ADS Shareholders.  Unfortunately, the sole purpose of this enterprise is, apparently, to line the pockets of insiders.  Therefore the Intrinsic Value of this business, and the corresponding share value is US$0.00.

6-K 9/30/14 - Condensed statement of Cash flows & Balance Sheet

http://www.sec.gov/Archives/edgar/data/1508913/000114420414070786/v395254_ex99-1.htm

IPO Filing 424b4

http://www.sec.gov/Archives/edgar/data/1508913/000104746911002864/a2203165z424b4.htm

Bond issue

http://www.sec.gov/Archives/edgar/data/1508913/000114420414047356/v385916_ex99-1.htm

Coolpad - $450 million joint venture 

http://www.sec.gov/Archives/edgar/data/1508913/000114420414074354/v396818_ex99-1.htm

$200 million Share buy back 10/3/14

http://www.sec.gov/Archives/edgar/data/1508913/000114420414059496/v390688_ex99-1.htm