So here is how I came across this name. As I mentioned in my old post “A Part Time Investor’s Investment Process”, I didn’t have a systematic way of sourcing idea, thus usually leaving the portfolio under-invested. More recently, I started playing around with some quantitative funds’ strategy selection criteria, and found LSV’s fit my style pretty well. It goes by two parts: 1) identify value opportunities, by looking at some traditional ratios including EPS, current P/B, current P/CF and current P/S, if any of the ratios is lower than industry median, keep them for step 2; and 2) eliminate “value traps” by examining the recent momentum (e.g. Relative Price Strength over past 26 weeks >=0 & Relative Price Strength over past 13 week is larger than that of past 26 weeks. What is does is basically to look for cheap stocks in a turnaround story, the idea being if the market recently recognize a name, it usually is not a value trap. For further information about LSV, you could visit http://lsvasset.com/research/ for further research done by them.

CYOU came out from these filters and happened to be a Chinese ADR, which I thought I may be able to gain some informational edge by researching in its local language. First, still need to give credits to following posts provided me some directions. By the way, their timings are much better as the stock price already went up 40% from the price level they posted their ideas. However, without the recent price surge, it possibly won’t go through the step 2 of momentum checking, meaning I wouldn’t be able to see it until the name started to rebound anyway.

https://www.valueinvestorsclub.com/idea/CHANGYOU.COM_LTD/137906

http://seekingalpha.com/article/3962034-changyou-extremely-undervalued-possible-privatization-candidate

A bit of company history (i.e. why it’s cheap?)

Changyou.com is an online game developer and operator, carved out from old time Chinese tech giant Sohu (not so much now) in 2007, and went public in 2009. It is best known by one of its top franchise Tian Long Ba Bu (天龍八部 in Chinese, TLBB hereafter), which also contributes the most of the revenue of the company over the years. Changyou.com had its prime years in 2011 and 2012 when PC online games were at the peak of their life cycles, generating strong cash flow and profits. However, it had a few missteps in subsequent years. With the goal of broadening its services to a “platform” company (instead of starting with diversifying the game portfolio, which appeared to me as a simpler way of building a quality company in hindsight), former CEO Tao Wang led the firm to acquire multiple software application firms, including RaidCall (a music and entertainment software) and Dolphin Browser (a mobile browser), which however both ended up being written down later.

Due to the poor financial performance (rumors from ex-employee said it could be Wang’s cult-like obsession  of a India religion “Oneness” and his rebellion against Sohu’s CEO Charles Zhang in corporate strategies leading to this decision as well), Wang was ousted by November 2014 and the President then Dewen Chen, along with Sohu’s CFO then Chuyuan Chen (who retired from the firm by July 2016, however looks more like a let-go ) took over the helm, as co-CEOs. Since then, the company shifted the focus back on game developing and operating and emphasized on mobile platform games initiatives. Revenue seemed to be stabilized in 2015 (2% revenue increase YTY) and profit was back to positive after aggressive cost cutting, which was just OK because the online gaming industry in China was still booming. During the management turmoil, the stock price inevitably suffered, dropping from high of $40 in 2013 to $18 at the beginning of 2016.

The Good – Why do I think it’s worth investing?

– Real estate value cushion. As pointed out by both posts, Changyou holds some prime real estate properties. “Company bought a 14,950 sqm office building in August 2009 for $33MM and then entered into a $171MM contract to purchase and develop 56,549 sqm headquarters in 2010”. Real estate price since then almost doubled according to the SeekingAlpha article (using Savills data source). I happened to have a friend in Beijing, coincidentally living in Shijiangshan District where both Changyou’s buildings are located. According to the local research from this friend, the current value of such properties could be north of $400m (= unit price 40,000 rbm/sm * 71500 sm / exchange rate 6.74), so I think the VIC post assumption of $350m appears to be reasonable. I also realize that there could be bubble in these prices, but presumably the parent company Sohu could simply buy the rest of the shares they don’t own, consolidate the workforce into Sohu’s buildings and then sell these properties to unlock the value (which I admit is unrealistic). Bottom line is that these real estate assets provide some cushion and keep the company attractive for privatization even the operating business continues to fail.

– Still cheap. The company is valued at 7.4 TTM P/E, which appears to be very cheap considering it’s still a positive cash flow business. However, given that 2016’s earnings are heavily deteriorated due to the aging of TLBB games, it’s not fair anymore to use the TTM earning. Even use forward earning (either analyst estimate or just 2*first 2 Q’s earnings), it’s still valued around 10.7 PE, still quite cheap. P/B ratio is about 1.4, and most of the assets are current assets (cash, short term investments, etc.), with no long term debt. This is a very clean balance sheet, all it needs the management to do is to deploy these cash more wisely. I think getting back to the game business and expand the mobile game portfolio is a right direction.

– Some new mobile based games like Da Da Da Luan Dou (DDDLD hereafter) & Hortensia Saga are hot and could be pivotal for the turnaround. Full disclosure upfront, this point is based on my own due diligence check as these games were launched in Q3, thus never made to any filing. Please view it as my own speculation with full caution.

