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Sohu Partners Tencent

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Shares of Inc (SOHU - Free Report) surged 7.51% ($4.86) to close at $69.61 on Sep 16, after the Internet service provider announced a partnership with Chinese e-commerce provider Tencent Holdings Limited.

Under the terms of the deal, Tencent agreed to invest $448.0 million in cash to acquire a 36.5% stake in Sogou (Sohu’s search business), which can be increased to 40.0% in the future.

Tencent’s Soso search related business and certain other assets will be merged with Sogou. Sohu will hold the controlling interest in Sogou, which will continue to operate as a subsidiary of Sohu.

Sohu Chairman and CEO Charles Zhang will remain Sogou's chairman. Tencent president Martin Lau and chief operating officer Mark Ren have joined Sogou's board of directors, as per the terms of the partnership.

The Sohu-Tencent partnership will improve Sogou’s competitive position against market leader Baidu Inc. (BIDU - Free Report) and Qihoo 360 Technologies , which ranks second in both PC and mobile search market, going forward.

The deal particularly hurts Qihoo’s prospects as it was looking to challenge Baidu in the search market. Qihoo launched its own search engine in Aug 2012 and reached the second position with 18.0% market share within a short span of time.

Sohu and Qihoo had been engaged in active discussions regarding the sale of the Sogou search engine. However, talks broke down in mid-August, this year. Qihoo shares plunged 5.61% ($4.93) to close at $82.93 on Sep 16.

Tencent’s strong mobile user base will boost Sohu’s mobile search traffic. Sogou will become the default search engine for Tencent’s mobile browser. Tencent will also promote Sogou’s mobile input method on mobile platforms such as mobile QQ and WeChat.

The partnership will boost Sohu’s user base and market share, which will further improve monetization efficiencies over the long term. Sohu expects Sogou to grow at a faster rate in 2014 based on the synergies from this partnership.

We believe that Tencent’s investment will improve Sohu’s liquidity, which will help it to invest further on developing video and other services. We believe that Sohu’s innovative product pipeline and monetization efforts by selling mobile ads on video for Apple’s (AAPL - Free Report) iPad will drive top-line growth going forward.

However, continuing investments in product development will keep margins under pressure in the near term. Despite higher spending and the recent partnership, we believe that market share gain will be difficult in the near term due to stiff competition in most of its operating markets.

Currently, Sohu has a Zacks Rank #5 (Strong Sell).

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