In writing this column for over 10 years, Citron has learned that any time a “fraud” has an opportunity to explain their business, it is a good thing for a short position.  Yesterday’s conference call was no different, as now the company has stated positions that they cannot take back.

   In the Company's Own Words

Yesterday, in a hastily called phone conference to respond to Citron's last posting, CFO Alex Xu fielded questions in an attempt to quell fears of shareholders and concerns of analysts.  Judge for yourself.  Below are some the highlights of the call in the words of Mr. Xu as he attempted to justify the number advertisers and their claimed rates on their homepage ( hao.360.cn)  Here he explains why so many of the links on Qihoo's home page do not contain tracking links.

Alex Xu statement #1:

Non transaction customers do not need to see the tracking patterns.

Citron Response:

Any customer of Qihoo is presumably buying web traffic, period.  Why would a non-transaction customer buy a link anyway?  Any company seeking branding buys banner or dynamic ads.  As Qihoo stated in their Q2 conference call:

“We are the best at really in Chinese Internet market in terms of advertising results for those e-commerce companies and because we don't do any branding ads or anything like that…”

So he is claiming that his customers are buying links because the generated traffic is so great, but have no interest in knowing where the traffic comes from?

Alex Xu statement #2:

In China users who scroll over a URL with their mouse and become suspicious of a long link and may decide not to click. So some customers decide not to put it up (eg not to click).  (We swear he said this)

Citron Response:

Every website throughout the world tracks ads and paid links with tracking id's in the links …..duh.  Do you know something Google, Yahoo,  Sina, Sohu, and Baidu don’t know?  Not to mention the tracking id can add as few as 7 or 8 characters (several examples of which are on Qihoo's own site) and Qihoo's user is the most novice of all internet users.

Alex Xu statement #3:

Companies don’t put tracking id into their URL’s in order to enhance the user experience.

Citron Response: 

Does this gentleman, the CFO of a company claiming to be China's 3^rd largest internet firm, know how the internet works?  Having a URL with 8 more characters does NOTHING to the “user experience.”  I cannot believe Citron actually had to respond to that statement.

Alex Xu statement #4:

There is confusion in the marketplace because we run such a differentiated business model — either in China or globally.

Citron Response: 

To the contrary, Qihoo's might be the most undifferentiated business model on the internet.   As Citron has shown in previous reports there are literally hundreds if not thousands of web directories in China.  If you just type HAO360.cn or HAO360.com (instead of HAO.360) you will see two examples of hundreds (more than a dozen of which we published URL's for in our prior report) of directories not belonging to Qihoo.  As for globally, there used to be many companies in the US with this business model…..until they all went out of business.

Alex Xu statement #5:

Customers with 2 links pay for both links and Citron only gave them credit for one link. 

Citron Response: 

We are supposed to believe that customers are paying double the rate to have two of the same links on the same exact page….really?  Or triple the rate for 3 links?  Hmmm…..

Alex Xu statement #6:

Qihu 360 has largest and most sticky internet sites in China.

Citron Response: 

How…why?  Qihoo has zero unique content.  Why would your sites be sticky?  In our opinion, just more internet jargon.

   More Qihoo Lies

On the last conference call we are told that their hao.360 website is now more popular than Baidu’s hao123.  The exact quote was:

 “regarding the question on market share. First of all, compared to hao123, both from our internal data as well as from third party data, we already surpassed hao123 in terms of UV as well as the clicks." 

Citron has the Comscore ratings on both sites. 

Comscore compares hao.360 and hao123

For those of you unaware, Comscore is the gold standard of internet ratings.  Its Media Metrix product generates the metrics  upon which all major brand internet advertising globally is priced from… including China.

http://www.comscore.com/Products_Services/Product_Index/Media_Metrix_Suite/Media_Metrix_Core_Reports

From this we see that as of October 2011, Baidu's hao123 directory site is generating 300% — 400% the traffic and reach of Qihoo's.  And for those who say that is not a fair measure, just read Comscore’s methodology from their site where they explain:

“comScore’s UDM is unique to the industry and provides a superior solution by overcoming common methodological shortcomings, such as the inability to measure the actual person not just machine, over- or under-counting usage based on cookie deletion habits and misrepresentation based on a multiple usage devices or the same person using multiple browsers.”

http://www.comscore.com/About_comScore/Methodology

So let's get this straight.  We are supposed to believe that companies call Qihoo directly and give them $50,000 USD a month on average (and in many cases multiples of that for multiple links) , all of such customers dealing direct — without an agency,  and without tracking identification?  And furthermore, these customers are accepting ad rate cost increases of 25% each quarter because of a blind auction, again without any verification? … Really?

   "Trust, but Verify" — Ronald Reagan

Someone has to teach the Qihu CFO how to lie better.  Much of the call was that whether it be the traffic or the auction model, QIHU advertisers do not require any verification from the company because they trust them.

That would make QIHU the largest and the only internet company in the world based on trust rather than analytics.

