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.

BEIJING ( TheStreet) -- Chinese Internet company Qihoo 360 ( QIHU) has been the subject of numerous fraud allegations over the past month in both public and private reports. Each time, the company has responded aggressively and the share price has remained basically flat.

During this time, I have spent a considerable amount of effort delving into the business of QIHU. Steps I have taken include: installing QIHU's antivirus software and browser on my Chinese-only computer, speaking with CFO Alex Xu for several hours on multiple occasions, engaging Internet consulting firm iResearch for a consulting session, and directly contacting QIHU's marketing department to replicate the experience of potential advertisers.

QIHU is a name which I am short due to its extreme valuation and due to the continuing implosion of all stocks that are Internet-related in China, so readers can feel free to take my observations with a grain of salt. However, for the record I wanted to point out the significant doubts that were raised during my experiences with iResearch and in trying to replicate the experience of a potential QIHU advertiser.

With a reported antivirus market share of nearly 90% and browser market share of over 55%, it would appear that QIHU rivals or surpasses the omnipresent Microsoft ( MSFT) in terms of popularity in China. In fact, QIHU did recently reveal that its browser has surpassed Microsoft's Internet Explorer in terms of popularity, even though IE comes preinstalled on nearly every computer in China (while QIHU's browser does not).

As for my installation of QIHU's products, there is nothing special to report. These products are free and work as expected. QIHU does not generate any meaningful revenues from these products, but instead generates all of its revenues from its website I would encourage readers to take a close look at the page. Notably, there are no banner ads, no pictures and no actual content. It is just a page of simple links to other pages. The revenue that QIHU generates comes from advertisers who pay to post a link on the web page, as well as search referral revenue from Google and revenue-sharing with gaming sites who also have links on the page.

In advance of its March 2011 IPO, QIHU engaged iResearch to provide a market survey report and provide detailed statistics to quantify QIHU's market presence in China. The report itself was never made public, but references to it are cited heavily in the IPO prospectus including that QIHU:
  • "is the number 3 Internet company in China"
  • "is the number 2 browser company"
  • "is the number 1 Internet and mobile security solutions provider"
  • has an "80%+ user penetration rate in China."
  • Based on these statistics, the IPO was a massive success, trading to over $36 from its IPO price of $14.50 -- an increase of 148%. Since that time, the share price has fallen by 50%, despite astonishing revenue growth.

    For just $300, I was able to engage iResearch to provide me with proprietary data and a one-hour consulting session. The biggest surprise was that iResearch data is compiled using the computers of only around 200,000 paid computer users. That represents about one-half of one-tenth of 1% of the Internet users in China, an absolutely miniscule sample size which ignores 99.95% of the Internet users in China. It is hard for me to understand how such conclusive market statistics could be generated using this sample size or methodology.

    According to CFO Alex Xu, the report cost approximately 10,000 to 30,000 RMB (roughly $2,000 to $5,000). This also struck me as an incredibly small sum given that iResearch is cited 66 times in the IPO prospectus and is effectively the only independent verification of QIHU's market presence. The IPO raised in excess of $200 million and QIHU has a $2 billion market cap which would seemingly justify a more thorough and extensive (and presumably more expensive) due diligence effort.

    My primary goal was to verify the revenue potential of QIHU's website. iResearch initially told me that the price of links on this type of web page should be no more than 100,000 RMB ($16,000) per month. When I pointed out that QIHU discloses an average of 350,000 RMB ($55,000), and sometimes as much as several million RMB, I was told that this simply wasn't possible, but that they would look into it further. They subsequently called QIHU and confirmed what I had said, that QIHU charges much more than the original iResearch estimate.

    I found this process to be quite disappointing because I had been hoping to get "independent" verification of the price of links as opposed to iResearch simply calling the company and asking what the price is (which anyone, myself included, can easily do). In short, the conclusion I reached was that I am not willing to rely on the iResearch data because of the miniscule sample size, the incredibly low price point of the report and the reliance by iResearch on direct interaction with QIHU to gather their data.

    Because I was unsatisfied with the iResearch approach, I decided to do some independent verification on my own by calling QIHU's marketing department. Oddly, less than 3% of QIHU's ad revenue comes via ad agencies. Instead, almost all of it comes via direct contact with the end client. So my goal was to replicate the experience of a potential advertiser.

    QIHU has disclosed that it has 125 paid links on the home page, and that prices for each of them are renegotiated every quarter. Obviously, from a practical standpoint, this sounds like a lot of work. QIHU has described its marketing department as consisting of "less than 10 people," but in my discussions with the marketing department,t I found that there were only two people who were designated to deal with potential advertisers. They were the same two people whose email addresses are listed on the website. Getting through to either of these two people was an exceptional chore because there is no phone number listed for potential advertisers.

    I engaged two other potential advertisers to try to place ads on QIHU's page and neither of them ever received a response from the marketing department despite sending repeated emails. I eventually managed to get contact numbers for both individuals in the marketing department by going through the corporate switchboard, however, it took me a full week to actually get either individual on the phone. In short, as I tried to replicate the experience of a potential advertiser, I found that attempting to place an ad on QIHU's website was nearly impossible unless one was truly determined. Incidentally, the price I was ultimately quoted by QIHU's marketing department was 100,000 RMB, which was in line with the original iResearch estimate.

    The list of links on QIHU's webpage includes China's biggest banks, Internet companies and e-commerce giants, all of which would be expected to normally delegate this type of process to an outside ad agency as part of their normal advertising spend. But with QIHU, apparently these companies are forced to call up individually to sign and renew contracts each quarter. From a practical standpoint, this does not seem possible either for the advertisers who must do the work themselves or for the marketing department which does not seem staffed to handle this type of volume.

    As I discussed the staffing issue with the CFO, he noted that due to increasing traffic, QIHU is able to simply notify clients each quarter of the price increases and that clients readily accept. The past threee quarters have seen QIHU report roughly doubling the price of its links despite the significant challenges which are facing its advertising clients.

    The chart below shows U.S.-listed companies with links on QIHU's page and where they are vs. their 52-week high share price. These are some of the companies which are presumably accepting a doubling of prices this year without a fight. And the price, according to QIHU, can be as high as $1.5 million per quarter for a single link on their page. Once again, this does not seem possible to me in the current difficult environment.

    Clearly, there are a number of issues at QIHU which I feel are cause for significant concern. First, QIHU claims to have a near monopoly on its products in China, but the data are based on a miniscule sample size which were compiled in a $5,000 report for its $200 million IPO. Second, placing an ad with QIHU was nearly impossible yet QIHU does not rely on ad agencies at all. Third, the prices charged for simple links and the continuing price increases are almost inconceivable given the current environment for Internet companies in China.

    Combine these concerns with a sky-high valuation and QIHU seems to be a very safe short over the next few months and as we head into the 20F filing season.

    Disclosure: the author is short QIHU.

    The author can be reached at

    Rick Pearson is a Beijing-based 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.