Chinese Internet Pair Trade? Mizuho Upgrades Sohu, Downgrades Youku

In a report published Monday, Mizuho Securities analyst Jin Yoon changed the ratings of two Chinese Internet companies - Sohu.com Inc SOHU and Youku Tudou Inc (ADR) YOKU, citing a trend to privatize US-listed Chinese ADRs.

So far in 2015, 17 Chinese ADRs in the internet and media sectors have announced privatization proposals. This has been triggered by the aim of seeking better valuation in China, against the backdrop of a favourable regulatory environment.

In the report Mizuho Securities noted, “Most of the companies privatized thus far have similar characteristics – ie, are small-to-mid-caps with low liquidity and low valuation multiples in relatively unattractive verticals where competition may be rampant, entry barriers are low or distant players in a growing market. Based on this criteria, we looked at two companies we cover – Sohu and Youku – and provide reasons we believe they could be possible privatization candidates.”

Analyst Jin Yoon upgraded the rating on Sohu.com from Neutral to Buy, while raising the price objective from $46 to $70. A robust balance sheet provides a floor to Sohu.com’s valuations, which makes it an attractive privations candidate.

Yoon cited two reasons for liking Sohu.com:

1. The company’s buildings appear “undervalued.” At a market cap of $2.3b, the liquidation value of its stake in cash and real estate is estimated as high as $1.46b, or 63 percent of total market cap
2. Using a SOTP method, the market cap is trading at a 17 percent discount to equity value, which indicates a privatization price premium of 17 percent to its valuation

Mizuho Securities downgraded the rating on Youku from Neutral to Underperform, while maintaining the price objective at $18. The company does not seem to be an attractive candidate for privatization nor does it seem to be a takeout target, given its “asset-light nature and loss-making operations.”

“In addition, if investors consider the USD30.5b price at which Alibaba invested in Youku one year ago as the benchmark price, without a privatization or takeout offer, we believe there is significant downside risk to the stock,” Yoon added.