Why Is Sohu So Blue?

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Shares of Sohu.com (NAS: SOHU) and Changyou.com (NAS: CYOU) opened sharply lower today after the first, a Chinese dot-com mogul, posted its quarterly results.

There may not appear to be a whole lot wrong with the report at first glance. Revenue soared 36% to $198.7 million, fueled by a 27% uptick in online advertising, a 31% boost in online gaming, and a whopping 252% surge at its Sogou.com search engine. Adjusted earnings climbed 27% to $1.21 a share. Analysts were settling for a profit of $1.06 a share on $190.8 million in revenue.

Sohu's guidance for the current quarter calls for an adjusted profit of $1.20 a share to $1.25 a share on $225 million to $230 million in revenue. Wall Street was perched at $1.19 a share in tweaked net income with $206 million on top.

Why are investors bailing on this seemingly cheap speedster? Well, it really boils down to margins.

Earnings growth didn't keep pace with revenue growth during the quarter. Guidance for the current quarter calls for further margin deterioration, as Sohu's outlook calls for revenue to climb a hearty 37% to 30% higher, but adjusted earnings will grow by just 19% to 24%.

Today's reaction is overblown, though.

Margins dipped slightly at Changyou, but the online gaming giant just completed an acquisition two months ago. It's also in the process of rolling out a licensed version of Electronic Arts' (NAS: ERTS) Battlefield Online. Changyou has also introduced open beta testing of two new games in recent months.

Sohu is also making a big splash in online video. Revenue at Sohu Video has soared 150% over the past year. Given the profitless ways of niche leader Youku.com (NYS: YOKU) , this isn't the kind of wager that will pay off right away.

At its intraday low this afternoon, Sohu was trading at just 17 times this year's projected profitability and less than 15 times next year's target. This is an inviting discount to Sohu's growth, margin bumps and all. There are some online gaming specialists that are cheaper, but it's a different story on the online advertising end where Sina (NAS: SINA) and Baidu (NAS: BIDU) fetch much loftier multiples.

It's not entirely fair to pit Baidu against Sohu. Sogou may be growing quickly as a fringe search engine, but the $13.6 million it generated in revenue accounts for just 7% of the revenue mix at Sohu. It also pales when compared with the $528.4 million that market leader Baidu drummed up during the same three months. Sina is a closer fit to Sohu given similar display advertising bents, but it also has become a market darling on the strength of its magnetic Weibo micro-blogging platform.

However, all one has to do is judge Sohu's valuation relative to its growth to realize that today's sellers have it wrong this time.

Sohu will be back, with or without help from its margins.

Are you buying Chinese dot-coms these days? Share your thoughts in the comment box below.

At the time this article was published Motley Fool newsletter services have recommended buying shares of Sohu.com, Baidu, and Sina. 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 has been a fan of China's high-margin online stocks for a long time. He does not own shares in any of the companies in this story. He is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.

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