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The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.



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Qihoo 360


has been the target of numerous allegations of fraud by short sellers over the past few months, but the share price has been largely unaffected. I have been doing a lot of work to get a better understanding of QIHU, including speaking with the CFO, interviewing advertising customers, speaking with iResearch in China and speaking with many other investors (both long and short) who are doing their own due diligence.

I am short the stock based on valuation, but at the current moment I still have many conflicting data points from each side regarding the fraud allegations. I have spoken with various institutional longs who have conducted detailed channel checks and who feel comfortable that QIHU's ad revenue is legitimate. On the other hand, I also noticed that sometime over the past two weeks the Web site

popped up targeting QIHU for fraud.

has only appeared twice before (once targeting

China Media Express

and once targeting

Longtop Financial

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), and in each case it presaged the resignation of Deloitte from the U.S.-listed China clients due to fraud.

This year


claims to have a "smoking gun" in the form of an interview with a current or former QIHU employee who states that revenue is inflated by 40% and that there exist "ghost links" which are claimed as revenue generators but which do not in fact generate revenue. It will certainly make for an interesting audit season.

I recently came across something interesting on QIHU's Web site that I am still puzzling over. I clicked on a link (a paid advertisement) for


(For those who don't read Chinese, Google translates this as "Wheat Bags"). They are an online seller of handbags and luggage and their link appears in the very top portion of QIHU's Web page (i.e., the most expensive part).

When I looked at the top of their Web page there was a note saying that Maibaobao was no longer advertising with QIHU and that users should bookmark this page themselves. I was curious about this so I called Maibaobao and spoke with about five different individuals, but couldn't really get an answer as to why they stopped advertising with QIHU.

The next day, after my calls, a funny thing happened. The message at the top of Maibaobao's page suddenly changed and no longer mentioned that the company had ceased advertising with QIHU but instead simply suggested that viewers bookmark the page. Odder yet was the fact that on the same day this message changed, Maibaobao suddenly had two links on QIHU's home page, where previously they only had one. I found this surprising because I had expected that their link would disappear altogether if they were no longer advertising with QIHU. For reference, I have included a screenshot of the before and after messages which were fortunately cached in my browser.

Using Google to translate, the first message reads as:"Welcome to the wheat bags, we are about to stop the advertising of 360 site navigation, to facilitate your next visit, please wheat bag Add to Favorites!"

The next day, the new Google-translated message reads as:"Welcome to the wheat bags! For your convenience, after browsing the Web site, place the wheat bag Add to Favorites!"

This series of events gives rise to a number of interesting observations. Most importantly, it demonstrates that in the Web directory business in China, customers do in fact have substantial leverage. QIHU has noted that it is increasing ad rates by 25% per quarter (over 100% per year), which I have found difficult to comprehend when competitors such as SINA and SOHU have only been increasing rates by 20% to 25% per year.

Maibaobao is now an example of a company that has walked away from QIHU, but is now allowed to simply keep its link in the best and most expensive spot on the page for free. And in fact, it now has two links instead of one. Presumably the extra link was given to Maibaobao in exchange for taking down the offending language regarding not advertising on QIHU. In any event, it is difficult to imagine that Maibaobao suddenly changed its mind and decided to buy two links just one day after canceling all advertising with QIHU.

Channel Checks

Many investors and sell-side analysts have performed substantial channel checks on QIHU to refute the fraud allegations and have confirmed to their satisfaction the revenue being attributed to certain ad customers. That is no doubt a positive for the stock. However, it is still worth remembering that similar channel checks were performed at both CCME and Longtop Financial (i.e. the two other DW targets) and provided similar satisfaction just weeks before the resignation of Deloitte in each case.

The problem is that channel checks can only validate some portion of the business and not 100% of it. In the case of CCME, Global Hunter randomly selected over 50% of the advertising contracts, verified them and was satisfied in giving CCME a clean bill of health. With Longtop, numerous bulge bracket investment banks verified the company's contracts with China's largest banks and were satisfied. It is an absolute fact that both of these companies had very substantial operations and revenue and could be validated. However, the existence of even some small amount of "revenue inflation" led to the auditor resignation and delisting.

Given the channel checks that have been performed on QIHU, it seems clear that the fraud allegations by the shorts are a good deal overstated in claiming that QIHU is an 80% fraud. There is ample evidence to the refute that. However, it is also the case that the various channel checks by the longs have not in any way made QIHU "bullet proof" or disproven the existence of some amount of revenue inflation.

The reason I found my experience with Maibaobao concerning was that it makes QIHU's revenue model harder to comprehend. There are more than 50 instances on QIHU's homepage where a single advertiser has more than one link. The only way for QIHU to be achieving the revenue it reports is if the ad client is paying twice, once for each link.

Yet with Maibaobao, we see a company that isn't paying for ads at all anymore and yet is still occupying some of the highest paying ad spots on the page. This is the type of observation that makes QIHU's revenue model breakdown. In other words, by adding up all of the links on the page and calculating the revenue per link, one doesn't get to 100%.

Needless to say, I also found it concerning that as soon as I called to ask about the message on their Web site it suddenly disappeared.

Lingering Doubts

In short, the channel checks performed by QIHU longs have gone a long way toward disproving the fraud allegations against QIHU, but there are still some common sense issues that leave room for doubt. The first issue is: How can QIHU continue to raise rates at over 100% per year when competitors can only raise them by 20% to 25%, even when advertisers are seen to be leaving QIHU? The second is: How can QIHU's revenue per link times number of links add up to 100%? If we learned anything from CCME and Longtop, it is that even a small problem is actually a huge problem and that common sense contradictions can still trump on the ground due diligence.

Longs seem very comfortable with QIHU following their detailed channel checks. Shorts also seem very confident in their various fraud theses. As a result the stock isn't really budging for the time being. QIHU's annual audit is now due in a matter of weeks and now the only opinion that matters is that of Deloitte when it comes to sign off on the audit. Given the extra pressure put on Deloitte by

, I am certain that Deloitte will be conducting an extremely thorough audit and will be verifying each of the contracts individually.

The stock is already richly valued vs. reported earnings and it hasn't run up much along with the rest of the China Internet space. As a result, shorts are probably feeling reasonably comfortable with their positions heading into the annual audit as the stock is unlikely to experience any meaningful pop.

For longs, the only thing that matters now is will QIHU pass its upcoming audit. The channel checks have been performed to satisfaction, but based on my recent experiences there are still some common sense issues that don't quite click. Given that QIHU is still a $2 billion company, I am guessing it will be one of the most closely watched audits in the US listed China space.

At the time of publication, the author was short QIHU, although positions can change at any time.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.