Sohu Beats Estimate, Sales Soar

Zacks

A leading online brand and Internet portal in China, Sohu.com Inc. (NasdaqGS:SOHU - News) reported strong second quarter 2011 results, driven by robust revenue growth, partially offset by higher expenses.

Earnings per share (NYSEArca:EPS - News) of $1.10 (including stock-based compensation) increased 34.1% from 82 cents reported in the year-ago quarter. Quarterly EPS also beat the Zacks Consensus Estimate of $1.06. However, EPS fell short of the company’s guided range of $1.13 to $1.18.

Second quarter earnings exclude Sohu’s non-controlling interest in the online gaming company Changyou.com Ltd. (NasdaqGS:CYOU - News).

Operating Performance

Gross profit was up 35.7% year over year to $145.5 million. Gross margin on a non-GAAP basis was 73.2%, down 20 basis points (bps) from the year-ago quarter.

The company’s margins were affected by the year-over-year decline in online games gross margin, which stood at 90.0% versus 91.0% in the year-ago quarter. Wireless gross margin plummeted 900 bps on a year-over-year basis to 39.0% in the second quarter.

Online brand advertising gross margin was 62.0% in the reported quarter, up from 58.0% reported in the prior-year quarter. Gross margin for the Search business was 55.0%, a huge increase from 14.0% reported in the year-ago quarter, due to higher volumes.

Operating expenses shot up 37.0% year over year to $76.8 million in the quarter due to the higher product development cost (up 47.3% year over year), sales & marketing expense (up 29.4% year over year) and general & administrative expense (up 38.3% year over year).

Operating profit decreased 6.0% year over year to $68.8 million due to higher operating expenses. The operating margin was flat year over year.

Revenue

Total revenue increased 36.0% year over year to $198.7 million in the reported quarter and surpassed the Zacks Consensus Estimate of $191.0 million.

Reported revenue also exceeded management’s expected range of $188.0 million to $193.0 million. The increase was primarily driven by higher brand advertising, a strong search business and online gaming revenues.

Brand advertising revenue in the quarter grew 27.3% year over year to $67.7 million, handily beating management’s guided range of $65.5 million to $67.5 million. The better-than-expected results were mainly driven by the increasing number of brand advertising customers and strong advertising demand from the IT sector including e-commerce companies.

Search revenue soared 248.7% year over year to $13.6 million in the second quarter. The year-over-year growth was mainly driven by increased search traffic and improved monetization of traffic.

Online game revenues increased 30.6% year over year to $101.5 million, surpassing management’s expectation of $95.0 million to $97.0 million. The increases were mainly due to the continued popularity of Tian Long Ba Bu (:TLBB) in China during the quarter and incremental revenue growth from the 7Road acquisition by Changyou.

Online gaming revenues grew on the back of higher active paying accounts (NYSE:APA - News) and user base expansion. Aggregate registered accounts for Changyou's games jumped 34.0% year over year.

Average revenue per user (:ARPU) was up 15.0% year over year. Aggregate peak concurrent users for Changyou’s games were approximately 1.0 million, down 15.0% year over year.

Wireless revenues increased 5.2% from the year-ago quarter to $11.6 million.

Balance Sheet

As of June 30, 2011, Sohu had a cash position of $734.1 million, compared with $737.9 million at the end of March. At the end of the quarter, Sohu had no debt on its balance sheet.

Outlook

Sohu provided an upbeat third quarter 2011 guidance, beating the Zacks Consensus Estimate. For the third quarter, Sohu expects total revenue in the range of $225.0 million to $230.0 million.

Sohu estimates brand advertising revenues in the range of $75.0 million to $77.0 million, implying a sequential growth of 11.0% to 14.0% and year-over-year growth of 27.0% to 30.0%.

Revenue from Changyou is expected to be between $115.0 million and $118.0 million, of which revenues from online games are expected in the $112.0 million to $114.0 million range.

Management anticipates Sogou revenues of $16.0 million for the third quarter.

Sohu projects net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $47.0 million to $49.0 million and EPS in the range of $1.20 to $1.25. The current Zacks Consensus Estimate for the third quarter is pegged at $1.19 per share.

Recommendation

Sohu is expected to benefit from its strength in online games and China’s growing online advertising industry. The company is also expected to benefit from strong growth in the online video market and increase in advertising spending for 2011.

Most recently, Changyou launched its highly anticipated game Duke of Mount Deer. Changyou has also begun open-beta testing of Legend of Ancient World, a massively multi-player online role-playing game. We believe that Sohu’s promising games portfolio and the growing popularity of Changyou’s games will drive profitability over the long term.

However, Sohu continues to face cut throat competition from Baidu Inc. (NasdaqGS:BIDU - News) and Sina Corp. (NasdaqGS:SINA - News). We, therefore, maintain our Neutral recommendation on the stock over the long term. Currently, Sohu has a Zacks #2 Rank, which implies a short-term Buy rating.

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