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Qihoo 360 Technology Co. Ltd. Beats Expectations, Continues to Pivot Into Games

By Brian Stoffel - Mar 10, 2015 at 3:20PM

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Search dominance may be hard to come by in mobile, but there's another avenue for growth.

Qihoo 360's legacy business is as an Internet security provider. Image: Qihoo 360 

Qihoo 360 (QIHU.DL) is something of an enigma for novice investors interested in China. The company got its start as an Internet security company, then morphed into the second-largest PC search engine in the Middle Kingdom, and is now getting a huge boost from its mobile gaming platform.

All of those pieces combined Monday when the company announced earnings that beat expectations on both the bottom and top lines. Read below to get the details, and see what long-term investors should keep their eyes on moving forward.

Just the numbers, please
The headline from Qihoo's quarterly release shows strength on both the top and bottom lines.

Analysts were expecting revenue of $417 million, but the company reported a $431 million figure, representing 95% growth over last year.

On the profit front, expectations were set for non-GAAP earnings of $0.72 per share, and Qihoo came in slightly ahead of that, with $0.75 per share -- a 7% jump from the previous year.

As you might expect, this represents a conundrum for investors: While revenue is booming, earnings aren't growing by anywhere near as much. In fact, gross margins contracted all the way from 86.9% last year, to 76.1% by the end of 2014. Management says this is due to a change in revenue mix -- but more on that later.

Throw added expenses for product development and SG&A in there, and profit margins contracted from a non-GAAP measure of 43.5% last year to 25.4% this year. Management says this is "mainly due to an increased level of spending in channel promotion, marketing and product development."

The future of search
Qihoo is not alone in seeing revenue rise much faster than earnings. Many technology companies with a focus on search, both in China and worldwide, are spending heavily to build out their infrastructure in a world that is shifting from PC to mobile devices.

While Qihoo has done a great job capturing market share in PC search, it lags far behind in mobile search. In fact, an August 2014 report from China Internet Watch says the company doesn't even have meaningful market share in mobile.

However, CEO Hongyi Zhou claimed that the company had established a solid position in mobile search by launching an independent search brand, "We remain confident that we can reach our mobile search market share in two years." 

Perhaps the company's smartphone security program can help it move the search needle. There were a total of 744 million smartphone users with Qihoo's security programs in use at the end of the fourth quarter, up 59% from the same time last year.

That being said, Qihoo is not coming from a position of strength in mobile search, and it will have to go up against rivals with much deeper pockets and larger market shares to make this transition.

But mobile gaming picks up the slack
While there remain significant challenges to Qihoo becoming as powerful in mobile search as it is in PC search, the company has been hitting the ball out of the park when it comes to mobile gaming.

Take a look at how revenue has grown over the past eight quarters in two main segments. Online ads, which are primarily from search advertising, and Internet value added services, which is where gaming is juicing returns.

Qihoo's Revenue Breakdown | Create infographics

The key aspect to notice here is that while revenue from ads were growing by 31% on a sequential basis in 2013, that growth slowed to 14% in 2014. Internet services, however, experienced no such slowdown. Revenue from the segment has grown by a steady 20% sequentially over the past two years -- largely thanks to mobile gaming.

That leaves investors to ask a few crucial questions: If you're investing in Qihoo, is it because of the company's ambitions for mobile search, its security products, or its mobile gaming platform -- or some combination of all three?

I would posit that while the company was able to gain a surprising hold on PC search market share, I don't think the entrenched powers will let that happen again -- meaning that mobile gaming may only become more important moving forward.

Brian Stoffel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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