In the real world, the internet is based on analytics.  Unlike advertising on an outdoor billboard, what makes internet advertising so effective for the advertiser is you can actually see what people click on and how to make more effective ad spends.  Google does not provide analytics because people do not trust them, they provide it because THAT IS HOW BUSINESS IS CONDUCTED, ANALYZED, AND EVALUATED IN THE DIGITAL WORLD.

The analysts on this name have it wrong.  They can stand by it just like the many analysts did on Longtop Financial.  We can start highlighting commentaries in the analysts reports, but it is nothing more than a sideshow.  Furthermore, even though Qihoo's gaming revenue reflects ARPU's way out of comparables of their competition, we will make the point on another day.  To stay focused, we are just discussing the largest part of Qihoo's revenue which is the HAO.360 website directory and the advertising revenue it generates.

For those of you who keep saying that Citron does not understand because we live in the United States and not China we offer this link.  Two weeks ago QIHU CFO Alex Xu was on CNBC Asia with Bernie Lo.  After hearing his pitch and apparently being unaware of Qihoo's  market cap, Bernie Lo makes the comment:

“You're not going to be a SOHU — they have way too long of a lead time and diversification in their business that makes you a minnow in their ocean”

http://video.cnbc.com/gallery/?video=3000057575

What Mr. Lo didn’t realize is that even though Qihoo is the minnow, Qihoo's enterprise market cap is already 70% larger than SOHU!  Ridiculous is not the word here. 

If Qihoo had the same market cap as SOHU, the stock would be 11. 

If it traded at the same multiple to revenue, it would be at $4. 

And if it is a fraud, it will trade at 0….you choose your poison.

BTW…we just have to mention that QIHU CFO Alex Xu used to be the CFO of China Finance Online (Nasdaq: JRJC) – a Chinese stock picking and touting site.  When Citron wrote about the company in 2007 as it was trading $30 a share….and today it is $1.85.

For those of you who believe 25% qtr over qtr ad revenue growth (eg 144% year-over-year) is not only credible but sustainable, SINA ad revenue has gone up just 26% year over year, despite owning the hottest web property on the China internet, which is Weibo.   And their ad revenue guidance for 2012 is "cautious".

   Conclusion:

This is fraud plain and simple.   Every component of Qihoo's parabolic revenue growth story is based on company assertions that can't be verified in the public domain, do not align to comparisons with industry competitors, and defy common sense.

When you find such a company in the US or China, especially one with a market capitalization over 2 billion dollars, watch out. 

Cautious Investing to All.

Note to Readers:  The intent of this research is not to cause short term volatility in the trading of the stock.  Citron believes the following research is worthy to be placed in the public domain so all investors can make investment decisions based on reading and considering carefully all available information.

Citron has developed a tremendous volume of forensic research on Qihoo 360 (Nasdaq:QIHU), and has concluded that the company has either not been forthright about their revenue model to Wall St., or there is a financial fraud unfolding.

Citron has received numerous comments on its previous writings on Qihoo, mostly to the effect that "Citron doesn't understand. " "Citron doesn't understand China", "Citron doesn't understand the internet" …"Citron doesn't understand the future", etc.

One thing Citron does understand is math.  Math is universal:
1 + 1 = 2, in the US, Antarctica, Mars, and yes, China.  And Qihu's numbers don't even come close to adding up … in any universe.

   Can Qihoo's Topline Revenue Withstand any Analytical Scrutiny?

QIHU reported 47.5 million USD in topline revenues and guides next quarter to 55 million USD.  What do we know about these revenues?

The company states that 75% of its advertising revenue is generated on its homepage hao.360.cn.  It further states that appx $4 million was generated from referring search to Google.  

Qihoo Revenue Analysis for its Most Recent Quarter 

   $20.9 million and the missing number

What we know:  Homepage advertising link revenue is the largest component of Qihoo's revenue.  The Company sells links on this page on a fixed fee per month basis.  The company states that the fees vary based on the customer's business type.  Yet it was extremely challenging to find the single most important metric :  The average advertising revenue per paid link.

We read everytning we could find on Qihu, to no avail.  But finally, in a single analyst report by Macquarie (the only one that seems to reflect any detailed knowledge of the company's actual business model)  we read:

“The average advertising price for a link on Hao.360.cn’s front page is RMB 200-250 K per month.”

This was published on August 29th, and notes it was after "the company raised its ad prices by 20% – 25% sequentially in Q1 2011".  Of course an average is an average — some links will be be priced higher, and others lower.  To make the math easy we will run the estimates on $225,000 RMB per month, a little more than $100,000 USD per paid advertiser per quarter. 

It is easy to see what sites are paid because they have tracking URL's attached to them; thereby the advertiser can judge the effectiveness of the campaign.  Links such as Hotmail, Vogue, CNTV sports, are displayed, as in all the Chinese directory home pages, for free, for user convenience.  Citron has made a heat map so investors can see how many links on the HAO.360.CN page are tracked, untracked, or lead to another 360 company page.  Here is the current hao.360.cn homepage, which generates for 75% of Qihoo's ad revenue. 

