Q1 2013 Earnings Call Transcript
Transcript Call Date 04/29/2013

Operator: Ladies and gentlemen, thank you for standing by, and very good evening. Thank you for joining Sohu's First Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. After managements' prepared remarks, there will be a Q&A session. Today's conference call is being recorded. If you have any objections, you may disconnect at this time.

I would now like to hand the conference over to your host for today's conference call, Mr. Tip Fleming from Christensen. Thank you, sir. Please go ahead.

Tip Fleming - IR, Christensen: Thank you, operator. Thank you all for joining us today to discuss's first quarter 2013 results. On the call are Chairman and CEO, Dr. Charles Zhang; Co-President and Chief Operating Officer, Belinda Wang; Co-President and Chief Financial Officer, Carol Yu. Also with us from Changyou our President Dewen Chen; and Chief Financial Officer, Alex Ho. And we also have CEO of Sogou, Xiaochuan Wang; and Vice President of Sohu and CEO of Sohu Video, Ye Deng.

Before management begins their prepared remarks, I would like to remind you of the Company's Safe Harbor statement in connection with today's conference call. Except for the historical information contained herein, the matters discussed in this conference call are forward-looking statements. These statements are based on current plans, estimates and projections and therefore you should not place no undue reliance on them.

Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. For more information about the potential risks and uncertainties, please refer to the Company's filings with the Securities and Exchange Commission, including its registration statement and most recent Annual Report on Form 10-K.

Now, let me turn the call over to Dr. Charles Zhang, Chairman and CEO. Charles, please proceed.

Charles Zhang - Chairman and CEO: Thank you, and thanks to everyone for joining our call. I'm pleased to report that Sohu Group's three key properties, namely online media, in particular video; Sogou and Changyou are all making strong starts into 2013. For the first quarter, the Group revenues were up 36% year on year, exceeding our expectations. By business unit, online video, delivered double digit sequential revenue growth in a typical slowest quarter of the year.

Sogou business was solid as its core products continued to gain user traction. Changyou set new records for both top line and bottom line, driven by decent performance of its MMO and web games. According to iResearch, the Sohu Group now has approximately 450 million users on a monthly basis, consuming the Group's news, video, Pinyin games or our other services. This puts us as a solid No. 3 in China's Internet industry. Traffic growth for our PC Internet services is stable, while our mobile products are gaining strong traction as the total user base of two of our popular mobile applications, apps surpassed 100 million mark each.

Now I'd like to share some first quarter financial highlights with you. Total revenues were $308 million, up 36% year-over-year and 3% quarter-over-quarter, exceeding the high end of our guidance by $9 million. Net brand advertising revenues were $80 million, up 32% year-on-year and down 2% quarter-on-quarter. Sogou revenues $39 million, up 73% year-over-year and down 4% quarter-over-quarter, exceeding the high end of our guidance by $3 million. Online games revenue were $167 million, up 33% year-over-year and 6% quarter-over-quarter. Non-GAAP diluted EPS were $0.62, exceeding the high end of our guidance by $0.07.

Now let me discuss our online video business in more detail. In the first quarter, Sohu Video continued to focus on its strategy of providing high-quality differentiated content and improving its monetization capabilities. We have been focusing on expanding our user base in metropolitan cities with group of users with high disposable income is most sought after by major brand advertisers. Our carefully articulated content portfolio such as American drama and in Japanese animation series is well suited to these demographic groups.

As the number one online destination for American drama series in March, Sohu Video added Netflix blockbuster series, House of Cards exclusively shortly offering its U.S. release. Our data shows that about 30% of the viewers live in Beijing and Shanghai.

Another classic example in our content library are Japanese animation, One Piece and the Fairy Tale, two of the top three most popular animations in China exclusively available now on platform.

Our pipeline in the third quarter, we will air the most anticipated variety shows of 2013, The Voice of China - Season 2.

