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Sohu.com Inc. (SOHU - Analyst Report) reported earnings of 56 cents per share in the second quarter of 2013, which decreased 26.8% year over year and 11.4% on a sequential basis.  Earnings including stock-based compensation comfortably surpassed the Zacks Consensus Estimate by 6 cents.

Revenues

Revenues jumped 18.8% year over year and 10.2% sequentially to $338.9 million, slightly ahead of the mid-point of the management guided range of $333.0–$342.0 million. Revenues also surpassed the Zacks Consensus Estimate of $337.0 million.

The year-over-year increase was primarily driven by strong performance from the online advertising and online gaming business.    

Online advertising revenues surged 29.3% year over year and 25.9% sequentially to $116.3 million. The year-over-year growth was primarily driven by strong performance from online video, Sogou, search and brand advertising.

Sohu video continued to maintain its dominant position, driven by a content portfolio that includes American television drama series, Japanese animation series, domestic variety shows and in-house programs.

During the quarter, Sohu Video started streaming The Voice of China (Jul 12), which attracted significant traffic. The superior content portfolio helped video advertising sales to grow double-digit on a sequential basis.

Sohu achieved significant growth in the mobile video segment as traffic increased massively in the second quarter. Mobile average daily active users and video views jumped 60% and 70.0%, respectively on a sequential basis.

Sogou revenues continued to grow in the quarter, up 64.0% year over year and 27.0% quarter over quarter to $50.0 million. This was higher than management’s guided range of $34.0 to $36.0 million.

The Sogou pinyin mobile version added 60.0% more users since the beginning of 2013. At the end of the second quarter, monthly Sogou mobile pinyin’s monthly active user base stood at 115 million.  Search and Others revenues jumped 30.9% from the year-ago quarter and 28.1% sequentially to $46.2 million.

Brand advertising revenues grew 28.7% from the year-ago quarter to $100.2 million and were slightly ahead of the higher end of management’s guided range of $90.0 million to $100.0 million. Revenues increased 24.9% sequentially, within management’s guided range of 22.0% to 25.0% growth. Brand advertising continued to benefit from strong traffic driven by an improving online video business.

Online games (operated by Changyou.com) revenues surged 11.4% year over year but inched up 0.5% sequentially to $168.3 million, toward the higherend of management’s expectation of $165.0 million–$170.0 million. Online gaming revenues grew on the back of expanding user base and improved monetization from Tian Long Ba Bu’s (“TLBB”) and recently launched Dou Po Cang Qiong.

Wireless revenues increased 7.0% year over year and 11.2% quarter over quarter to $15.3 million. Others revenue surged 31.1% year over year but declined 11.7% sequentially to $8.9 million in the reported quarter.

Margins

Gross margin expanded 550 basis points (“bps”) from the year-ago quarter to 66.5%. The year-over-year expansion was primarily due to significant increase in online advertising gross margin, which was 48.0% compared with 31.5% in the year-ago quarter. On a sequential basis, gross margin increased 20 bps.

Operating expenses, as a percentage of revenues, were 47.5% compared with 43.0% in the year-ago quarter. On a sequential basis, operating expenses as a percentage of revenues improved 420 bps in the quarter.

The sharp year-over-year rise in operating expenses was primarily due to higher sales & marketing as well as product development expenses, which as a percentage of revenues jumped 190 bps and 180 bps, respectively. General & administrative expenses increased 80 bps from the year-ago quarter.

On a sequential basis, product development and sales & marketing expenses jumped 200 bps and 190 bps, respectively. General & administrative expenses increased 30 bps from the previous quarter.

The sharp increase in operating expenses fully offset a higher gross margin base. Operating margin expanded a modest 100 bps from the year-ago quarter but contracted a massive 410 bps from the previous quarter.

Net margin declined to 6.4% from 6.7% reported in the year-ago quarter and contracted 150 bps on a sequential basis.

Balance Sheet & Cash Flow

Sohu exited the second quarter with cash and cash equivalents of $770.5 million compared with $798.3 million in the previous quarter. Long-term debt was $159.0 million compared with $157.5 million at the end of the previous quarter.

Outlook

For the third quarter of 2013, Sohu expects total revenue in the range of $358.0 million–$370.0 million. Sohu estimates brand advertising revenues in the range of $120.0 million to $125.0 million, representing 54% to 61% year-over-year growth and 20.0% to 25.0% sequential growth.

Although Sohu has started selling mobile ads on video for Apple’s (AAPL - Analyst Report) iPad, the company does not expect significant revenue generation in 2013. However, this initiative is expected to meaningfully contribute to revenues in 2014. The Voice of China is expected to contribute 80.0% of the increase of advertising revenues for the third quarter. Sohu expects online video to breakeven in 2015.

Sogou revenues are expected to be in the range of $54.0 to $56.0 million, representing 45% to 50% year-over-year growth and 8.0% to 12.0% sequential growth. Online game revenues are expected in the $161.0 million–$166.0 million range.

Non-GAAP net income is expected in the range of $19.0 million to $21 million and earnings are projected between 50 cents and 55 cents per share.

Our Take

We believe that Sohu’s innovative product pipeline, and strong traffic growth from the search, online video and mobile business will drive top-line growth going forward. Moreover, strong growth potential exists in the online gaming business, which may further catapult the stock in the near term.

However, Sohu is a relatively small player in the online advertising market and continuing investments in product development are necessary to expand market share. This will keep margins under pressure in the near term.

Despite higher spending, we believe that market share gain will be difficult in the near term due to stiff competition from the likes of Baidu (BIDU - Snapshot Report) and Qihoo 360 Technology (QIHU - Snapshot Report) in most of its operating markets.

Currently, Sohu has a Zacks Rank #4 (Sell).

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