Remember the 1980s oil & gas partnerships? Large E&P firms would pocket investor’s cash to shell out for leases, acrage, and the assorted equipment necessary to drill. The sky-high upfront leasing costs made sense only to investors with graphs prediction ever-rising energy prices. At the time, such pie-in-the-sky numbers looked like consensus. It was only when oil prices collapsed that in retrospect the O&G partnerships, as construed as an asset class, looked foolish. The losses were so steep, and the damage so widespread, that it took more than a decade before the Wall Street underwriting machine was able to lure the marks (er, clients) back into the business.

This time around, investors demanded cleaner, easier to follow, publically traded vehicles and Wall Street responded with such plays as Sandridge Permian Trust (NYSE: PER) or Chesapeake Granite Washington Trust (Nasdaq: CHKR), two vehicles where the rules and risks are stacked heavily in the investor’s favor.

Much like the O&G partnership collapse, speculating in Chinese equities almost came to a complete halt earlier last year with the string of collapses that took place within mere months of each other of well known and widely owned stocks.

RINO International. China MediaExpress. China-Biotics. Longtop Financial. It wasn’t too long ago that these names dominated headlines. It was just last April that the New York Times published its front page business section piece entitled “The Audacity of Chinese Frauds”, detailing the absurd lengths Longtop’s management had gone to interfere with Deloitte’s audit of the company’s cash on hand. 

Yet, implausibly enough, in the case of the feverish buyers in Qihoo 360 Technology Co. Ltd. (Nasdaq: QIHU) they have only let a handful of months pass from when the height of the Chinese frauds hit the fan to when these self-styled momentum investors collectively hit the buy button on a multi-billion dollar Chinese internet stock trading at 10 times trailing revenue.

I find the whole shebang extremely fascinating for the following reason. Qihoo is a classic ‘battleground’ stock. To it’s supporters, Qihoo has revolutionised the Internet market in China by using its free anti-virus software to help it catch hundreds of millions of page views per month in ‘home page’ or ‘web-directory’ traffic.  Qihoo describes itself as the 3rd largest Chinese internet company, with a customer base of over 300 million users.

The bears on Qihoo, led by veteran short seller Citron Research, has pointed out numerous holes in the firm’s financials, business model and market share. In a followup, detailed piece published in early December, Citron Research calls Qihoo and out-and-out fraud.

A more recent addition to the debate is Deloitte-Watch, a website apparently devoted to tracking the shadier side of Deloitte’s Chinese auditing arm. It was most likely DW that pushed Deloitte to go the extra distance on auditing Longtop Financial last year, a level of scrutiny that ultimately pushed that fraud into the spotlight with antics described so deliciously in the above-referenced NY Times article.

These types of ‘battleground’ stocks are not unique to China and there are literally dozens of plays at any given time where in-depth research on highly controversial names can bring out the winning side. As an investor and trader one can try to pick apart each competing side’s claim and take a stand on the issue. However, it’s not my intent today to wade through the various claims and counter-claims of each side.

What I do find fascinating in this particular case is the relative odds implied by the current market price of Qihoo’s common stock. Usually, in a battleground name where each side has strong arguments, the stock price in question implies a 30%,40% or 50% of success for each side coming away victorious.  A good example of this is tonight’s Amazon.com earnings release. Speak to the analysts and you’ll come away with the arguments for either a $1b+ topline beat leading to a 10-20 point blowout to the upside, or else a major miss on the operating margins and earnings which would probably get the stock down 15-25 points. Pull up the option chain and you’ll discover highly pumped price tags all up and down the strikes. Bottom line, the options are pricing in a near 50/50 for each side in this battleground earnings play.

Qihoo is different. Given its 10x revenue valuation, hundreds of millions of dollars of insider stock holdings that are now available for sale, and the recent speed bump most Chinese ecommerce names have hit, you’d expect this name to trade somewhere between the $5 price tag the bears have put on it, and the $2-$2.5b valuation that even the most optimistic bulls can get to on a discounted future cash flow analysis.

