Shares of Qihoo 360 (UNKNOWN:QIHU.DL) declined more than 10% after the company reported its second-quarter earnings for 2014 late last month. Although both top- and bottom-line results beat analysts' estimates, concerns over the company's diminishing margins threw a wrench in an otherwise solid report.
Margins declined with competition from companies like Baidu (NASDAQ:BIDU) and Tencent Holdings (NASDAQOTH:TCEHY), which both offer products in PC and mobile security, mobile gaming, and Internet search. As those companies aggressively promote their products, Qihoo is forced to do the same.
So, what does management have planned to quell the growing margin concerns and overcome the competition? Here are five things from Qihoo 360's second-quarter earnings call that investors should know.
About those margins
For the second quarter, Qihoo posted a gross margin that declined two percentage points from the first quarter. Operating margin was 13.8% compared to 14.9% in the first quarter. Management attributed the margin decline to marketing expenses -- specifically, advertising during the World Cup -- and one-off expenses such as its acquisition of MediaV.
Going forward, CEO Hongyi Zhou sees the margin pressure dissipating, and expects those metrics to improve in the second half and in 2015. He gave two reasons:
One is that from industry perspective by the end of the year the penetration is done in terms of smartphones. You are getting into the replacement cycle. I don't think it's a wise way to spend ... huge money in pre-installation or channel in the replacement cycle. And two, we already achieved position, for the most part that we want to be. ... So many of those spendings we did this year ... was really from product and the channel and the marketing perspective prepared for us for the future growth and we certainly see that kind of growth coming
As the Chinese mobile market enters the top end of the S curve, Zhou is banking on the idea that Qihoo's cachet with current smartphone users will pay dividends in the replacement cycle. Meanwhile, Baidu is spending heavily on preinstalled apps, so that its app store and other apps are already on the phone when a consumer purchases it. Both strategies have their merits.
Revenue is increasingly mobile-based
Qihoo's app store competes with Baidu and Tencent for share of the market, with the real money coming from games. Qihoo has made tremendous progress with games. Game revenue is growing faster than its online advertising revenue, and accounted for about 46.1% of sales last quarter.
Zhou pointed to the progress on the earnings call:
In the second quarter we continued to make progress in monetizing our mobile app store through both advertising and mobile games. Despite a seasonally slower game market mobile already accounted for over 20% of our business in the second quarter.
The company's mobile user base exceeds its PC user base with 641 million smartphone users and 496 million PC users. Eventually, mobile revenue ought to increase beyond PC revenue, but it's slow going at first. The competition here is fierce as well with Tencent using its WeChat and QQ messengers to sell games and Baidu offering two app stores as well.
Search monetization is around the corner
Qihoo reported that its search engine, So.com, has grown to take 30% of the market. That's quite impressive considering it's only 2 years old and competes against the strength of Baidu. The amount of money search traffic is generating for the company, however, is minuscule. The company didn't report any exact figures, which is telling of how far search monetization has to go.
On the conference call, Zhou gave an indication that a ramp-up in monetization isn't far off.
In terms of the monetization of the mobile search, I think first of all we have been following very conservative and very careful route in terms of monetizing our PC search so far. And the reason behind that is ... we learned a lesson from our competitors. We don't want to really [be] hurting user's experience. But as the technology, moving forward, as well as the overall kind of a user behavior and the user habits change, we actually see the opportunity that we can increase the intensity of monetization of our search engine without really hurting user experience.
There's plenty of room for growth in mobile search revenue. Last quarter, Baidu -- with about twice as much traffic as Qihoo -- generated approximately $577 million in mobile search revenue. Many users have complained, however, that Baidu is too full of ads and promotes its own products. A fate Qihoo is clearly trying to avoid.
An ad exchange may be in the works
In order to help monetize search, Qihoo acquired MediaV last quarter. The acquisition will help in the near term with improved targeting for display and app store ads. Zhou also sees the acquisition helping with search advertising and contextual ads.
Long term, MediaV sets up Qihoo to offer an ad exchange, and profit off of other publishers. Zhou told analysts:
MediaV will enable us to offer an ad exchange ... basically using MediaV to [help] others to improve their advertising efficiency. ... You know, we certainly benefit from that.
As Qihoo continues to grow its share of Internet search and increase its mobile users, setting up an ad exchange is a natural progression. With tons of data on its users, advertisers will certainly be interested in using it to target potential customers.
Imminently entering enterprise
Qihoo has had tremendous success providing security to consumers on their PCs and smartphones, but the company has yet to introduce a product for the users that could benefit most from security products -- businesses.
Although the company has been working on enterprise products since the beginning of 2014, it has yet to release anything. That's about to change according to Zhou:
The Chinese government policy shift in this area [bank/enterprise security] is actually a trigger for us to sort of accelerate this kind of an effort, basically given what happened in the last couple of years in terms of information ... monitoring or spying ... activity globally. Now, most of the Chinese enterprises and institutions should realize that security is a very important aspect of their daily operation, and also using domestic products is also a very top priority among those kind of institutions.
Qihoo can leverage its strong brand recognition in security to move into this multibillion-dollar industry. With the Chinese government now heavily promoting domestic businesses in enterprise security, the competition in the space is sparse. Therefore, Qihoo could gain an advantage from releasing a product as soon as possible -- as long as it's up to the high standards enterprises expect.
Near-term pain, long-term gain
Management is confident that its margin pressures are merely a short-term problem, one that will turn around as soon as this quarter. I'm not as confident. With the tasks of improving mobile monetization, integrating MediaV, and accelerating its enterprise product development, there's still a lot on the table for Qihoo 360.
Adam Levy has no position in any stocks mentioned. The Motley Fool recommends Baidu. The Motley Fool owns shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.