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In a world where a link directory can be valued at 2 billion USD going into the year 2012, the fraud allegations become a mere sprinkling on top of the cake. From a long-term perspective, Qihoo 360 (QIHU) is an unequivocal sell.

Background

Qihoo 360 Technology Company Limited (QIHU) is one of the Chinese stocks listed on the NYSE through ADRs, where 2 ADS correspond to 3 class A ordinary shares. The numbers in this article refer to the ADS.

The company has developed a suite of anti-virus software that they have given out for free to gain a large penetration among Chinese Internet users. The company also offers a sort of portal page where they monetize the traffic by selling links in their link directory. They also get revenue from search referral and further profit-sharing with developers whose games can be reached through Qihoo’s game page. They claim that over 300 million people use their free “Safe Browser”, and that the combined penetration of their products is 88% in China. However, it is important to note that many of these users do not produce any revenue for the company, as they are not required to pay for the products or use their sites.

Recently the short-seller Citron Research has been putting out reports meant to expose alleged frauds in the company’s accounting. Any investor should check out the Citron reports, while keeping in mind that they have a vested interest in destroying the reputation of the company, and also read Qihoo 360′s rebuttals to these claims.

While Citron’s stated target price for the share is 5$, a loss of over 75% from the time of publishing the first report, the market reaction has been more muted. The valuation has been down 20% at the most, and at the time of writing is basically the same as when the controversy started. But Citron has not backed down, instead providing more research and sharpening their tone.

Citron’s accusations

In the last round, Citron Research has taken their attacks up a level and called Qihoo 360 an outright fraud. The short-seller has leveled a series of criticisms, of varying degree of relevance. Prominently:

- They question the large amount of traffic Qihoo claims to be getting, pointing out that metrics tools like Alexa, Comscore, DoubleClick, and Chinese sites alike don’t rate the site very highly.
- To further highlight the questionability of the company’s projection of itself as a major player in the Chinese Internet space, reference is made to other big players on the Chinese Internet market, none of whom mention Qihoo as a threat.
- According to Citron, the massive growth in advertising revenue should be cast in doubt as other sites, although growing healthily, cannot come anywhere near the 26% quarterly revenue increase claimed by Qihoo.
- Citron criticizes that many of the paid links do not track the clicks, and make it impossible for customers to do analytics and know what they’re getting for their advertising yuan.
- An even stronger growth in gaming revenue is light-years beyond what competitors have accomplished, with 47% quarterly growth in players, each of whom produces 53 USD worth of revenue per month.

Although it hasn’t been at the focus of Citron’s charge, the last point is perhaps the most stunning. While one could theoretically conceive of a gaming site growing 47% from one quarter to the next, there would probably be some identifiable reason for it, such as one game in particular becoming a huge success. But the company doesn’t even bother to address this spectacular growth, as if it were perfectly ordinary, and the analysts (who are also lambasted by Citron Research) don’t bother to ask.

But as if that wasn’t enough, the revenue per player is otherworldly. At 53 USD per month, wan.360.cn is supposedly several times more profitable than webgaming giant World of Warcraft. A more appropriate point of comparison should be the hugely successful Zynga, who (according to Citron) collects an average revenue per paying customer of 1-4 USD.

Not to be remiss in our own research, How-to-invest-in-China.com has tried out the gaming site. While there is nothing wrong with their offering, there seems to be nothing on the site that would justify the notion of bringing in revenue per customer several times their competitors. Indeed, with thousands of similar pages out on the web by now, including countless Chinese ones, it’s hard to find any way in which this one distinguishes itself.

Qihoo’s response has been weak, claiming that their customers don’t care to track how much traffic they’re getting from their links! Their CFO has also suggested that the Chinese market is different and that people outside of China just don’t understand it. To quote a contributing analyst from CNBC, this statement is “preposterous”. Even if it were true, How-to-invest-in-China.com is specifically intended for foreigners, hence the message to the readership here must be to stay away from this stock – management itself says so! And why did the company pursue a listing in the US in the first place, forcing them to deal with these hopeless foreigners?

