Sohu Fires a Warning Shot

Shares of Sohu.com (NASDAQ: SOHU  ) opened lower this morning after chasing away a solid quarterly report with crummy guidance for the current quarter.

The Chinese dot-com pioneer closed out 2012 in fine fashion. Revenue climbed by a better-than-expected 22% to $299 million, closing out the year with more than $1 billion in revenue for the first time in the company's history.

Profitability slipped, primarily as gross margin tumbled as Sohu invests in costly video-sharing and other growth initiatives. However, Sohu's quarterly profit of $0.60 a share (or $0.73 a share on an adjusted basis) obliterated the $0.53 a share that the market was forecasting.

Despite is brand advertising roots, online gaming and search have been the true growth drivers at Sohu lately.

Its online gaming arm -- essentially Sohu's stake in its publicly traded spinoff Changyou.com (NASDAQ: CYOU  ) -- saw revenue climb 29% to $159 million. There were some problematic trends there. The number of paying accounts and peak concurrent players for its organic titles slipped. However, Changyou's decisions to give away more virtual items and scale back in-game promotions have increased the average revenue that it does collect from its smaller base of paying gamers. Its move to acquire a majority stake in web game developer 7Road two years ago also continues to pay off here.

Sogou -- Sohu's search engine -- continues to be the speedster. Sogou's revenue climbed 78% to $41 million. That's a headier growth rate than niche leader Baidu, but it's not as if China's largest search engine needs to worry about a company that's servicing a sliver of the market. Sogou's search is also accounting for less than 14% of Sohu's overall revenue, so it may take some time before it starts moving the needle.

Sohu's weakest business was its flagship brand advertising stronghold. Despite attracting a 25% increase in traffic to its Sohu.com homepage over the past year, Sohu's brand advertising only clocked in 6% higher during the quarter.

Investors accept that following niche leader Youku Tudou (NYSE: YOKU  ) by exploring video sharing will sting margins. Serving up chunky video files in a format that's tricky to monetize will do that. However, when Sohu's overall brand advertising business can't keep up with China's economic growth rate, we have a problem.

The real downer at Sohu is guidance. Sohu now sees just $290 million to $299 million in revenue, suggesting the likelihood of a sequential dip on the top line. It's also forecasting sequential declines in revenue for its Sogou and brand advertising businesses, setting the stage for what Baidu will offer when it reports tonight. There are seasonal factors at play here, but its call this morning calling for revenue at Sogou to slide as much as 17% sequentially this quarter is shocking. 

Sohu is the first of the major Chinese Internet companies to report this earnings season. The near-term outlook is now a concern for its peers unless they argue otherwise in the coming days and weeks.

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