First are a few facts I observed:

1) DDDLD (大大大亂鬥), launched on 08/30/2016, seems to gain good traction. Baidu search of the name has 2,930,000 results, compared to TLBB3D (one of their big hits) which had 2,050,000.

Additionally, the average number of daily threads during past few days on Baidu Tieba (the Chinese version of Reddit) for DDDLD is about 27. That is comparable to the same life cycle stats of 33 (mid December 2015, which is 1.5 months after official launch) for TLBB3D.

2) Hortensia Saga (蒼之騎士團） is a classic Japanese RPG game, developed by well-known Japanese game maker Sega. The game has proven its quality in both Japan and Taiwan markets. It was launched in the beginning of July, and was very well received according to following news & ratings.

• News on its official site on 7/5/2016: [220,000 preorders accomplished] 
• News on its official site on 7/8/2016:[Epic opening, Hortensia Saga got Apple AppStore’s featuring right after the launch]
•  iTunes ratings (full 5 stars) & numbers of ratings  (17,920 as of 10/19/2016) 
• I could not obtain stats on Andriod side, since Google Play is not available in mainland China. Andriod users there usually install apk directly or go through some third party app management software, thus no reliable consolidated stats exist. But I think it’s safe to assume a comparable user base, thus the total would be 2 times of iOS side numbers.

3) Strange price surge since late August. Not long after CYOU’s 2Q release on 8/1/2016, the stock starts to outperform significantly. Specifically, on 8/26 & 8/29, the price shot up 10% two trading days straight (20% in 2 days, vs. Nasdaq composite’s 0.25% in the same period)! And you would assume there must be some material information being released around that time, but I could not find any, in neither English nor Chinese, coincide with that time.

Then here goes my opinion. If I were trying to connect all the dots, one obvious inference is that these two mobile games seem to be well received and could be the next cash cow (assuming same user spending behavior as TLBB3D, warranted that there would be revenue split between Sega and Changyou on Hortensia Saga). If this type of licensing strategy proves to be working, they could scale up relatively easily (just by going after these big Japanese game makers who had tons of great IPs, using their pile of cash) and it could help turn around the company’s operation. Second thing is that I have no way to explain the surges, and could not help attributing it to the strong form of market efficiency (i.e. people with nonpublic material information are trading ahead of the market). I get it there could be market impact if some institutions are moving big positions, but 20% in 2 days is just too much, I mean no PM using public information can justify such a position, thinking it could generate further alpha after pushing the market by 20%. Last but not least, my thesis doesn’t rely on this point to be valid. I think other aspect of the company provided enough attractiveness, and I only see this point as a short term catalyst.

The bad – risks

– Concentrated revenue source, mainly from a single IP (hopefully not anymore soon), really no moat whatsoever. If they could not build or license other hot game IP like TLBB in short term, we would have to see the revenue and profit decreasing as the legacy TLBB game enters its final years of its life. Assuming the revenue deceases in a constant 20% rate and no changes on cost side, it will take a little more than a year to reach break even and start to burn cash. This is the thing (and probably the only thing) I dislike about this company — it’s not a good business. But any asset/business could be either a bargain or a bubble, simply based on price. When price is low enough, a “bad” business could still be a bargain. Plus, I guess this is what happens for a “turnaround” special situation by nature.

– Executive redirection/fail to execute the plan. So given tight timeline calculated in last point (although very conservative, since I assume no cost adjustment), it’s very crucial for the management to create and find more cash generating game IPs. From the recent conference calls and press releases, they seem to get the point and be on the right direction. Specifically they seem to recognize the mobile gaming trend in the new smart phone era with users’ behavior shifted toward fragmented pieces of time, and casual playing. The current CEO Dewen Chen seems to be a much less exposed guy than former CEO Tao Wang. My search didn’t find a lot of rumors or stories about him. Chen is a organically grown Sohu veteran and came up from sales, which are a good thing (at least for now) that he should be able to manage the pipeline expansion and will be loyal to the plan (presumably) orchestrated by the parent company Sohu.

– FX risk. Many people may overlook this one, but I think it is the largest risk in this idea. As the Chinese government tries to dilute its mountainous local currency dominated debt and stimulate exports, China RMB yuan will be on a steep depreciation channel in following years. More recently, after the RMB was officially included in the SDR on October 1st, CNY offshore market has seen 7 days straight depreciation, and 1% cumulative value loss since 10/7 (when China market reopened after the week long National Day holiday). The rate now hit a 6 years low and is expected to keep sliding. I wouldn’t be surprised if RMB depreciates 20% further in 1 to 2 years. All been said, the risk to this thesis is that, since all Changyou’s income are in RMB, the FX translation loss could potentially wipe out operation improvement. For this, I’m still need to think of some good way to hedge the FX risk.

Conclusion

Changyou.com is cheap because of poor management decisions in the past. The industry they operate in are still booming. All it needs to take is to have a capable management team to execute on the game developing and operating business and take advantage of the industry tailwind. My takeaway is that it’s possibly not going to be a value trap causing permanent capital loss and would worth a value investor’s consideration.