Initial Hypothesis and Thesis

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Based on the good business framework, SFUN is a fantastic company to invest in. It is the market leader in its industry, and also generates strong, positive free cash flows and has high ROCE. The only risk is the cyclical nature of its business. We believe that it is because of this particular aspect that caused the stock price to be so low. Even though many analysts have stressed that the housing crisis may not happen in China, and even if it does, the impact will be much smaller compared to the U.S., many people have the memories of 2008 rooted in their heads, which explains the cheap stock price and valuation.

Primary Research – Survey Results:

We conducted a survey on the popularity of SFUN, but the results were surprising. Unlike what we expected, SFUN is actually not the most popular provider of O2O service. Our survey shows that SFUN’s main competitors, WUBA and Ganji, are both more popular. About 38% of the respondents chose WUBA as the most popular provider, followed closely by Ganji at around 29%. SFUN is only third with 22% of the votes, with LEJU coming in at fourth, with 11% (Exhibit 3).

Furthermore, when asked about why they would use SFUN, the majority of the people (62%) answered that they never use SFUN (Exhibit 4). This, coupled with the fact that an overwhelming majority of the respondents (86%) do not think that the Chinese real estate market will be more attractive in 5 years (Exhibit 5), we now think that SFUN may actually not be such a great buy.

Comparable Analysis:

SFUN is currently valued at below the market average based on our comparable analysis using the metrics of TEV/EBITDA and TEV/Total Revenue. SFUN’s year over year revenue growth fell dramatically for the year of 2014, specifically in the first two quarters of the year. Based on the industry, a company of SFUN’s size should be growing at a higher rate than 10.3%. The industry average growth was 66.2% for the year of 2014 and revenue growth for SFUN had been 48.1% and 25.1% for the years of 2013 and 2012 respectively (Exhibit 6). The company revenue growth has for the most part been decreasing over time since 2010 when it had a growth rate of 76.7%. For this reason, 2014 does not look like an outlier when compared to previous years and management expects that 2015 will not be any better. Revenue is decreasing partly because SFUN is cutting back on its listing service, which saw a decrease in revenue of 9.8% in 2014 due to lower prices and an overall decline in Chinese secondary home sales. SFUN is instead focusing on its e-commerce services, and this transition will continue into 2015. In 2014, revenue from e-commerce increased by 29.9% and was largely responsible for keeping growth positive. Despite having positive EBITDA margins for an industry where most companies have negative earnings, a company’s revenue potential is given a far greater weight. This is because it is assumed that once a company has realized the potential of the market and growth has slackened then they will begin to produce earnings and higher revenue companies will produce greater earnings. SFUN appears to have already prematurely focused on maintaining good margins, which is established by the low growth and positive earnings. Based on the rapid growth of the Chinese comps, LEJU and WUBA, it would appear that the market has not yet been saturated. This would suggest that despite the fact that SFUN has positive earnings, income for the company is not as high as it should be. Furthermore, EBITDA actually decreased by 10.3% for SFUN in 2014. For this reason, we suggest a discounted valuation compared to SFUN’s peers and SFUN seems to trade at this discount (Exhibit 7).

Potential Corporate Governance Problem:

Like many Chinese firms, SFUN has potential corporate governance issues. While this problem may be as insignificant as having a rubber stamp board of directors, there may be more substantial corporate governance issues that make this stock a more difficult choice to purchase. In March 2012, SFUN spent $14 MM purchasing 47 hotel rooms from Sanya Property SPV, controlled by Chairman Mo and his nephew, then CEO, and this was not reported in the related party transactions. That $14 MM could have paid for 113,322 nights at the rooms, suggesting that SFUN overpaid. Interestingly, SFUN loaned Villa Management (the previous name of the same entity) $15 MM previously, perhaps fronting the capital for the hotel purchase. The loan was repaid three weeks after SFUN completed the purchase. In a sense this could have been a transfer of wealth from the company to the CEO and Chairman in a related party transaction that was not reported to the SEC.

For a company earning as much and growing as fast as SFUN, $14 MM is a relatively small sum. However, as Warren Buffet said when evaluating management, “You look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you.” There are some mitigating factors, as the company has continued to pay dividends, although the net amount borrowed from banks is almost double the amount paid in dividends. Borrowings from the company is also interesting, as one of the justifications for the loan to Villa Management was to earn a higher return on the cash on the company’s balance sheet. Then just 2 years later the company borrows more money to inflate the cash and short-term investments from $150 MM to $850 MM.

In another potential problem, SFUN’s average revenue per user (ARPU) is also abnormally high when compared to its industry peers (Exhibit 8). While this does not necessarily imply accounting shenanigans, other Internet companies that have been accused of accounting misstatements (NQ Mobile, Qihoo) also have abnormally high ARPU. For an internet company looking to inflate revenue, which is the easiest way to inflate profits, ARPU often becomes inflated as it is very easy to verify total website users. SFUN could very well be an extremely profitable company that can earn a lot of money simply from charging a small fee on large real estate transactions. However, given SFUN’s success, it is odd that other portals like LEJU, WUBA, and Z would not copy SFUN, when SFUN is so successful in its advertising strategies

Facebook was not used to calculate the comp ARPU. However, Facebook should be a ceiling on SFUN’s ARPU. On average, Facebook users spend probably north of 15 hours a month on the social media website, while even the heaviest SFUN users don’t spend nearly as much time on SFUN. It does not make any sense that SFUN would have a higher ARPU than even Facebook, which is basically the gold standard of all online advertisement companies.

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