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Sohu.com Inc. (SOHU - Analyst Report) reported earnings of 60 cents per share in the first quarter of 2013, which increased 13.7% year over year but remained flat on a sequential basis. Earnings including stock-based compensation comfortably surpassed the Zacks Consensus Estimate by 4 cents.

Revenues

Revenues jumped 35.7% year over year and 2.7% sequentially to $307.6 million, ahead of management’s guided range of $290.0–$299.0 million. Revenues also surpassed the Zacks Consensus Estimate of $290.0 million. The increase was primarily driven by strong performance from the online advertising and online gaming business.    

Online advertising revenues surged 40.8% year over year but decreased 3.7% 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 dominating 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 Netflix’s (NFLX - Analyst Report) House of Cards shortly after its US release. The introduction of the show attracted significant traffic mostly from metropolitan cities such as Beijing and Shanghai. As a result, video advertising sales grew double-digit on a sequential basis.

Sohu achieved significant growth in the mobile video segment as traffic increased massively in the first quarter. Mobile average daily active users and video views both jumped 40% sequentially and accounted for 30.0% of total video traffic. During the quarter, Sohu entered into partnerships with the likes of Samsung and China Unicom (CHU - Analyst Report).

Sogou revenues continued to grew in the quarter, up 73.0% on a year-over-year basis to $39.0 million. This was much better than management’s guided range of $34.0 to $36.0 million. Although revenues fell sequentially, the 4.0% decline was much better than the management’s forecasted 12.0% to 17.0% sequential decline in the quarter.

Sogou pinyin added 11 million new users from the previous quarter and its penetration rate reached 88.0% at the end of the first quarter. Sogou mobile pinyin’s monthly active user base jumped 34.0% from the end of December last year. As a result, Search and Others revenues jumped 66.6% from the year-ago quarter to $36.1 million. Search revenues decreased 6.9% on a sequential basis.

Brand advertising revenues grew 31.6% from the year-ago quarter to $80.2 million and were slightly ahead of the lower end of management’s guided range of $80.0 million to $82.1 million. Revenues decreased 2.2% sequentially,  within management’s guided range of 2.0% to 5.0% decline. Brand advertising continued to benefit from strong demand from FMCG and real estate.

Online games (operated by Changyou.com) revenues surged 32.9% year over year and 5.3% sequentially to $167.4 million, well ahead of management’s expectation of $160.0 million–$165.0 million. Online gaming revenues grew on the back of expanding user base and improved monetization.

Aggregate registered accounts for Changyou's games jumped 45.0% from the year-ago quarter and 10.0% sequentially to 272.7 million.  Average revenue per user (ARPU) soared 77.0% year over year and 13.0% sequentially to RMB399, driven by higher spending from Tian Long Ba Bu’s (“TLBB”) advanced level players in the reported quarter.

Wireless revenues increased 3.2% year over year and 9.0% quarter over quarter to $13.8 million. Others revenue surged 116.1% year over year and 41.2% sequentially to $10.1 million in the reported quarter.

Margins

Gross margin expanded 140 basis points (“bps”) from the year-ago quarter to 66.3%. The year-over-year expansion was primarily due to significant increase in online advertising gross margin, which was 43.5% compared with 39.4% in the year-ago quarter. On a sequential basis, gross margin contracted 250 bps.

Operating expenses, as a percentage of revenues, were 43.3% compared with 41.9% in the year-ago quarter. On a sequential basis, operating expenses as a percentage of revenues improved 400 bps in the quarter.

The sharp year-over-year rise in operating expense was primarily due to higher sales & marketing expenses, which as a percentage of revenues jumped 200 bps to 19.1% in the reported quarter. This fully offset a 20 bps improvement in product development and 60 bps improvement in general & administrative expenses.

On a sequential basis, both product development and sales & marketing expenses improved 70 bps and 390 bps, respectively. This fully offset a 50 bps increase in general & administrative cost.

The modest increase in operating expenses and higher gross margin base drove operating margin to 23.1%, up 10 bps from the year-ago quarter and 180 bps from the previous quarter. Net margin declined to 7.5% from 8.9% reported in the year-ago quarter. Net margin contracted 20 bps on a sequential basis.

Balance Sheet & Cash Flow

Sohu exited the first quarter with cash and cash equivalents of $798.3 million compared with $833.5 million in the previous quarter. Long-term debt was $157.5 million compared with $126.4 million at the end of the previous quarter.

Outlook

For the second quarter of 2013, Sohu expects total revenue in the range of $333.0–$342.0 million. Sohu estimates brand advertising revenues in the range of $98.0 million to $100.0 million, representing 41% to 44% year-over-year growth and 22.0% to 25.0% sequential growth.

Sogou revenues are expected to be in the range of $48.0 to $50.0 million, representing 58% to 65% year-over-year growth and 22.0% to 27.0% sequential growth. Online game revenues are expected in the $165.0–$170.0 million.

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 (as a result of continuing investment on product development), 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. Moreover, competition from the likes of Baidu (BIDU - Snapshot Report) will remain a major headwind going forward.

Currently, Sohu has a Zacks Rank #3 (Hold).

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