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Sohu.com Inc. (SOHU - Analyst Report) reported non-GAAP earnings of 77 cents, which was down 38.9% year-over-year due to higher expenses and margin contractions. Earnings including stock based compensation came at 67 cents, comfortably surpassing the Zacks Consensus Estimate of 42 cents.  

Quarter Details

Total revenue increased 22.5% year over year to $285.4 million in the reported quarter and was ahead of management’s guided range of $272.0 million-$277.0 million. Reported revenue also surpassed the Zacks Consensus Estimate of $276 million. The increase was primarily driven by strong search business and online gaming revenues.

Total online advertising revenue increased 19.3% year over year to $113.2 million. Brand advertising revenue in the quarter grew 1.7% year over year to $77.9 million and was at the higher end of management’s guided range of $76.0 million to $78.0 million. Search and others revenue soared 91.8% year over year to $35.3 million in the reported quarter, primarily driven by better monetization opportunities due to increase in traffic.

Online game (operated primarily by Changyou.com) revenue increased 30.5% year over year to $151.1 million, comfortably ahead of management’s expectation of $141.0 million-$144.0 million. Wireless revenue increased 0.7% year over year to $14.3 million.

Gross profit on non-GAAP basis increased 14.1% year over year to $188.9 million. Gross margin on a non-GAAP basis decreased from 71.1% in the year-ago quarter to 66.2% primarily due to margin contraction in all of its business segments.

Operating expenses increased 36.1% year over year to $124.9 million in the quarter, due to higher product development cost (up 62.3% year over year), sales & marketing expense (up 23.5% year over year) and general & administrative expense (up 25.5% year over year). Moreover, operating expenses as a percentage of revenue increased from 39.4% in the year-ago quarter to 43.8%.

The higher-than-expected increase in operating costs had a negative impact on the quarterly profits. Non-GAAP operating profit decreased 13.2% year over year to $67.6 million, while margin was down from 33.4% in the previous-year quarter to 23.7%.

Net income on non-GAAP basis was $29.5 million or 77 cents per share, which was down from $49.0 million or $1.26 per share in the year-ago quarter.

Sohu exited the third quarter with cash and cash equivalents of $773.5 million compared with $764.6 million in the previous quarter. At the end of the quarter, Sohu had no debt on its balance sheet.

Outlook

For the fourth quarter of 2012, Sohu expects total revenue in the range of $288 million-$293 million. Sohu estimates brand advertising revenue in the range of $80 million to $82 million. Online game revenue is expected in the $152 million-$155 million range, representing a 23% to 26% year-over-year growth.

Non-GAAP net income is expected in the range of $23 million to $25 million and earnings are projected between 60 cents and 65 cents per share.

Sohu already boasts a robust product pipeline and is slated for more releases going forward. Sohu, in association Electronic Arts Inc. (EA - Analyst Report), will release Battlefield Online in November. The company will also release another web based game, Qu Shen, in December. Moreover, Sohu plans to release at least 4 massively multiplayer online (MMO) games along with several web based games for 2013.

Recommendation

Although Sohu reported a better-than-expected third quarter, we believe that Sohu’s continuing investments in product development (online gaming, video) will keep margins under pressure going forward.

However, increasing investments are also expected to expand Sohu’s product portfolio over the long term.  Sohu’s intention to offer expansion packs for its subscription-based games on a regular basis is also expected to boost its customer base going forward.  

Thus, we have a Neutral recommendation on Sohu over the long term.

Sohu’s strong product pipeline is expected to boost its top line in the near term. Currently, Sohu has a Zacks #2 Rank, which implies a short-term Buy rating.

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