GREEN:  Tracked Link to a 3^rd party website.
RED:  Link to another 360.cn or qihoo.com page – a Qihoo company page
YELLOW:  Untracked link, presumed free.

With this key, lets look again at QIHU's homepage again:

There are appx 92 green links on this page; however many are duplicates and dispatch clicks to the same domain.  Eliminating links to Google (paid separately) and Baidu, there remain appx 60 – 65 links with tracking IDs to the websites of 3^rd party entities.  (There are appx 9 links to Taobao.com, which Qihoo claims is now appx 10% of Qihoo's revenue; presumably these are at the high end of the scale of revenue per link.)

This is what we assume are the paid links.  UBS verifies this by publishing a list of Qihoo's paid links in its Nov 17^th note, totaling about 65.  UBS includes several untracked links in their list, but for now let's not quibble about details.  UBS's list very closely matches the spreadsheet we compiled with all the links from the hao.360.cn homepage here:

List of Tracked and Untracked Links on hao.360.cn homepage

An interview with competitor 2345.com confirmed that around 60 links on their homepage are sold and they believe the same to be with their competition.

This is a very similar pattern to Baidu's directory page hao123.com:

So now we try to construct a picture of Qihu's homepage revenue:

Exactly where is the $20 million in advertising revenue from the home page, or anything even close to it??

We expect the company will now claim that many of the non-tracked links are paid.  This would be very challenging to believe, as anyone paying real money for a link would want to track the traffic generated.  And we would need an additional 130 paid advertisers on the home page.  WHO ARE THEY?  (We wanted to ask this pivotal question on the conference call but the company would only take questions from their “cheerleading” analysts.)

Or calculating in the reverse direction:

Neither the company nor any of its analysts, nor any of the numerous mainline ad agencies in China nor any of Qihoo's competitors have have EVER quoted an advertising rate for a web traffic link in China within an order of magnitude of this astronomical number. 

   And now the 7 million in ad revenue that doesn't come from the homepage

Now we try to construct a picture of Qihu's non-homepage and non-game revenue (the other 25% of advertising revenue ):   Citron was able to procure a contract for a non-home page link.  We were quoted a rate of $20,000 RMB per month, which seemed reasonably within expectations, as rates fall off rapidly because traffic is much lower by any measure on pages only linked from the home page.  

Who are these customers???  Citron has searched all pages on 360.cn and QIHOO.com and cannot come anywhere close to a number approaching 700.  Some of the 360.cn linked pages have only one customer…or none.

    But the "Games" Do Not Stop There!

Qihoo runs a game directory page, which is extremely similar in appearance to those run by many major competitors, for example Sohu and RenRen: 

RenRen  http://wan.renren.com/  

Sogou: http://wan.sogou.com/

Qihoo:  http://wan.360.cn/

What isn't similar is the astonishing revenue per customer Qihoo claims in their last quarterly report.

"Within IVAS, web games revenue were $9.7 million, up 187% from same period last year and 47% from the prior quarter. The strong performance was driven by a large user base on our web game platform."

"At the end of the second quarter, we have about 62,000 paid game players. At the end of the third quarter, we have about 87,000 paid game users."

These revenue numbers are simply absurd.   Nobody in the games business, in China or the US or anywhere, generates $53.00 per month per paying customer – not NTES, not CYOU and not SNDA.  Other Chinese games vendors report ARPU's appx $3 to $8 per month USD.  Zynga generates about $1.00 to $4.00 per month per paying customer, depending on which number you compute.  Even the "gold standard" Blizzard International, whose World of Warcraft is in a league of its own for online gaming, charges US and European gamers, who typically pay far more than Chinese gamers, $15/month for subscription.

And nobody in China is growing games revenues at 47% quarter over quarter.  For comparison, RenRen, one of the hottest properties on the internet, grew games revenue at 26.3% year over year, and Shanda, one of China's largest game companies, increased revenue just 3.7% quarter over quarter. 

Like the advertising revenue numbers, these numbers are simply not believable either.  Yet the analysts simply nod and offer the perfunctory "great quarter, guys!"

Citron has no idea how the company will even attempt to explain this glaringly unbelieveable revenue per player number.  Too bad not one analyst on the call even asked about it!

Why does Qihoo make it impossible to verify their web traffic claims?

Citron has presented a compelling case as to why the current business of QIHU can be questioned.  Yet, the multiples afforded to the stock by analysts are obviously not based on their current business but rather their future business, which is all predicated on the web traffic generated from their homepage — both in its generic and "personalized" forms. 

Even though the analysts don't agree on how Qihoo will generate money in the future, the one thing they all agree on is that its current revenue depends solely on internet traffic generated through its website.  Therefore the company should be taking extra steps to clarify and make transparent 3rd party verification of the reach, penetration, and page views they claim. But instead, the company does the opposite.

Citron first challenged Qihoo's hao.360.cn homepage traffic claims because the industry standard measurements of internet traffic – including Alexa, Google, CNZZ,  and Comscore — all report ranges of lower penetration, reach and traffic rankings than the company's paid-for statistics from iResearch.  The company's defense was that "Citron doesn't understand" the internet –  because the company's anti-virus software prevents all analytic tools from being installed on a users computer.

