Sohu Q2 Earnings Recap: Laying A Runway For Growth, Attractive Valuation

| About: Inc. (SOHU)

Sohu (SOHU) reported Q2 results on August 6th.

Key highlights:

  1. Revenue: $256 million, +29% y/y
  2. Brand advertising revenue: $69 million, +2% y/y
  3. Sogou revenue: $30 million, +123% y/y
  4. GAAP EPS: $0.28 per share
  5. Non-GAAP EPS: $0.42 per share

What I liked: Revenue above estimate; resilient growth in search, video, and gaming

Sohu's revenue of $256 million beat the consensus of $247 million. The 3.6% upside surprise was encouraging given the soft advertising environment in China.

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Sogou Search continued to execute and see revenue growth at twice that of Baidu (BIDU).

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In Q2, Sogou has approximately 375 million users and ranks as the 4th largest Chinese internet company by user base. In addition, the robust revenue growth over the past two years has propelled Sogou to become the 8th ranked Chinese internet company in terms of revenue from 12th place. Heading forward, Sohu will continue to view Sogou as a key growth driver and invest heavily in the unit. I note that Sogou's R&D headcount increased by 82% and for the remainder of the year the unit plans to introduce enhanced browser, Chinese character input software and mobile platforms.

After purchasing Alibaba's stake in Sogou, Sohu currently has a 63% stake in Sogou.

Online video continues to gain traction over the quarter with some of Sohu's exclusive and original content attracting over 350 million viewings in the first 30 days of airing. According to comScore, viewer traffic increased 26% y/y in June 2012. Heading forward, we will continue to see 1) stabilization of content price and 2) a robust pipeline of exclusive and original content.

According to management, content price has stabilized to the 2011 level. Most notably, exclusive drama now cost RMB 500K per episode compared with RMB 1 million+ in late 2011 and early 2012. In the next six to twelve months, Sohu will to aim for one or two TV hit dramas per month and work with producers on original contents. In my view, Sohu's current investment in content and dedicated sales force on video will bear fruit once the Chinese economy recovers because advertisers are increasingly shifting ad spend to online video sites as the government limits the number of popular programs on TV and Sohu will likely see revenue acceleration in its video unit next year. For a closer look at China's online video trend, please see my August 6th note titled "Banking On China's Secular Online Video Market."

Finally, Changyou (CYOU) continues to maintain the momentum on its hit title, Tian Long Ba Bu and see revenue grow at 30% y/y. According to management, TLBB will introduce another expansion pack for the gaming community.

What concerned me: Soft growth in brand advertising and continued margin deterioration

Brand advertising was weak with only 2% y/y growth. Two of the top branded advertising clients for the quarter were transportation and FMCG.

Sohu's margin continued to slide amid heavy investment in video and search.

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Bottom line: I feel that Sohu delivered a strong quarter. The company is trading at the cheapest level since its 2003 IPO, and is well positioned for multiple expansions once the Chinese economy starts to pick up.

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