Sogou (NYSE:SOGO) controls 18% of China's online search market, according to StatCounter, placing it in second place behind Baidu's (NASDAQ:BIDU) 65% share. Competing against Baidu has been tough for Sogou, which is backed by Tencent (OTC:TCEHY) and its former parent company Sohu, but it continues to grow in the tech giant's shadow.

Sogou recently posted its first-quarter numbers, which bore the full impact of the COVID-19 lockdowns across China. Its revenue grew 2% annually to $257.3 million, beating estimates by $6.6 million. Its non-GAAP net loss widened from $2.7 million to $31.1 million, or $0.08 per share -- but still matched analysts' expectations.

For the second quarter, Sogou expects its revenue to decline 8%-14% annually due to the impact of COVID-19, the contraction of the Chinese economy, and other macro and advertising-industry challenges.

That decline wasn't surprising since Baidu also recently posted a 19% annual drop in its ad revenue in its first quarter. But will Sogou emerge from the crisis a stronger company, or will the macro headwinds weaken its defenses against Baidu and other competitors in China's crowded advertising market?

A young woman checks her smartphone.

Image source: Getty Images.

How wide is Sogou's moat?

Tencent integrates Sogou's search engine into WeChat, the most popular messaging platform in China with over 1.2 billion monthly active users, to process internal searches. It also processes search results for Microsoft's Bing and the question-and-answer site Zhihu.

Sogou further differentiates itself from its rivals with its Mobile Keyboard app, the most widely used input app for Chinese characters in China. It subsequently added voice typing and searches to the app, which expanded its ecosystem beyond text-based searches.

The Mobile Keyboard app's daily active users grew 9% annually to 482 million during the quarter and processed up to 1.4 billion voice requests daily. Sogou also sells hardware devices, like AI-powered voice recorders, to tether more users to the platform.

How fast are Sogou's businesses growing?

Sogou's search and search-related revenue rose 1% to $237.6 million during the quarter. Auction-based "pay-for-click" services, which only charge an advertiser when an ad is clicked, accounted for 91% of that revenue, up from 87.2% a year earlier.

A person accesses a search engine on a laptop.

Image source: Getty Images.

However, Sogou's traffic acquisition costs (TAC) rose 27% annually and accounted for 70.5% of its total revenue, up from 56.6% a year earlier. Sogou claims it spent more money to acquire traffic as users remained confined to their homes during the COVID-19 outbreak, but it also indicates Sogou lacks pricing power in the online advertising market.

Baidu didn't disclose its exact TAC (which typically remains below a fifth of its online advertising revenue) in the first quarter, but it claimed the figure "decreased" annually. In short, Baidu can simply wait for advertisers to buy ads without ramping up its TAC, while Sogou must aggressively increase its TAC to maintain its current market share.

Sogou's "other" revenue, which mainly comes from its hardware devices, rose 6% to $19.7 million. However, that lower-margin revenue couldn't offset its surging TAC, and its non-GAAP gross margin contracted annually from 27% to 16%.

Baidu isn't the only problem

Sogou remains relevant, albeit in Baidu's shadow, in online searches, but China's advertising market is expanding beyond basic search engines.

Alibaba's Taobao and Tmall marketplaces are technically advertising platforms with paid product listings. Tencent sells its own ads across WeChat, its third-party mobile advertising network, and its streaming media platforms. ByteDance's short video app TikTok (known as Douyin in China) and news aggregator Toutiao are also lucrative platforms for advertisers pursuing China's Gen Z users.

Sogou's voice search ecosystem might help it expand beyond PCs and mobile devices, but it doesn't own a major virtual assistant platform like Baidu's DuerOS or Alibaba's Tmall Genie, which are both integrated into market-leading smart speakers.

Those challenges suggest Sogou is falling behind a tech curve as the biggest ecosystem leaders carve up the market. Sogou won't run out of cash anytime soon, since it still held $1.2 billion in cash and equivalents at the end of the quarter, but its surging TAC could overwhelm its revenue growth and result in wider losses.

Stick with the market leaders instead

Analysts expect Sogou's revenue to rise 5% this year, but for its earnings to tumble 26% on higher expenses. The stock only trades at 16 times forward earnings, but it's cheap because its moat is narrowing, its competitors are evolving, and it lacks pricing power in a tough market. Investors should stay away from Sogou and stick with established market leaders like Baidu and Tencent instead.