Sohu: Underappreciated Company in the Midst of a Brand Reinvention

| About: Inc. (SOHU)

“Our greatest glory lies in not never falling, but in rising every time we fall.” – Confucius

In my article on The Power of Brand Investing, I pointed out that company with a successful brand could generate spectacular shareholder value from its introductory to domination phase. However, misjudgments by the management could result in painful shareholder return, as we have seen in Research In Motion (RIMM) and Blockbuster.

While a fallen brand company could face insurmountable challenges in revitalizing its brand or shareholder recognition, a combination of right leadership and sound strategy can rejuvenate the brand that ultimately translate to rewarding shareholder return, such was the case with Apple Computer (NASDAQ:AAPL), Nintendo (OTCPK:NTDOY), and Coach (NYSE:COH).

There is another company that I believe is in the midst of a brand reinvention and is underappreciated by the investment community. After its CEO made several strategic errors during the company’s early growth phase that cost its market share and competitiveness, he is determined to restore its prior industry leadership. The CEO is Charles Zhang, and his company is (NASDAQ:SOHU).

Sohu operates web portal and online gaming in China. It ranks 2nd in online advertising and 5th in online gaming. The company has a market cap of about $3 billion and is trading at 15x FY2011. To truly appreciate Sohu, it is better to first understand Charles Zhang and Sohu’s history.

Charles Zhang grew up near Xi’An, a relatively poor region of China that is home to the Terracotta Warriors. From a very young age, Zhang developed an interest in science and later studied physics at Tsinghua University (MIT-equivalent of China). Upon graduation in 1986, Zhang attended MIT, and later graduated with a PhD in experimental physics in 1993.

After working at Internet Securities Inc. for a year, Zhang envisioned creating a search engine company in China. That idea became Internet Technology China (ITC), which Zhang founded in 1996 with the help from Nicholas Negroponte, founder of MIT’s Media Lab, and Ed Roberts, founder of MIT Entrepreneurship Center, and VC funding. The VC funding was the first on a Chinese Internet startup. Later in 1998, Zhang renamed ITC to Sohu, literally meaning “search fox” in Chinese.

1998 was a year to remember. Sohu became China’s first search engine and it was widely accepted by China’s nascent web user base. The success of Sohu marked the beginning of China’s internet age, and laid the foundation for future technology VC investing in China.

In the same year, both Dow Jones and Intel invested in Sohu, and Sohu’s revenue reached $1 million. By autumn, 1999, Sohu entered e-commerce with the backing of Intel, which provided Sohu with technology that allowed internet users to make transactions using debit cards. To further expand its online presence, Sohu acquired, China’s first generation social networking site (SNS), in 2000. By then, Sohu was one of top ranked internet companies in China, and Charles Zhang accomplished this before the birth of “Chinese Google” Baidu (NASDAQ:BIDU), “Chinese Facebook” RenRen (NYSE:RENN), and “Chinese Amazon” E-Commerce Dangdang (NYSE:DANG).

By the time Sohu became the leading website for internet search, SNS, and infotainment, Zhang made the error of being overly content and disregarded the company's emerging threats. As a result, this error laid the seed that brewed the success of Baidu (BIDU), RenRen (RENN), and Sina (NASDAQ:SINA).

In late 1999, Baidu was launched using the RankDex site-scoring algorithm for search engine that its current CEO Robin Li developed while working in the US. Because of the superior search results Baidu provided to users, it quickly took 60% of China's internet search market share after just five years of operation.

In 2005, Jack Xu, founder to and who was still working at Sohu, approached Zhang and raised the possibility of SNS becoming the next big thing in China. That was the same year that Xiaonei, which was later renamed to RenRen (RENN), was founded. However, Zhang was indifferent about developing ChinaRen to be the leading SNS in China, a decision which he now regrets. RenRen eventually climbed its way to become China's most widely used SNS with over 160 million users and is valued at approximately $3 billion.

Like both Baidu and RenRen, Sina was a late-comer in China's internet boom, but nonetheless quickly gained recognition and popularity after its extensive coverage of NATO bombing of Chinese embassy in Belgrade in 1999. This event allowed Sina to gain increasing traction and recognition by the users, which allowed Sina to overtake Sohu as the largest infotainment web portal in China.

