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Morningstar | Sohu Is Undervalued as Its Business Improves From a Very Low Base

We plan to maintain our fair value estimate for no-moat Sohu at $48.50 per share as our fourth-quarter estimates are broadly in line with guidance. We maintain our view that the company will not be able to make a profit on a net basis until 2021. Sohu appears undervalued, as we think reduced content costs and head count will eventually help the company to reach profitability, although this will take time as it needs to improve the mobile apps and the existing advertising system. Sohu's revenue in the third quarter was in line with expectations, with the bottom line beating expectations as a result of tax benefits. On a constant-currency basis, revenue would have declined 9% year over year instead of 11%.

Although Sohu’s key mobile apps have gained daily active users (20% in September) and time spent, and its video paying user base is growing slowly, we continue to see brand advertising revenue down 24% year over year versus negative 29% in the second quarter. Sohu video continues to reduce content costs by developing lower-cost new original programs instead of purchasing expensive content; as such, the operating loss of the segment contracted 55% year over year to $27 million. We expect Sohu’s core business to see reduced costs as a result of head count reductions and a continuous decline in content costs.

Sogou, the separately listed business unit with the search business, received a tax benefit in the quarter, which was the main reason for the earnings beat. Revenue in the quarter missed consensus. Sogou’s search and search-related revenue was up only 13% year over year, a significant slowdown from 45% in the second quarter due to a 10-day suspension of certain advertising services in July after a government investigation into noncompliant advertisements on Sogou’s platform. Excluding the impact of the suspension, the segment’s revenue growth is estimated to be in the mid-20s.

Sogou registered an operating loss of $6.8 million versus a profit of $36 million in the same period last year due to a 58% increase in traffic acquisition costs and a 26% increase in research and development expenses. We expect traffic acquisition costs to continue to increase in the coming years, albeit at a slower rate, and research and development expenses to rise approximately 20%-30% in the next two years due to competition for talent.

Changyou beat expectations on revenue and profits, helped by the promotional events in the summer expansion pack of TLBB PC and mobile games and tax benefit. Changyou swung to a net income of $54 million from a net loss of $5 million in the same quarter last year, helped by the $12 million tax benefit.