I'm also delighted to report our progress on the video advertising sales. For the first quarter a typically soft advertising season, our revenues posted double-digit sequential growth. We already began preselling ad slots for the new season of The Voice of China and to-date we have received a strong demand. We are confident about the continued strong sales momentum in the second half of 2013.

Mobile video has been one of our top priorities with us stepping up investments and are seeing some early successes. Our content and technology gained the recognition from important players such as Samsung and China Unicom, which entered into separate strategic cooperation agreements with Sohu Video. Belinda will discuss more details about Sohu Group's mobile strategy in her remarks later.

Moving onto our Sogou business, Sogou is off to a good start in 2013, supported by strong performance in our Search and Web Directory businesses. First quarter revenues grew 73% year-over-year to $39 million, exceeding previous guidance. Despite intensified competition in this space, Sogou added up its search traffic market share compared with the fourth quarter of 2012.

Sogou Pinyin, predominant Chinese language-input software, continued to gain user traction, benefitting from its unparalleled popularity in the market. In the first quarter, Sogou Pinyin added 11 million new users from the previous quarter and boosted its penetration rate to an unprecedented 88%.

For the year ahead, Sogou plans to continue to enrich the functionality of its core products. For example, Sogou recently launched the Sogou Pinyin intelligent version 2.0 with a significant new feature called (indiscernible). Based on user typing input, it proactively offers corresponding search results, automatically displaying search results beneath the typing input bar. For example, when user's typing name of some movie using Sogou Pinyin, this feature will display Internet links directing them to such content without going through a search function. This feature essentially converts Pinyin from a pure typing tool to a search tool. We are excited that this new feature has received very favorable feedback from users.

Moving on to Changyou business; for MMO games our flagship game TLBB continues to be a leading martial art MMO game in China. In the first quarter we continue our player (rec) segmentation strategy. We worked on new content and managed the in-game promotions with the need of both advanced level players and the casual players in mind. We also added new games to our portfolios. On April 10 we launched Dou Po Cang Qiong, an in-house developed 2.5D fantasy MMO game.

For web game DDTank and Wartune continue to be popular games in China. We launched a new game (indiscernible) DDTank brand name with a new design and gameplay that is targeted at players who prefer a single player experience. For Wartune we added new virtual items to the games and its growth continued to pick up overseas. In April we released an updated version of the Wartune with a new system to attract users. In the second quarter we plan to launch Spanish, Italian and Russian versions.

Regarding our game pipeline in the third quarter, we plan to distribute a PC game called (Xiao Ao Jiang), the sixth sequel in a popular (Xiao Ao Jiang) game series developed by Taiwan software Soft-World.

For the second half of 2013, we plan to launch two licensed side-scrolling MMO game Grand Chase and (Dark Blood). We have also secured exclusive licenses for two web games, (Indiscernible) and (Xiao Ao Jiang) which is another (Xiao Ao Jiang) name.

And now, I’ll pass the call over to Belinda for an overview of our group’s mobile strategies and achievements as well as a result of brand advertising business. Belinda?

Belinda Wang - Co-President and COO: Thanks Charles. Recognizing Internet’s excess profound shift from PC to mobile, Sohu Group has made mobile one of the most important parts of our strategy, and thanks to our early investments, the Group now owns a number of leading mobile applications across our business lines, including Sohu News mobile apps and the Sohu Video app for our online media businesses, as well as Sogou Pinyin and the Sogou Voice Assistant for Sogou. Our range of products are becoming (Indiscernible) for tens of millions of China’s mobile internet users. I will discuss each of these in more detail.

For our online media business, Sohu News mobile app is indisputably the number one mobile news applications in China, as total user base just surpassed $100 million in April compared to other news apps. A distinct feature is that besides providing Sohu’s own content, it also serves in an open platform (Indiscernible) partner with hundreds of traditional news media and integrate their content into our app. As such, users can customize content for themselves. Going forward, we will strive to build our news app into our one-stop mobile news portal. And for online video, Sohu Video's mobile traffic is growing rapidly. In the first quarter, the average daily active users and video views both grew by 40% from the previous quarter accounting about 30% of our total video traffic. Accumulatively, installation of Sohu Video app is close to 100 million. Recently we entered into a three year exclusive partnership with Samsung starting with Galaxy S4, we designed a customized Sohu Video app which will be preinstalled in Samsung's China Mobile product.

