Focus Media Holding Limited Q3 2008 Earnings Call Transcript

Focus Media Holding Limited (FMCN)

Q3 2008 Earnings Call Transcript

November 10, 2008, 8:00 pm ET

Executives

Jane Lu – IR Director

Tan Zhi – CEO

Daniel Wu – CFO

David Zhu – CEO of Allyes

Analysts

Jason Brueschke – Citigroup

James Mitchell – Goldman Sachs

Murthy Lee [ph] – Morgan Stanley

Wallace Cheung – Credit Suisse

Jason Helfstein – Oppenheimer

Eddie Leung – Merrill Lynch

Ming Zhao – SIG

Clark Wong – Needham & Co.

James Lee – Stern, Agee Capital Markets

Tian Hou – Pali Capital

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 Focus Media Holding conference call. My name is Michelle, and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question and answer session towards the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to Ms. Jane Lu, Investor Relations Director of Focus Media. Please proceed, ma'am.

Jane Lu

Thank you. Welcome to Focus Media’s third quarter 2008 earnings conference call. Today, our management will discuss the company's financial results for the third quarter of 2008 and business outlook for the fourth quarter of 2008.

With me here are Tan Zhi, Chief Executive Officer; Daniel Wu, Chief Financial Officer; and David Zhu, CEO of Allyes. After management updates you on our third quarter operational and financial performance, we will open the call for questions. This call is also broadcasted through Internet and available through our Investor Relations Web site, ir.focusmedia.cn.

Before we begin, I would like to remind you that during the course of this call we will make forward-looking statements that are subject to risks and uncertainties. The statements include, but are not limited to, statements regarding Focus Media's business objectives and plans, the expectation of the development of our networks and our outlook for the fourth quarter 2008. For example, you can also identify forward-looking statements by terms such as will, expects, anticipates, future, intends, plans, believes, estimates and similar statements.

The accuracy of these statements may be affected by a number of business risks and uncertainties that could cause our actual results differ materially from those projected or anticipated. These risks and uncertainties include, but are not limited to, our limited operating history for our current operations and the short history of the new digital media sector, which may make it difficult for you to evaluate the viability and prospects of our business, the integration of acquired business, competition from present and future competitors in China's growing advertising market, and other risks outlined in our filings with the Securities and Exchange Commission, including our registration statement on Form F-1. We do not undertake any obligation to update this forward-looking information, except as required under applicable law.

Now I will turn the call over to our CEO, Dr. Tan Zhi, for a summary of the third quarter results.

Tan Zhi

Good day, everyone. We saw a hugely challenging advertising environment towards the end of the third quarter, early in the fourth quarter. The recent global financial turmoil and the slowdown in consumer demand in the US and European markets have had a significant negative impact on the Chinese economy, as well as on the mindset of the corporate decision-makers in China. The market we are facing is the most severe in the recent history of the Chinese advertising industry.

Our conservative fourth quarter guidance reflects our current business expectations in such a difficult marketing environment. In addition, during the integration of CGEN, although we have made a meaningful progress in reducing the location cost of our in-store advertising business, in order to achieve profitability and further growth, we plan to further restructure the CGEN business in the fourth quarter. However, we believe that Focus Media with our largest skill and highly effective media coverage of high-end urban consumers in China is better positioned today than ever to face today's challenging market backdrop.

Now Daniel will update you on the third quarter financials.

Daniel Wu

Thank you. Thank you, Dr. Tan. Let me provide everyone a summary of our 2008 third quarter results.

Our total revenue, excluding sales tax, for the third quarter of 2008 reached $224.8 million, increasing 63.7% from the same period last year and 6.2% from the previous quarter. Our third quarter revenues include $153.8 million from digital out-of-home advertising business and $70.8 million from our Internet advertising business.

First, let me review in detail the results of our digital out-of-home advertising business. Total advertising revenue from our digital out-of-home advertising reached $153.8 million in the third quarter of 2008, up 62.4% as compared to $94.7 million in the same period in 2007 and 13.6% sequentially.

