Are’s High-Growth Days Over?

Shares of Sohu (NASDAQ: SOHU) tumbled 13% on July 30 after the Chinese internet services company posted mixed second quarter 2018 numbers. The company's revenue rose 5% year-over-year to $486 million, which missed analysts' estimates by $16 million and represented its slowest growth rate in five quarters. However, Sohu's non-GAAP net loss narrowed from $72 million a year earlier to $49 million, or $1.27 per American depository share (ADS), which cleared expectations by $0.22.

Unfortunately, that bottom line beat was overshadowed by dismal guidance for the third quarter. Sohu expects its third quarter revenue to fall between 9% and 14% against the third quarter of 2017, compared to expectations for 8% growth. That would mark its first quarter of negative sales growth since the first quarter of 2017. Let's see what happened, and whether Sohu -- which lost nearly 40% of its market value this year -- has a chance to recover.

A group of young people take a selfie.

Image source: Getty Images.

Why is Sohu's growth decelerating?

Sohu generates its revenue from online ads, online games, and other services. Here's how those businesses fared last quarter:

Business unit Revenue YOY growth
Online ads $331.87 million 22%
Online games $94.25 million (23%)
Other services $59.89 million (9%)

Source: Sohu Q2 2018 quarterly report.

Sohu sell ads across its portals, its Sogou (NYSE: SOGO) search engine and browser, and other online services. Sohu spun off Sogou in an IPO in late 2017, but still owns over 30% of the company. Tencent (NASDAQOTH: TCEHY) is now Sogou's largest stakeholder.

Sohu's ad revenue growth was uneven during the quarter. Its brand advertising revenues declined 29% annually to $61.5 million, but its search-related advertising revenues rose 45% to $270.4 million. Sohu attributed its declines in brand ad revenues to softer demand for portal and real estate ads, and its growth in search ad revenues to higher traffic and the improved monetization of mobile searches.

The company also locked in more users with Sogou's Mobile Keyboard app, which saw its daily active users (DAUs) jump 36% annually to 380 million during the quarter. Sogou and Baidu 's mobile keyboards are two of the most widely used input apps in China.

Sohu's online gaming revenues come from subsidiary Changyou (NASDAQ: CYOU) , which was spun off in another IPO back in 2009. Sohu attributed the steep drop in Changyou's sales to a "natural decline" in revenues from the company's "older games," including Legacy TLBB Mobile and Dao Jian Dou Shen Zhuan .

A young woman plays a mobile game.

Image source: Getty Images.

Facing competition on all fronts

Sohu doesn't expect its two softest spots -- brand advertising and online games -- to recover anytime soon. For the third quarter, it expects its brand ad revenues to fall another 13% to 20% year-over-year due to headwinds similar to those in the second quarter.

Sohu's brand ad revenues are fading because companies are flocking to more popular advertising platforms like Baidu (which controls nearly 70% of China's search market, compared to Sogou's 5% share) and Tencent's WeChat, the top messaging app in China. Sohu's portals also face competition from SINA 's aging portals, which are tethered to Weibo 's higher-growth social network.

Sohu expects its online game revenues to tumble 32% to 40% year-over-year in the third quarter due to a lack of compelling new titles and the drag of its older games. Changyou still owns a lot of older PC games, which experienced flat sequential growth last quarter, and its mobile games aren't topping the charts like Tencent's hits.

Tencent dominates the mobile market with games like Honor of Kings ( Arena of Valor ), PUBG Mobile , and QQ Racing , which are the top three Android games in China according to gaming market intelligence provider Newzoo. None of Changyou's games even crack the top 20 on that list. The weakness of its online games business is particularly disappointing since the unit has a much higher gross margin (85%) than Sohu's other businesses.

Simply put, Sohu remains a distant underdog in its core markets, and it needs to keep boosting its spending to stay competitive. That's why its operating expenses rose 10% (outpacing the organization's revenue growth) to $244 million last quarter.

Sohu's stock is cheap for a reason

Sohu's stock looks dirt cheap at about 0.5 times this year's sales. Unfortunately, its core growth engines are also sputtering out, and it doesn't have many catalysts on the horizon. Instead, Sohu faces tough competition from tech titans like Baidu and Tencent -- which could result in softer sales growth and uglier losses over the next few quarters.

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Leo Sun owns shares of Baidu, Sina, and Tencent Holdings. The Motley Fool owns shares of and recommends Baidu and Tencent Holdings. The Motley Fool recommends Sina and The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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