The research note was written by Pat Maloney, an analyst at RedTech, a Shanghai-based advisory firm specializing in China’s ConsumerTech, CleanTech and MedTech sectors.


Summary: Qihoo 360 is in the crosshairs of well-known short-report writer Citron Research, the company that deserves kudos for bringing down Longtop Financial. But this latest effort is reminiscent of the Muddy Waters/Spreadtrum debacle, where the HK research outfit published a thinly sourced hit piece that backfired and severely diminished its reputation. Citron’s review of Qihoo recycles questions that have been asked before, partly in our excruciatingly detailed initiation. Unfortunately, many of Citron’s punch lines are based on ill-conceived apples to oranges comparisons or weak supporting evidence. However, there is one area where we do agree with Citron – Qihoo remains overvalued. For added context, take a look at our thoughts on some of the key issues raised in the Citron drive-by.

 

  • Citron On … Sky-Mobi

On May 2, 2011, Citron reported on Sky-Mobi (NASDAQ:MOBI) when the stock was $18. Citron placed a price target of $3 on the stock. … Not more than 4 months later, despite the protests, the MOBI traded at $3 — not because of Citron, but rather the inevitable fate of their business model’s value.

  • RedTech Fact Check

Citron has it right that MOBI didn’t drop just because of it. We seem to remember that the entire, wildly overvalued Chinese Internet imploded in April/May. As a small cap stock, it’s no wonder that MOBI dropped more than its China Net peers. It plummeted 75% over six months, but SNS site RenRen dropped 65% and so did online video site Youku. Even Sina dropped 40%. (See Fig 1).

We’re no fans of Sky-Mobi, but that’s because most of its business is in feature phones and the company still needs time to prove it can be a contender in smartphones.

Lots of recycled questions but no conclusions based on evidence or fieldwork.

 

 

  • Citron On … Free Antivirus

In fact, 2008-2009 the company had generated the bulk of their revenues selling anti-virus protection, a revenue stream that rapidly dwindled to zero. After realizing that this was a dead-end business model, in the Q4 2009, QIHU began to give away its software.

  • RedTech Fact Check

Qihoo started to give away its antivirus software for free in 2008, understanding that Chinese Internet users don’t typically pay for software. So instead of letting the pirates engineer its demise, Qihoo did so itself. But by giving it away, the company gained a large user base that it could then monetize. It did so by bundling the security software with a free browser, which set hao.360.cn as its default landing page – a page full of text links that destination web sites pay handsomely for.

 

  • Citron On … The Browser & R&D

In reality, (the browser) was simply a customized version of Google’s Chrome, bundled with antivirus technology mostly licensed from 3rd party providers, Qihoo’s R&D has been historically minimal. … BIDU’s new browser is being released to cement its position as the unquestioned leader in search, much as Google developed Chrome to make sure it had a foothold with web surfers.

  • RedTech Fact Check

Baidu’s browser has been a complete flop and it’s technically inferior to Qihoo’s. Qihoo’s web browser, a key conduit in the company’s revenue chain, uses both the Trident (IE) and Webkit (Chrome) engines so calling it a customized version of Chrome isn’t an entirely fair shake. Qihoo’s browser has been the only browser to challenge Internet Explorer’s dominance in the China market. We estimate Chrome has a market share of ~2% in China versus 35% for Qihoo. On R&D, Qihoo’s product development expenses from 2008-2010 were $7.2mn, $10.6mn and $24.5mn, or 43%, 33%, and 43% of the company’s revenue.

 

 

  • Citron On … Qihoo Revenue From Google

More than 21% of QIHU’s revenues are derived from Google, primarily by referring search queries.

  • RedTech Fact Check

21% is a dated number. In Q1-11, it was 15%, then 11% in Q2-11 and we project 10% for all of 2011. This was mentioned in the management interview Citron linked to in its report, but the report failed to update the recent numbers. We hear Google is looking to increase its cooperation with Qihoo in China, even as unpalatable as they may be to the “do no evil” do-gooder.

 

  • Citron On … User Stats

According to Doubleclick ad planner as powered by Google, 360.cn is the 21st most visited site in China with a reach of only 10%. See Ad Planner link.

  • RedTech Fact Check

How often do users return to Trend Micro’s website after installing its software? 360.cn is where Qihoo users download Qihoo’s software, not where users are exposed to ads. This methodology would be similar to judging iTune’s downloads based on apple.com’s page ranking.