Over the next three year, we expect that over 100 million Samsung devices including phones and tablets will have this app pre-embedded. We also called a strategic dal with China Unicom, the 90 million 3G subscribers of the operator can now sign up for RMB15 fixed monthly data plan and watch our massive video content.

For Sogou we focused on developing different popular apps including Pinyin, map, voice based search and the yellow page like number of past products, leveraging a strong brand on PC market, Sogou Pinyin mobile version has become one of the top mobile apps. In March its monthly active users rose 34% from last December to 123 million.

Lastly for Changyou, we are seeing strong growth in the mobile games market in China, particularly in free to play mobile games. For the past few months our teams of over 200 game engineers made up of both internal employees and outside mobile industry professionals have been working hard on developing free-to-play mobile games. We expect to launch two mobile games this year.

Now let me turn to our brand advertising business. In the first quarter our brand advertising revenues reached the high end of our prior guidance, thanks to solid demand from FMCG advertisers and a strong pickup in real estate sector. For the second quarter based on the current information we expect for Sohu group, including 17173 brand ad revenues before tax to be between $108 million and $110 million, net brand ad revenues to be between $98 million and $100 million. This implies a sequential increase of 22% to 25% and an annual increase of 41% to 44%.

Now I will turn the call over to our Co-President and CFO, Carol Yu, who will walk you through the quarter's financials. Carol.

Carol Yu - Co-President and CFO: Thank you, Belinda. Hello everyone. I will now take you through our financials for the first quarter. One, total revenues were $208 million, up 36% year-over-year and 3% quarter-over-quarter. Brand advertising revenues were $80 million, up 32% year-over-year and down 2% quarter-over-quarter. Sogou revenues were $39 million, up 73% year-over-year and down 4% quarter-over-quarter.

Our search related revenues were $36 million, up 67% year-over-year and down 7% quarter-over-quarter. The number of search customers and the average spend per customer increased by 24% and 35% on a year-over-year basis. Online game revenues were $167 million, up 33% year-over-year and 6% quarter-over-quarter. Wireless revenues were $14 million, year-over-year increase of 3% and quarter-over-quarter increase of 9%.

Now let me provide some more details about our other financials. From now on, most of the figures discussed will be non-GAAP. As a reminder, you can find a reconciliation of these non-GAAP measures in our official earnings release.

Two, gross margins; non-GAAP gross margins for the first quarter were 66% compared with 69% in the previous quarter and 65% in the same period last year.

Three, operating expenses; non-GAAP operating expenses for the first quarter of 2013 totaled $132 million, a decrease of 4% from the previous quarter, and an increase of 43% from the same period last year. The year-over-year increase was primarily due to an increase in the number of employees, average compensation and higher expenses associated with marketing and promotional activities.

Four, operating margins; non-GAAP operating margin was 23% compared with 33% in the previous quarter and 24% from the same period last year.

Five, income tax expense; for the first quarter, both GAAP and non- GAAP income tax expense was $20 million.

Six, net income; before deducting the share of net income pertaining to the non-controlling interest, non-GAAP net income was $59 million. Non-GAAP net income attributable to Inc. was $24 million or $0.62 per fully diluted share.

Seven, net margin; Non-GAAP net margin before deducting the share of net income pertaining to the non-controlling interest was 19% compared with 19% in the previous and 20% in the same period of 2012.

Eight, moving on to the balance sheet and cash flow statement. For the first quarter, we generated about $47 million in operating cash flow. Changyou generated $82 million while operating cash flow for the other business units were the net outflows of $35 million.

As of March 31, 2013, the net accounts receivable was $116 million compared with $98 million as at the end of the fourth quarter. Brand advertising DSO for the first quarter was 58 days compared to 53 days in the previous quarter and 76 days in the first quarter of 2012.

