Many Chinese companies are available for American investors to purchase. Trading as American Depositary Receipts, or ADRs, which are negotiable securities that represent shares of non-U.S.-listed companies, some have shown a volatile history. While they may offer attractive opportunities, they also present plenty of risk.
One example is Changyou.com (NASDAQ:CYOU), a leading developer and operator of online games in China. This game maker's shares have traded as high as $50 and as low as $17 since January 2011. After a recent disappointing earnings report, the stock dropped over 20% in one day. Is the latest decline a good buying opportunity, or an accurate assessment of a suspect enterprise?
The risk of a bogus firm
There are some unique risks to consider when investing in Chinese ADRs. The most damaging might be what could be termed "foreign fraud" risk. While outright swindles are rare, they have been known to happen. There was a mini-mania for Chinese ADRs in 2010 after the successful offering of a few high-profile Internet companies. Unfortunately, when the boom ended, many investors suffered when lower-quality issues were found to be extremely weak businesses or phantom operations.
While it's impossible to know for sure if Changyou is questionable, there are signs that suggest the company is legit. The first is cash flow. A fraudulent company typically goes through noticeable convolutions on its cash flow statement when reporting phony profits beside dropping cash levels. Changyou reported comforting annual operating cash flows of $200 million-$340 million over the last few years with positive free cash after investments in the business, which offers some confidence.
A further boost is Sohu.com's (NASDAQ:SOHU) approximate 68% ownership of Changyou. Sohu, a leading online media, search, gaming, and mobile service firm, operates one of the most comprehensive Internet-based hubs in China. Its games business, delivered by Changyou, accounts for around 71% of gross profit. With over $1 billion of reported revenue in 2012, a U.S.-based market capitalization around $2.6 billion, and an easily verifiable web presence, it seems unlikely that Sohu.com is bogus. Thus, it's sizable stake in, and significant reliance on, Changyou suggests that the game maker is also genuine.
Changyou's corporate governance risk
Chinese ADRs pose another distinctive risk -- suspect corporate governance. Changyou's corporate organization is disturbingly complex. It does business through over 20 subsidiaries, each with its own affiliates and various ownership structure. Corporate officers having equity interests in these entities only increases the concern. Changyou's CEO owns 60% of some of the major subsidiaries, and its president owns 40%. While this kind of interlocking, insider-owned corporate structure is not uncommon in China, it suggests that corporate governance risk is real for Changyou's foreign shareholders, who are basically at the mercy of the company's officers and directors. One saving grace could be Sohu's majority stake. As Changyou prospers, so does Sohu. Sohu has a vested interest in seeing Changyou deliver adequate income to shareholders. Being able to dictate most company actions and elect all directors, Sohu seems to have enough clout to keep management honest.
Business risk, but an interesting valuation
Changyou investors also face general business risk. Competition in the Chinese online game market is becoming increasingly intense. This has caused sales and production expenses to explode. The result can be seen in Changyou's recent quarterly report. While total revenue reached a record $183.1 million, up 10% year-over-year, net income was only equal to the prior year, mainly due to a 69% increase in product development and marketing costs. Projections for the current quarter show a similar trend. Revenue is expected to be around $196 million, a 13% increase, but the anticipated income of $20 million is a sizable drop from 2012's profit of $75.2 million.
Product risk is also a concern. One game, called Tian Long Ba Bu, or TLBB, generates most of the company's sales. A few other games make up most of the rest. The business would suffer greatly if these games lose popularity. Changyou continually tries to provide new features to keep user interest, however. The company recently released its annual major expansion pack for TLBB, and management believes it met with a positive response.
The most inviting Changyou faces is valuation. Taking expected 2013 results as a base, the company looks to generate around $735 million in sales and cash earnings around $178 million at a 24.2% profit margin. Given a subdued 10-12 times multiple, the company's fair value might be around $33-$39 per share.
Competitor NetEase (NASDAQ:NTES) offers a good valuation comparison. NetEase is a top online game provider, operating some of China's most popular online games. In its latest reported quarter ending in June, revenue was up around 20% to $393.3 million compared with the prior year. Net profit was up around 25%, though the game maker saw increased marketing and development outlays. This could hint at even higher expenses for the company's September and current quarters.
NetEase is actively growing its game portfolio. The company launched a new 3D real-time game and four expansion/update packs in the June quarter. It also introduced an upgrade with an accompanying mobile version for one of its most popular games. The company is keenly focused on extending its reach into the mobile space, and plans to release an increasing number of wireless games.
When annualizing second quarter results, a technique that may be overly liberal, NetEase revenue would come in around $1.5 billion, with cash earnings of $471 million at a 31.4% profit margin. That would put the company trading around a full 18 times at the recent U.S. market cap.
One can't fault an investor fleeing from Changyou.com, given the risks involved. But, there are factors that might make it a reasonable speculative play. Furthermore, the company's guidance for its fourth-quarter profit could possibly be overly conservative. The expected 70%+ drop in net income seems extreme, and might not be indicative of future operations. While buying into Changyou is clearly a risky bet, if things aren't as bad long-term as the near-term might suggest, it may prove to be a reasonable gamble.
Bob Chandler has a long position in Changyou.com. The Motley Fool recommends NetEase.com and Sohu.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.