Will Sohu's Falling Margins Ever Stop?

Sohu.com (NAS: SOHU) , the Chinese online media, search, gaming, community, and mobile service group, reported a jump in third-quarter net income, but expenses relating to the launch of games and video offerings ate into its revenues. Let's take a closer, Foolish look at the action.

The results
Revenues for the quarter jumped 42%, to $233 million. The company's net income increased by 19%, to $64.3 million, from the year-ago quarter.

Sohu's online advertising business saw robust results as two of the company's fastest-growing divisions -- Sogou and Sohu Video -- sustained their uptrend.

Sogou sustained its dreamy top-line growth with revenues at $18.4 million, more than triple last year's figure on the back of terrific traffic growth and enhanced monetization.

Sohu's online video business, Sohu Video, boasted a 110% jump in advertising revenues from the same period last year. This is because from June to September, monthly unique visitors to the site increased by 49% and the number of videos viewed or released onto the video site was up 33%. This is according to statistics provided by comScore, a digital marketing intelligence firm.

Moving to Sohu's online gaming unit and subsidiary Changyou (NAS: CYOU) , revenues for the quarter shot up by 35%, to $116 million. But the division saw higher spends on bandwidth and hiring for its new game Duke of Mount Deer. This contributed to a decline in Sohu's operating margins from a loftier 39.8% in the previous year's quarter to 31.6%.

Spiraling costs
Sohu's results have shown a rather disturbing statistic. Operating margins dropped by a whopping 800 basis points, to 32% from 40% in the previous year.

The main problem causing this is Sohu's promotion-crazy gaming division. The brutally competitive gaming market prompts companies to shell out heavily for promotional activities, building and maintaining infrastructure, and employing operators.

This has left analysts questioning where the company is heading and when the erosion of margins will finally come to a halt.

China's very own Internet boom
China is the world's largest Internet market, with more than 450 million users. But the potential for growth is still there, with Internet penetration at approximately 30%.

And Sohu.com is not the only company trying to catch the action in the Chinese Internet market. Competitors also looking to cash in include search engine Baidu.com (NAS: BIDU) , online video content provider Youku.com (NYS: YOKU) , and social-networking site Renren (NAS: RENN) . The Chinese government doesn't seem to be too delighted about all this.

Government plays party pooper
China's ruling party has made it clear that it's going to strictly monitor microblogs, social media, and instant messaging services. The law would strictly punish the publication of supposedly "harmful information." This is especially applicable to Sohu rivals SINA (NAS: SINA) and Tencent Holdings, which run Weibo, a microblogging service, and QQ, an instant messaging service, respectively.

Tighter censorship may not have any immediate impact on such companies, but in the long run, censorship could drive away users.

The Foolish bottom line
While Sohu has posted impressive top-line growth, the company's declining margins are a source of concern. In addition to growing revenues, the company needs to dedicate some of its attention to bottom-line performance.

It will be interesting to see how Sohu deals with these problems in the coming quarters. To stay up to speed with the latest developments for Sohu.com, add it to your very own personalized stock watchlist. It's free.

At the time thisarticle was published Keki Fatakia does not own shares in any of the companies mentioned in this article.Motley Fool newsletter serviceshave recommended buying shares of Sohu.com, Baidu, and SINA. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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