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SOHU Outlook

Sohu just reported 2004 Q2 earning report. What is my current outlook on SOHU from investor point of view?

SOHU business can be broken down into 2 categories: Internet ads and wireless subscription. Since SINA is closest competitor to SOHU, I use SINA as comparison to measure SOHU performance.

Internet Ads

SOHU SINA reported different numbers, SOHU report GAAP earning only while SINA report Pro Forma earning.  Since Ads margins are very similar,  Ads revenue is used for comparison.

      Internet Ads historical revenue in $ millions

	02Q3	02Q4	03Q1	03Q2	03Q3	03Q4	04Q1	04Q2	04Q3(est)
SOHU	3.7	4.3	4.5	6.8	8.7	9.5	11	13.4	15.8
SINA	6.5	7.4	7.3	9.5	11.4	12.9	13.1	15.5	18.3

The above table clearly shows that SOHU has been out-performing SINA in internet ads business over past 2 years.
In revenue basis SOHU is lagging SINA only by 1 quarter while 2 years ago the gap was 3 quarters. 

Internet website popularity is leading indicator of Ads revenue growth.  SOHU web property now is most visited web portal in China according to Alexa. Historically, SINA was the most visited web portal and was famous for its popularity of news channel.  According to Chinalabs, SOHU news channel has more reach than SINA news in recent month.  The trend is in favor of SOHU to surpass SINA in internet ads revenue in the future.
 
Breakdown of ads gross profit in  recent quarter number:
SOHU ads profit is 56% of total gross profit.
SINA  ads profit is 30% of total gross profit.

SOHU generates  more and more profit from internet ads while SINA business is mainly in wireless business. 

The success of SOHU Ads business is not just  out-performing in existing business such as news content but also in  expansion into new business such as  search, gaming portal, localized sales network with acquisition or more internal re-investment spending.   Specifically, the new search will be engine for next phase of Ads growth  in the near future.  In comparison , SINA has not focused that much in Ads business as SOHU did.

As I already said before, the main reason for investing into SOHU is its internet portal ads business. The ads business has high barrier of entry and has consumer monopoly power.  Right now SOHU and SINA have shared this new media monopoly in China.  The have been raising  ads fees regularly over past years.  This is very stable business that long term investors can count on.

Wireless business

The outlook for wireless business is clearer from this Quarter.

SOHU reported lower revenue in wireless revenue , down sharply over past quarter.  2.5G wireless business has been growing fast and SMS business dropped fast.  The SMS part is expected to bottom out in next Q.
2.5G wireless revenue is  20% of total wireless revenue for current quarter and will be 40-50% of   total wireless business next quarter.  Since the 2.5 G wireless business is a growing business ,   the risk of SMS trouble is much smaller from now on.

SINA  increased wireless revenue  mainly due to acquisition.  In organic growth, SINA is also expecting  wireless revenue negative  sequential growth for next quarter.

Wireless business in general is commodity-like business that is not suitable for long term investment.  For that matter,
Although I will value SOHU with  multiple of 10  on the wireless part of net income, the investment focus should be internet ads business.

Dark horse - Game
 
Blade online has generated lots of  users  for beta testing. Currently SOHU  has 27 servers after 2 weeks of public testing. For comparison Netease popular XYQ game had 58 servers after 1 month of testing. The game momentum is very strong so that  it is possible to see huge upside from this game. If it is indeed as successful as XYQ game to obtain 50k average con-current users or more, it will add 5 cents per share earning for SOHU in 2004 Q4.

Expense

SOHU increased expense a lot recently. However, SOHU spend extra dollar mostly in new search, new game expansion, I do not view this as problem.  To evaluate this expense correctly, the expense usually should be amortized into proper years. However since SOHU did not provide detail and the amount is still not  very big,  I am not too worried about this.

Further more, after new search launch next week and  charging fee for new game in Q4, the payoff of the extra will  come  soon. For that matter, I will also want to look at next Q guidance in revenue base rather than EPS earning base:

NEXT Q  outlook

SOHU :  28.1-29.1  next quarter revenue is about  3% to  6.6%  increase over current Q. 
SINA:     49.0 - 50   next quarter revenue is about  - 0.4% to  1.6%  increase over current Q.

SOHU is expected to out-perform SINA in net revenue growth next Q.  SOHU has smartly been focusing on more profitable internet ads and online game business while SINA has spended money in acquiring and growing wireless business.

Valuation

SOHU  PE = 22            56% business in  ads, 44% in wireless in terms of gross profit
SINA PE = 33              30% business in ads, 70% in wireless in terms of gross profit

SOHU:  less  commodity-like wireless business, more  high-growth profitable ads business,  cheaper stock.
SINA:    more  commodity-like wireless business,  less high-growth profitable ads business,  more expensive stock.

Conclusion

I continue to like SOHU business outlook and its low valuation and huge growth potential in Chinese exploding internet business.
I continue to hold the SOHU position in Blast Investor model portfolio.

 

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