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10 Years After Spinning It Off, Sohu Wants Changyou Back

By Leo Sun - Updated Sep 11, 2019 at 1:52PM

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But merging two underdog Chinese tech companies won’t create one market leader.

Shares of (CYOU) surged nearly 50% on Monday after its former parent company, Sohu (SOHU 0.27%), offered to acquire all its remaining class A shares for $5 apiece, or $10 per ADS.

Sohu spun off Changyou in an IPO 10 years ago, but it retained a 68% equity stake and a 90% voting stake in the video game maker. If the deal is approved, Changyou's stock would be delisted, and the company would continue operating as a private subsidiary of Sohu.

Two figures pushing jigsaw pieces together.

Image source: Getty Images.

Sohu noted that its offer represents a premium of 69% over Changyou's closing price on Friday, as well as a 57% premium to its average closing price over the past 30 trading days. However, the offer remains far below Changyou's IPO price of $16 -- and the stock traded in the low $40s just two years ago.

Changyou's other investors can't refuse the offer since Sohu holds a majority voting stake in the company. However, Changyou's board -- which is comprised entirely of independent directors -- can still block the deal. Let's examine the ties between these two Chinese companies and see if a takeover benefits investors.

Understanding Sohu and Changyou's businesses

Sohu generated 67% of its revenue from online ads last quarter. Those ads are mainly displayed across its news portal sites, streaming videos, and the Sogou (SOGO) search engine, which it spun off in another IPO in late 2017. Tencent (TCEHY -1.38%) is currently Sogou's largest stakeholder.

Sogou controls 11% of China's online search market, according to StatCounter, making it the country's second most popular search engine after Baidu (BIDU -0.69%). Sogou's Input Method keyboard, which comes with a popular voice search feature, is also the country's most widely used digital keyboard. A sliver of Sohu's advertising revenue also came from Changyou's advertising unit, which sells ads on its gaming website and movie theaters.

Sohu's total advertising revenue fell 4% annually last quarter, due to the economic slowdown in China and tough competition from rivals like Baidu.

21% of Sohu's revenue came from Changyou's online gaming business. Changyou's top franchise is Tian Long Ba Bu (TLBB), an online multiplayer game that was launched on PCs 12 years ago and ported to mobile devices by Tencent.

Sohu's online gaming revenue grew 8% annually last quarter, thanks to the "improved performance" of Changyou's older games, but it also faced an easy comparison to the unit's 23% annual drop in revenue last quarter. TLBB Mobile currently ranks 20th in App Annie's list of top-grossing iOS games in China -- but that ranking still pales in comparison to hit Tencent games like Game for Peace, Honor of Kings, and Perfect World.

Why Sohu wants to tighten its grip on Changyou

Sohu's total revenue fell 2% annually to $475 million last quarter as the softness of its advertising business offset Changyou's stable growth. Sohu expects its revenue to stay nearly flat annually in the third quarter, and analysts expect a 3% decline for the full year.

Its GAAP net loss widened from $48 million to $53 million, while its non-GAAP net loss (excluding an impairment charge related to Changyou's movie advertising business) narrowed from $49 million to $38 million. Analysts expect Sohu's bottom line to stay in the red for the foreseeable future.

Promotional art for TLBB.

Image source: Changyou.

Meanwhile, Changyou plans to launch a major expansion pack for TLBB in the third quarter, but it still expects its online gaming revenue to decline 6%-17% annually as it loses PC gamers and faces tougher competition in mobile games.

Yet Changyou doesn't seem concerned about that ongoing decline. During last quarter's conference call, CEO Chen Dewen stated that Changyou's "key strategy remains unchanged": "maintain player engagement and maximize the longevity of our legacy PC games such as TLBB." In other words, Changyou still doesn't have any comparable franchises lined up to succeed TLBB as its growth stalls out.

Sohu likely believes that it can boost its gaming revenue and spur the development of new franchises upon taking direct control of Changyou. Moreover, Changyou is profitable by both GAAP and non-GAAP measures -- so the takeover could be accretive to Sohu's long-term earnings growth. Sohu also wants to scoop up Changyou at a discount, since its $10 per ADS offer only values Changyou at about five times forward earnings.

Changyou bailed out Sohu before

Earlier this year, Changyou declared a special cash dividend of $4.70 per class A and class B share, or $9.40 per ADS. Changyou stated that it was to celebrate TLBB's better-than-expected results during the first quarter, but it was arguably a thinly veiled bailout for Sohu. Changyou paid out $503 million in dividends, but $337 million of that total went to its top shareholder Sohu -- which still couldn't post a quarterly profit after that big one-time gain.

Sohu's offer for Changyou is a continuation of that desperate strategy, and the combined company will remain an underdog in the crowded advertising and gaming markets. Therefore, I'd ignore this deal and stick with diversified market leaders like Tencent (which already owns stakes in Sohu's top businesses) instead.


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