To many North American investors today, Zhang's Sohu is a neglected brand. The company doesn't have Weibo, the Chinese Twitter owned by Sina, an SNS that's comparable to RenRen, an e-commerce site that rivals DangDang (DANG), or a video streaming site that is as popular as Youku (NYSE:YOKU). Even Sohu's gaming unit, Changyou (NASDAQ:CYOU), approximately 50% of Sohu's revenue, only ranks fifth in online gaming and competes with Shanda Interactive (NASDAQ:SNDA), Giant Interactive (NYSE:GA), NetEase (NASDAQ:NTES), and Perfect World (NASDAQ:PWRD) in the MMORPG space that is dominated by capricious gamers who demand continuous innovation.

How can Sohu reinvent its brand image to be the dominant internet company it once was?

The answer lies in Sogou, Sohu’s search engine unit that has 1.2% of China’s search market share, behind Baidu (83%) and Google (NASDAQ:GOOG) (11%), according to Analysis International. Sohu could cultivate its expertise in search while creating value-added products, such as the Sogou Browser and Sogou Pinyin Input (used to type Chinese characters using computer keyboard) to attract and retain users that could ultimately result in future advertising revenue.

It comes as no surprise that North American investors do not appreciate Sogou’s products, since many prefer to use Google or Microsoft's (NASDAQ:MSFT) Bing for search, or a choice of Internet Explorer, Firefox, or Chrome for browsing. As for Pinyin Input, many of us here in North America do not use it because we don’t type Chinese characters. When a majority of investors do not use any of Sogou’s products, it is hard to grasp their significance and the value they present to internet users.

Seven years after its founding, Sogou has become the third widely used search engine in China. Similar to Baidu in its early years, Sogou offers internet search, streaming music and videos, photos, map, forum, news, and blogs. In 2Q11, Sogou generated $13.6m in revenue, up 252% y/y and 71% q/q. Unfortunately, Sogou registered a $3m loss in profit. But, according to its Chief Executive Wang Xiaochuan, search volume doubled over the past year and Sogou is on track to be profitable by 2012. Ultimately, Sogou hopes to overtake Google as the second most widely used search engine in China.

Sogou’s success will depend on its value-added products and Google’s diminishing presence in China’s internet search market

Sogou Pinyin Input is the most widely used Chinese input software with 84% of the market share and over 300 million users. This software is also available for over 900 million mobile phone users in China.

Sogou Browser is third widely used browser in China with 6% market share behind Internet Explorer (64%) and Qihoo 360 (19%) by Qihoo (QHOO). Sogou Browser is unique in that it embeds both Internet Explorer and Google Chrome features, which greatly improves compatibility when browsing. As of most recent quarter, Sogou Browser generates 80% of Sogou’s search traffic, and it will be increasingly significant after Sohu introduces a Taobao optimized browser for e-commerce because majority of online shoppers use web-based search engine to seek items online. Sogou also plans to expand its headcount by 30% to 800 by the end of the year to improve its R&D capabilities.

Sogou Music Player, the software that allows users to stream both Chinese and English music on their PC, could be another overlooked driver behind Sogou’s future success. Streaming music was a key feature for Baidu’s success over Google during the early phase of China’s internet search war. By the time Google created its own music streaming service to compete with Baidu, it lacked the scale and was too late to attract Baidu users to switch. Sogou music has both English and Chinese music in its database compare to only Chinese music in Baidu’s database. Even though Chinese music is extremely popular among users, there is also a growing acceptance of English music. Streaming English music service, along with popular character input and browser products, could generate user stickiness and brand loyalty to Sogou, and that could result in incremental adoption of Sogou search as an alternative to Baidu.

Finally, Google’s poor execution could also help Sogou to gain market share. Google’s low quality Chinese search results are likely to encourage web users to switch to Baidu and Sogou, because both home-grown search engines are customized to the local market and meet users’ needs. Once Google becomes irrelevant in China, Sogou would be in a favorable position to compete with Baidu by offering advertisers a different, or possibly better, value propositions.

I have deep respect for Charles Zhang. After all, we both grew up in the same region of China and share the same last name. But most importantly, Charles Zhang is an entrepreneur and an innovator of China’s internet industry. Because he is unmarried, Charles Zhang dedicates his life to Sohu’s development. I am sure his legacy will not only be based on his creation of China’s first internet search engine, but will also be based on his ability to bring Sohu back on its feet and to be appreciated by investors here in North America.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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