All tools except of course those from iResearch and their 200,000 sample size.

Wait a minute!  What kind of excuse is this?  How is it that Qihoo's software coexists with iResearch's monitoring tool, but can't coexist with Alexa?   Does anyone seriously consider Alexa's voluntarily installed toolbar to be malware?  Like all anti-virus software, Qihoo's anti-virus updates the desktop without user intervention, so the company could easily change its software to make it Alexa compatible any time it wanted.  The fact that the company actively prevents any independent verification of web traffic metrics remains a huge red flag for this company.  This is not Citron's issue, it is Qihoo's issue.  In the real world, this limitation would impose a huge obstacle for a coompany trying to sell web advertising.

This should make any interested investor question the depth of the relationship between iResearch and Qihoo. 

   What business is Qihoo in?….a terminal one.

Each of the analysts covering Qihoo seems to present a different idea of what business Qihoo is in and where the company is headed.  One says its "mobile" (which won't be monetized before 2014), one says it's "search" as though they operate in a fantasy world where they could turn on a switch and compete with Baidu.  Another says it's going to operate an app-store with an interface copied from iPhone.  The only thing these three strategies have in common is that all of them currently generate zero revenue for Qihoo.

Citron will not address search, mobile, or desktop platform because the company has generated no revenues nor presented any notable proprietary technology.  The analysts involved in the name do not even have a cohesive story as to where this company will be in 3 years — every analyst describes the company's future differently. 

The truth is Qihoo's revenues come nearly 100% from what can only be called "Web Directory Services".  They devised a clever low-cost strategy to give away anti-virus software as an indirect method to entice internet users to their home page.  But they generate no revenue from the anti-virus software, and no revenue from their browser. 

But this model — "get in front of the eyeballs"  — is hardly new.  We can observe the same in the early days of the internet in the US, where the gold rush was on for eyeballs and clicks, and of course Wall Street's dollars. 

AltaVista, Lycos, Excite, anyone?  Does anyone even remember these web directory businesses? 

http://web.archive.org/web/19990125093146/http://www.altavista.com/ http://web.archive.org/web/19990224192939/http://www.infospace.com/ http://web.archive.org/web/19980212232333/http://www06.excite.com/

Billions of investors' dollars went into them, all of which was vaporized.  Why?

Because they provided neither durable content nor services, they quickly ebbed into the background.  They were mostly a short-run and shallow land rush to "get in front" of the user's internet experience.  Look at what happened to the US Web Directories — they are a virtual internet graveyard.  Even Qihoo's biggest cheerleader Mirae says:

“Our assumption is that PSP will run out of momentum by the end of 2012.” 

So where does that leave Qihoo?

   Analyst Malpractice

Citron has commented on the incredibly shoddy analyst work on this stock, but in our opinion, the work of Mirae goes even farther, to professional malpractice.   For a firm that writes glossies on QIHU nearly every week, we find the most disturbing pattern of promotional claims without foundation that we have ever seen from an investment banking firm. 

Mirae will probably want to comment on this piece as well, so we thought we'd offer them some topics to address.   Mirae has raised its 2013 topline revenue estimates for Qihu twice just in November. 

This topline number which includes no breakdown or financial basis looks like this:

The Mirae analyst's work reveals the following gross deficiencies:

• Provides no breakdown or foundation of the prediction of massive revenue gains for Qihoo in 2012 or 2013.
• Completely ignores the red flag inconsistencies in Qihoo's current reported revenue, the lack of transparency in how the revenue is generated, the gross discrepancies in Qihoo's claims of reach and penetration vs industry standard metrics from Comscore, Alexa, Doubleclick and CNZZ, and ignores the crazy ARPU in Qihoo's games revenue
• Completely ignores that China e-commerce was grossly disappointing in 2011; investments have collapsed due to gross revenue shortfalls, massive losses, lack of fulfillment infrastructure, low demand of Chinese consumers wary of poorly made counterfeit products that they feel the need to inspect before buying, and other obstacles.  See the charts of DANG and MCOX – both down 80% year to date. 
• Displays a clear and fundamental misunderstanding of Qihoo's business.    Unfathomably, in the November conference call, despite management having made perfectly clear that their revenue is derived from selling links on its homepage on a negotiated fixed-fee-per-month basis, Ms. Nancy Yang, Mirae's internet / media analyst, asks:

"Firstly, can you help us get a sense how much of your fourth quarter revenue guidance will come from growth in users and growth in per click per user? It seems that growth in per click per user is much faster than growth in monthly active users, should we expect this trend to continue? "   (She got her answer in Chinese)

Instead of analysis, Mirae publishes screen shots of a mockup of a yet-unreleased Google product and claim that because Qihoo has hired an unidentified former senior Google employee, that Qihoo will be able to monetize this unreleased technology in 2012.   Note that the product sketch simply clutters up the user's screen with more ads – exactly the opposite strategy of Qihoo's homepage.  The mockup's main feature is a product price comparison, which would itself be an anathema to Qihoo's main e-commerce advertising customers.

