Forget Search and Video -- Check Out This Stock's Gaming Profits

Sohu (NASDAQ: SOHU  ) finds itself in a tight space -- it competes in many areas, but it's not the best in any of them. Fortunately, Sohu does have one business that's raking in the dough: online gaming.

Two surprising facts from Sohu's annual report 
When analyzing Sohu's business, you may quickly get this picture: Sohu lags behind Baidu in search, Youku Tudou in video, and Tencent and SINA in online portals.

The company does have a $1 billion war chest to tackle its competitors. But, it's doubtful that $1 billion will go far. Sohu is competing in extremely competitive industries, and will probably burn all of its cash to battle these top dogs. Luckily, Sohu can choose to forgo any confrontation in search, video, and online portals.

Instead, Sohu can choose to tackle online gaming.

Now, before you laugh, consider this: Last year, Sohu raked in 60% of its revenues from its gaming division. That means that Sohu generates more of its money from online gaming than it does from search, video, and portal advertising combined! If you don't believe me, just check out the income statement in their annual report.

To be fair, these revenues come from their stake in game company Changyou (NASDAQ: CYOU  ) . Because Sohu owns a majority stake in Changyou, Sohu must consolidate all financials into its statements -- even as Changyou is independently listed on stock exchanges. Whatever the case, Sohu actually created Changyou -- it started as a business unit in 2003, then was spun out in 2007. In any case, Sohu should do some serious soul-searching.

Just look at its fat profit margins from online gaming. In 2012, Sohu's advertising gross profit margin was 44%. Not bad, but Sohu's gaming gross profit margin was about DOUBLE that. Surprisingly, compared to the gross profit margin from the gaming industry, Sohu is among the best.

Company

Gross Margin

Giant Interactive (UNKNOWN: GA.DL  )

87%

Sohu

86%

Perfect World

84%

Netease (NASDAQ: NTES  )

68%

Source: 10-Ks

However, it's understandable that you may worry about Sohu's gaming business. If it focuses solely on this industry, Sohu will have to go toe-to-toe with industry giants.

One company Sohu will have trouble with is Giant Interactive. Like Sohu, Giant Interactive creates games specifically for the Chinese market. But, unlike Sohu, Giant Interactive has done so for longer -- it started in 2001 -- and with more focus than Sohu. So, Sohu has its work cut out for it. Luckily, Giant Interactive has taken a hit since insiders cashed out this month – giving Sohu an opening if it can react quickly enough.

Another company Sohu would also have to compete and catch-up with is Netease. Not only does the company continue to push out new domestic titles -- its last three helped Netease increase revenues 14% QoQ -- but it is also building foreign partnerships. Netease already has a licensing agreement with Activision Blizzard to bring World of Warcraft to China. Luckily, World of Warcraft is censored, and it remains to be seen if the game mechanics will profit Netease.

Should you buy Sohu for its games?
While there are big competitors to fight, Sohu seems like it has a better chance battling gaming competitors than online portal, search, and video giants. Additionally, as China's online gaming market has grown 56-fold over the past decade, there may still be room for even greater gaming profits going forward.

All you need to look for is where Sohu invests its $1 billion war chest. If it tackles gaming, then Sohu may be a great buy.

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