Within our digital out-of-home advertising business, the revenue from our commercial location network in the third quarter was $93.1 million, up 44.1% year over year and 14.8% quarter over quarter. Revenue from our in-store advertising network was $16.8 million, up 136.6% year over year, but down slightly from $17 million in the previous quarter due to continuing efforts to optimize the combined net-store advertising network coverage during the post acquisition integration of CGEN’s business. The revenue from our poster frame network in the third quarter was $44 million, up 90.6% year over year and 17.8% quarter over quarter. The commercial location network, in-store network, and poster frame network contributed 16.5%, 10.9% and 28.6% of the total digital out-of-home advertising revenue in the third quarter of 2008 respectively.

Advertising service revenue from our Internet advertising business was $70.8 million in the third quarter of 2008, an increase of 66.5% compared to $42.5 million for the third quarter of 2007, and a decrease of 7% compared to $76.1 million for the second quarter of 2008. Internet advertising business saw the slowdown of Internet advertising spending after the Beijing Olympics.

Gross profit for the third quarter of 2008 was $109.7 million, representing an increase of 58.5% compared to $69.2 million for the same period a year ago and a 22.7% increase compared to $89.4 million in the second quarter of 2008.

In the third quarter of 2008, gross margin for the company was 48.8%, increasing from 42.2% in the second quarter of 2008. Excluding non-cash share-based compensation expense of $0.4 million and acquisition-related intangible asset amortization expense of $6.1 million in the cost of revenues, gross margin on non-GAAP basis was 51.7% in the third quarter of 2008, compared to 45.8% in the second quarter of 2008.

In the third quarter, excluding non-cash share-based compensation expense and acquisition-related intangible asset amortization expense, digital out-of-home gross margin on non-GAAP basis increased to 64.7% from 56.4% in the second quarter of 2008 and Internet advertising gross margin on a non-GAAP basis dropped to 23.7% from 26.9% in the second quarter.

Third quarter operating expense totaled $52.7 million. Our operating margin in the third quarter of 2008 was 25.4%, compared to 20.4% in the second quarter of 2008. Excluding non-cash share-based compensation expense and acquired intangible amortization expense, operating margin on non-GAAP basis was 34.3% in the third quarter of 2008, as compared to 30.3% in the previous quarter.

Total intangible amortization expense in the third quarter of 2008 resulting from historical acquisitions was $9.3 million. Non-cash share-based compensation expense was $10.8 million in the third quarter of 2008.

Total income tax expense was $8.4 million.

GAAP net income for the third quarter of 2008 was $51.3 million. Non-GAAP net income, excluding non-cash share-based compensation expense and amortization of intangible assets due to acquisitions, and any one-time items in the third quarter of 2008 was $71.4 million, or $0.53 per fully diluted ADS.

Now I would like to provide Focus Media's business outlook for the fourth quarter of 2008. Please note that the following outlook statements are based on our current expectations. These statements are forward-looking and actual results may differ materially. The company estimates its total net revenue, excluding sales tax, for the fourth quarter of 2008 will range from $190 million to $200 million. Fourth quarter 2008 net income, excluding share-based compensation expense and amortization of intangible assets resulting from acquisitions on a non-GAAP basis is expected to be between $60 million and $61 million, or $0.45 to $0.46 per fully diluted ADS based on 134 million ADS equivalent shares outstanding. This is excluding any potential one-time charges relating to the CGEN restructuring mentioned above.

Thanks very much. Now I would like to open the call for your questions. Operator, please.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Jason Brueschke with Citigroup. Please proceed.