Don't believe us?  Have a look here:  Mirae Nov 15th

The US Securities and Exchange Commission has a long history of regulatory enforcement actions against analysts and other 3^rd party enablers of stock promotion who issue "baseless or unfounded revenue projections".  Literally dozens of regulatory links against firms and individuals for this practice have been filed over the years.  Here are just a few examples:

http://www.sec.gov/litigation/litreleases/2008/lr20644.htm

http://www.sec.gov/litigation/complaints/comp17674.htm

http://www.sec.gov/litigation/complaints/2007/comp20375.pdf

http://www.sec.gov/litigation/litreleases/lr16456.htm

http://www.sec.gov/litigation/litreleases/lr17050.htm

http://www.sec.gov/litigation/litreleases/2010/lr21565.htm

http://www.sec.gov/litigation/complaints/complr17300.htm

http://www.sec.gov/litigation/litreleases/2009/lr20940.htm

http://www.sec.gov/litigation/litreleases/lr16924.htm

http://www.sec.gov/litigation/complaints/comp18652.htm

Citron believes Mirae Research is publishing thinly disguised reports on Qihoo that are in fact promotional materials masquerading behind the appearance of "analyst coverage", and is worthy of immediate SEC enforcement scrutiny for stock promotion activities.

   Conclusion

Based on the data presented above, and the interviews we conducted to gather it, it is Citron's belief that Qihoo's current web directory business is generating far less in revenue than the company is reporting. 

Its presence in China's web market is, by the company's own choice, opaque to third party metrics.  Its advertising links are sold only by a small sales staff, not any of China's many agencies that would represent major advertisers.  There is no pricing transparency.   There is no media kit, typical of major online advertising providers.  We are told that their rates are soaring, but e-commerce revenue and investment in China is currently being crushed due to brutal price competition and logistics pressures.  We are told there is an "auction process" driving ad rates higher, but there is no auction functionality.  In short, nothing about Qihoo's main line of revenue is independently verifiable.  That was a common problem among several dozen US-traded China stocks halted and delisted in the last year. 

But even if Qihoo's revenues were reported accurate to the penny, the company is still overvalued by a factor of 4 or 5 x. 

Analyst claims that Qihoo could be in search, or could be in mobile, or could be a leading app store, are patently ridiculous.  Qihoo has no more claims on those highly competitive spaces than Citron.  It is pure fiction.  Qihoo is no more likely to be able to compete with Baidu in search than Microsoft's money-losing attempt to compete with Google. 

What Qihoo does have is a web directory, which competes with other web directories for advertising dollars.  The company's topline would have to double and double again just to grow into its current valuation.

You could say that the last standing monetizable "directory" in the US is Yahoo.  Of course Yahoo offers a lot more than a menu to web services, it has tons more content than Qihoo.  But even so, when you strip out its other equity positions, the multiple afforded by the market for its advertising revenue is about 1:1.  For Qihoo, we're talking 14:1 or higher (even if you believe their highly questionable numbers).

If Qihoo makes sufficient metrics available to allow independent verification of its claimed web penetration and reach, and if Qihoo were to provide transparency to its advertising revenue sources so that a credible revenue model could be built, Citron would generously afford a 2:1 multiple on its current revenue run rate to the company.  This plus the company's cash yields a price target of appx $5.00 per ADR.

Cautious Investing to All.

Note to all readers :  This report is not to be misunderstood as Citron holding any antipathy toward China or China investments.  Citron believes the China investing space (especially China-domiciled companies trading in US markets) are subject to extreme risks due to the absence of independent 3rd party verification and regulatory remedies for corporate misbehavior at all levels.  This condition is similar to the US market before the Securities Acts of 1933 and 1934, which set the standard for investor protection that underpins the US equity market.  There will be successes and failures in this space, and as the market matures, the worst ones will tend to be washed out. 

Disclaimer:  As of the date of publication, the editor of this report is short QIHU for the reasons stated above, and long SINA and SOHU.

Our intended part 2 on QIHU was planned to focus on the naïve analyst commentary and the dubious history of management.  But all that has become a sideshow to what our research found, so hold on to your seat and call your class action attorney.

While Qihoo does in fact have penetration in the free anti-virus software business — that we do not question — the rest of the business seems to be nothing more than an illusion that defies validation by any third party source.  Either Qihoo has some magic pill that neither Citron nor the major players in the China internet space knows about, or this is a FRAUD.

There are a number of chilling parallels to CCME in QIHU's current business model.   Citron suggests that investors and analysts — especially those who are quick to proclaim "Citron doesn't get it" — read this report with an open mind.

   Foundation

The main criticism of the initial Citron report was that we did not understand  Qihoo's business model and therefore we could not draw a comparative valuation to any other business.  The analysts describe Qihoo as a "master aggregator".  We get that.  They say they generate a lot of web traffic. 

