Qihoo 360 (UNKNOWN:QIHU.DL) reported its third-quarter earnings after the market close on Monday, beating estimates for both its top and bottom lines. The company reported revenue of $376.4 million and earnings per ADS of $0.63 versus expectations of $0.61 per ADS on $$365.4 million.
The company continues to show strength in gaming as well as web search, where it's cutting into rival Baidu's (NASDAQ:BIDU) market share. Meanwhile, the growth in revenue is starting to show the leverage in the company's business model, as operating margin started to bounce back from its disappointing lows last quarter.
Here are the key takeaways from Qihoo's third-quarter earnings report.
Searching for a growing user base
While Qihoo 360 started as a PC-based software company, it's rapidly shifting to a mobile and Internet company.
Last quarter, its mobile security software, 360 Mobile Safe, was installed on 673 million smartphones, a 65% increase year-over-year, but only a 5% sequential improvement. Meanwhile, its PC-based software has largely penetrated the market with 94% of PC users using Qihoo's software. Similarly, Qihoo seems to have found the limit on its market penetration with its PC web browser, with its penetration actually declining from 69% to 68% (although total users still increased).
Search is growing well, though, exceeding the company's goal of 30% market share by the end of the year. That's a vast improvement from the company's 19% share at this point last year. Meanwhile, Baidu's share of the web search market in China has shrunk from about 80% two years ago, to closer to 50% today. The company is still working on improving its mobile search share as well, but search was a key driver of Qihoo's 67% increase in online advertising revenue.
Gaming the system
Games also continue to drive Qihoo's revenue growth. Internet value-added services, which is comprised mostly of games, grew 158%. The segment accounted for 46% of total revenue this quarter, flat from last quarter, but up from 35.6% in the third quarter last year.
The growth in China's gaming industry has treated Qihoo 360 very well. The company has successfully leveraged its popular security software to increase the install base of its Mobile Assistant (a third-party Android app store). As a result, it has the most popular app store in China, taking a 30% revenue share of mobile games in the second quarter.
Baidu is working diligently to compete with Qihoo 360's mobile app business. It purchased 91 Wireless last year and it has its own app store as well. In the near term, the mobile app market is growing rapidly enough for both Internet giants to improve their revenues. Qihoo currently holds the long-term advantage, however, with its market share. (It'll be interesting to see if Qihoo can improve adoption of its search app with its app store market share.)
Last quarter, investors sold off Qihoo 360 stock after operating margins came in much lower than expected. Management told investors that it was a temporary issue, and that they expected margins to bounce back in the second half.
Indeed, margins improved significantly, with the company posting a non-GAAP operating margin of 24.8% compared to 21.9% in the previous quarter. That's still way down from the prior year, when the company posted an operating margin of 35.5%. A similar pattern is seen in the company's net margin.
The year-over-year decline was largely due to increased marketing expenses, personnel costs, and equipment depreciation expenses. Those won't be going away anytime soon, but should grow more slowly than revenue in the near term as the company ramps up monetization of its search engine.
What to expect going forward
Management guided above analysts' consensus expectation for fourth quarter revenue of $405 million. Management expects revenue to come in between $410 million and $415 million. While the company doesn't give guidance on earnings per ADS, analysts are expecting $0.82 per share on average.
Considering, Qihoo's guidance above revenue expectations and the improving margins, we could see a round of revised earnings estimates. Last year, the company reported a net margin of 43.5% in the fourth quarter. While it likely won't reach those levels again, net margin could creep back up to the 30% range on the strength of advertising and gaming, putting earnings results well ahead of current expectations should Qihoo hit its revenue outlook.
Adam Levy has no position in any stocks mentioned. The Motley Fool recommends Baidu. The Motley Fool owns shares of 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.