INTERNET: Sohu Playing Video with Tencent?

Bottom line: Sohu is likely to combine its online video service with Tencent’s in an ongoing consolidation of the Chinese sector, and the tie-up could presage a Tencent-backed privatization bid for Sohu later this year.

Sohu, Tencent in video merger?

More consolidation could be coming in China’s online video sector, with word that web portal Sohu (Nasdaq: SOHU) may soon sell a major stake in its video service to social networking giant Tencent (HKEx: 700). The move would follow a similar tie-up between this pair in the online search space, and might lead some to wonder if Tencent may even be preparing an eventual bid for Sohu itself. I’ll end the suspense on that matter by saying such a sale seems unlikely, for reasons I’ll explain later. But the pair could still ultimately do more deals together

This particular tie-up would mean that China’s online video sector is firmly consolidating around the country’s 3 biggest Internet companies and a handful of others. Leading search engine Baidu (Nasdaq: BIDU) is closely associated with, a leading player, while Alibaba (NYSE: BABA) last year purchased Youku Tudou, another leader. The other major player is LeEco (Shenzhen: 300104), formerly known as LeTV, and state-owned broadcasters in Shanghai and Hunan are also making big pushes into the space.

But for now let’s turn our attention to this latest deal, which would see Tencent buy an unspecified stake in Sohu’s video service for $1 billion. (Chinese article) Sourcing on the report is quite vague, but it says a formal announcement could come later this week. A nearly identical report that Sohu and Tencent were in talks to merge their video services appeared nearly 2 years ago, though nothing even was announced. (previous report)

The latest report points out that this new tie-up would be similar to another one between the pair back in 2013. That deal saw Tencent and Sohu pool their search services into a single company, with Tencent buying 36.5 percent of Sohu’s Sogou search engine for $450 million as part of the tie-up. Thus this new deal might also see Tencent buy about a third or more of Sohu’s video service, though probably for a smaller price.

Sohu’s shares jumped 6.8 percent in Friday trade, perhaps on speculation about this latest deal and even the potential for a Tencent buyout of the company. Such a buyout would be consistent with a broader wave of privatizations by US-listed Chinese firms that feel they are undervalued. Sohu certainly fits that definition, as it’s only worth a relatively modest $1.9 billion, and its shares now trade well below levels from 5 years ago.

Fickle Founder

I still wouldn’t say definitively that a deal will be announced this time, since Sohu’s founder and chief Charles Zhang is notoriously fickle and many of his deals have collapsed even when they were reportedly near completion. But Zhang is probably realizing his video service could have difficulty competing against such well-funded rivals, and thus perhaps a deal this time will finally happen.

In the case of the earlier search tie-up, Sohu maintained firm control of the combined business, since its Sougou search engine was much larger than Tencent’s Soso. But even after the merger, the new search engine has failed to gain much ground. That poor result may lead Tencent to insist on control for this new video tie-up, since in this case the 2 sides are relatively equal in terms of size.

Sohu may be more inclined to agree to such a condition, since its latest results show its video unit posted flat revenue growth in last year’s fourth quarter, and the figure was actually down 8 percent quarter-on-quarter. What’s more, the unit wasn’t a huge money spinner, generating just $51 million for the quarter and $213 million for all of last year.

We’ll end with some thoughts on whether this move could presage a bid by Tencent for Sohu, or perhaps whether Tencent might financially back a Sohu privatization. I doubt the former will happen, even though it would certainly be a logical move after these 2 smaller tie-ups. Sohu’s other major business, its Changyou (Nasdaq: CYOU) gaming unit, is also struggling and would be a good fit for Tencent, which is China’s biggest gaming company.

The main obstacle to an acquisition is Charles Zhang, who is fiercely independent and would probably be loathe to sell his fading empire to another company. But Zhang may also realize that his company’s glory days on the Nasdaq are in the past and unlikely to return, meaning it’s still possible he could launch a privatization bid that would be backed by the cash-rich Tencent.

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