Jason Brueschke – Citigroup

Good morning, gentlemen. Can I maybe ask a series of questions? The first, could we get some more color on exactly what happened, say, at the end of September and into October, November. I know at the Analyst Day, things seemed to be looking pretty good. And I think there was a good bit of optimism. And my understanding is that generally the business model should give pretty good visibility out maybe 10 or 12 weeks. So, if you could tell us kind of how the weakness happened, where the weakness happened, which verticals? And maybe give us an update of what your visibility is on your businesses, both the digital out-of-home and the Internet in light of this new environment we find ourselves in? That would be very helpful. Thanks.

Tan Zhi

This is Tan Zhi. Honestly speaking, this is very difficult to answer to. And back in September, our Analyst Day, we did have some visibility for the upcoming quarters, and we have worked hard with our sales team. Normal year, we do have – we always have slow fourth quarter in the last three, four years. This year, since the economy changed so much dramatically, it started from late September; we have experienced some delay, postponed on our current contract with customers. That’s a major reason, delays decreased our upcoming forecast. Yes, that was the major reason.

Jason Brueschke – Citigroup

Was it across the board or are there certain industries like maybe the dairy industry or the auto industry that you guys are seeing particular weakness in the willingness of customers to spend?

Tan Zhi

In general, it’s across the board, because the people psychologically believe they want to – conservatively to their upcoming year forecasting budget. However, you are right; the dairy industry was the hardest one. They withdrew some contracts with us, already.

Daniel Wu

This is Daniel Wu. I just want to add; compared to the auto industry, dairy contributes much smaller percentage of revenue of Focus Media. Auto is much more significant. So, due to the dairy incident, we did see some cancellations, but we also saw some come back. But overall, as Dr. Tan said, it is pretty across the board from all sectors.

Jason Brueschke – Citigroup

Great. And maybe just one or two more questions. With respect to the Internet division, Sohu, 10 days ago or so gave us a pretty strong set of results and a pretty bullish outlook for the fourth quarter. And I know that the Focus Media Interactive Agencies are collectively the biggest client, I think for Sohu, or certainly one of them. Could you maybe help us understand what maybe going on with respect to the weakness that the Allyes business or the AC business saw in the third quarter and the outlook, as well as, I mean I would say compared to maybe the strength that Sohu was seeing in their business; the portals in general.

Daniel Wu

Sure, Jason. This is Daniel Wu. Let me address this first. First of all, as we have announced in the press release, I think everyone knows that Focus Media’s Internet division is undertaking an IPO of itself. So, it’s very restricted from making forward-looking statements. So, we cannot specifically discuss any event, which we expect to occur in late or fourth quarter of 2008 and 2009. We do expect our Internet advertising business, given the full guidance of – full company guidance we provided on this call to the Internet business was decreased, the revenue was decreased slightly in the fourth quarter. But just forgive us, due to this restriction and we only can discuss what exactly happened in the third quarter of 2008. So, maybe I will have David Zhu to address – give you some color on what happened in third quarter of 2008.

David Zhu

This is David here. (inaudible) in Q3 is during August our subsidiaries in Beijing sales office was a little bit negative impact between 30% to 40% on sales compared to July. This is the main reason for slowdown in Q3. In Shanghai and other regions, relative business was not impacted during Olympics in Q3. In September, we saw sales move back to the original anticipated level for Beijing areas. Thanks.

Jason Brueschke – Citigroup

Great. And then just as a segment the final. Could you maybe give us some color Daniel on the guidance. It’s lower than it was certainly I think they imply, the guidance for the fourth quarter. Could you maybe give us some color about the individual networks like how you expect them to do in the fourth quarter, your main networks to get to the guided numbers?

