Sohu Q3 Earnings Preview: Strengthening Network Externalities Is Key

| About: Inc. (SOHU)

Sohu (NASDAQ:SOHU) is expected to announce 3Q11 results on October 31 before the market opens. The Street expects the company to earn $1.16 per share (+15% y/y) on $228 million in revenue (+39% y/y). Sohu’s gaming unit, Changyou (NASDAQ:CYOU), is also expected to report its earnings before the market opens.

In 2Q10, Sohu saw strong growth in ad sales (+43% y/y) and online gaming (+31% y/y). Online video ad sales grew 150% y/y, with the number of advertisers growing 50% y/y. Sogou Search, the third widely used search engine in China, saw sales grow 250% y/y.

As I mentioned in my previous article, Sohu is in the midst of brand reinvention by creating externalities, such as the Sogou Browser and Chinese character input software, to drive search traffic. The strategy is so successful that rival Baidu (NASDAQ:BIDU) started to mimic Sohu by introducing its own proprietary web browser.

Heading into the earnings, investors should see whether the network externalities continue to drive search and online video ad sales as both units become bigger components of Sohu’s total revenue. Last quarter, the company guided triple y/y revenue growth in search revenue, which is on track to account for 17-18% of total ad sales.

One area of concern is how Sogou Search is going to differentiate itself from Baidu after Baidu’s partnership with One-Stop China to provide Chinese and international MP3 tracks for streaming and download. As I mentioned in my previous article, Sogou MP3 had an edge over Baidu MP3 due to its wide selection of both Chinese and international tracks. Since Baidu has narrowed the MP3 gap, one cannot help but wonder whether search traffic on Sogou Search might decrease as a result.

Sohu TV, which is estimated to be 15% of total advertising revenue, is likely to grow further as online video advertising sale is expected to growth at a 60% CAGR in the next two years. Sohu’s large licensed online video content and its success in producing in-house content has helped the unit to become the fastest growing online video site in China, taking 13% of the market share from 7.9% a year ago, while rival Tudou's (NASDAQ:TUDO) market share fell to 14% from 17% and Youku’s (NYSE:YOKU) market share grew 2ppts to 23% over the same period. Upon earnings announcement, I expect Sohu TV to replace Tudou as the second largest online video site in China.

Results from the newly released MMORPG game, Duke of Mount Deer (DMD), will also be a key focus. DMD underwent four years of development, the longest development cycle in Chinese online game history, and is the second most anticipated online game in China this year. Investors need to watch for the peak concurrent user (PCU) statistic that gauges DMD’s popularity among gamers.

Aside from DMD, investors should also note that Changyou plans to release another expansion pack, TLBB3, for its widely popular title Tian Long Ba Bu (91% of Changyou’s sales). TLBB3 will be the franchise’s largest expansion pack and could drive additional growth in this aging title.

CEO Charles Zhang stated that Sohu looks to focus on microblogging, online video, and Sogou Search, and expects to spin off Sohu TV for an IPO in 2012. Eventually, Sogou Search and Sohu Video will become bigger revenue components so that Sohu can be less reliant on Changyou, which operates in a highly competitive and unpredictable market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.