Third Attempt To Acquire Changyou – If Not Now, Then Never – Changyou.com Limited (NASDAQ:CYOU)

Current price: $9.50

Offer price: $10.00

Upside: 5%

On the 9th of September 2019 online gaming company Changyou.com (CYOU) has received a non-binding acquisition proposal at $5/share or $10 per ADS share from its parent company Sohu (SOHU) (currently owns 68%). The main reason for the spread is most likely market’s distrust in the firmness of the offer as Charles Zhang, the CEO and major holder of Sohu, himself has already tried to acquire CYOU back in 2017 at $42.5/ADS. Both parties went silent and the proposal was reaffirmed 2018 again with no further developments. Nonetheless, this time I believe that situation could be different as the acquisition is priced cheaper than ever, while Sohu is in a position where it very much needs the cash flow CYOU can offer to it.

There is no mentioning of the shareholder approval requirement in the offer so far and as both companies are incorporated in Cayman Islands, it is rumored that this could be a short form merger and no shareholder approval will be required. However, even if it will be required, consideration price is not as bad as it looks (comparing to the previous proposal), because in these 2 years CYOU has already paid two $9.40/ADS share special dividends. So the actual offer is not that far from the all time high. Moreover, for 12 years CYOU has been living from its one star game and has failed to add any significant revenue streams so far, so taking that into account, shareholders might be fine with the offer.

Initially, the market has also viewed this merger very positively as after the announcement SOHU stock has jumped 7% and increased up to 20% before rolling back down again.

Changyou.com

SOHU has spun off CYOU in 2009 and since then has retained ownership of 68% of common shares and 90% of voting rights.

Changyou revenue streams come from (2018 report): online gaming (over 80%), online advertising (4%), cinema advertising (15%), other (1%). However, aside from gaming, all other segments are performing poorly and are mostly unprofitable.

Online gaming segment incorporates 11 games, out of which 3 are just different versions of the TLBB – their most popular game, which came out in 2007. TLBB makes about 78% of online gaming revenues and 65% of total revenues. Besides TLBB, the company has released numerous games over the years with no similar success. So given that TLBB has been on for 12 years already and its natural lifecycle is declining, while the company is unable to produce any new stars, performance of the company is slowly going down each year.

First two quarters of ‘19 came with (YoY) -10% and +5% in revenues respectively. The increase in Q2 was a result of the promotional activity for some older games. Q3 guidance comes with -20% decrease in revenues and -17% in gaming revenues, but CYOU has a history of beating their guidance, so the actual decline could be smaller.

SOHU

SOHU is mostly an online advertising company that has spun off its two most profitable segments: in 2017 – SOGO ($2bn MC 2nd largest search engine in China) and in 2009 – CYOU. SOHU has kept large stakes in both firms (45% stake in SOGO) and remains largely dependent on them for the revenue streams.

Third Attempt To Acquire Changyou - If Not Now, Then Never - Changyou.com Limited (NASDAQ:CYOU)

So aside from SOGO and CYOU, the remaining segment – brand advertising (excluding 17173.com) – has been strongly underperforming and unprofitable for years (net income table above).

Apparently all 3 brand advertising segments – Sohu Media Portal, Sohu Video and Focus operate in markets where the leaders are already established and backed by giant companies.

  • Sohu Video (video streaming) 3 main competitors are – iQiyi backed by Baidu ($37bn), Tencent Video and Youku Tudou (backed by Alibaba).

  • Sohu Media Portal (news aggregator) competitors again are companies backed by Sina ($3bn), Tencent and NetEase ($35bn).

  • Focus (real estate information and services provider) is summed up with this excerpt from the annual report: “Revenues from Focus were $31.1 million for 2018, compared to $57.3 million and $103.7 million, respectively, for 2017 and 2016. The decreases from 2017 to 2018 were mainly due to the PRC government’s implementation of tightened real estate policies and increasingly intense competition in the real estate market.”

So the company seems to have a knack to dive into very saturated markets. In June ‘19 SOHU has launched a new social networking app Huyou. Although CEO states that its “Sohu’s future”, the market is currently controlled by the likes of WeChat (Tencent) and Weibo (SINA) that already have over 1bn and 0.4bn users respectively.