Yet the stock sits today at $17 and change. With 122 million shares outstanding on a full-diluted basis, ‘Mr. Market’ has apparently decided that the bear case on Qihoo has little to no chance of bearing fruit. (am I the only one who finds it interesting that Qihoo hides the fully diluted count in its cash flow per ADS statement in the company’s earnings release? You can calculate it by dividing the net income by the Diluted earnings per ADS) This, despite the fact that Citron Research has a 10 year track record of uncovering corporate fraud. This, despite the fact that DW’s work on China MediaExpress and Longtop literally changed the outcome of those two corporate audits.

It seems to me that the investor base in Qihoo have all-too quickly forgotten recent history. DW claims it is in possession of a whistle blower interview that, if true, would blow the doors off Qihoo’s legitimacy wide open. Consider this description of these insider allegations:

• Deloitte-Watch has obtained a copy of a detailed interview with an individual associated with Qihoo 360′s sales department who states that the company is inflating revenues by over 40%, and has detailed the existence of “ghost links”on the hao.360.cn web page…
• The interviewee states that Qihoo 360′s homepage traffic peaked some time ago and now is actually falling. ..
• For safety and security of this person, the identity of the interviewee cannot be publicly disclosed. But, a copy of the interview has been sent to your legal department.

Think to yourself for a moment. Is it possible that DW is completely making this up out of whole cloth? More importantly, What are the odds that this whistleblower actually exists?

If Qihoo were any ordinary ‘battleground’ name, this stock would trading somewhere in the midpoint between the two sides. Gun to my head, I’d guess $10,11 or $12 a share. Its an absolute shock to me that with all the accusations flying on this name that the sum total of market participants are giving Qihoo a $2b+ valuation.

Investors have forgotten that China MediaExpress had its’ stock halted when it was $11. Longtop’s final trade before the plug was pulled by Deloitte’s aborted audit was $18.93 a share implying a $1.1 billion market cap (last trade I could find : 8 cents). It wouldn’t shock me if Qihoo collapsed in the same, shocking fashion.

I’m not implying that Qihoo is or isn’t a fraud, although for the record the bulls I’ve spoken to have never confirmed to me their revenue model, or that they’ve even confirmed that customers actually pay the 200 to 250K RMB a month Qihoo’s management claims is the going rate for a top level link.

What I am pointing out is that, unlike virtually all the ‘battleground’ stocks I track, Qihoo is giving the shorts a golden opportunity to enter the trade-  if you believe the thesis. Its been a long time since I’ve seen a ‘battleground’ name involving  top-tier shorts trade at a price that practically begs you to do the homework and enter the trade.

Skepticism is the currency of a trader who can survive a twisted tape. Qihoo is a very difficult stock to borrow, and trading in size makes it hard to get in and out of positions easily. I’ve spoken to all the major players in the names I could identify, and it seems to this trader that its’ the bulls who ought to be skeptical of management’s claims. But I respect the fact that my confidence threshold can’t possibly approach that of traders who’ve invested months and tens of thousands of dollars researching this name.

What I can add to the debate is the price and sentiment. Its about as bad a time to be a Chinese bear as I’ve seen in the past 6 quarters. Anyone I’ve spoken to outside of the committed Qihoo bears have no patience anymore for high borrow fees, illiquid options and a stock that trades as random as these names get.

But Wall Street desk skepticism doesn’t change the facts on the ground. And the facts on the ground in this case are that serious questions have been raised about the legitimacy of Qihoo’s operations and financials. And the fact is,  if even a fraction of these questions cannot be adequately answered, Qihoo’s stock is going lower, much lower.

As a contrarian by nature, I embrace the trade where I can stack the odds highly in my side’s favor. It may be  a hard trade, it may be one where the exact endpoint isn’t quite known – Qihoo needs to file its yearly financials sometime around April I believe – but its one where the desk jockey’s exhaustion with Chinese frauds works heavily in your favor. While Qihoo’s shareholders are currently in ‘see-no-evil, hear-no-evil’ mode, that type of smooth sailing for Chinese stock  cannot last forever.

I never made big money by being the last one into a trade. I think I’m early here but on the right side of the facts, and most importantly, sentiment. And the fact is, as Qihoo approaches its audit, you can be sure that the pressure will be on Deloitte to get the job done right. At a certain point before then, although I don’t know exactly when, the market will stand up and take notice of the risks inherent in passing or failing the audit.

And I strongly doubt when that time comes this stock will be anywhere near $17.

At the time of this article the author was short Qihoo