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Just a half year after pooling their online search assets, leading web firm Tencent (OTCPK:TCEHY,HKEx: 700) and the much smaller Sohu (Nasdaq: SOHU) are reportedly in talks to also merge their video businesses amid a broader wave of consolidation sweeping China's Internet. I have some doubts about whether this new deal will happen for reasons I'll explain shortly, though I'm far less skeptical now than I would have been at this time a year ago. If such a deal does happen, it could mark the latest step in what could become Tencent's eventual acquisition of Sohu, one of China's oldest Internet companies.

According to the latest reports, Tencent CEO Pony Ma and Sohu CEO Charles Zhang have reached a tentative deal to pool their video businesses, which would create a new company that would be one of China's top 3 players (English article). Zhang would head the new company, while Tencent would own a major but not controlling stake, according to the reports, citing an unnamed source close to both parties.

This particular deal looks quite similar to another tie-up between Tencent and Sohu formed last year in the online search space. That deal saw Tencent combine its Soso search service with Sohu's much larger Sogou to create a major new player with around 13-15 percent market share (previous post). In that case, Tencent acquired a major but not controlling 36.5 percent of Sogou for $448 million. In both cases, Sohu's assets that it contributed to the tie-ups were significantly larger than Tencent's.

This latest Sohu-Tencent tie-up would nearly complete a consolidation in the online video space that has taken place over the past 2 years. Industry leader Youku Tudou (NYSE: YOKU) is itself a result of that consolidation, following the merger of China's 2 largest players in 2012. A clear second-largest player has emerged more recently, after online search leader Baidu (Nasdaq: BIDU) pooled its iQiyi video service last year with its purchase of PPS, another leading player. A Sohu-Tencent tie-up would create a third major player with nearly 15 percent of the market, versus about 17 percent for iQiyi and 30 percent for Youku Tudou.

If rumors of this deal had been reported at this time last year, I would have said there was only a 20-30 percent chance that a final deal would happen. That's because Sohu's CEO Charles Zhang is quite famous for both his independence and stubborn nature, which often causes his deals to collapse. Before last year's online search deal, Sohu was in talks with several other companies for similar tie-ups involving Sogou, but all ended in failure. The final Sogou tie-up surprised many, including myself, since Tencent was always considered a longshot for the deal.

But that deal and these latest rumors show that Zhang has perhaps finally found a partner he likes in Tencent's Pony Ma. Zhang must certainly like the fact that Ma is giving him big new money and Tencent's own related assets, and also that Ma is only buying non-controlling stakes in the new tie-ups. That's important for someone like Zhang, who considers himself a Chinese Internet pioneer and wants to remain a player in the industry despite Sohu's failure to keep pace with other top companies.

As I've said at the outset of this post, a Sohu-Tencent video deal could easily be a prelude to an outright acquisition of the former by the latter. Tencent would already own major stakes in 2 of Sohu's 3 biggest assets if the pair reach a video deal. Sohu's third major asset, its Changyou (Nasdaq: CYOU) online game business, would also be a strong natural complement for Tencent's own industry-leading game business. Tencent could easily afford to purchase Sohu, which would cost less than $4 billion based on its latest market value. Zhang might be tempted to take such a deal, which would allow him to remain a significant player in China's Internet while ensuring his company doesn't rapidly fade into obscurity.

Disclosure: No positions

Bottom line: Sohu and Tencent are likely to reach a deal to pool their video assets, which could be the prelude to an eventual purchase of the former by the latter.

Source: Tencent Eyes Sohu Video, Merger Ahead?