Sohu Reported Strong Q4 results, but Video Cost Hike and Macro Headwinds Pose Near-term risks
By Dan Su | 06 Feb 12
Strong revenue growth in online gaming as well as in brand and search advertising helped leading Chinese Internet firm Sohu SOHU deliver solid fourth-quarter results that came slightly ahead of our estimates, but the differences are immaterial and we are maintaining our fair value estimate of $86 per ADR. We think the stock looks undervalued, trading at a price/fair value ratio of 0.63 and at only 9.4 times our 2012 earnings. Nonetheless, we'd demand a high margin of safety for investments in Sohu given its exposure to the volatile gaming business that accounts for half of total revenue. Total revenue grew by 42% in the fourth quarter to a record $246 million, as major business segments including gaming, brand advertising, and search advertising all delivered solid growth in the December quarter. While performances in online games (50% of revenue), which is operated by Sohu's majority-owned subsidiary Changyou CYOU , and brand advertising (32% of revenue) were in line with our estimates, Sohu's search business Sogou exceeded our expectations again with a 250% year-over-year increase, albeit from a relatively small base. After seven quarters of consecutive triple-digit-rate increases driven by growth in search traffic and better monetization, the Sogou business accounted for 9.3% of total revenue in the fourth quarter, up from 2.2% in the first quarter of 2010. Given a favorable installed base of the Sogou browser, which helps drive search traffic, a relatively small client base, and lower average ad spend compared with search giant Baidu, we see a long runway of growth ahead for Sogou and forecast the business to double its revenue in 2012. On the other hand, our estimates for brand advertising revenue growth in the near future are more conservative, given a slowing Chinese economy as well as sluggish sales in the auto and real estate sectors, previously top spenders for online advertising on major portals. That said, continued strength in consumer spending for packaged goods and favorable trends in e-commerce will continue to justify strong online advertising spend, in our view. Our valuation model now assumes a midteens increase in brand ad revenue in 2012 and 2013, down from an average of 29% during the past five years. Cost inflation for popular online video content and higher bandwidth expenses and new head counts associated with the new gaming operations were to blame for the gross margin contraction in the brand ad and online gaming business. Overall gross margins narrowed to 71.3%, compared with 73.8% in the year-ago quarter. In particular, management highlighted rising costs for top-rated video content in the second half of 2011, which was hardly a surprise to us given the fierce competition in the fragmented online video space in China. Because Sohu enjoys an early lead in the online video market in terms of viewer traffic, and already generates meaningful online video ad revenue ($42 million in 2011, or 15% of total brand advertising revenue), we expect the firm to continue spending on a high-quality video library in the coming quarters and believe the firm is actively exploring ways to offset the cost inflation, including content bartering with other online video sites, and diversification into variety shows, news programs, and user-generated content.