Sohu Reports Strong 1Q

Zacks

A leading online brand and Internet portal in China, Sohu.com Inc.’s (SOHU) first quarter 2012 earnings came ahead of the Zacks Consensus Estimate by eight cents. Although earnings decreased 48.2% year over year to 53 cents per share (including stock-based compensation and non-cash tax benefit from excess deductions related to share-based awards), it was slightly above the mid-point of the company’s guided range of 50 cents to 55 cents.

Earnings (excluding stock-based compensation expense and non-cash tax benefit from excess deductions related to share-based awards) were 61 cents per share, down 46.0% year over year from $1.13 reported in the year-ago quarter. The decline was primarily attributed to a higher-than-expected increase in operating expenses, which fully offset strong top-line growth in the quarter.

Revenue Details

Total revenue increased 30.0% year over year to $226.6 million in the reported quarter and surpassed the Zacks Consensus Estimate of $224.0 million. Reported revenue was also in line with the management’s guided range of $219.0 million to $225.0 million. The increase was primarily driven by strong search business and online gaming revenues.

Total online advertising revenue increased 26.8% year over year to $82.6 million. Brand advertising revenue in the quarter grew 6.7% year over year to $61.0 million and surpassed the lower end of management’s guided range of $60.0 million to $63.0 million.

Search revenue skyrocketed 171.2% year over year to $21.6 million in the reported quarter, primarily driven by higher revenues from pay-for-click services and online marketing services.

Online game revenue increased 34.3% year over year to $127.4 million, surpassing management’s expectation of $121.0 million to $124.0 million. Online gaming revenues grew on the back of higher active paying accounts (APA) and user base expansion. Aggregate registered accounts for Changyou's games jumped 62.0% year over year in the quarter.

Aggregate active paying accounts (APA) increased 8.0% year over year in the quarter. Average revenue per user (:ARPU) increased 7.0% year over year, while aggregate peak concurrent users for Changyou’s games were up 8.0% on a year-over-year basis.

Wireless revenues surged 14.0% from the year-ago quarter to $13.4 million. Others (which include Sogou’s IVAS business) increased 23.0% year over year to $3.2 million in the quarter.

Operating Performance

Gross profit increased 15.5% year over year to $147.1 million. Gross margin on a non-GAAP basis was 65.0% versus 73.0% in the year-ago quarter. The company’s margins were affected by the year-over-year decline in online advertising, games and wireless gross margins.

Online advertising gross margin declined 39.4% from 56.3% reported in the year-ago quarter. Online brand advertising gross margin was 40.0% in the reported quarter, down from 62.0% reported in the prior-year quarter. The decline was primarily attributed to higher content and bandwidth costs in the quarter.

Search business gross margin expanded significantly to 39.3% from 16.5% in the year-ago quarter. The margin expansion was driven by higher revenues from online marketing services. Online games gross margin was 87.1% as compared with 90.6% in the year-ago quarter. Higher bandwidth and server costs and increasing headcount primarily dragged down margins in the quarter.

Operating expenses shot up 48.5% year over year to $95.0 million in the quarter, due to higher product development cost (up 66.2% year over year), sales & marketing expense (up 35.0% year over year) and general & administrative expense (up 46.3% year over year).

The higher-than-expected increase operating costs had a negative impact on profitability in the first quarter. Operating profit decreased 17.9% year over year to $52.0 million while margin plummeted to 23.0% in the quarter from 36.3% reported in the year-ago quarter. Net profit also decreased 46.1% in the quarter due to higher non-operating and interest expense.

Balance Sheet

As of March 31, 2012, Sohu had a cash position of $761.0 million compared with $750.2 million at the end of December. At the end of the quarter, Sohu had no debt on its balance sheet. As of March 31, 2012 Sohu spent approximately $55.0 million under its $100.0 million share repurchase program.

Outlook

For the second quarter of 2012, Sohu expects total revenue in the range of $244.0 million to $250.0 million. Sohu estimates brand advertising revenues in the range of $68.0 million to $71.0 million, implying a growth of 0.4% to 5.0% on a yearly basis.

Revenues from online games are expected in the $130.0 million to $133.0 million range, representing a year-over-year growth in the range of 28.0% to 31.0%. Management anticipates Sogou revenues to be $29.0 million for the second quarter, which implies a year-over-year growth of 113.0%.

Sohu projects net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $15.5 million to $17.5 million and earnings in the range of 40 cents to 45 cents per share.

Recommendation

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

However, higher operating costs due to continued investments in video may hurt profitability in the near term. Moreover, cut-throat competition from the likes of Baidu Inc. (BIDU) and slowing Chinese macro environment (declining auto sales and weakness in real-estate) may hurt Sohu’s growth in the near term.

We, therefore, maintain our 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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