Who’s keeping track?

The auditing of Qihoo 360 is done by the Chinese arm of the global accounting form Deloitte Touche Tohmatsu. While a “Big 4″ agency is generally assumed to be reliable, the auditors at Deloitte have been repeatedly embarrassed by revelations of fraud at some of the Chinese companies they have audited.

Qihoo’s business model

What’s disturbing about the Qih00 vs. Citron battle is that the fraud accusations, which are hard to prove, risk overshadowing that which nobody can deny, namely that the underlying business model is untenable. It is based on paid links in a directory, a model that has been tried and failed before.

Even under the best of circumstances, you can only fit so many links on a page. The idea then is that the traffic will continue to grow and that the company will be able to charge more and more for their links. This flies in the face of previous experience from the US, where the link directories have failed. Simple reason: people don’t use them.

We believe that an Internet population with growing Internet savvy will follow the pattern of developed online markets and move away from curated hub content and find what they’re looking for through search engines. This is good news for Baidu, but not for Qihoo. We foresee long-term dwindling traffic to sites like hao.360.cn in spite of rapidly growing traffic overall.

China’s Internet market

How-to-invest-in-China.com is generally highly sceptical of the Chinese Internet market, which seems to prove that the financial world came away from the dotcom bubble and learned exactly nothing. Although there are a few exceptions, Chinese Internet stocks generally follow a pattern familiar to those who were around at the turn of the century – inflated valuations based on dream scenarios, for companies that in reality produce losses year after year. Yet once again, “this time it’s different”. China is apparently not like other countries, as Qihoo CFO Xu Zuoli would tell us.

We believe the opposite: that history will repeat itself and the Chinese Internet space will see a shakeout similar to what took place in the US, where a few brilliant companies become massive winners, like Google and Amazon before them, while many others will fail completely. We see no reason whatsoever why Qihoo 360 and their 1990s website would be in the former category.

However, the dotcom bubble also showed us that reality can be suspended for years. If history were to prove itself even more repetitive, it’s absolutely possible that failed companies can reach even more ludicrous valuations before coming down. This makes us very wary of short positions, especially if Citron Research’s attacks continue to fail to really stick.

Valuation

We have no doubt that a link directory in the year 2012 is doomed as a basis for a multi-billion dollar business. Speculations about the possibility that the company might move into other parts of the Internet space are not worth much as long as they remain mere speculations. In the coming years, we project that the Chinese Internet users will follow in the footsteps of their Western brethren and move away from link directories, and that hao.360.cn will see declining traffic in spite of the growth in Internet users. On the other hand, as long as the web browser is given out for free it will, by definition, produce zero revenue.

Of course, Qihoo 360 might still be able to squeeze some profits out of the site before its demise, and they might be able to leverage the broad penetration of their software into some new monetization stream. Even though there are points in Qihoo’s reports that seem literally unbelievable, we do not seek the legal liability of calling the company a fraud. Instead, we will take the company at their word and assume their accounting to be 100% correct.

Based on all this, let us afford Qihoo 360 a reasonable P/E multiple of 12. Furthermore, we will sidestep their poor YTD results and base our valuation only on the good results of the last quarter. Finally, we add their entire cash balance.

This gives a total value of 842.4 million, equivalent to 6.95 USD per American Depositary Share. This is higher than the 5 USD target price stated by Citron Research, but still takes NO ACCOUNT of the accusations of foul play. To be clear, if any substance comes out of Citron’s accusations, the valuation will be even lower.

At the time of writing, the share price stands at 19.31 USD. Hence our 6.95 price target implies a 64% downside from the current valuation. We feel it is only a matter of time before the market adjusts itself to reality, but how much time is impossible to tell.

Even if the reporting of Qihoo 360 (QIHU) is completely truthful (and that’s a big “if”), their whole business model is predicated on the Internet of yesteryear. While there is no accounting for what follies Mr Market may produce in the near term, How-to-invest-in-China.com is utterly convinced that QIHU will prove to be a disaster over time and issues a STRONG SELL recommendation.

Disclosure: The author does not hold any position in QIHU.