Giving away free software is not a business…lets call that a hobby.  A business generates revenue.  If you don’t believe us, just read QIHU's prospectus:

"In 2008 and 2009, we generated a substantial portion of our revenues from sales of third-party anti-virus software. In the second half of 2009, we started offering 360 Anti-Virus to users free of charge as we adopted the business model of offering free Internet and mobile security products to build up a large and loyal user base and generating revenues through providing Internet services, including online advertising and Internet value-added services."

So advertising is how they generate their revenues, and that is consistent with their revenue mix disclosure last quarter. 
 

The company states that they generate this advertising revenue by posting links through their portal site. 

   Undifferentiated Business Model

Qihu's homepage, shown below, resembles dozens or hundreds of other web directory / navigation sites which are very popular in China.   Here are just a few:

http://www.2345.com/

http://www.265.com/

http://www.1616.net/?www2

http://www.tao123.com/  (taobao)

http://www.wu123.com/

http://www.0460.com/

http://www.91913.cn/

http://www.44244.com/default.html

http://www.9991.com/

http://www.537.com/

http://www.5566.net/

http://www.zgwdq.com/

http://www.46.com/

http://www.176176.com/

http://www.155.com/

http://www.haokan123.com/

http://www.129139.com/

http://www.wndhw.com/

You can see they're all very similar, (English speakers can get a pretty good sense of these using Google translate)    In fact there's a fierce battle for domain-brand identity.  In Qihoo's case, their portal is hao.360.cn.  It is not hao360.com or hao360.cn, which appear to belong to others. 

These sites typically focus on link traffic, not brand (display) advertising.  Companies that pay for links on these are paying out of their advertising budgets … their online advertising budgets.  Qihoo classifies this as "advertising revenue".   Citron gets that … do you?

   Comparing to Baidu

Some analysts and commentators have been comparing Qihoo to Baidu.  This is fatally flawed logic.  Baidu also operates a directory / portal (hao123.com), but it is such a small part of the business that they don't break out its revenues or costs separately.  Baidu's primary business is search, which is proven to be a highly profitable business model — at least for the winner in a winner-take-all category. 

   Breaking Down The Top Line

Qihoo's pre-eminent revenue generator is their flagship portal and within that domain, their PSP's (users can personalize their own start page).   Linked to that are their vertical niche portal pages.   Together, these sites generate 100% of Qihoo's current revenue. 

Below is a screen shot of Qihoo's flagship revenue driver HAO.360.CN :

There are appx 200 links on this page.   But how much revenue is generated from this site, and who is paying what?  We are supposed to believe that this site is generating over $40 million revenues this quarter, and further, is growing at a rate that outstrips all the major players in the China internet space, raising serious questions about its credibility. 

Below is a screenshot of the same site 21 months ago when it was generating less than $10 million per qtr in revenues: 

Feb 12, 2010 (QIHU revs of $9 million in that quarter) - http://web.archive.org/web/20100212202913/http://hao.360.cn/

And lastly the same page from early 2009, when it was generating only $3 mil a quarter in online revenues.   http://web.archive.org/web/20090210050039/http://hao.360.cn/

A few less links, but essentially identical in structure and function.  So exactly how did revenues increase 400% from last year and 1200% from two years ago?  The quantity of links certainly hasn’t increased 400%.  We have no verification that the traffic has increased anything near 400%.  Have the ad rates gone up 400%? 

   Or is this just a fraud??

For that matter, are there even verifiable ad rates for this page?   Below is a list of advertisers on the front page of HAO.360 that we believe do not pay QIHOO one dime.

• Yahoo Mail
• NBA
• Hotmail (Microsoft)
• Amazon
• Vogue (Conde Nast magazine)
• Self  (Conde Nast magazine)

Further, of these well-known Chinese brands, some of whom directly compete with Qihoo for games or traffic, isn't there a serious business issue requiring disclosure as to how much they are paying for links?    

• Ctrip
• QQ Mail
• Baidu
• China Mobile
• Sina (8 links)
• Sohu  (6 links)
• Todou
• Netease
• Taobao  (2 links)
• Youku (2 links)
• Tencent
• CNTV
• Dangdang

Our favorite of the "advertisers" is West Point Military Academy ( Look in the "Military academies" section, left column, 4^th row …  http://translate.google.com/translate?hl=en&ie=UTF8&prev=_t&rurl=translate.google.com&sl=zh-CN&tl=en&twu=1&u=http://hao.360.cn/junshiguofang.html

… Yep, that's it, … right next to the link to the "U. S. National Defense University".

   E-commerce aggregator

Qihoo recently launched an "e-commerce aggregator page" which sounds exciting. 

OK, so let's look under the hood at this page :  http://mall.360.cn/

It is filled with logos of global companies you will recognize :

Nokia, Samsung, Motorola, Sony, Sharp, Giordano, Reebok, Converse, Puma, Nike, Lee and many others.   Ask on the conference call how much revenue this page generates for the company.   We did.

Despite the lack of revenue, here's a selection of logos displayed on Qihoo's "mall" page: 

The creepy thing is this is exactly what CCME's strategy was.  In order to convince investors that it was a huge advertising channel, it produced a small number of copies of a very glossy catalog filled with logos from top-name brands like Coach, Lexus, and Coca-Cola. 