The most recent quarter came with brand advertising revenues down 29% YoY. Media Portal revenues were down 27% YoY with a net loss of $38m (in line with last year). Sohu Video revenues fell 34% YoY with a net loss of $23m (up from $35 loss last year). No detailed information was provided on Focus.

Q3 guidance is also not very inspiring: revenue -1% YoY and -4% QoQ, -17% YoY in revenues from brand advertising, -12% YoY decline in revenues from online gaming and +12% increase in revenues from SOGO. GAAP net loss excluding contributions from SOGO and CYOU is estimated to be $55m.

Interestingly though, the CEO seems to have a strong believe in company’s future and recently has been buying shares (currently owns 25.6%).

  • From April to December of 2018 has added almost 3% at prices well over $30/share and the highest price being $41.30/share.

  • Until June ‘19 has added nearly another 2% at the highest price of $19.44/share, 1.5m in 2018

Why does it make sense

The acquisition is very cheap. Currently CYOU is being acquired at 1.86x EV/FCF, which is significantly lower valuation than at the initial announcement in 2017 May (4.4x) and reaffirment of the first offer in 2018 February (2.43x). So in essence Sohu is paying $534m (actual price that needs to be payed – $171m) for a company that brings a bit less than $200m of cash flow annually (more details below), which means that the investment should pay back itself in about 3 years and looks very attractive.

So despite constantly shrinking revenues (more details below), CYOU is able to produce stable and relatively (to its size – $485m) strong operating and free cash flow.

CYOU ($m)

Revenues

Operating Cash Flow

CAPEX

Free Cash Flow

Q2 ’19

119

66

Q1 ’19

123

31

2018

486

200

17

183

2017

580

201

3,6

197

2016

525

206

13

193

2015

761

213

35,6

177,4

Sohu, on the other hand, heavily struggles with all of its segments (aside from CYOU and SOGO). As it was already mentioned – it has made several not-so-successful attempts to enter new markets, but even usual strong profits from CYOU and SOGO, the company is constantly facing considerable losses and in 2.5 years had only one profitable quarter.

SOHU GAAP net income (loss) in $m

SOHU total

from SOGO

from CYOU

Q3 ‘19 (guidance)

-30

Q2 ’19

−33

21

16

Q1 ’19

−47

−4

37

Q4 ’18

15

26

10

Q3 ’18

−34

24

55

Q2 ’18

−48

33

30

Q1 ’18

−93

15

−13

Q4 ’17

−294

15

34

Q3 ’17

−103

31

−6

Q2 ’17

−88

23

51

Q1 ’17

−68

8

30

Also, despite its strong net cash position ($1.5bn), the company is also having difficulties with generating cash.

SOHU ($m)

Operating Cash Flow

CAPEX

FCF

2018

84

199

−115

2017

188

145

43

2016

240

289

−49

So with CYOU acquisition, Sohu could at least partly stabilize its cash flows.

CYOU still has $217m of net cash left and despite its star game (65% of total revenues) life cycle is coming to an end (more details below), the company still expects it to generate stable cash flow in the future (CYOU Q2 conference call): “believe in the future it can still generate stable revenue for us”. Interestingly, Sohu does not seem to be willing to make any changes or innovations to CYOU strategy and even after the acquisition it will probably just keep milking it until nothing is left (Sohu Q2 conference call): “Going forward for PC games, Changyou’s key strategy is to maintain player engagement and maximize the longevity of legacy PC games such as TLBB”.

CYOU has already been used as a cash cow and even in the last two years the parent has received over $800m (two special dividends dividends + net income) from it.

Concerns

Both companies have been very silent about the transaction. Even in regards to the first proposal in 2017, the companies didn’t provide any updates and did not answer any questions about it in the conference calls as well. Only when the offer was reaffirmed in 2018, Charles Zhang has stated that the hurdles for advancing the proposal are: weaker than expected financial performance from CYOU, increased competition and “strengthened regulatory oversight on Chinese outbound mergers and acquisitions transactions”. So far there seems to be no improvement in either of these problems, so the risk remains that the proposals won’t get anywhere this time as well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.