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Article / 25 August 2014 at 2:31 GMT

Sohu's future may have plenty to do with Tencent

China Watcher / Shanghai
China
  • Sohu can't compete with bigger firms on TV content
  • Subsidiary Changyou getting less from its current portfolio of games
  • Tencent likely to acquire a larger stake in Sogou

By Neil Flynn

Sohu has reached a period of uncertainty, regarding the sustainability of its revenues. Other than the search engine Sogou, all revenue streams are seeing decreasing margins. With rising content costs for TV program, and one of China’s most popular online games coming to the end of its lifecycle, falling margins are likely to continue. 

Even as recently as last year, I was able to watch popular US programmes in China on several different platforms, but this year has seen a notable change in content protection, as video platforms look to grow advertising revenues.

In Sohu’s second quarter earnings conference call, CEO Charles Zhang discussed how the price structure for foreign TV content is too high. This is because the market is relatively new, and there are a lot of firms with large financial backing that are able to bid content costs higher. Sohu is guiding year-on-year video advertising revenues to fall from 80% to 40% in the third quarter. Last year Sohu had the rights to The Voice Of China 2, which is China’s most popular show, but lost the rights for the third season to Tencent.

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Sogou Pinyin has been working exclusively with Tencent’s QQ messenger. Photo: Thinkstock

Sohu's online game subsidiary Changyou had 252 million average monthly users over the second quarter, which grew 192% over the year. Mobile growth continues to be strong, as 50m of these average monthly users were sourced from mobile apps. However, Changyou has seen slowing performance from its current portfolio of games, particularly from one of China’s leading MMOGs called Tian Long Ba Bu (TLBB), which has been coming to the end of its life cycle.

Changyou has been releasing expansion packs which helps to reduce the difficulty for users. But the big spending players will have already completed the game, which means that the game currently only generates revenue from the small spending and casual gamers.


Sohu's Falling Margins















Changyou has discussed that it is releasing a new portfolio of games in the second half of the year. This creates further uncertainty about revenues, because these new games need to replicate the success of TLBB and attract the high spending gamers. Another source of uncertainty comes from Tencent expanding its own game network on its WeChat and Mobile QQ platforms, which makes it a very large competitor in the market.

To show the effect of the TLBB’s life coming to an end, online game revenues have either remained stagnant or have fallen, whilst total revenues have risen. Just over a year ago, online games represented over 50% of total revenues, but it has since fallen to below 40%. Along with the rising costs for video content, I expect that Sohu’s revenues will become more unstable.

Falling Online Game Revenue Contribution















Sogou is the one strong point about Sohu’s business, as it holds a strong position in the PC and mobile search engine markets. It also produces the Sogou Pinyin system, which allows users to type Chinese characters using a western keyboard. It uses search data to understand which characters are the most common and popular. Sogou Pinyin has been working exclusively with Tencent’s QQ messenger, so that QQ users can use Sogou Pinyin to type their personalised emoticons in other programs.

Closer Ties To Tencent

Since Tencent’s $448m strategic investment in Sogou, the two firms have been integrating their platforms, such as the recently launched dedicated search engine for WeChat accounts. But as further integration continues, it poses the question as to whether Tencent will continue its strategic investment in the firm as Sohu’s revenues become more uncertain.

I believe that there are two likely outcomes for Sohu’s future. Firstly, I expect Tencent to acquire a larger stake in Sogou. Tencent has recently been closing down its unprofitable and unpopular businesses, such as its Weibo microblogging service and its search engine Soso, so as it is integrating Sogou into its ecosystem, I expect Tencent to increase its stake or pursue an outright acquisition.

Whilst Sohu’s other media content are seeing falling margins, Tencent could make an investment into Sohu, or even pursue an outright acquisition. Tencent’s own video streaming service could integrate Sohu TV, which would allow Tencent to compete with the two industry leaders: Baidu’s iQiyi & PPStream, and Youku Tudou, which Alibaba has invested in.

In addition,
Tencent was originally an online game company, and its WeChat and QQ Mobile platforms have seen new games added. A large stake in Changyou would improve the quality of games on the two platforms.

-- Edited by Adam Courtenay

Neil Flynn is head equity analyst at Chinese Investors


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