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Sohu.com Inc. (SOHU - Analyst Report) reported non-GAAP EPS of 66 cents in the fourth quarter of 2012, which decreased 47.8% year over year and 14.1% sequentially due to higher expenses and margin contractions. EPS including stock-based compensation came at 60 cents, which comfortably surpassed the Zacks Consensus Estimate by 7 cents.

Revenues

Total revenue jumped 21.7% year over year and 4.9% sequentially to $299.5 million, ahead of management’s guided range of $288.0–$293.0 million. Revenues also surpassed the Zacks Consensus Estimate of $293.0 million. The increase was primarily driven by strong search business and online gaming revenues.

Total online advertising revenue increased 19.9% year over year and 6.7% sequentially to $120.8 million. This strong growth in advertising revenues was driven by 68.4% year-over-year growth in Search and Others revenue, which reached $38.7 million. Search revenues increased 9.7% on a sequential basis.

The strong year-over-year growth in search was primarily attributable to higher contribution from pay-per-click services. Online marketing services on the Sogou Web Directory also contributed significantly, driven by higher traffic and improved monetization. In the last quarter, Sogou revenues jumped 78% year over year and 10% quarter over quarter to $41.0 million.

Brand advertising revenue grew 5.6% from the year-ago quarter to $82.1 million and was in line with the higher end of management’s guided range of $80.0 million to $82.1 million. Revenues increased 5.4% sequentially. Brand advertising continued to benefit from strong performance of the auto, online video and real estate sectors.

Total number of clients grew 18% sequentially as the company’s coverage expanded to include non-FMCG clients in the reported quarter. Brand advertising revenue growth also benefited from higher marketing spending among non-Japanese auto makers, which fully offset cautious spending from Japanese car makers in the quarter.

Sohu video continued to maintain its dominating position, driven by content portfolio that includes American television drama series, domestic variety shows and in-house developed programs. Video views for American television channel jumped 136.0% sequentially in the fourth quarter.

Online games (operated by Changyou.com) revenue surged 29.0% year over year and 5.2% sequentially to $158.9 million, well ahead of management’s expectation of $152.0 million-$155.0 million. Online gaming revenues grew on the back of expanding user base and improved monetization.

Aggregate registered accounts for Changyou's games jumped 41.0% from the year-ago quarter and 11.0% sequentially to 248.1 million.  Average revenue per user (ARPU) soared 60.0% year over year and 11.0% sequentially to RMB353, driven by higher spending from Tian Long Ba Bu’s (“TLBB”) advanced level players in the reported quarter.

Wireless revenues decreased 12.6% year over year and 11.7% quarter over quarter to $12.6 million, due to new operator policies to reduce consumer complaints. Others revenue decreased 7.4% year over year but increased 5.1% sequentially to $7.2 million in the reported quarter.

Margins

Gross margin contracted 220 basis points (“bps”) from the year-ago quarter to 68.8%. The year-over-year contraction was primarily due to significant decline in online advertising gross margin, which was 52.4% compared with 59.1% in the year-ago quarter. On a sequential basis gross margin expanded 270 bps.

Operating expenses as a percentage of revenues was 47.3% compared with 40.1% in the year-ago quarter. On a sequential basis, operating expenses as a percentage of revenue surged 350 bps in the quarter.

The sharp rise in operating expense was primarily due to higher product development cost, which jumped 51.5% year over year and 11.6% from the previous quarter to $52.4 million. Sales & marketing expenses surged 49.9% from the year-ago quarter and increased 18.2% sequentially to $68.8 million.

The higher-than-expected increase in operating costs had a negative impact on the quarterly profits. Operating margin declined to 21.5% from 30.9% in the year-ago quarter. Operating margin declined 80 bps sequentially.

Net margin declined to 8.5% from 19.9% reported in the year-ago quarter. Net margin contracted 190 bps on a sequential basis.

Balance Sheet & Cash Flow

Sohu exited the fourth quarter with cash and cash equivalents of $833.5 million compared with $773.5 million in the previous quarter. Long-term debt was $126.4 million at the end of the quarter.

Outlook

For the first quarter of 2013, Sohu expects total revenue in the range of $290.0–$299.0 million. Sohu estimates brand advertising revenues in the range of $78.0 million to $80.0 million, up 28% to 31% year over year. However, revenues are estimated to decline in the range of 2.0% to 5.0% sequentially.

Sogou revenues are expected to be in the range of $34.0 to $36.0 million, representing 50% to 59% year-over-year growth. However, revenues are estimated to decline in the range of 12.0% to 17.0% sequentially.

Online game revenues are expected in the $160.0–$165.0 million range, representing 26% to 29% year-over-year growth. Revenues are forecasted to increase in the range of 1.0% to 4.0% sequentially.

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

Although Sohu did not provide any guidance for the full year, the company expects strong growth from video, Sogou and online games due to innovative product portfolio. Sohu expects to release four expansion packs for TLBB in 2013. Sohu also plans to launch at least 3 new massively multiplayer games and a number of new web games.

Our Take

We believe that Sohu’s results will continue to be negatively impacted by increasing product development costs in the near term. Sohu is a relatively small player in the online advertising market and continuing investments in product development are necessary to expand market share.

However, we believe that market share gain will be difficult in the near term. Sohu faces stiff competition from Baidu (BIDU - Snapshot Report) in search and advertising, Youku Tudou (YOKU - Snapshot Report) in online video and NetEase (NTES - Snapshot Report) in online gaming markets.

Moreover, Sohu’s first-quarter guidance reflects sluggish top-line growth on a sequential basis, which further compels us to remain on the sidelines.

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

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