Hong Kong-based S&P analyst David So re-affirmed his "sell" rating on Sohu (ticker: SOHU) yesterday. On Monday, Sohu announced Q4 2005 earnings results, held a conference call with analysts, and yesterday, enjoyed a 17%+ gain in the stock market. The company was also upgraded by Citigroup analyst Jason Brueschke this week. Key points from So's note to clients:
Sohu reported Q42005 net profit of US$8.9 mln and fully diluted EPS of US$0.23. Although operating earnings were lower than expected, the headline results were in line with our forecasts largely due to one-time gains of US$2.4 mln related to the repurchase of convertible notes and tax exemptions. Sales grew 8% QoQ to US$30.5 mln (+27% YoY) thanks to solid growth in brand advertising (+8% QoQ, 28% YoY) and WVAS (+7% QoQ, +55% YoY). Core EBITDA margin was lower than expected, contracting to 20.7% from 26.5% in Q32005 and 26.6% in Q42004, largely due to higher sales and marketing expense related to Sohu’s 2008 Olympic Games sponsorship role and sales commissions. We are cutting our net profit forecasts by 21% and 22% for 2006 and 2007 respectively to account for higher opex associated with the official 2008 Olympic Games website. In addition, we are introducing our explicit forecasts for 2008. We are raising our 12-month target price to US$19 from US$14 based on a higher blended valuation reflecting the mid-point of our DCF valuation of US$16 and relative valuation of US$22 based on the Chinese Internet sector PE of 21x for 2006. Our DCF valuation of US$16 assumes a WACC of 18%, free cash flow CAGR (2006-2020) of 20% and terminal growth of 2%. We believe the stock is overvalued as the market is pricing in rather high free cash flow growth of well over 20% on a compounded annual basis from 2006 to 2020, based on our model. On this basis, we are retaining our 2-STARS (Sell) call. Although the stock price may react positively to the better-than-consensus Q42005 headline results, we see limited upside given that the net profit was boosted by one-time gains. Risk factors that could drive the price down to our target price include the negative impact from operational dependencies on the two Chinese mobile operators in the WVAS business and an inability to monetize its search traffic through Sogou.