A leading online brand and Internet portal in China, Sohu.com Inc. (SOHU) reported strong first quarter 2011 results, driven by solid revenue growth, partially offset by higher expenses.
Earnings per share (EPS) of $1.01 (including stock-based compensation) increased 38.4% from 73 cents in the year-ago quarter. Quarterly EPS also beat the Zacks Consensus Estimate of 97 cents. However, EPS missed the company’s guided range of $1.03 to $1.08.
First quarter earnings exclude Sohu’s non-controlling interest in the online gaming company Changyou.com Ltd. (CYOU).
Operating Performance
Gross margin on a non-GAAP basis was 74.0%, down 100 basis points (bps) from the year-ago quarter.
The company’s margins were affected by the year-over-year decline in online games gross margin, which was 91% versus 93.0% in the year-ago quarter. Wireless gross margin plummeted 300 bps on a year-over-year basis to 45.0% in the first quarter.
Online brand advertising gross margin was 61.0% in the reported quarter, up from 56.0% reported in the prior-year quarter. Gross margin for the Search business was 39.0%, a huge increase from 3.0% reported in the year-ago quarter, due to higher volumes.
Operating expenses shot up 34.3% year over year to $65.1 million in the quarter due to the higher salaries and benefit expense and increased marketing expense.
Operating margin fell 100 bps year over year to 36.0% due to higher operating expenses.
Revenue
Total revenue was up 34.7% year over year to $174.4 million in the reported quarter, and surpassed the Zacks Consensus Estimate of $168.0 million.
The revenue was also above management’s expected range of $164.5 million to $169.5 million. The increase was primarily driven by robust growth in brand advertising, search business and online gaming revenues.
Brand advertising revenue in the quarter escalated 44.6% year over year to $57.2 million, handily beating management’s projected range of $55.0 million to $57.0 million. Search revenue soared 182.50% year over year to $8.0 million in the first quarter.
The company’s market share grew from 13% in the fourth quarter of 2010 to 16% in the first quarter of 2011, attributable to higher online video revenue.
Sohu’s search engine, Sogou, gained traction in the reported quarter. Management reported that active users of the Sogou browser, related search traffic and search revenue conjointly grew 20% sequentially in the quarter.
Online game revenues increased 31.7% year over year to $94.9 million, surpassing management’s expectation of $91.0 million to $93.0 million. The growth was primarily driven by an increase in demand for Tian Long Ba Bu (TLBB), Changyou’s flagship game in China.
Online gaming revenues grew on the back of higher active paying accounts (APA) and user base expansion. Aggregate registered accounts for Changyou’s games increased 21.0% year over year to 2.88 million.
Average revenue per user (ARPU) was up 4.0% year over year. Aggregate peak concurrent users for Changyou’s games were approximately 1.0 million, up 10.0% year over year.
Overseas licensing revenues in the reported quarter climbed 7.0% year over year to $2.0 million. The growth was primarily attributable to increased momentum of TLBB in Vietnam and Thailand during the first quarter of 2011.
Wireless revenues plummeted 12.0% from the year-ago quarter to $11.7 million.
Balance Sheet
As of March 31, 2011, Sohu had a cash position of $737.9 million, compared with $678.4 million at December-end. At the end of the quarter, Sohu had no debt on its balance sheet.
Outlook
Sohu provided an upbeat second quarter 2011 guidance beating the Zacks Consensus Estimate. For the second quarter, Sohu expects total revenue in the range of $188.0 million to $193.0 million.
Sohu estimates brand advertising revenues in the range of $65.5 million to $67.5 million, implying a sequential growth of 15.0% to 18.0% and year-over-year growth of 23.0% to 27.0%.
Revenue from Changyou is expected to be $97.0 million to $100.0 million, of which revenues from online games are expected to be $95.0 million to $97.0 million.
Management anticipates Search revenues of $11.0 million for the second quarter.
Sohu projects net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $44.0 million to $46.0 million and EPS in the range of $1.13 to $1.18. The current Zacks Consensus Estimate for the second quarter is pegged at $1.11.
Recommendation
Sohu is expected to benefit from its strength in online games and China’s growing online advertising industry. The company expects advertising spending to increase in 2011.
While TLBB remains a strong contributor to revenues, the company plans to unveil the full version of the highly anticipated Duke of Mount Deer game this summer, which will likely drive growth going forward. We believe that Sohu’s promising games portfolio and the growing 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, therefore, maintain our Neutral recommendation on the stock over the long term. Currently, Sohu has a Zacks #3 Rank, which implies a short-term Hold rating.
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