Sohu's Upside Driven by Branded Advertising

Filed in archive Studies on July 30, 2006

Does the global private equity investor need any reminder of the dangers posed by doing business in China. Despite the news that the Chinese Internet company Sohu had its search engine blocked last month by Beijing authorities, apparently due to their failure to effectively block access to sites with content the government considers offensive, Piper Jaffray's senior analyst Safa Rashtchy is still bullish about Sohu's branded advertising. His recent trenchant analysis of Sohu includes the following:

• Revenues ($34.1M vs estimate of $33.6M) exceed estimates on strong branded advertising and wireless. EPS of $0.20 in line excluding a non-cash benefit.
• Brand advertising grew 39% y/y vs our estimate of 35%, accelerating slightly over the strong pace set in Q1.

• Increased ad growth guidance of 25%-30% for '06 is still too conservative - expect upside.

• Premium content, however, is getting more expensive - advertising gross margins fall. 

• Revenue and EPS estimates coming down to reflect previously disclosed effects of the new wireless policies.

Although the Chinese government's Internet crackdown last month was widely reported in the mainstream media, I credit Rafat Ali of Paid Content with his succint comments about the government's intervention in the Net again. " Two of the biggest portals in China, Sina.com and Sohu.com have seen their search engines being temporarily shut down, in a sign of intensified internet censorship, with millions of users expected to be affected. Chief editors of Web portals were summoned to the State Council Information Office and Sina and Sohu were ordered to shut down their search engines after they failed an on-the-spot censorship test, one of the sources said."

Sure, the search engines of China's most popular web portals Sohu and Sina were back in operation after only a few days since they were effectively upgraded to censor and sanitize Internet content. The paradox is that Beijing is eager to take global center stage with China's Next Generation Internet (CNGI). It's suppose to be a faster, more secure, more mobile version of the current one. CNGI is the centerpiece of China's plan to steal leadership away from the United States in all things Internet and information technology.

Ben Worthen's excellent reporting in CIO is a must read for all China watchers. He writes, "The strategy, outlined in China's latest five-year plan, calls for the country to transition its economy from one based almost entirely on manufacturing to one that produces its own scientific and technological breakthroughs-using a new and improved version of today's dominant innovation platform, the Internet."

With nearly 112 million Net users, the question is how can Beijing reconcile its strictly enforced Internet policy so that it does not translate as bad for business.