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Sohu So Hot in China Internet Sector

Just days ago Baidu had big numbers, and this week it's Sohu's turn to impress.

Investors were promised big profits with the Internet in China, and that promise is coming to fruition.

Last month, China surpassed the U.S. to become the world's largest Internet market with 253 million users, and that's still only 19% of its population of 1.3 billion. By 2010, estimates say that China will have 406 million Internet users, more than the whole population of 301 million people in the U.S.

Most important, the Web surfers in China are starting to be monetized. Last week, it was


(BIDU) - Get Baidu Inc. Report

spiking on a

solid earnings report


This week, it's

(SOHU) - Get Ltd. Report

reporting a great second quarter. The Chinese online media and Internet portal blew away Wall Street estimates with earnings of $1.02 a share, which was 35 cents ahead of consensus estimates, a monster 52% upside beat.

Profits jumped nearly seven-fold from 15 cents in the same quarter a year earlier. Sales increased at an eye-popping 161% pace year-over-year to $102 million.

On top of that, management issued upside guidance for the next quarter, projecting earnings of $1 to $1.05, far above the 71-cent consensus. Sohu now trades at 20 times forward 2009 earnings estimates. With its 33% long-term growth rate and PEG ratio of 0.6, shares have plenty of upside from the current quote.

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Right after the earnings release on Monday, the stock spiked to a pre-market trading high in the upper $80s but then proceeded to sell off.

What gives?

First, analysts and investors didn't like the news that the company plans to carve out its online gaming subsidiary in a possible IPO. The benefits from Sohu's various segments have had a multiplier effect that would be diminished if the gaming division is separated.

Pali Research says the company, "... has benefited from its current integrated structure of games and advertising as the high margin game business allows SOHU to spend liberally on marketing and content. ...

We believe its game business creates 1+1 > 2 effect for the whole business. However, if the game business is separated from the company, we believe SOHU would not have the leeway to market itself aggressively on the advertising side without margin compression."

Second, the uncertainty around the post-Olympics economic environment has led investors to be more cautious. Management has not been clear on the outlook for 2009, and that's causing investor anxiety.

Third, the stock had a tremendous advance leading into the earnings report. Shares hit a near-term low of $61.81 on July 15 and ran into the upper $80s. Anytime a stock moves more than 40% in such a short amount of time, profit-taking should not only be expected, but warranted.

After such a spike, it's obvious and natural for traders to lock-in profits. Anything else is just piggish.

All in all, I think these concerns are overdone, as the core secular growth story is on fire. Simply put, growth of the Internet in China is strong and will continue to grow.

I want to be a buyer of weakness going forward. I see the analysts being way behind the curve in raising their estimates. Understandably, they have been conservative in their projections as the Chinese stock market has been battered this year. But, just recently, shares of Chinese Internet companies are showing increasing strength both fundamentally and in the way their stocks trade. Something positive is happening, and I think it will continue.

Look to


(SINA) - Get SINA Corp. Report

, which is scheduled to report earnings on Aug. 6, to further confirm the healthy prospects for the group. I am looking for strength in Sina shares as its quarterly report approaches and an upside earnings surprise from its reported number.

Patrick Schultz is a research associate at He has previously obtained securities licenses under the NASD's Series 7, Series 24, Series 52 and Series 63 exams and has worked in the financial markets on various trading desks in addition to trading for his own account. Schultz holds a bachelor's degree in applied economics from Cornell University.