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Article / 23 October 2015 at 2:33 GMT

Earnings Preview: Sohu stays static as sector speeds past

China Watcher / Shanghai
China
  • Sohu will report its third-quarter earnings on Monday 
  • Investors are concerned about the long-term feasibility of its business model 
  • The company may need to sell its valuable assets, such as Sogou

By Neil Flynn

Former star of China’s tech industry, Sohu, will release its third-quarter earnings on Monday morning before the markets open. Investors will be focusing on the return to stable revenue growth after a disappointing first quarter, but the same concerns about the long-term feasibility of its business model. Current market consensus is for revenues of $491.26 million and non-GAAP earnings of negative $0.62. 

Short-term revenue recovery but for how long?

After a disappointing first quarter, Sohu bounced back and beat revenue expectations in the second quarter. The previous three quarters have seen year-on-year revenue growth of around 24%, which is far less than the 40% year-on-year revenue growth rates that Baidu and Alibaba have both experienced over the same period. 

However, as we approach the release of the third-quarter earnings, it begs the question of how long revenue growth will remain at this stable level. My long-term thesis on Sohu is that it is a tech firm that hasn’t been able to keep up with its rivals, and, like Sina, is remaining relatively static in a fast-moving industry.
Sohu's revenues
Source: Sohu Investor Relations

In the third quarter, I expect that the same problems will be present. The business as a whole is falling behind larger competitors, which are actively spending more in order to maintain growth. 

Quite simply, Sohu can’t and won’t do that, so investors should expect management to discuss how their investment levels are sustainable. That’s all well and good, but when Sohu is being outspent by rivals, it cannot possibly remain competitive. 

Other than the search engine Sogou, the only real asset of value to Sohu is its video platform Sohu Video. While it is unable to compete financially with Baidu (iQiyi), Alibaba (Youku) and Tencent (QQ Video), Sohu Video still has a large library of content, which is of value. However, this value will diminish as more quarters pass, because the content won’t be as new. Selling this business unit would be a wise decision for the firm, particularly as its value will be reasonably high. 

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 Falling behind ... Sohu is a tech firm that is finding it increasingly
difficult to keep up with its rivals. Source: iStock

Sogou remains promising

Sogou revenue is growing strong and is the only bright spot for the company. Investors should pay close attention to the specific revenues from the search engine in Sohu’s third-quarter report, because it is the engine of revenue growth for the whole company, and has been for a while. 

The year-on-year revenue growth rate for Sogou has been at least triple that of total net revenues for the past few years. This has recently been aided by the adoption of Sogou into Tencent’s platforms.

Sogou Revenues
Source: Sohu Investor Relations

Sogou’s revenues and business metrics in the second quarter were strong, and will likely continue to impress in the third quarter. Year-on-year revenue growth of 61.5% is much higher than the 23.3% growth for total net revenues. 

Quarterly growth of net revenues excluding Sogou has average just 2.5% over the past eight quarters, while year-on-year growth over the same period has averaged 13.6%. However, this raises an interesting quandary for Sohu, because as Sogou contributes an increasing proportion to total revenues, should investors expect to see the unit spun-off or sold? 

It has been a long-held expectation that Sogou will hold a US IPO in the coming 12 months, but I believe that a domestic rival, namely Tencent, will more likely acquire it. Tencent has already allowed Sogou to search within WeChat pages, and doesn’t have its own search service. 

Sogou Sohu Revenues
Source: Sohu Investor Relations

For investors, strong numbers from Sogou in the third quarter will be positive, but will only fuel the expectations of the IPO or acquisition. Conversely, disappointing numbers would raise further questions about where future growth will come from. 

Will investors see a profit soon?

Gross margins have been declining over the past four years, although they remained stronger than operating and net margins during 2014. The problem that the firm has is that it is finding it very difficult to keep its costs under control, and when paired with slow growth in revenues, it is becoming difficult for the firm to regain profitability. 

Sohu Margins
Source: Sohu Investor Relations

While the firm posted a non-GAAP loss in 2014, the trend was evidently clear in 2012. Sohu has been unable to arrest the decline in profits for the past three years, and I have very little reason to believe any long-term fixes can be made. 

Over the past few quarters, the net margin has stabilised at around negative 10%, but the longer losses are posted, the more the company will realistically have to contemplate selling its valuable assets.  

Sohu Earnings
Source: Sohu Investor Relations. Create your own charts with SaxoTrader; click here to learn. 

– Edited by Gayle Bryant

Neil Flynn is a Shanghai-based China watcher and equities specialist. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.

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