Will Sogou’s Costly War Against Baidu and Alibaba Pay Off?

A woman uses her smartphone and laptop.

Shares of Sogou (NYSE: SOGO) tumbled 8% on July 30 after the Chinese search engine provider posted mixed second-quarter numbers. Sogou's revenue surged 43% year-over-year to $301.4 million, but that missed estimates by about $3 million and marked its slowest growth rate since the company's IPO in late 2017. Net income rose 41% to $33.2 million, or $0.09 per American Depository Share (ADS), which beat consensus expectations by two cents.

Sogou offered some messy guidance for the third quarter. The company expects revenue to rise just 7% to 11% against the previous year due to a one-time charge related to a regulatory probe (caused by ads which allegedly "insulted a national hero"), the discontinuation of its sales of non-AI hardware products, and the depreciation of the renminbi (RMB). Sogou didn't offer any guidance for the full year.

To make matters worse, Sogou's rising expenses and tumbling margins indicate that it's fighting a losing battle against Baidu (NASDAQ: BIDU) and Alibaba (NYSE: BABA) for China's search market. Let's take a look at what Sogou is up against, and whether it can continue growing over the next few quarters.

Understanding Sogou's business

Sogou was originally a search engine integrated into Sohu 's (NASDAQ: SOHU) network of online portals. Sohu spun off Sogou in an IPO last year, and retained over 30% of its outstanding shares. Tencent (NASDAQOTH: TCEHY) also invested in Sogou, and eventually acquired over 40% of the company.

Tencent owns WeChat, the most popular mobile messaging app in China, the older QQ messaging platform, and the Qzone social network. Tencent has been expanding WeChat into an all-in-one platform for mobile payments, e-commerce transactions, ride-hailing services, deliveries, and other services in recent years.

That expansion pivoted Tencent toward Baidu and Alibaba's core markets. But since Tencent didn't dominate either the search or e-commerce markets, it started investing heavily in Baidu and Alibaba's smaller competitors -- including Sogou and online .

Sogou only controls about 5% of China's online search market, according to web analytics provider StatCounter. That puts it in a distant third place behind Baidu and Alibaba's Shenma , which control 69% and 20% of the market, respectively. However, Tencent's integration of Sogou's search engine and other tools into WeChat -- which hit 1.04 billion monthly active users (MAUs) last quarter -- could help it gradually expand.

How fast is Sogou growing?

Sogou's search and search-related revenue rose 45% to $270.6 million, or 90% of its revenue, last quarter. Sogou attributes that growth to robust demand for its auction-based pay-for-click services, which was supported by the growth and improved monetization of its mobile searches.

Auction-based pay-for-click services generated 85% of Sogou's search and search-related revenues, compared to 83% in the prior year quarter. The number of advertisers on this platform rose 10% year-over year to 83,000, while average revenue per advertiser jumped 35% to $2,760.

Sogou's "other" revenues, which accounted for the remaining 10% of its top line, rose 27% on stronger sales of smart hardware products and higher internet value-added revenues.

But mind those rising expenses...

Sogou's top line growth looks solid, but its margins are contracting. The company's gross margin tumbled ten percentage points in the second quarter to 40% as its traffic acquisition costs jumped 91% to $135.7 million. Management attributed those higher costs to tougher competition.

Sogou's second-quarter operating expenses rose 21% to $96.8 million due to a 48% jump in R&D expenses (reflecting higher spending on AI-related hardware projects) and a 27% increase in general and administrative expenses. As a result, operating margin fell four percentage points to 8%.

In other words, Sogou is spending a lot of money to challenge Baidu and Shenma in the search market, but its market share has remained roughly the same over the past year. Meanwhile, Tencent shoulders less risk since it merely classifies Sogou as an investment, while it gains Sogou as WeChat's default search engine.

Should you bet on this underdog?

Sogou's stock looks cheap at about 19 times next year's earnings, moreover, it's trading at a near-30% discount to its IPO price. However, investors are shunning this stock for two clear reasons: It faces a costly uphill battle against Baidu and Alibaba, and Tencent seems to be a safer way to invest in Sogou. Therefore I'd buy those three stocks instead of Sogou, which simply faces too many headwinds as a stand-alone investment.

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Leo Sun owns shares of Baidu,, and Tencent Holdings. The Motley Fool owns shares of and recommends Baidu,, and Tencent Holdings. The Motley Fool recommends 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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