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Morningstar | Cut Sohu's FVE to USD 48.5, Following Weak 2Q Earnings and Disappointing 3Q Guidance. See Updated Analyst Note from 31 Jul 2018

We lower no-moat Sohu's fair value estimate to USD 48.5 per share from USD 64.0, following the company's weak second-quarter results and disappointing third-quarter guidance. Net revenue growth slowed to 5.4% in the second quarter from 21.6% in the first quarter, with weakness spreading across all non-Sogou segments--Sohu Media portal, Sohu Video, and its online game subsidiary Changyou. Sogou continued to be the growth driver, with a decent 43% year-over-year revenue growth in U.S. dollars and 33% growth in Chinese yuan. However, intensified competition saw its traffic acquisition cost rise sharply by 91% from a year ago, which leading to 10% gross margin squeeze for Sogou. We expect cost inflation to continue to be the key drag for Sohu's bottom line, despite the company's cost-cutting efforts on its online video business, and we maintain our view that Sohu will remain loss-making until 2021. We think the shares are slightly undervalued after 41% share price declines amid the current headwinds. We expect the company's profitability to improve and become profitable from 2021, following a series of strategic moves within business segments, including stricter cost controls, improving product quality, as well as new product initiatives.

For the third quarter, Sohu guided to a continuous weak outlook, with double-digit declines at both brand ads and online game segments. In addition, Sogou also expects its revenue growth to slow to 7%-11%, driven by the 10-day suspension of its advertising business in early July due to improper ads content related to Douyin, and the restructure of product portfolio of AI-related hardware sales, as well as renminbi depreciation against the U.S. dollar. These will lead to 9%-14% revenue decline for Sohu.

In the second quarter, Sohu's online video business saw its quarterly loss narrowing to USD 35 million from USD 103 million a year ago, as a result of lower spending on licensed content, which helped to lift the quarterly gross margin from brand ads to 23% from negative 1% a year ago. However, net loss from the media portal business widened to USD 37 million, compared with USD 10 million a year ago. We think this is largely owing to the high spending for the preinstallation of the Sohu News App on Huawei's smartphones. We expect the preinstallation, along with Sohu's efforts in consistently refining its product design and content quality, to derive positive growth momentum, in terms of daily active user and user time spent on Sohu News App, in the next four to six quarters.

Sogou maintained healthy growth in the second quarter, with quarterly revenue and net profit rising 43% and 58%, respectively, from a year ago. The company's third-quarter revenue guidance of USD 275 million to USD 285 million, or 7%-11% year-over-year growth, is below our expectation, which was partially due to the off-one impact of the 10-day suspension, and foreign exchange risks. Despite the near-term challenges, we continue to expect Sogou's dominant position in mobile keyboard, and its alliance with Tencent with increasing search services on weChat content, as well as the company's new initiatives in AI-related products to help the company resume a healthy growth in 2019.

Changyou posted 25% decline in second-quarter revenue and 54% in the quarterly net profit. While this was largely driven by restructure of its cinema business, we see a weakening trend of its aggregate active paying accounts, which fell 13% sequentially in the third quarter. Changyou's profit has been largely relying on its key IP TLBB over the past 10 years, including TLBB PC and legacy TLBB mobile. Without visible IP/game pipelines, we think the lifecycle of Changyou's TLBB may suggest high uncertainty for the company's online game business, and we remain cautious on Changyou.