Chinese Internet firm Sohu SOHU posted first-quarter revenue and earnings that slightly exceeded the firm’s guidance and our internal estimate, thanks to solid top-line growth across brand advertising, search, and gaming. Revenue grew by 36% year over year to $308 million (versus $299 million at the high end of guidance), while non-GAAP net income came in at $24 million (versus $21 million at the high end of guidance). The latest results support our view that a rebound in revenue and profits is well under way for Sohu, after several quarters of strategic investments in research and marketing to ramp up the video and search unit. We are sticking to our view that the firm has yet to build an economic moat in areas of advertising, gaming, and search. We plan to raise our fair value estimate to $54 (from $52) to account for better-than-expected first-quarter earnings and the time value of money earned since our last model update. The shares are fairly valued, trading at 18.7 times our 2013 EPS, and we suggest investors wait for a pullback before building a position.

Online gaming and search (together two-thirds of sales) drove the bulk of incremental revenue growth in the March quarter, posting increases of 33% and 67% year over year respectively. The gaming revenue growth was mainly driven by solid performance of the MMO and web game portfolio operated by Sohu subsidiary Changyou CYOU , while we attributed the strength in search to traffic growth and improved monetization. In a welcome improvement from several quarters of single-digit revenue growth, brand advertising posted a 32% gain from the year-ago quarter, which was attributed to rising popularity of Sohu video advertising and the build-out of a dedicated sales force. Gross margins expanded by 144 basis points to 66.3%, the first expansion in the past two years, thanks to better profitability in search and brand advertising. These gains were offset by continued heavy investments in product innovation and marketing, which outpaced revenue growth, but we think these investments are crucial to Sohu’s high ambitions in the PC and mobile internet in China and expect Sohu to maintain these spending levels in the coming quarters. Operating margins were flat from a year ago at 23%.