A leading online brand and Internet portal in China, Sohu.com Inc. (SOHU) reported strong third quarter 2010 results, attributable to growth in each of its business segments, including online games and brand advertising. Moreover, better-than-expected growth in search ad revenues boosted results. Sohu provided an upbeat fourth quarter guidance that beat analysts’ expectation.
Earnings per share (EPS) of $1.01 (including stock based compensation expense) increased 14.8% year over year from 88 cents and 23.2% from 82 cents reported in the previous quarter. EPS beat the Zacks Consensus Estimate of 90 cents by 11 cents. Earnings exclude Sohu’s non-controlling interest in the online gaming company Changyou.
Earnings benefited from lower expenses and increased sales in the quarter, partially offset by higher taxes.
Revenue
Total revenue was up 20.1% year over year and 12.3% sequentially to $164.1 million in the reported quarter, well above the Zacks Consensus Estimate of $157.0 million. Revenues were above management’s expectation of $153.0 million to $158.0 million. The revenue increase was primarily driven by a robust growth in brand advertising, search business and online gaming revenues.
Brand advertising revenues in the quarter escalated 22.0% year over year and 11.0% sequentially to $59.1 million while sponsored search revenues of $5.4 million were up 134% year over year and 38% sequentially. Management had estimated brand advertising revenues in the range of $57.0 million to $59.0 million.
As a result, advertising revenues soared 27% year over year and 13% sequentially to $64.5 million. Advertising revenues were above management’s expectation of $61.0 million to $63.0 million, attributable to growth from World Cup, Shanghai Expo and Asian Games and a surge in online video demand.
Online game revenues increased 25.0% year over year and 10.0% sequentially to $85.6 million, well above management’s expectation of $80.0 million to $83.0 million, primarily driven by an increase in demand for Tian Long Ba Bu (TLBB), Changyou’s flagship game in China and a higher spending from game players.
Online gaming revenues grew year over year on the back of higher active paying accounts (APA) and user base expansion, reflecting the growing popularity of Changyou’s online games. Aggregate registered accounts for Changyou’s games increased 7% sequentially and 40.0% year over year to 105.2 million. APA declined 6.0% sequentially, but increased 9% year over year to 2.61 million.
Average revenue per user (ARPU) increased 16% sequentially and 13.0% year over year. Aggregate peak concurrent users (PCU) for Changyou’s games were approximately 980,000, a decrease of 14% year over year and sequentially.
Overseas licensing revenues in the reported quarter decreased 7% sequentially, but increased 11% year over year to $2.0 million. The sequential decrease was primarily due to increased competition in mature overseas online game markets while the year-over-year increase was largely due to an increased momentum of TLBB in Vietnam and Malaysia.
Wireless revenues fell 19.0% from the year-ago quarter, but were up 23.0% from the prior quarter to $13.6 million.
Gross margin on a non-GAAP basis decreased 200 basis points on a year-over-year basis and was in sync with the previous quarter to 74% in the quarter.
Year over year, margins were impacted by a lower advertising gross margin, due to a weak result from brand advertising, which was 62.0% in the quarter as compared with 69.0% in the year-ago quarter and 60.% in the previous quarter.
Online game gross margin was 90.0% in the reported quarter, as compared with 91.0% in the prior quarter and 93.0% in the year-ago quarter. Wireless gross margin was 46%, compared with 48% in the second quarter of 2010 and 43% in the third quarter of 2009.
Operating expenses grew year over year, primarily due to higher product development expenses, partially offset by general and administrative expenses and sales and marketing expenses. Operating expenses shot up 7.0% year over year, but declined 1% sequentially to $50.1 million in the reported quarter.
Lower operating expenses had a favorable impact on operating margin, which increased 500 basis points sequentially and 200 basis points year over year.
Balance Sheet
As of September 30, 2010, Sohu had a cash position of $534.7 million as compared with $599.1 million at June 30, 2010. At the end of the quarter, Sohu had no debt on its balance sheet.
Outlook
For the fourth quarter, Sohu expects total revenue in the range of $163.0 million to $168.0 million. Sohu estimates advertising revenues to be in the range of $64.0 million to $66.0 million.
Sohu expects brand advertising revenues in the range of $58.0 million to $60.0 million and online game revenues in the range of $86.0 million to $89.0 million.
Sohu projects net income on a non-GAAP basis after deducting the non-controlling interest in Changyou to be in the range of $43.0 million to $45.0 million and earnings in the range of $1.10 to $1.15.
According to Reuters, fourth-quarter earnings are expected to be 95 cents a share on revenues of $162.6 million.
Recommendation
Sohu is expected to benefit from its strength in online games and China’s growing online advertising industry. The company expects an increased advertising spending in 2010. We believe that Sohu’s promising games portfolio and ongoing popularity of Changyou’s games will drive profitability on a long-term basis.
However, Sohu continues to face cut-throat competition from Baidu Inc. (BIDU) and Sina Corp. (SINA).
We believe Sohu is a 2011 growth story. We therefore maintain our Neutral rating on the stock over the long term. Currently, Sohu has a Zacks #3 Rank, a short-term Hold.
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