Article / 24 April 2015 at 5:13 GMT

Earnings Preview: How long will Sohu remain sustainable?

China Watcher / Shanghai
China
  • Sogou has benefited since Tencent acquired a stake in the search engine
  • Net income has been declining, and the firm posted a net loss in 2014
  • Video firms need to make their own content: the syndicated model is failing

By Neil Flynn

Chinese tech firm Sohu will report its first quarter earnings on this Monday (April 27) before the opening of the US markets, with investors continuing to have doubts about the feasibility of the company in its current form. The portal business that was successful a decade ago is in decline, and the popular video site is facing increasingly higher content costs. The firm’s search engine Sogou has benefited greatly since investment from tech giant Tencent, and will likely list in the US in the second half of the year. Here are the three key points that investors should focus on in the earnings release and the subsequent conference call. 

Gone are the heady heights of yesteryear

Sohu was once a leading Chinese internet firm, but with the emergence of the BAT trio of Baidu, Alibaba and Tencent, Sohu simply cannot compete in the same markets. Its main business lines of news portals, online video, gaming and search are all dwarfed by its larger rivals, and it is suffering under the weight of growing costs to remain competitive. 

Revenue growth for the firm has remained steady, with the search engine Sogou and its spun-off games division Changyou driving revenues. But with Sohu Video posting net losses due to rising content costs, and Changyou failing to replace the revenue of its wildly popular TLBB game, Sogou is becoming the most important revenue driver for Sohu.

Sogou has benefited greatly since Tencent acquired a 40.9% stake in the search engine, as it has since been integrated into Tencent’s huge ecosystem. As investors anticipate a US IPO for Sogou this year, they will likely have concerns as to how successful Sogou can be, given that it is competing with the dominant market leader Baidu.

Sohu revenues
Sohu Revenues
Source: Sohu Investor Relations  

Despite the steady revenue growth, net income has been declining, and the firm posted a net loss in 2014. This was disappointing, but far from a surprise, as the firm has seen declining profits since 2012. The exponential rise of content costs has affected the firm, and with no sign of this industry wide problem abating, the firm needs to refocus its video strategy towards original programing. Management should discuss its 2015 strategy with particular focus on cost control.

Sohu earnings

Sohu Earnings
Source: Sohu Investor Relations 

The proposed sogou IPO

Last month, it was reported that Sohu’s search engine business Sogou is planning an IPO in the US, which would value the business at over $3bn.Since the Tencent it is the only search engine that can search WeChat public accounts. There has been no official confirmation from the firm, but I would be surprised if management doesn’t give some sort of commentary on the fund raising plan. Sogou has been steadily growing revenues, and became profitable in the second quarter of 2014, which should make it attractive to investors.

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Video sites have been producing their own content including The Voice Of China. Photo: iStock

For me, the most valuable part of Sogou is the cooperation with Tencent, because as one of the BAT trio, Tencent will allow Sogou to be leveraged on its huge user base in order to actively compete with the likes of Baidu and Qihoo. In addition, Sohu and Sogou have been actively transitioning their businesses onto mobile, and Tencent, which has the best mobile ecosystem in China, should aid this transition.

Sogou Revenues
Source: Sohu Investor Relations  - Create your own charts with SaxoTrader. Click here to learn more

After seeing a number of large Chinese firms listing in the US during 2014, 2015 has been notably slow, with the only IPO of note being the small service directory app 55Tuan. Sogou is a relatively well-known name in China, but as I have discussed previously about Qihoo, the search engine market has limited upside for these firms because Baidu has such a dominant market share. This is why Qihoo has been diversifying into enterprise security and wearables.

My longer term concern is that when Sogou is spun off, just as the gaming business Changyou was, Sohu will be left with a video business that is being priced out of the market, and news and web portals that are simply outdated for China’s fast growing consumer tech scene, and will therefore predominantly earn revenue from its holdings in Changyou and Sogou. It seems that Sohu, like Sina, is slowly becoming an outdated business in China.

How long is the video business sustainable?

Sohu Video is a popular site for Chinese to watch their favourite TV shows and films, and has been boosted by the integration of the video site 56.com into its platform, after Sohu purchased the site from Renren. These video sites are more advanced than western counterparts in the sense that there is a lot more syndicated and partner generated content, as well as user generated content, and as such, they have become the main format for which to watch both domestic and international content.

Because of this, firms have monetised the content through advertisements, and have been a strong driver of overall revenues. This has seen many new entrants into the market, with heavy financial backing, and coupled with the government’s restrictions on foreign content, there are more firms bidding for less content. This has seen content costs grow exponentially, and without strong financial backing, it is becoming more difficult to compete. Therefore it is no surprise that the top three video sites in China are the Alibaba backed Youku Tudou, the Baidu backed iQiyi and PPS, and Tencent Video. 

In 2013, Sohu generated a lot of revenue from the hosting of the TV show Voice Of China 2, which was wildly popular, but lost the third series to Tencent Video. This poses a problem for Sohu because if they are able to find success with a TV show, then investors will likely fear that the firm will be priced out of hosting subsequent seasons.

From another perspective, because rising content costs are a major problem for the industry as a whole, video sites have been producing their own content. Using The Voice Of China as an example, the success of the singing contest TV format has seen many varieties of the same concept produced by each video site, which reduces the revenue potential of each program, because there is very little differentiation between the shows in the eyes of the viewers. In the fourth quarter, Sohu hosted a singing show called Sing My Song, which will see content cost grow even further.

Content costs are so high that Sohu Video isn’t profitable, and despite revenues of $51m in the fourth quarter, the business unit posted a net loss of $21m, and with content costs showing no sign of slowing down, it’s very difficult to see how Sohu can compete with its wealthier rivals.

As I discussed in my review of Youku Tudou’s fourth quarter earnings, video firms need to focus on producing their own content, because the syndicated content model is unsustainable. Original programing allows video sites to increase monetisation, through product placements, and vastly reduces content costs. The acquisition of 56.com should help Sohu to do this, because it is a partner- and user generated content focused site. For Sohu Video to remain sustainable, it needs to focus on this form of content, because it simply cannot compete with the BAT trio.

-- Edited by Adam Courtenay

Neil Flynn
is a portfolio manager at Alcuin Asset Management. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.

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