Nine, our outlook for the second quarter of 2013 is as follows. We are expecting total revenues to be between $333 million to $342 million. This implies an annual increase of 30% to 34%. Brand advertising revenues to be between $98 million to $100 million, this implies a sequential increase of 22% to 25% and an annual increase of 41% to 44%. Sogou revenues to be between $48 million to $50 million, this implies a sequential increase of 22% to 27% and an annual growth 58% to 65%. Online games revenues to be between $165 million to $170 million. This implies an annual increase of 20% to 24%; before deducting the share of non-GAAP net income pertaining to the non-controlling interest, non-GAAP net income to be between $53 million and $56 million; non-GAAP net income attributable to Inc. to be between $19 million and $21 million; and non-GAAP fully diluted earnings per share to be between $0.50 to $0.55. Assuming no new grants of share-based awards, we estimate that the compensation expenses relating to share-based awards to be around $2 million to $3 million. The isolated impact of this expense is expected to reduce Sohu's fully diluted earnings per share by $0.05 to $0.07. While many of our key initiatives are at investment phase, all of our key properties are progressing well on both PC and mobile front. Management is confident that our investment will create long-term returns for our shareholders.

This concludes our prepared remarks. Thank you for joining the call today. Operator, we would now like to open the call to questions.

Transcript Call Date 04/29/2013

Operator: Alicia Yap, Barclays.

Alicia Yap - Barclays Capital: My question is related to your online video business. So, can management share with us the overall demand for the online videos and also the outlook for the rest of this year? And are we continuing to see the budgets shifting from offline to online? And also, can you provide us the update on the latest competitive landscape and how are we performing relative to the peers? Thanks.

Carol Yu - Co-President and CFO: Hi Alicia, this is Carol. Let me take your question one by one. Our video business is doing very well. We feel that while some of our competitors have not announced their earnings, the video sales have been outperforming our peers, at least that's what we believe. And the competitor's landscape remains very, very competitive. But our premier content like what Charles has said in terms of Voice of China, American drama series as well as our Japanese animation series are all very sticky and have been attracting users to our platform.

Alicia Yap - Barclays Capital: Then can you just roughly on the outlook – the overall outlook for the rest of this year, the growth rate?

Carol Yu - Co-President and CFO: We saw a growth of – north of 70% for Q1 and we expect that to at least continue for the rest of the year.

Operator: Dick Wei, JPMorgan.

Dick Wei - JPMorgan: Just want to – wonder if you could mention and give some guidance or shed some light in terms of the margins for the Company on both, on the Sogou side and then for the rest of the year, that will be great.

Carol Yu - Co-President and CFO: We expect the margin will remain stabilized at the Q2 level for the entire Group for the rest of the year.

Dick Wei - JPMorgan: Just wanted to make sure, is some of the investment on the Sohu side, is that mainly related to the video related investment?

Carol Yu - Co-President and CFO: Sorry, say that again.

Dick Wei - JPMorgan: Most of major investment for Sohu side, is that mainly from the video investment, any other new areas of investment?

Carol Yu - Co-President and CFO: On two of our very important strategies, video being one of them and the other is the overall mobile strategy. As you probably know that the mobile right now, we haven't been massively monetizing it, and neither do our competitors. But we have been investing heavily on the mobile side.

Dick Wei - JPMorgan: Just wondering if you can share how much revenue is from video last quarter.

Carol Yu - Co-President and CFO: From video?

Dick Wei - JPMorgan: Right.

Carol Yu - Co-President and CFO: We are not disclosing that.

Operator: Philip Wan, Morgan Stanley.

Philip Wan - Morgan Stanley: My question is related to the mobile internet. I wonder how much among the brand advertising sales you generated from mobile. And also for your Sogou business, how does the increasing mobile traffic impacting your (page search), traffic or monetization?

