Sohu Misses on Higher Expenses

A leading online brand and Internet portal in China, Sohu.com Inc.’s (SOHU - Analyst Report) third quarter 2011 earnings missed the Zacks Consensus Estimate by a penny. Earnings per share (EPS) of $1.17 (including stock-based compensation) increased 15.8% from $1.01 reported in the year-ago quarter.

However, reported EPS fell short of the company’s guided range of $1.20 to $1.25. The miss was primarily attributed to higher operating expenses in the quarter. Third quarter earnings exclude Sohu’s non-controlling interest in the online gaming company Changyou.com Ltd. (CYOU - Snapshot Report).

Operating Performance

Gross profit surged 37.3% year over year to $166.0 million. Gross margin on a non-GAAP basis was 71.3%, down 230 basis points (bps) from the year-ago quarter.

The company’s margins were affected by the year-over-year decline in online games gross margin, which stood at 87.4% versus 91.6% in the year-ago quarter. Wireless gross margin decreased to 38.6% from 45.7% in the third quarter of 2010.

Online brand advertising gross margin was 58.7% in the reported quarter, down from 60.6% reported in the prior-year quarter. Gross margin for the Search business was 59.1%, up significantly from 31.9% reported in the year-ago quarter, due to higher volumes.

Operating expenses shot up 66.0% year over year to $92.3 million in the quarter due to higher product development cost (up 43.8% year over year), sales & marketing expense (up 91.4% year over year) and general & administrative expense (up 45.5% year over year).

Operating profit increased 12.8% year over year to $73.6 million due to strong top-line growth. However, operating margin plummeted 820 bps to 31.6% in the quarter, primarily due to higher operating expenses.

Revenue

Total revenue increased 42.0% year over year to $233.0 million in the reported quarter and surpassed the Zacks Consensus Estimate of $226.0 million.

Reported revenue also exceeded management’s expected range of $225.0 million to $230.0 million. The increase was primarily driven by higher brand advertising, strong search business and online gaming revenues.

Brand advertising revenue in the quarter grew 29.6% year over year to $76.6 million, in line with the high end of management’s guided range of $75.0 million to $77.0 million. The better-than-expected results were mainly driven by the increasing number of brand advertising customers and strong advertising demand from the IT and real estate sector.

Search revenue soared 243.7% year over year to $18.4 million in the reported quarter. The year-over-year growth was mainly driven by increased search traffic and improved monetization of traffic.

Online game revenue increased 35.2% year over year to $115.8 million, surpassing management’s expectation of $112.0 million to $114.0 million. The upside was mainly due to the continued popularity of Tian Long Ba Bu (TLBB) in China, full quarter revenue contribution from 7Road (acquired by Changyou in the second quarter) and higher revenue contribution from the newly launched game Duke of Mount Deer (DMD).

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 51.0% year over year. Average revenue per user (ARPU) spiked 2.0% year over year. Aggregate peak concurrent users for Changyou’s games were approximately 3.0 million, up 17.0% year over year.

Wireless revenues increased 4.5% from the year-ago quarter to $14.2 million.

Balance Sheet

As of September 30, 2011, Sohu had a cash position of $729.7 million compared with $737.9 million at the end of June. At the end of the quarter, Sohu had no debt on its balance sheet.

Outlook

Sohu provided an upbeat guidance. For the fourth quarter, Sohu expects total revenue in the range of $241.0 million to $246.0 million. Sohu reported revenues of $173.2 million in the year-ago quarter.

Sohu estimates brand advertising revenues in the range of $77.0 million to $79.0 million, implying a sequential growth of 1.0% to 3.0% and year-over-year growth of 28.0% to 32.0%.

Revenue from Changyou is expected to be between $122.0 million and $125.0 million, of which revenues from online games are expected in the $119.0 million to $122.0 million range. Management anticipates Sogou revenues of $21.0 million for the fourth quarter, which implies a year-over-year growth of 218.0% and sequential growth of 14.0%.

Sohu projects net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $50.5 million to $52.5 million and EPS in the range of $1.30 to $1.35. The current Zacks Consensus Estimate for the third quarter is pegged at $1.25 per share.

Recommendation

Sohu is expected to benefit from its strength in online games and China’s growing online advertising industry. The company is also expected to benefit from strong growth in the online video market and upside in advertising spending for 2011. We believe that Sohu’s promising games portfolio and the growing popularity of Changyou’s games will drive profitability over the long term.

However, Sohu continues to face cut throat competition from Baidu Inc. (BIDU - Snapshot Report) and Sina Corp. (SINA - Analyst Report), which will hurt its profitability going forward. Moreover, increasing government scrutiny in the Chinese internet is also expected to hurt Sohu’s growth over the long 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.