CYOU Changyou com Limited

A leading online brand and Internet portal in China, Sohu.com Inc.’s (SOHU) fourth quarter 2011 earnings came ahead of the Zacks Consensus Estimate by four cents. Reported earnings increased 21.8% year over year to $1.27 per share (including stock-based compensation). However, it fell short of the company’s guided range of $1.30 to $1.35. Fourth quarter earnings exclude Sohu’s non-controlling interest in the online gaming company Changyou.com Ltd. (CYOU).

Revenue

Total revenue increased 42.2% year over year to $246.2 million in the reported quarter and surpassed the Zacks Consensus Estimate of $243.0 million. Reported revenue also exceeded management’s expected range of $241.0 million to $246.0 million. The increase was primarily driven by higher brand advertising, strong search business and online gaming revenues.

Brand advertising revenue in the quarter grew 29.4% year over year to $77.7 million and surpassed the low end of management’s guided range of $77.0 million to $79.0 million. Search revenue skyrocketed 248.4% year over year to $23.0 million in the reported quarter.

Online game revenue increased 34.4% year over year to $123.2 million, surpassing management’s expectation of $119.0 million to $122.0 million. Online gaming revenues grew on the back of higher active paying accounts (APA) and user base expansion. Aggregate registered accounts for Changyou's games jumped 58.0% year over year. Average revenue per user (ARPU) inched up 1.0% year over year. Aggregate peak concurrent users for Changyou’s games were approximately 3.17 million, up 18.0% year over year.

Wireless revenues crept up 0.6% from the year-ago quarter to $14.4 million.

Operating Performance

Gross profit surged 37.3% year over year to $175.4 million. Gross margin on a non-GAAP basis was 71.3%, down 250 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 stood at 86.7% versus 90.3% in the year-ago quarter. Wireless gross margin decreased to 36.7% from 44.7% in the fourth quarter of 2010.

Online brand advertising gross margin was 58.1% in the reported quarter, down from 60.2% reported in the prior-year quarter. Gross margin for the Search business was 65.3%, up significantly from 31.8% reported in the year-ago quarter, due to higher volumes.

Operating expenses shot up 60.9% year over year to $99.4 million in the quarter due to higher product development cost (up 40.4% year over year), sales & marketing expense (up 75.1% year over year) and general & administrative expense (up 69.9% year over year).

Operating profit increased 15.2% year over year to $76.0 million due to strong top-line growth. However, operating margin plummeted 720 bps to 30.9% in the quarter, primarily due to higher operating expenses.

Balance Sheet

As of December 31, 2011, Sohu had a cash position of $750.2 million compared with $729.7 million at the end of September. At the end of the quarter, Sohu had no debt on its balance sheet.

Outlook

Sohu provided an upbeat guidance. For the first quarter of 2012, Sohu expects total revenue in the range of $219.0 million to $225.0 million. Sohu estimates brand advertising revenues in the range of $60.0 million to $63.0 million, implying a sequential decrease of 19.0% to 23.0% but growth of 5.0% to 10.0% on a yearly basis.

Revenues from online games are expected in the $121.0 million to $124.0 million range. Management anticipates Sogou revenues to be $21.0 million for the first quarter, which implies a year-over-year growth of 163.0% but a sequential decrease of 9.0%.

Sohu projects net income on a non-GAAP basis, after deducting the non-controlling interest in Changyou, in the range of $19.5 million to $21.5 million and earnings in the range of 50 cents to 55 cents per share. The current Zacks Consensus Estimate for the first quarter stands at $1.16 per share.

Recommendation

Sohu is expected to benefit from its strength in online games. We believe that Sohu’s promising games portfolio and the growing popularity of Changyou’s games will drive profitability over the long term.

However, higher operating costs due to continued investments in video may hurt profitability in the near term. Moreover, cut-throat competition from the likes of Baidu Inc. (BIDU) and increasing government scrutiny into Chinese Internet usage may also hurt Sohu’s growth over the long term.

We, therefore, maintain our Neutral recommendation on the stock over the long term. Currently, Sohu has a Zacks #1 Rank, which implies a short-term Strong Buy rating.

 
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