Here are some screen shots from Citron's 3 favorite pages out of CCME's "Investor Presentation, October 2010":

Qihoo’s other sites are the following 4 vertical portals, for group buying, video, games, mini games, and literature.  They are merely aggregators and the company has told us that none of them except games represents more than 3% of revenues:

Wan.360.cn -  Games

Tuan.360.cn -  Group Buying

Xiaoyouxi.360.cn – Minigames

Xiaoshou.360.cn – Literature

   Competition

An early sign to Citron that China Media Express was a fraud was simply the incredible pace that they were growing revenues and profits compared to their well-known competition.

During the trailing twelve months, both SINA and SOHU have grown their top line revenue around 23%.  Both companies have diversified revenue streams and a PROVEN internet footprint.  During the same trailing twelve months we are supposed to believe that Qihoo has grown their revenue 400%?

Yet, just like China Media Express… none of their pre-eminent competitors even consider them competition.  Qihoo fancies themselves as competition for BIDU.  Yet in its own filings, BIDU describes their competition as:

" Google and Microsoft, and China-based Internet companies, such as Netease, Sohu, Tencent and Alibaba"

SOHU, who recently launched a popular browser and who also sells games and lists their competition this way.

“not limited to Sina Corporation (or Sina), Tencent Holdings Ltd. (or Tencent) and NetEase.com, Inc. (or NetEase), and vertical sites, such as YouKu.com Inc. (or Youku), Tudou, Inc. (or Tudou), Ku6 Media CO., Ltd (or Ku6), Pacific Online Limited (or PConline), SouFun.com Limited (or SouFun), China Real Estate Information Corporation (or CRIC), and Bitauto Holdings Limited (or BitAuto).  In addition, we compete with operators of leading global websites and Internet service providers, including Yahoo! Inc. (or Yahoo!), Microsoft Corporation (or Microsoft) and AOL Inc. "

SINA, who describes themselves AS AN INTERNET PORTAL and fights for ad dollars as well, voluminously defines their competition as:

Our competitors include existing or emerging PRC Internet portals as well as vertical websites competing in a specific niche such as automobile, finance and IT information. Our competitors in these areas include Baidu.com, Inc. (“Baidu”), Tencent Holdings Limited (“Tencent”), Netease.com, Inc. (“Netease”), TOM Online, Inc. (“TOM Online”), Sohu.com Inc. (“Sohu”), ifeng.com, Hexun, East Money, China Finance Online, PCAuto, Auto Home and PCOnline.      outdoor media, more directly compete with traditional media, such as television, they ultimately compete with us to convert advertisers from traditional media to new media. These competitors include Focus Media Holding Limited (“Focus”), Air Media Group Inc., Vision China Media Inc. and other China-based private or public new media advertising companies…There issignificant competition among MVAS providers. A large number of independent MVAS providers, such as Kongzhong Corporation (“Kongzhong”), Tencent, TOM Online, Hurray! Holding Co., Ltd. (“Hurray”), Sohu and Linktone Ltd. (“Linktone”), compete against us. We may be unable to continue to grow our revenues from these services in this competitive environment. In addition, the major operators in China, including China Mobile and China Unicom, have entered the business of content development. Any of our present or future competitors may offer MVAS that provide significant technology, performance, price, creativity or other advantages over those offered by us, and therefore achieve greater market acceptance than us.

     Our other areas of focus for future growth include WAP portal, search, online video and Web 2.0 services. We also face intense competition from domestic and international companies in these areas. The main competitors for our WAP portal include Tencent, Kongzhong and WAP portals operated by mobile telecom operators such as China Mobile’s Monternet. The main competitors for our search service include Baidu, Yahoo!/Alibaba, Google, Microsoft (Bing), Tencent (Soso) and Netease (Youdao). The main competitors for our instant messaging service include Tencent (QQ), Microsoft (MSN Messenger) and Yahoo! China (Yahoo Messenger)/Alibaba. Web 2.0 companies are defined as those that offer tools to: companies such as Baidu, Tencent, Netease, Sohu, Youku, Renren.com Microsoft (MSN), Shanda (Shanda Literature), and Giant (51.com) as well as private companies such as 56.com, Tudou, Ku6, PP Live, PP Stream, Bokee, Blogbus, Poco, Blogcn, Hexun, Kaixin001.com and hainei.com in China and international players such as YouTube, MySpace, Twitter and Facebook."

What sticks out like a sore thumb is that Qihoo says they are the #3 internet company in China by active user base, the #1 provider of internet and mobile security solutions by active user base, and sport a user penetration rate of 92% … yet the aforementioned companies list everyone as their competition except … Qihoo, of course.

So we are supposed to believe that the 3rd largest internet company in China with revenues growing at 400% a year has just been forgotten about by their competition?   Sounds very CCME- like to us.

    Mainstream Media Attention:

Exposing CCME was difficult because nowhere online was there ever a compilation or ranking of their competitive sector (video advertisers on intercity buses in China).   

