Sohu Tops Zacks Consensus - Analyst Blog

A leading online brand and Internet portal in China, Sohu.com Inc. (SOHU) reported strong fourth quarter 2010 results, attributable to growth in each of its business segment, including online games and brand advertising. Moreover, better-than-expected growth in search ad revenues boosted results.

Earnings per share (EPS) of $1.07 (including stock-based compensation expense) increased 40.8% from 76 cents in the year-ago quarter and 5.9% from $1.01 in the previous quarter. The quarter's EPS also beat the Zacks Consensus Estimate of 99 cents.

Fourth quarter earnings exclude Sohu's non-controlling interest in the online gaming company Changyou.com Ltd. (CYOU). Earnings benefited from increased sales in the quarter, partially offset by higher expenses.

Revenue

Total revenue was up 27.0% year over year and 6.0% sequentially at $173.2 million in the reported quarter, and surpassed the Zacks Consensus Estimate of $167.0 million.

The revenue was also above management's expectation of $163.0 million to $168.0 million. The increase was primarily driven by robust growth in brand advertising, search business and online gaming revenues.

Brand advertising revenues in the quarter escalated 31.0% year over year and 2.0% sequentially to $60.1 million while Search revenues of $6.6 million shot up 126.0% year over year and 23.0% sequentially.

Management had estimated brand advertising revenues in the range of $58.0 million to $60.0 million. Growth in online video drove the company's market share from 3.4% to 13.4% in 2010.

Sohu's search engine, Sogou has gained traction. As pointed out by management, active users of the Sogou browser, related search traffic and search revenue conjointly grew 20% sequentially in the reported quarter.

Online game revenues increased 30.0% year over year and 7.0% sequentially to $91.7 million, well above management's expectation of $86.0 million to $89.0 million. The growth was primarily driven by an increase in demand for Tian Long Ba Bu (TLBB), Changyou's flagship game in China.

Online gaming revenues grew on the back of higher active paying accounts (APA) and user base expansion. Aggregate registered accounts for Changyou's games increased 6.0% sequentially and 38.0% year over year to 111.4 million. The quarter's APA increased 3.0% sequentially and 13.0% year over year to 2.7 million.

Average revenue per user (ARPU) increased 2.0% sequentially and 12.0% year over year. Aggregate peak concurrent users for Changyou's games were approximately 1,030,000, up 7.0% year over year and 5.0% sequentially.

Overseas licensing revenues in the reported quarter increased 11.0% sequentially and 7.0% year over year to $2.2 million. The growth was primarily attributable to increased momentum of TLBB in Vietnam, Thailand and Malaysia.

Wireless revenues fell 8.0% from the year-ago quarter, but grew 6.0% from the prior quarter to $14.4 million.

Margins

Gross margin on a non-GAAP basis increased 100 basis points sequentially and was in sync with the year-ago quarter at 75.0% in the quarter.

Year over year, margins were hurt by a lower brand advertising gross margin, which was 63.0% in the quarter, down from 65.0% in the year-ago quarter but up from 62.0% in the previous quarter.

Online game gross margin was 90.0% in the reported quarter, in sync with the prior quarter but down from 92.0% in the year-ago quarter. The year-over-year decline was mainly attributable to an increase in salary and benefits and higher bandwidth and server depreciation costs associated with the operation of increased number of games in the quarter.

Gross margin for the Search business was 32.0%, a huge increase from 2.0% in the year-ago quarter but in sync with the previous quarter. Wireless gross margin was 45.0%, compared with 46.0% in the third quarter of 2010 and 44.0% in the fourth quarter of 2009.

Operating expenses shot up 23.0% year over year and 11.0% sequentially to $55.5 million in the quarter due to the hiring of more game engineers and increased expenditure related to royalties for licensed games. Operating margin increased 100 basis points year over year but declined 100 basis points sequentially to 43.0%.

Balance Sheet

As of December 31, 2010, Sohu had a cash position of $678.4 million compared with $534.7 million at September 30, 2010. At the end of the quarter, Sohu had no debt on its balance sheet.

Outlook

Sohu provided an upbeat first quarter 2011 guidance that beat Zacks Consensus expectations.

For the first quarter, Sohu expects total revenue in the range of $164.5 million to $169.5 million. This is higher than the Zacks Consensus Estimate of $162.0 provided at the time the company reported results.

Sohu estimates brand advertising revenues in the range of $55.0 million to $57.0 million. This implies a sequential decline of 5.0% to 8.0%, but an increase of 39.0% to 44.0% year over year.

Revenue from Changyou is expected to be $92.0 million to $95.0 million, of which revenues from online games are expected to be $91.0 million to $93.0 million. This excludes revenues from Jing Mao.

In January 2011, Changyou entered into a definitive agreement under which it will acquire the remaining 50.0% stake in Shanghai Jing Mao to secure additional advertising resources for the promotion of Changyou's online games. Jing Mao is primarily engaged in film advertisement in China.

Management anticipates Search revenues of $6.5 million for the first quarter.

Sohu projects net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $40.0 million to $42.0 million and earnings per share in the range of $1.03 to $1.08. The Zacks Consensus Estimate is pegged at 95 cents.

Recommendation

Sohu is expected to benefit from its strength in online games and China's growing online advertising industry. The company expects an increased advertising spending in 2011.

While TLBB continues to be a strong contributor to revenues, the company plans to unveil the full trial version of the highly anticipated Duke of Mount Deer in March this year, which will likely drive growth. We believe that Sohu's promising games portfolio and continued popularity of Changyou's games will drive profitability on a long-term basis.

However, Sohu continues to face cut-throat competition from Baidu Inc. (BIDU) and Sina Corp. (SINA). We therefore maintain our Neutral rating on the stock over the long term. Currently, Sohu has a Zacks #3 Rank and a short-term Hold rating.