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Sohu's New FPS in Open Beta

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Online media and entertainment services provider Inc’s (SOHU - Free Report) online gaming subsidiary, (CYOU - Free Report) recently announced that an open beta version of the upcoming new game Battlefield Online is now available to Chinese players.

Battlefield Online is the Chinese online version of Electronic Arts (EA - Free Report) popular first person shooter (“FPS”) game Battlefield. However, the Chinese version is not a conventional FPS as it allows players to use jet fighters, tanks and aircraft carriers as the primary weapons, while firearms and ammunitions become secondary weapons.

Moreover, Battlefield Online not only allows players to compete as small teams but also provides a large scale combat mode that may involve up to 100 players. The Chinese version offers different infantry classes for players to select.

Battlefield Online is Changyou’s first FPS game. Although the Chinese FPS market is quite overcrowded, we believe that the distinct features and new variations of the upcoming game will attract new players, thereby expanding its subscriber base going forward.

Changyou has a dominant position in the Chinese online gaming industry (Changyou operates Tian Long Ba Bu, one of the most popular massively multi-player online games in China, and DDTank, one of the top-ranking web-based games in China), which will help the new game to solidify its position going forward.

Online gaming in China, which includes massively multiplayer online role playing games (MMORPG), and casual, social & web games grew 32% in 2011. Changyou ranked #4 in terms of revenue in the Chinese market and garnered approximately $485.0 million from online games. In a recent study from Pearl research, China's online gaming market is expected to touch $9.2 billion by 2014 from $6.6 billion in 2011. We believe that Changyou will continue to benefit from the strong growth trends of online gaming in China over the long term.

Besides Battlefield Online, Changyou’s turn-based MMORPG Tao Yuan is also expected to drive revenue growth going forward. Changyou has three more MMO games scheduled to release this year along with four web-based games. We believe that this strong product pipeline will drive Changyou’s top-line growth going forward.

Lately, online gaming operated by Changyou has been a major revenue driver for Sohu. In the recently ended third quarter of 2012, online game revenue increased 30.5% year over year to $151.1 million, well ahead of management’s expectation of $141.0 million–$144.0 million. We believe that Changyou’s improving subscriber base will boost Sohu’s top-line growth over the long term.

However, both Changyou and Sohu are facing significant competition from Tencent, Shanda Games and Renren Inc. . This has compelled both the companies to increase spending on product development and promotional expenses, which is hurting profitability. Moreover, a slowing Chinese macro environment (declining auto sales and weakness in real estate) may hurt Sohu’s growth in the near term. Thus we remain Neutral on Sohu and Changyou over the long term.

Currently, both Sohu and Changyou have a Zacks #2 Rank, which implies a Buy rating in the near term.

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