Sohu Beats on Strong Sales

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Sohu.com Inc. (SOHU), a leading online brand and Internet portal in China, reported second quarter results, wherein the earnings per share surpassed the Zacks Consensus Estimate by a couple of cents and revenue moved past the Zacks Consensus Estimate of $247.0 million by 3.5%.

Quarter Details

Total revenue increased 28.6% year over year to $255.7 million in the reported quarter and was ahead of management’s guided range of $244.0 million to $250.0 million. The increase was primarily driven by strong search business and online gaming revenues.

Total online advertising revenue increased 20.6% year over year to $98.1 million. Brand advertising revenue in the quarter grew 2.4% year over year to $69.3 million and was within management’s guided range of $68.0 million to $71.0 million. Search revenue soared 111.3% year over year to $28.8 million in the reported quarter, primarily driven by higher revenues from pay-for-click services and online marketing services.

Online game revenue increased 35.1% year over year to $137.2 million, comfortably ahead of management’s expectation of $130.0 million to $133.0 million. Online game revenue was driven by the 51.0% increase in the Aggregate registered accounts for Changyou's games.

Lesser number of in-game and virtual items distribution in the martial arts MMO game TLBB resulted in  the 10.0% year-over-year decrease in the Aggregate active paying accounts (APA) for Changyou's games. However, the Average revenue per user (:ARPU) increased 31.0% year over year driven by the decline in low-spending active paying accounts.

Wireless revenue increased 34.0% from the year-ago quarter to $15.6 million.

Gross profit on non-GAAP basis increased 7.6% year over year to $155.8 million. Gross margin on a non-GAAP basis decreased from 73.0% in the year-ago quarter to 61.0% as most of its business segments suffered margin contractions.

Online advertising gross margin was down from 60.0% in the year-ago quarter to 31.0% due to the contraction of margins in the online brand advertising (down from 64.0% in the year-ago quarter to 26.0%).  However, search business gross margin expanded 40 basis points (bps) on a year-over-year basis driven by higher revenues from online marketing services.

Online games gross margin was 87.0% as compared with 90.0% in the year-ago quarter.

Operating expenses shot up 49.4% year over year to $112.8 million in the quarter, due to higher product development cost (up 67.8% year over year), sales & marketing expense (up 34.0% year over year) and general & administrative expense (up 33.6% year over year).

The higher-than-expected increase in operating costs had a negative impact on the quarterly profits. Non-GAAP operating profit decreased 32.4% year over year to $49.5 million, while margin plummeted to 19.0% in the quarter from 37.0% reported in the year-ago quarter.

Net income on non-GAAP basis was $16.4 million or 42 cents per share, which was down from $47.4 million or $1.21 per share in the year ago quarter. Net income including stock-based compensation came at $10.8 million or 28 cents per share, which was down from $38.9 million or $1.10 per share.

Sohu exited the second quarter with cash and cash equivalents of $764.6 million compared with $761.0 million in the previous quarter. At the end of the quarter, Sohu had no debt on its balance sheet.

Outlook

For the third quarter of 2012, Sohu expects total revenue in the range of $272.0 million to $277.0 million. Sohu estimates brand advertising revenue in the range of $76.0 million to $78.0 million.

Online game revenue is expected in the $141.0 million to $144.0 million range, representing a year-over-year growth in the range of 22.0% to 24.0%. Management anticipates Sogou revenue to be $37.0 million for the third quarter, which implies a year-over-year growth of 101.0%.

Non-GAAP net income, after deducting the non-controlling interest in Changyou, is expected in the range of $19.0 million to $21.0 million and earnings are projected between 50 cents and 55 cents per share.

Recommendation

Sohu is expected to benefit from its strength in online games going forward. We believe that the growing popularity of Changyou’s games will drive profitability over the long term.

However, higher operating costs due to continued investments in online video business may hurt Sohu’s profitability in the near term. Moreover, cut-throat competition from the likes of Baidu Inc. (BIDU) and slowing Chinese economic environment are the other near-term headwinds.

Therefore, we maintain a Neutral recommendation on the stock over the long term. Currently, Sohu has a Zacks #3 Rank, which implies a short-term Hold rating.

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