Sohu Inches Past Consensus - Analyst Blog

Sohu.com Inc.'s (SOHU) net income in the first quarter fell year over year and quarter over quarter due to poor operating performance as operating expenses rose in the quarter. However, earnings beat the Zacks Consensus Estimate by a penny. 

Revenue for the quarter was up year over year but declined sequentially due to lower advertising revenues. However, it was above consensus expectations.

Sohu provided a strong second quarter outlook as it expects to grow year over year in the second quarter. Sohu is expected to benefit from China’s growing online advertising industry, and expects increased advertising spending in 2010 with the World Cup, World Expo and Asian games around the corner. This will lead to higher advertising revenue, which constitutes more than 30% of its total revenue.

Moreover, the diversification in Sohu's games portfolio and the acquisition of licensed video content for its online portal will help drive growth this year.

Operating Performance

Excluding Sohu's non-controlling interest in the online gaming company Changyou, net income (including stock based compensation expenses) was 73 cents per share in the quarter, down from $1.15 per share last year and 76 cents per share in the previous quarter. However, first-quarter earnings beat the Zacks Consensus Estimate of 72 cents.

Gross margin on a non-GAAP basis was 75% in the first quarter of 2010, compared with 76% in the third quarter of 2009 and 75% in the fourth quarter of 2009. Margins were impacted by a lower gross margin in advertising, which was 55% in the quarter compared to 61% in the previous and year-ago quarter.

Advertising gross margin was lower due to a drop in brand advertising margin to 59% from 65% in the previous quarter and 65% in the year-ago quarter. Online game gross margin was 93% in the quarter compared to 92% in the previous quarter and 94% in the year-ago period.

Operating expenses for the quarter increased 19.3% year over year, primarily due to continued investment in product development and increased sales and marketing expenses. Sequentially, expenses were down by 4.4%. As a result, operating margin on a non-GAAP basis decreased 300 basis points year over year to 42% but remained constant on a sequential basis.

Revenue

Revenue for the quarter was $129.5 million, up 12% from the year-ago period but down sequentially by 4.7%. Revenue was above the company’s guidance of $123 - $128 million and consensus expectations of $128.2 million.

The year-over-year increase in revenue was mainly driven by an advance in online game revenue, as well as Advertising revenue. However, revenue fell sequentially as the decline in Advertising revenue more than offset the rise in game revenue. However, both online game revenue and brand advertising revenue were in line with the company’s guidance.

By segment, Advertising revenue decreased 13% sequentially but increased 4.2% year over year to $42.3 million. Within the Advertising revenues, Brand advertising revenue fell 14% sequentially due to the global financial crisis and weak advertising spending but increased 1% year over year to $39.5 million in the quarter.

Online game revenues increased 2% sequentially and 17% year over year to $72.1 million, primarily due to the increased popularity of Changyou's flagship game, TLBB. The company said that the expansion pack for TLBB helped drive upside in its online games segment. However, this increase was offset by a decrease in overseas licensing revenues by 10% sequentially and 17% year over year to $1.9 million due to the result of greater competition in mature international online game markets abroad.

The increase in online gaming revenue was due to the higher active paying accounts (APA) and user base expansion, which reflects the growing popularity of Changyou's online games. Aggregate registered accounts for Changyou's games increased 8% sequentially and 38% year over year to 87.4 million, while APA was flat quarter over quarter and increased 5% year over year to 2.4 million.

Average revenue per user (ARPU) also increased 2% quarter over quarter and 12% year over year. Aggregate peak concurrent users (PCU) for Changyou’s games were approximately 1.04 million, an increase of 7% year over year and 5% sequentially.

Wireless revenues of $13.3 million decreased 15% sequentially and 1% year over year.

Balance Sheet

We are encouraged by the company’s cash balance of $599.2 million at the end of the quarter as well as its debt free balance sheet.

Guidance

For the second quarter of 2010, Sohu expects total revenue in the range of $139 million to $144 million, with advertising revenues within the $54 – $56 million range. Brand advertising revenue is expected within the $51 – $53 million range and Online game revenues in the range of $74 – $77 million.

Sohu expects non-GAAP net income for the second quarter of 2010, before deducting net income pertaining to the non-controlling interest in Changyou, between $48.0 –$50.5 million.

The company expects its net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $34 million to $36 million, or 87 cents to 92 cents per share, in the second quarter.

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