Chinese stocks have been crushed over the past year due to fears of an economic slowdown and a stock market bubble. But amid that panic, many solid stocks got tossed out with the bathwater. Two such stocks are Sohu.com (NASDAQ:SOHU) and Changyou.com (NASDAQ:CYOU).

Beijing Station. Source: Author.

Sohu is an Internet ecosystem that includes its Sogou search engine, the Hulu-like Sohu Video platform, and various portal sites. Changyou was originally Sohu's online gaming division, but it was spun off in an IPO in 2009, with Sohu retaining a controlling stake. Since being spun off, Changyou has become a leading game publisher in China.

Both companies recently reported strong third-quarter earnings that soundly beat analysts estimates, yet their stocks remain down for the year. Let's take a closer look and see which stock might be a better buy.

Revisiting Sohu's third quarter
During the third quarter, Sohu's revenue rose 21% annually to $522 million, exceeding estimates by $30.7 million. Non-GAAP net income came in at $49 million, or $1.27 per share, up from a net loss of $23 million in the prior-year quarter. Analysts had expected a loss of $0.62 per share.

Sohu's search platform revenues rose 50% annually to $148 million as both paid clicks and ad prices rose. Sogou's mobile traffic also exceeded its desktop traffic for the first time. Brand ad revenue grew 2% to $152 million, while Sohu Video revenue rose 9% to $52 million. The only soft spot was online gaming revenue from Changyou, which remained nearly flat year-over-year at $153 million.

Sohu's gross margin of 59% also represents an improvement from 55% in the second quarter and 58% in the prior-year quarter, thanks to lower operating expenses. Overall, Sohu's numbers were impressive considering the slowdown in the Chinese economy and the depreciation of the yuan.

Revisiting Changyou's third quarter
Changyou's third-quarter revenues rose 4.5% annually to $188.9 million, beating expectations by $12.45 million. Non-GAAP net income surged from $4 million in the prior-year quarter to $78 million, or $1.43 per share, which beat estimates by a whopping $0.71.

As previously noted, Changyou's online game revenues, which accounted for 81% of the company's top line, were flat. The company attributed the lack of growth to a decline in revenues from its top online title, Than Long Ba Bu 3D (in English, Demi-Gods and Semi-Devils), the divestment of its internal developer, 7Road, which produces browser-based games, and the depreciation of the yuan against the dollar.

Changyou's Than Long Ba Bu 3D. Source: Company website.

Changyou's earnings got a boost from its online advertising revenues, which rose 9% to $18 million, thanks to a higher utilization rate of advertising on its 17173 website and higher revenue from mobile game advertisers. Internet value-added services declined 27% to $5 million, due to the closure of wan.com, a platform for third-party web-based games, earlier in the year. However, "other" revenues (which mostly derive from cinema advertising) nearly doubled to $13 million, thanks to the growth of the Chinese movie industry.

Overall, Changyou's third quarter reveals a company that is steadily diversifying away from online games and becoming more dependent on advertising.

Different and similar challenges
Sohu and Changyou might seem connected at the hip, but the two companies face different challenges. Sohu's Sogou controls about 12% of the Chinese search market, making it the third largest search engine in China after Baidu (NASDAQ: BIDU) and Qihoo 360's (NYSE: QIHU) 360 Search, which control 71% and 13% of the market, respectively.

However, the Chinese search market is evolving toward streamlined O2O ("online to offline") ecosystems that let users  buy products and services directly from a single app. Since Sohu has a smaller search presence and only generated about a fifth as much revenue as Baidu last year, it will be a challenge for it to keep up in the O2O market.

Changyou faces a classic problem for online game publishers -- retaining its current players while launching new hit franchises. Last quarter, Changyou's total monthly active PC and mobile accounts respectively declined 62% and 71% annually. Those decreases were due to the company's ongoing efforts to shut down fraudulent accounts as well as waning interest in its older titles.

Meanwhile, both Sohu and Changyou must compete against Chinese Internet giant Tencent, which has built formidable O2O and gaming platforms on top of its popular WeChat/WeiXin messaging app, which has 600 million active users.

So which is the better buy?
Fundamentally, both Sohu and Changyou look fairly cheap with price-to-sales multiples that are far lower than their industry peers. But if I had to choose one, I'd invest in Sohu for three simple reasons: It's more diversified, advertisers are willing to pay higher prices for its ads, and you still get a piece of Changyou. On its own, Changyou is much a less diversified play on video games, which can be a tough market due to its fickle customer base.

 

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends BIDU. The Motley Fool recommends SOHU. 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.