YOKU Youku Tudou Inc. American Depositary Shares, Each Representing 18 Class A Ordinary Shares.

Sohu.com (SOHU) quashed recent rumors of going private in an 8K filed with the Securities Exchange Commission (“SEC”). The Chinese online media, search and mobile service provider announced that it has not approached any investment bank and private equity fund to take the company private.

Sohu also denied rumors about delisting its common stock from the NASDAQ Global Select Market. The statement from Sohu was in response to a report from South China Morning Post, which claimed that the company is in talks with investment banks about financing for a potential private transaction. South China Morning Post cited four industry sources as the base of its report.

Following the news, Sohu’s share price jumped approximately 12.0% to close at $48.84 on Mar 5, 2013. However, post the 8K filing on Mar 6, Sohu’s share price declined approximately 11.0%. Over the past 12 months, Sohu has underperformed the broader market as its share price declined 9.2% versus a 12.6% growth in S&P 500.

The underperformance is due to investors’ skepticism on Sohu’s ability to remain profitable in the near term. Although Sohu reported a better-than-expected fourth quarter of 2012 beating the Zacks Consensus Estimate on both lines, margins contracted sharply primarily due to higher operating costs.

Operating expenses as a percentage of revenues were 47.3% compared with 40.1% in the year-ago quarter. The increase was primarily due to higher product development costs (up 51.5% year over year) and sales & marketing expenses (surged 49.9% from the year-ago quarter). Operating margin declined to 21.5% from 30.9% in the year-ago quarter.

Sohu is a relatively small player in the online Chinese advertising market and continuing investments in product development are necessary to expand market share. This is expected to hurt its profitability in the near term.

Moreover, we believe that market share gain will be difficult in the near term. Sohu faces stiff competition from Baidu (BIDU) in search and advertising, Youku Tudou (YOKU) in online video and NetEase (NTES) in online gaming markets.

In such a scenario, we believe that the private buyout rumor creates uncertainty for investors. Although a better buyout offer will be positive for investors, we believe that current sluggish macro-economic conditions in China will act as an impediment toward fetching a higher price.

We also believe that Sohu’s strong product pipeline and the growing popularity of Changyou’s games will drive profitability going forward.

Currently, Sohu has a Zacks Rank #3 (Hold).

 
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