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Article / 09 September 2015 at 0:17 GMT

Qihoo hangs up on smartphone joint venture

China Watcher / Shanghai
China
  • Qihoo is not pursuing its joint venture with smartphone manufacturer Coolpad
  • Coolpad will have to buy Qihoo's share, at a likely price of $742.5 million
  • The reason for the move is unclear considering three phones were just launched
  • One reason may be the issues surrounding Qihoo's ongoing privatisation bid 

By Neil Flynn

Qihoo announced on Monday evening that it was exercising a put option that would force domestic smartphone manufacturer Coolpad to purchase its share of the joint venture Qiku, which was only established at the end of last year. 

Coolpad will likely pay $742.5 million for Qihoo’s 49.5% stake. The announcement caught most investors off guard, mainly because the logic behind the decision is unclear. The joint venture has only recently released three new smartphones, and Qihoo's management has been bullish about the outlook for the business.

l;l;l
 Qihoo's announcement not to pursue its smartphone joint venture
with Coolpad caught investors by surprise. Photo: iStock

When the joint venture was originally announced in December, I was positive on the deal. Coolpad has a strong standing in China's domestic smartphone industry and Qihoo has a strong technological and software background, meaning that a combination of the two could produce a top smartphone for the budget and mid-range markets. 

In addition, the key strategy for China's technology firms last year was to develop a mobile ecosystem, which is the concept of a firm offering a whole range of apps and services so that consumers wouldn't need to use those of another firm. 

The key purpose of this is data collection. The more that a firm can understand about each individual user, and its user base as a whole, the more it can grow its advertising revenues through more tailored monetisation of user data. The smartphone joint venture has seen Qihoo preload its mobile ecosystem onto the Coolpad Dazen smartphone range, meaning that purchasers would automatically enter into Qihoo's mobile ecosystem.

The problems regarding the dissolution of the joint venture appear to stem from two causes: the ongoing privatisation bid and the investment in Coolpad by rival firm LeTV.

Mismanaged privatisation bid

I've been particularly vocal on Qihoo's privatisation bid, because for something that was in the best interests of all parties, it has been poorly managed and has ended up as a farce. Wall Street has perpetually undervalued the firm, despite a very impressive record of consistently strong revenues and earnings ever since its 2011 IPO. 

The undervaluation is not particularly anybody’s fault. Investors tend to attach a Western equivalent to Chinese companies in order to understand them better, hence why Baidu is known as ‘China’s Google’ and Alibaba is known as ‘China’s Amazon’. Of course, such labels are far too basic, and actually do an injustice to these Chinese firms, but the point is that Western investors tend not to understand what most Chinese firms actually do because their business models are almost completely focused on China

In Qihoo’s case, it isn’t the industry leader in search, and so it’s difficult for investors outside China to actually understand what it does, hence why it’s perpetually undervalued.  

At the time of the privatisation bid announcement, the offer price valued Qihoo at $10 billion, and was at a 16.6% premium to the previous close price of its shares, which was reasonable given the average premiums of other privatisation bids from Chinese firms. 

Likewise, it was apparent that the firm intended to delist from the US and relist in China, where, at the time of the announcement, it was estimated that Qihoo’s market value in Shanghai would be $60bn. Given the six-fold increase, it seemed well within management’s interests to go ahead with the deal.  However, as Chinese equities began to fall, doubts grew about Qihoo’s bid, yet prior to the earnings release, there had only been one public comment from management, with a senior executive confirming that the firm intends to go ahead with the outstanding bid.

Prior to the second-quarter earnings release, I stated that management needed to communicate to investors about its intentions regarding the bid, given that it had looked more and more likely that it wouldn’t go ahead. However, in the earnings release, management stated that it is still in review, and declined to hold an earnings conference call, which in my view was simply to avoid questions about the bid.

The problem is that investors simply don’t know what is happening at Qihoo. Despite management’s bullish commentary on the smartphone joint venture in the earnings statement of September 1, they exercised an option to sell it a week later.

Rivalry with LeTV

Online video firm LeTV acquired a stake in Coolpad earlier in the year, which riled Qihoo’s management. The issue is that LeTV is actively developing its own smartphone business and so the investment in a domestic smartphone manufacturer is a standard strategy. 

However, due to Coolpad’s involvement in the joint venture with Qihoo, where Qihoo would be sharing its proprietary technology for the Dazen brand smartphone, there is the clear risk that LeTV would directly or indirectly benefit from Qihoo. 

This doesn’t necessarily mean that LeTV would take technology from the Dazen brand smartphone and use it in their own products, but it’s more likely that Qihoo’s technology would influence Coolpad’s R&D, and LeTV would hence benefit from that. Given that the firms (and CEOs) are rivals, this was a situation that was never going to last.

Earlier in the year, I stated that the likely outcome would be that either Qihoo would leave the joint venture or would buy out LeTV’s stake in Coolpad (likely at a large premium). Although this prediction has been realised, the timing of it makes very little sense as the smartphones have just been released.

Amidst the confusion, there is one thing that investors can take away: the $77 per share privatisation is now surely off the table. The value of the joint venture contributed to the original value of the company, and with the cash that the firm receives, it decreases the enterprise value of the company. 

It could be assumed that the firm is trying to raise capital for the eventual privatisation of the firm, but the sale of the joint venture is the final nail in the coffin for the $77 per share valuation.

– Edited by Gayle Bryant

Neil Flynn is a China watcher based in Shanghai. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform. 
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