In the case of Qihoo, there are plenty. 

Citron scoured the internet to try to find just one list that would have hao.360.cn or any Qihoo site in their top rankings of internet traffic. …. to no avail.  Here look for yourself.

http://www.chinarank.org.cn/

http://www.edu.cn/20010101/22272.shtml

http://371.li/cn/

http://top.chinaz.com/

In Qihoo's rebuttal, we learn that we cannot use Alexa or Google Doubleclick to judge Qihoo's traffic, because their toolbar is incompatible with Alexa …  Then who are we supposed to use?   We challenge anyone to find one independent piece of research that would rank HAO.360 as a significant player.  Citron cannot, and neither can their “competition”.  Besides the commissioned iResearch report, prepared for Qihoo's IPO, are there any other lists that rank Qihoo's sites in the top 5 in China in terms of traffic?

What makes all of this even more ludicrous is just like CCME, Qihoo doesn’t even have an online media kit.  Sina and Sohu both have online media kits to be explored by potential advertisers, but Qihoo’s link tells potentials to just “send them an email”  … Very CCME like.

SOHU's:  http://ad.sohu.com/adprice/

SINA's:  http://emarketing.sina.com.cn/

But QIHU's is only this:  http://hao.360.cn/mkt.html   (eg.  "Send us an email")

   Meanwhile, Who is Counting The Beans??

Citron has made a strong case why the advertising revenue volume at Qihoo just does not add up – either to their competitors or us.  Yet, it is in an SEC filing so it has to be true … no?  In our last but most telling comparison to CCME we have the auditor.  

Qihoo is audited by none other than Deloitte Touche in China.  Deloitte was also the auditor of CCME and most notably, Citron exposed fraud Longtop Financial.  Anyone who follows the saga of Chinese stocks knows that Deloitte China recently refused to cooperate in an investigation by the SEC of Longtop and is being taken to federal court by the SEC.

http://www.reuters.com/article/2011/09/09/us-sec-deloitte-idUSTRE78768R20110909

Citron will follow through with Deloitte Touche and make sure their auditors are aware of the many "holes" in Qihoo's story.  

   What will happen when QIHU reports earnings??

Tomorrow, QIHU reports earnings.  We are confident that, despite the warnings and cautious guidance from the pre-eminent Chinese internet companies, whose revenues are largely dependent on advertising, they will put up a topline number that will beat analyst estimates.  This is reminiscent of CCME’s last Q in 2010 when they put up record numbers and raised guidance. 

http://www.businesswire.com/news/home/20101108006165/en/China-MediaExpress-Holdings-Announces-Quarter-Financial-Results

All this will be oblivious to the strong headwinds in the online advertising space in China.  No one questions that SINA's Weibo is among the “Hottest” internet properties in China.  But last week SINA CEO Charles Chao, was cautious on online ad spending as he said on a conference call, "Overall, the sentiment is good but not great based on our assessment … There may be some increase (in advertising spending), but not significant.”

http://www.reuters.com/article/2011/11/09/us-sina-idUSTRE7A81O120111109

So we are supposed to believe that SINA is not seeing significant increases in online ad spend yet Qihoo is able to grow their top line 30% per quarter….but no one in China seems to know about it….which leads us to our next point.

   Questions for the Conference Call

As investors, we are fortunate that QIHU will host a conference call tomorrow.  Here are some questions that must be addressed as the company needs to give more transparency to their “business model”:

• Please explain what verifiable metrics besides revenue have increased 400% in the last year (as revenue has to be tied to another verifiable metric
• Besides the commissioned iResearch report, what independent third party verification of Qihoo's reach and exposure can the investing public actually rely on?
• Who are your five largest advertisers?  Where do they appear on your site, and what percentage of their revenue do they generate in aggregate and individually?
• How many of the links on the HAO.360 site are free links?  What percentage of the total number of links on the site are free vs paid ?
• What metrics does an advertiser use to evaluate how much to pay for a link?  Why would an advertiser pay for a static link if the party they compete with, or the party whose product they sell, receives a link for free ?
• Please walk investors through your site and identify the specific links and the revenue generated by the ones that substantiate $40 million in quarterly revenue.
• What is the catalyst for the next 300% increase in your revenues from here?   What barrier to entry prevents others from copying your model and topping your growth? 

In order to justify its current market cap, Qihoo must both make transparent its revenue growth to date, but also justify 300% — 400% revenue growth over the next year. 

  Conclusion

Citron acknowledges that Qihoo found a niche when it offered anti-virus software for free in China.  Its product was downloaded by a remarkable number of China's internet population.  But to become a business, it had to establish true cash flow out of something it gave away for free.  Qihoo's current efforts resemble more a hall of mirrors than a roadmap to the future.   Investors should be extremely wary of investing in a multi-billion dollar valuation to a story as thin as this one.  

Cautious investing to all.

Disclosure:  As of the date of publication, Citron is short QIHU, long SINA and SOHU.   Its positions can and do change at any time without further disclosure.