INTERNET: Sohu Runs Out of Steam, Borrows from Game Unit

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Bottom line: Sohu may be forced to separately sell off its portal, video, search and gaming units over the next 1-2 years, or risk seeing them gradually fall in value as the company’s losses mount.

Sohu plunges after latest results

After running for years as a solid second-tier player, Internet veteran Sohu (Nasdaq: SOHU) is finally showing signs of running out of steam, based on its latest quarterly results and word of a major new loan to the company from its cash-rich but fading Changyou (Nasdaq: CYOU) gaming unit. This kind of turn isn’t all that surprising, since status as a second-tier player should only be temporary and such companies should either aspire to top-tier positions or sell themselves to rivals to ensure their longer term survival.

But Sohu has defied such pressures, largely due to the fiercely independent nature of its founder Charles Zhang, who is both quite shrewd but also famously averse to giving control of his empire to others. These latest results show that Zhang may soon have no choice but to sell some or all of his company, or risk seeing it slowly relegated to oblivion due to pressure from better-run rivals.

Topping the latest results are a headline net loss of $75 million for the third quarter, reversing a $39 million profit a year earlier. (company announcement; Chinese article) Here it’s worth noting that Sohu seems to float freely back and forth between the profit and loss column these days, and posted a net loss of $63 million in this year’s second quarter, and also forecast a loss of about $85 million for the current quarter.

The losses nicely summarize the company’s situation, which has seen its 2 most promising growth engines, search and online video, suddenly show signs of running out of steam. Sohu’s 2 largest revenue sources, gaming and advertising from its original portal business, have both been slowing and even contracting for years.

That trend continued in  the latest quarterly report, with gaming and online advertising revenues down 35 percent and 13 percent, respectively. But most worrisome were the big slowdowns in Sohu’s online search business, whose revenue was up an anemic 2 percent, and online video, which plunged 54 percent. Those trends look set to continue in the current quarter.

The company’s cash position still looks relatively solid, with Sohu reporting it had $1.36 billion at the end of the quarter, down from $1.42 billion a year earlier. But at the same time, the company said in a separate filing with the US securities regulator that it had secured a 1 billion yuan ($150 million) loan from its Changyou unit. (Chinese article)

Funding Operations

A description of the loan appears to show it’s more like a credit facility, designed to assist Sohu in running its daily operations. It carries a 6 percent interest rate, which looks relatively high but not outrageous in the current environment. But the fact that Sohu has to turn to its own subsidiary for such funding suggests it can’t get equally good terms from a private sector lender, which looks a bit worrisome.

Investors certainly weren’t too excited about the latest results and disclosure of the Changyou loan, sparking a sell-off that saw Sohu shares plunge nearly 7 percent in the trading session after all the news came out. That drop brought the stock to nearly a 3-year low, and gives the company a relatively modest market value of just $1.5 billion.

All that said, the future certainly doesn’t look too bright for the company, and I would expect to see its shares come under growing pressure in the months ahead. The company has touted its Sogou search unit as a big growth engine for years, but the latest figures show that part of the business may have crested and could even start to contract. Meantime, the video business is suffering from Zhang’s refusal to combine that unit with a rival, even as most other major players have been purchased in the last 2 years.

That brings us to my final assertion, namely that Sohu’s days as an independent company could be numbered and that Zhang may finally be forced to sell off his various assets one at a time over the next 1-2 years. At this point he could still possibly get a decent price for many of those businesses, since most still enjoy relatively strong reputations. But if he waits much longer, those businesses will continue to wither, reducing their value to any potential buyers.

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