Charles Zhang - Chairman and CEO: Okay, so on the mobile side the monetization hasn’t started yet on the advertising. On the mobile search side it is also similar, but…

Carol Yu - Co-President and CFO: For search we have not separately selling our – monetizing our mobile search, and the traffic accounts for about 5% of the total market share. And for the video side, if I may just add, we plan to officially monetize our video mobile traffic starting from Q3 with the compelling content such as The Voice of China – Season 2.

Philip Wan - Morgan Stanley: Just very quickly, have you seen any further deterioration in terms of PC traffic growth because of the increasing mobile traffic?

Charles Zhang - Chairman and CEO: We haven’t seen any decline of our PC traffic. Actually, traffic on our PC platform, the portal side, actually has increased more than 20% over the last year. Actually because of the popularity of the Sohu news client software on the mobile side, general public actually get used to or like Sohu content, so it actually helped our PC traffic. But on the monetization front, I think video will be probably the first one to start to monetize on the mobile side, while the general text-based content and picture and text-based content, the monetization probably will take – for the whole industry to take another one year or two years to develop its business model, how to identify on the mobile platform.

Operator: Jiong Shao, Macquarie.

Jiong Shao - Macquarie: I'm trying to better understand the overall sales of the Chinese advertising business. If you're going to exclude video revenue this year and last year and also exclude the real estate advertising this year and last year, because last year I think there's been a bit change owing to the cash accounting for the real estate business. What was the growth rate for the rest of the advertising business? And in a broader sense, if you can comment on the general advertising business industry in China for now and for the rest of the year, it would be great. Thank you.

Carol Yu - Co-President and CFO: You are asking the growth rate for advertising sales excluding real estate and video. Is that what your question is?

Jiong Shao - Macquarie: That's correct, yes.

Carol Yu - Co-President and CFO: I think it's around mid-20% to 30%.

Belinda Wang - Co-President and COO: And also we see overall soft pick-up across the industry. I mean the overall economy have been recovering and also the impact of (indiscernible) doing by the growing experience of the online video. So FMCG is a very strong industry category for driving the revenue growth for the total online brand advertising revenue. Other industries like auto, financial sectors and telecom sectors, we see a steady growth from this side.

Jiong Shao - Macquarie: For your video business can I just have a one quick follow-up, and could you talk about the self-production and I think some of your peers are making a big push in the self-produced content. I was hoping you can talk a bit on that if you have a strategy in place.

Carol Yu - Co-President and CFO: I think we are one of the very successful pioneers in terms of our self-produced content. We have kind of – take that for granted, so we didn't say much on that. For example, (Mr. Dias) is an overwhelming successful self-produced content which hits 100 million VV in a very relatively short period of time. It's chased after by advertisers and the like. We intent to have very strong pipeline regarding the self-produced content, and we are doing the content very tailor-made to the Internet users, which are very different from some of the TV drama series demographics. So with our self-produced content, we'll be able to cover an even bigger group of world of users.

Charles Zhang - Chairman and CEO: We have a number of popular programs (indiscernible) is a weekly program. And then also we have launched new program called Sohu Entertainment Commentaries, and also we have the Sohu Video Report Broadcasting by Sohu (indiscernible). So basically we've become the leading reporter or broadcaster about entertainment industry of China. So this drives a lot of users and drive them to view video and TV dramas on our platform.

Operator: Mark Marostica, Piper Jaffray.

Mark Marostica - Piper Jaffray: My question is related to your plans to monetize mobile video beginning in Q3. Can you walk us through the incremental costs we should be considering as you plan to turn on (monetization) for mobile video?

Carol Yu - Co-President and CFO: We do not expect any incremental costs whether or not we monetize the video content, because although system has been in place. We're just waiting for very compelling content to be broadcasted before we actually solicit advertisers' demand.

Mark Marostica - Piper Jaffray: Would you be launching any new content or buying any new content specific to mobile or is it such that defined as affordable.

Carol Yu - Co-President and CFO: It's The Voice of China Season 2 with a pilot monetization plan.

Mark Marostica - Piper Jaffray: For mobile?

Carol Yu - Co-President and CFO: Yes.

