Shares of Sogou (NYSE:SOGO), China's second-largest online search provider after Baidu (NASDAQ:BIDU), surged over 40% on July 27 after the company received a buyout offer from its top stakeholder, Tencent (OTC:TCEH.Y).

Tencent already owns 39.2% of Sogou's shares, which grants it a voting stake of 52.3%, and wants to buy all the remaining shares for $9 per ADS in a $2.1 billion all-cash deal. Tencent would buy most of those shares from Sohu (NASDAQ:SOHU), Sogou's former parent company and second-largest shareholder.

If the deal is approved, Sogou would be delisted and become a wholly owned subsidiary of Tencent. Sohu and Sogou haven't agreed to the deal yet, but the takeover could significantly strengthen Tencent's ecosystem and spell trouble for Baidu.

A young woman uses a smartphone.

Image source: Getty Images.

How Tencent kept Sogou relevant

Sogou controls 22% of China's online search market, according to Statcounter, putting it in a distant second behind Baidu's 66% share.

As the underdog, Sogou spends a lot more money to secure traffic and advertisers than Baidu. Sogou spent nearly half its revenue on traffic acquisition costs (TAC) last year, while Baidu's TAC usually account for less than a fifth of its total ad revenue. 

Tencent kept Sogou relevant by integrating its search engine into WeChat, the top messaging platform in China with over 1.2 billion monthly active users. WeChat also hosts Mini Programs, which enable over 400 million daily active users to make payments, buy products, play games, hail rides, and access other services without ever leaving the app.

Why does Tencent want to buy Sogou?

But three years ago, Tencent launched its own internal search engine for indexing content within WeChat's own walled garden, sparking fears that it could render Sogou obsolete if it expanded into online searches. Tencent's buyout offer allays those fears, and suggests it would be cheaper to buy Sogou instead of expanding WeChat Search into a full-featured search engine. Buying Sogou would also widen Tencent's moat against ByteDance, which launched an internal search engine for its popular news app Toutiao last year.

Sogou's other main product is its Mobile Keyboard app, the most popular input app for Chinese characters in China. Sogou subsequently added voice typing and searches to the app, which expanded its reach beyond its text-based search engine. The app reached 482 million daily active users and processed 1.4 billion daily voice queries last quarter.

Baking Sogou's Mobile Keyboard into WeChat would enable Tencent to gather more data and improve the platform's voice-activated features. That integration could strengthen Tencent's position in China's virtual assistant and smart speaker markets, which are currently dominated by Baidu, Alibaba, and Xiaomi. Sogou also develops AI devices like smart voice recorders; integrating that technology into Tencent's own AI ecosystem could help it compete more effectively against Baidu, which currently leads China's AI market with its virtual assistants, natural language processing tools, and driverless cars.

How could this buyout hurt Baidu?

Baidu remains the market leader in PC and mobile searches, but WeChat's growing "walled garden" of Mini Programs and Sogou's Mobile Keyboard could both pull users away from its search engine.

Two adjacent keys on a keyboard, one with a Chinese flag, and the other labeled "web".

Image source: Getty Images.

That's why Baidu launched a similar Smart Mini Program (SMP) platform for its mobile app two years ago. However, its mobile app only had 222 million daily active users last quarter, and it hosts fewer Mini Programs than WeChat. Baidu also launched its own Mobile Keyboard app, but it still processes fewer daily voice queries than Sogou's Mobile Keyboard.

Baidu is already struggling to keep pace with Tencent in the online advertising market. In their latest quarters, Baidu's online advertising revenue dropped 19% annually, while Tencent's ad revenue jumped 32%.

Tencent attributed its growth to robust ad spending from the gaming, e-commerce, and online education sectors throughout the COVID-19 lockdowns -- yet those companies seemingly ignored Baidu, which blamed the pandemic and competition for its ongoing slowdown.

Even Sogou fared better than Baidu, as its search and search-related revenue rose 1% annually in the first quarter. Therefore, Tencent's takeover of Sogou would unite two faster-growing ad platforms under a single umbrella -- and cause serious headaches for Baidu.

The key takeaways

In previous years, Tencent has mainly invested in companies instead of buying them out. But over the past year, Tencent made more acquisitions, including Norwegian game developer Funcom and China's game streaming platform Huya.

Those moves, along with Tencent's recent pledge to invest 500 billion yuan ($70 billion) over the next five years in the development of its digital infrastructure, indicate it's taking the gloves off in its ongoing ecosystem war against Baidu, Alibaba, and ByteDance. If Baidu doesn't respond soon to Tencent's latest moves soon, its ad revenue could continue to wither as users migrate to WeChat and other platforms.