Sohu.com Inc. (SOHU - Analyst Report) reported earnings of 45 cents per share in the third quarter of 2013, which decreased 34.4% year over year and 19.1% on a sequential basis. Earnings including stock-based compensation comfortably beat the Zacks Consensus Estimate by a nickel.
Revenues jumped 29.1% year over year and 8.7% sequentially to $368.3 million, towards the higher end of the management guided range of $358.0–$370.0 million. Revenues also surpassed the Zacks Consensus Estimate of $364.0 million. The year-over-year increase was primarily driven by strong performance from the online advertising and online gaming business.
Online advertising revenues surged 56.5% year over year and 21.0% sequentially to $177.1 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 streamed The Voice of China, which attracted significant traffic. The superior content portfolio helped video advertising sales to triple on a year-over-year basis and was up 60.0% from the previous quarter.
Sohu achieved significant growth in the mobile video segment as traffic increased massively in the third quarter. To-date, total number of active users for Sohu’s mobile applications reached 140 million.
Sogou revenues continued to grow in the quarter, up 53.0% year over year and 14.0% quarter over quarter to $57.0 million. The Sogou pinyin mobile version added another 30 million new users as monthly active users reached 180 million.
Search and Others revenues jumped 48.2% from the year-ago quarter and 13.3% sequentially to $46.2 million.
Brand advertising revenues grew 60.2% from the year-ago quarter to $124.8 million and were close to the higher end of management’s guided range of $120.0 million to $125.0 million. Revenues increased 24.5% sequentially, within management’s guided range of 20.0% 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 (CYOU - Snapshot Report) revenues increased 7.5% year over year but declined 4.0% sequentially to $161.5 million, toward the lower end of management’s expectation of $161.0 million–$166.0 million.
Wireless revenues increased 1.5% year over year but declined 5.2% quarter over quarter to $14.5 million. Others revenue surged 99.1% year over year and 70.4% sequentially to $15.2 million in the reported quarter.
Gross margin contracted 20 basis points (bps) from the year-ago quarter to 65.9%. The year-over-year decline was primarily due to decrease in online advertising gross margin, which was 48.9% compared with 49.4% in the year-ago quarter. On a sequential basis, gross margin increased 90 bps.
Operating expenses, as a percentage of revenues, were 51.8% compared with 43.8% in the year-ago quarter. On a sequential basis, operating expenses as a percentage of revenues increased 430 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 420 bps and 270 bps, respectively. General & administrative expenses increased 110 bps from the year-ago quarter.
On a sequential basis, product development and sales & marketing expenses jumped 50 bps and 350 bps, respectively. General & administrative expenses increased 40 bps from the previous quarter.
The sharp increase in operating expenses hurt operating margins. Operating margin was 14.2% compared with 22.3% in the year-ago quarter and 19.0% in the previous quarter.
Net margin declined to 4.7% from 9.3% reported in the year-ago quarter and contracted 170 bps on a sequential basis.
Balance Sheet & Cash Flow
Sohu exited the third quarter with cash and cash equivalents of $1.24 billion compared with $770.5 million in the previous quarter. In the third quarter, Sohu generated $124.0 million in operating cash flow. Changyou generated $97.0 million, while operating cash flow for the other business units were $27.0 million.
During the quarter, Sohu and Tencent Holdings Limited entered into a partnership, under which Tencent invested $448.0 million in cash to acquire a 36.5% stake in Sogou, which can be increased to 40.0% in the future.
As per the terms of the agreement, Tencent’s Soso search related business and certain other assets will be merged with Sogou (over the next two months). Sohu will hold the controlling interest in Sogou, which will continue to operate as a subsidiary of Sohu.
The Sohu-Tencent partnership will improve Sogou’s competitive position against market leader Baidu Inc. (BIDU - Snapshot Report) and Qihoo 360 Technologies , which ranks second in both PC and mobile search market going forward.
Tencent’s strong mobile user base will boost Sohu’s mobile search traffic. Sogou will become the default search engine for Tencent’s mobile browser. Tencent will also promote Sogou’s mobile input method on mobile platforms such as mobile QQ and WeChat.
The partnership will boost Sohu’s user base and market share, which will further improve monetization efficiencies over the long term. Following the partnership with Tencent, Sohu’s market share in PC reached 13.5% and 16.0% in mobile. Sohu expects Sogou to grow at a faster rate in 2014 based on the synergies from this partnership.
For the fourth quarter of 2013, Sohu expects revenues in the range of $378.0 million–$390.0 million. Management estimates brand advertising revenues in the range of $120.0 million to $125.0 million, representing 46.0% to 52.0% year-over-year growth. However, on a sequential basis, brand advertising revenues are expected to remain flat or decline up to 4.0%.
Sogou revenues are expected to be in the range of $68.0 to $70.0 million, representing 66.0% to 71.0% year-over-year growth and 19.0% to 23.0% sequential growth. Online game revenues are expected in the $171.0 million–$176.0 million range.
Non-GAAP net loss is expected in the range of $11.0 million to $13.0 million and loss per share is projected between 30 cents and 35 cents per share.
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. Additionally, the partnership with Tencent will boost Sogou’s traffic, which will further drive Sohu’s top-line growth going forward.
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 in most of its operating markets.
Currently, Sohu has a Zacks Rank #5 (Strong Sell).