Chart of the Day – $QIHU: Fall Down Seven Times, Stand Up Eight?

by Enis October 21, 2014 12:15 pm • Chart of the Day• Commentary

QIHU is one of the huge momentum leaders in 2013 and early 2014 that has been smacked in the past 2 months.  The stock was a favorite among investors looking to get exposure to the secular growth trend in the Chinese internet sector. However, the aggressive selling recently took the stock below the longstanding $80 support level:

QIHU weekly chart, courtesy of Bloomberg
QIHU weekly chart, courtesy of Bloomberg

Since the break of support, the stock has stabilized above $60 in the past two weeks.  QIHU’s cut in valuation has made the stock’s fundamental case much more interesting.  QIHU is focused on desktop/mobile search, and mobile gaming. The stock’s rapid ascent in 2013 was driven by its gain in market share in the search space relative to BIDU, though that has slowed in the past year.

While growth estimates have been cut for QIHU (35% year over year EPS growth expected in 2014, on a doubling of sales), the drop in the stock could possibly more than reflect those lowered expectations.  QIHU is trading at a P/E of around 29x the 2014 estimates, vs. expected EPS growth in the 30-60% range over the next few years.  Even if that growth is at the low end of around 30%, QIHU is trading at a P/E vs. EPS growth ratio of 1, which is quite cheap for most early stage growth stocks.

QIHU also has the wind at its back when considering the overall Chinese internet sector.  The sector remains in a nascent stage compared to developed markets, so early movers will have major advantages in holding market share going forward.

The stock fell 8% after its last earnings report in late August.  The company actually beat Q2 estimates, but higher than expected expenses in its mobile search and security business led to a downgrade of future margins.  Increased competition hurting margins is an ongoing concern for the company.  The GS analyst summed up the situation in his note in August:

We lower our 2014E EPS by 12% to reflect mobile search-related expense, but raise our 2015-16E EPS by 1%/6% on its long-term profit potential driven by strong revenue momentum, especially from the search business, as well as mitigated sales and marketing expenses. Thus, we lower our 18-month target price to US$105 from US$108, still based on 1X PEG. Key risks: New segment’s profitability, competition.

Since that weak earnings report, the stock is down another 25%.  At what point is the competitive backdrop already priced into the shares?  My hunch is that we have likely reached that point.  The stock’s next earnings report is in late November, which will give more clarity on the expense trends in the business.  Implied volatility is quite elevated, making long call spreads a tough proposition.  We might look to buy the stock and buy protection ahead of the earnings event as one possible way to play this name.  At the moment, we’d rather try to time a better entry than risk a move back to the $60 support level in short order (even if that means missing the upside), so no trade for now.