Operator: Thomas Chong, BOCI.

Thomas Chong - BOCI: I just have one question. Does management has any change in terms of the timeline for breakeven with regard to your online video business? I remember the last time you guys had mentioned it should take 18 to 20 months at the start of the year. Given the monetization of mobile video, any change in the timeline? Thanks.

Carol Yu - Co-President and CFO: We will remain the same plan. I think right now it's still in the land graph mode, so we do not expect to cut down on our investments.

Operator: Fei Fang, Goldman Sachs.

Fei Fang - Goldman Sachs: Can you talk a little bit about the strategy for Sogou? So given the intensified competition of search and your competitors' greater tough acquisition efforts, how do you think about the competitive positioning of Sogou in the long run? Thank you.

Belinda Wang - Co-President and COO: We are very confident about the long term future of Sogou, because we believe that the team has very strong capabilities in terms of coming up with innovative products, suiting the needs of the hundreds of millions of Internet users across the board, and we believe, for example, the new feature brought about like Sogou Pinyin would be unprecedented and would be quite a bit of a killers app in terms of bringing us to the search destination that we wanted to be.

Fei Fang - Goldman Sachs: Can I have a follow-up question if I may. So, regarding mobile, across your mobile product portfolio, which services or product offerings do you see the most potential for monetization in the future. And is there any cannibalization mostly on the traffic side between your mobile apps and PC offerings?

Charles Zhang - Chairman and CEO: Definitely. I think the first monetization definitely will start with mobile video side, but in the long run, I think the Sohu News application will be the most important application. Of course, coupled with Sogou Pinyin are the two most promising – most promising application that has on a major – with a massive scale. And from our past year experience, instead of any cannibalization there's actually enhancement of both the PC usage because of the mobile's content, we are becoming the leading news provider of China on mobile side and then that helps Sohu's PC-based portal to continue to gain momentum.

Operator: Mi Zhou, UBS.

Mi Zhou - UBS: I have a question about the rebate rate for your video business. Do you see an upward trend for the rebate rate or is it coming down? I also wonder how much of your video traffic is from mobile devices.

Carol Yu - Co-President and CFO: Let me answer your second question first. The mobile traffic now accounts for about 30% of our total video traffic. On the rebate rates I'd say we're very much at par with the industry. Comparing to our peers it would be very much similar to what they are paying for last year.

Operator: Chit Tsang, HSBC.

Chit Tsang - HSBC: I just had a couple of questions on the video side. You folks have done a great job of really ramping up business with (content and offshore sales chip off). I'm wondering if you're thinking for the balance of the year and going forward how much of your increased monetization will be coming from pricing versus adding advertising inventory on video?

Carol Yu - Co-President and CFO: Just to start with pricing side, Sohu Video has always been setting out prices closer to the industry number one. So we do not believe that while we are spending, grabbing our market share in terms of advertising revenues, we would have – we do not have plans in terms of bringing in significant rate hikes other than going hand in hand with the industry. The only exception will be again what we call the compelling content – portfolio of content such as American drama series and in particular The Voice of China that we will be launching in Q3. So, this is on the pricing. What was the other question.

Chit Tsang - HSBC: Well, I'm wondering in addition to pricing, if you have any intention to actually increase the amount of advertisements that you will roll out with your video product, whether increasing pre-roll or mid-roll or any other type of thing.

Carol Yu - Co-President and CFO: I think right now, we're again at industry – we have up to a max of four pre-rolled with 15 seconds each, so we do not expect them to increase at, say to, six or eight. So we are coming up with innovative advertising products such as mid-rolls and post and so on and so forth. So, we are adding inventory, but other than pre-roll.

Operator: As there are no further questions at this time, I would now like to hand the conference back to your hosts for today, Mr. Tip Fleming from Christensen. Thank you, sir.

Tip Fleming - IR, Christensen: Thank you everyone for joining our call today. If you have any further questions, please don't hesitate to contact us or the Company directly. Thank you very much.

Operator: Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.