We also believe that totally relying on Google or Alexa metrics for Chinese webpage data is like putting on make-up with a shotgun; neither accurate nor pretty. But for the sake of argument, let’s look at Baidu’s text-ad links page hao123.com, which ranks ninth on the DoubleClick list with 24.1% reach. While web traffic sources should never be the sole basis for any report, we take some comfort from the fact that last month iResearch’s tracker reported Qihoo’s hao.360.cn surpassed hao123.com in September in daily traffic and user coverage.

 

  • Citron On … Valuation
Now look at the comparative valuations of SOHU and QIHU. SOHU is widely acknowledged as direct competition to QIHU. The below chart shows how ridiculous their comparative valuations are. (See charts here.)
  • RedTech Fact Check

Here is one area where we are somewhat in agreement, if not on methodology. Qihoo is overvalued, especially when considering the entire Chinese Internet has been rerated downward. In our initiation, it traded at 37x our 2012 estimates and we noted it was too rich then even though we fundamentally liked the company from a biz dev and strategy point of view. We assign a 2012 P/E multiple of 25x to get a maximum value of $16, which represents 12% downside risk.

 

  • Citron On … Management

Can you Trust Top Leadership? If Qihoo was a US internet company, it could never have gone public because of its litigation history and questions surrounding its business model.

  • RedTech Fact Check

We’ve gone over Qihoo’s colorful past before in our initiation and the legal proceedings can be found in Qihoo’s filings. None of them have or will have substantial material impact on the company. Long story short; Qihoo’s CEO Zhou Hongyi is a pit- bull in gentlemen’s clothing. More than a few would say he’s an !%^%$! But he was not the first nor will he be the last internet entrepreneur to double-cross potential competitors, just watch Pirates of Silicon Valley or the Social Network for a refresher.

 

  • Citron On … The Mobile Biz

The only thing more disturbing than skewed numbers are boldfaced lies. In both the prospectus and quarterly filing from the company refers to themselves as “the leading mobile security provider in China.”

  • RedTech Fact Check

Let’s pump the brakes here and return to sanity. Citron provides a link that incorrectly lists mobile operating systems and not mobile security software. We can only guess that the data Citron wants to refer to is the difference between Netqin’s Registered Users and Qihoo’s Active Users filed with the SEC (link). Qihoo recently launched its antivirus program, Mobile Safe, as well as a What’s App-style messenger called Kouxing, an Android app store, an LBS Group Buy aggregator and web browsers. These programs are available on multiple O/S’s such as Symbian, iOS and Android. Not a bad line-up.

That said, Citron has stumbled into an area of uncertainty for Qihoo. Our concern is since the firm will not try to monetize mobile until the end of 2013, it may be vulnerable to slowing revenue growth if its ads platform moderates. That’s a big IF, given that e-Commerce is currently creating a lot of ads demand, which is pushing prices higher for 2012. Either way, Qihoo has gone out of its way in our talks with management to note that mobile is not a near-term win.

 

  • Citron On … Qihoo

So what is left here? With no disruptive technology and no fast growing properties (such as Weibo, Yoku, or Q+) Qihoo has … a browser … that is it … plain and simple.

  • RedTech Fact Check

Well, to clarify, Tencent’s Q+ is a copy of Qihoo’s desktop product, which seems pretty darn innovative to us if you have ever used it. And not to knock Sina, but Weibo isn’t earning money, and Youku has been hemorrhaging money. So why the unabashed love for Web 2.0? in China (and other places) Web 1.0 actually makes money. I think we might classify Baidu and Google as solidly in the Web 1.0 camp. Keyword search. Simple. Easy to understand. Very profitable. Yes, more Web 1.0, please.

 

Conclusion
Nothing we see diminishes the fact that Qihoo has access to one of the largest audiences in China, with more than 300mn users of its computer safety products. Given Zhou Hongyi’s colorful background as an alleged malware creator, we find it amazing that he’s reformed and repackaged himself to Chinese consumers as a trusted vendor. But we’ve seen stranger things in China.

We credit Qihoo with having the foresight to change its business model and tap into the incredible growth of the online ads market. It may be so Web 1.0 but so what – growth is growth.

The only clear takeaways here are judgment calls about the potential of the mobile business and what valuation metrics should be used for Qihoo. We’ve stated ours (25x 2012 EPS for a company that will grow ~70% YoY – compared to 32x 2012 consensus for Baidu, which is expected to grow 66% YoY.) We do not factor in any contribution from mobile in 2012 and only a smidgen in 2013.

(Original Report: Link)