Sohu: Brand on the Run

Brand advertising isn't all it has been cracked up to be at Sohu.com (Nasdaq: SOHU  ) .

Shares of the Chinese dot-com pioneer opened 9% lower this morning after it posted uninspiring quarterly results and troublesome top-line guidance for the current quarter.

Revenue climbed 30% to $226.6 million, though net income was cut nearly in half to $0.53 a share. The decimation on the bottom line was expected. In fact, analysts were banking on a profit of $0.48 a share on $225.8 million in revenue. The outlook is where things get problematic, but let's take a closer look at the reasons for the shrinking bottom line.

There are plenty of moving parts at Sohu these days, but all it takes is weakness in one of them -- in this case, brand advertising -- to drown out the success that the company is having in online gaming and search.

Brand advertising revenue climbed 7% to $61 million at the popular portal, but revenue costs in the division soared 69%. The end result is that brand advertising's gross margins have gone from a hearty 62% a year ago to a mere 39% today. Sohu blames the increase in content and bandwidth costs for the margin decimation. A major culprit here is the growing popularity of video in China.

Market leader Youku (NYSE: YOKU  ) is still at least a year away from profitability, so it's not a surprise to see Sohu taking a hit as it shores up its ad-supported eye candy. Until advertisers are willing to pay up for chunky video streams, this will remain a hard category to monetize in China.

It's a shame, because the rest of Sohu is blazing. Sogou, Sohu's fast-growing search engine, saw its revenue soar 184% to $23 million. The much larger Baidu (Nasdaq: BIDU  ) only grew its top line by 75% during the same three months, though there's obviously a world of difference between Baidu's $677 million and Sogou's $23 million nibble.

Sohu's online gaming business -- essentially its majority-owned Changyou.com (Nasdaq: CYOU  ) arm -- is also holding up well with a 34% gain in revenue.

It's not just the margins in brand advertising leading to the steep drop in profitability. A sharply higher effective tax rate, along with a deduction of the share of net income pertaining to the non-controlling interest in Changyou, mangles the bottom of the income statement.

Sohu's guidance for the current quarter is where the negative surprise rests. Sohu is targeting $244 million to $250 million in revenue -- well short of the $250.8 million analysts forecast. Sogou should continue to be a speedster with revenue up 113%, and Changyou should pull through with a 28% to 31% surge. The problem, once again, is brand advertising, where Sohu is bracing investors to expect no more than 5% year-over-year growth.

Fortified with a debt-free balance sheet and a whopping $761 million in cash, Sohu has no problem investing in video and other online content that may not deliver material profitability right away. However, investors don't appear to be as patient.

Sohu isn't yet a poor man's Baidu
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Motley Fool newsletter services have recommended buying shares of Sohu.com and Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Longtime Fool contributor Rick Munarriz calls them as he sees them. He does not own shares in any of the stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.


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