RedTech Advisors Rebuts Citron Research Report on Qihoo 360

Research Note
Sector: Software
November 2, 2011

Qihoo: Citron’s Hit & Miss
Short-report Writer Expels A Lot Of Ink But No Smoking Gun
Companies in note
Qihoo, Baidu, Netqin

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 Lots of recycled
Internet imploded in April/May. As a small cap stock, it’s no questions but no
wonder that MOBI dropped more than its China Net peers. It conclusions based on
plummeted 75% over six months, but SNS site RenRen evidence or fieldwork.
dropped 65% and so did online video site Youku. Even Sina
dropped 40%. (See Fig 1 on next page).

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.

michael.clendenin@redtechadvisors.com www.redtechadvisors.com
Page 1 of 7 © RedTech Advisors (China) Ltd., 2011. All rights reserved

Figure 1
Peers Performance

Source: Google.

 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.

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.


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.
Figure 2

Browser Market By Usage

Safari, 1.25% Maxthon,
Firefox, 1.00%
C hrome, 2.00% Others, 1%
2.25%
Tencet TT,
3%
Sogou
Browser, 5%

Internet
Explorer,
50.00%
Qihoo 360
Safe
Browser,
35%

Source: CNNIC, RedTech estimates

 Citron On … Qihoo Revenue From Google
More than 21% of QIHU's revenues are derived from Google,
primarily by referring search queries.

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.

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.)

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.


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.”

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.


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.

Citron says it has a part two, which we’ll eagerly await.


RedTech Advisors (China) Ltd.

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China

Tel: +86 21 6248 3973

Last edited: 02 November 2011
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RedTech Advisors Rebuts Citron Research Report on Qihoo 360

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RedTech Advisors Rebuts Citron Research Report on Qihoo 360