Daniel Wu

Sure, very good question. If you see the guidance we’re providing, it shows – it’s slightly over 10% sequential decrease of revenue. And the areas we see weakness is across the board, especially – in particular, if you look at commercial and residential, basically commercial location and residential network the decreases are actually less. And maybe potentially it’s about approximately 5%, potentially 5% plus or minus. The in-store network, as we have mentioned on the call as well as in the press release may see the most significant decrease in revenue because we plan to restructure the business; as we also discussed on the press release, as you see although the location cost is coming down very quickly for our in-store network, still we are not making money. The gross margin in the in-store network is slightly over 20% in Q3 of 2008. So, given the current performance, we don’t expect CGEN to achieve their earn-out target. So, we believe now maybe the right time to look at this business and restructure the business, and actually just make – restructure the business in a way that in 2009 it will achieve better margin and achieve profitability and growth. So, you may see – we actually are expecting potentially more than 50% revenue drop in our in-store advertising network due to our restructuring effort. However, the current restructuring plan to be discussed among the management, have not been approved by the Board. So, we cannot have an exact number for you. But when the plan is finalized and approved by the Board, we will make announcement to update investors regarding exactly what it’s going to do and how much it’s going to affect our financials. The Internet division, as we said earlier may see potentially also 5% to 10% sequential revenue drop.

Jason Brueschke – Citigroup

Great. Thank you very much, Daniel.

Daniel Wu

Sure.

Operator

Your next comes from the line of James Mitchell with Goldman Sachs. Please proceed.

James Mitchell – Goldman Sachs

Thank you for taking the questions. First question on Allyes, as a follow-up. Is Allyes losing advertiser accounts? And then second question (inaudible), you took a $6 million bad debt provision, your receivables were up quarter on quarter, given receivables grew fairly quickly in a good economy, do you think it will be possible for you to control receivables without incurring more bad debt charges in a more difficult economy.

Daniel Wu

David, please answer the first question. Then I will address the receivable question.

David Zhu

The account receivable question –

Daniel Wu

I will take that, James’ question says, this quarter did you lose any accounts?

David Zhu

For the third quarter, we didn’t see any account losing. And actually at the end of third quarter, we have received some call pitches from the non-existing customers. Okay. Thank you.

Daniel Wu

Sure. This is Daniel Wu. Let me address the receivables question. If you look at Q3 2008, end of the period balance sheet, account receivable relatively speaking to Q2 increased about slightly over $10 million. So, the DSO actually increased from 126 days to 135 days, yes, 135, 136 days. So, the reason for the DSO increase actually is limited in a way that in our internet advertising division – and that the other commercial location and residential frame network, the DSO itself looks very normal and there is no really any materially change within management’s expectation. But in-store advertising DSO actually decreased a little bit from roughly about 300 days to about 260 days. The internet advertising division, actually DSO increased from about 120 days, 117 days to 155 days. So, that’s why accounts receivable actual amount went up as well as DSO went up on blended basis.

Looking at bad debt provision, the reason why we took a little bit more conservative bad debt provision is because we are – the internet advertising business is going through an IPO process, and they have already gone through an audit process for the first nine months. So, we took a very conservative approach in bad debt provisioning and as well as also the company, Focus Media itself, when we implement a new system, we actually – that new system kicking July 01 of 2008, we had some small amount of increase of bad debt, but it is not really different from our historical level that much. So, we are very comfortable with our current accounts receivable situation for our main business. And have not seen any material change of our customer paying behavior, at least for this moment. So, given the client base of Focus Media, now a lot of them have been doing business with Focus Media for a long time. So, I cannot give you – specifically say what’s going to happen if the economy really goes bad, what’s going to happen to the current receivables. But at this time, we think Focus Media’s accounts receivable policy, as well as our provisioning policy are very conservative. And we have not changed any outlook regarding provisioning policy. And we are comfortable with our current account provisioning policy.

James Mitchell – Goldman Sachs

Okay. Sorry David, so if Allyes is continuing to win net new accounts, why are Allyes’ revenues going to be lower in the fourth quarter than in the second quarter when (inaudible) and Sohu seem to expect?

Daniel Wu

James, as we said, given the restriction we have in the SEC filing process, we cannot specifically have David to address your question. I think maybe after we pass this stage maybe David is better able to address those questions. Because we really cannot – we need to stay away from forward-looking statements for the internet division.

James Mitchell – Goldman Sachs

Okay. I will await that stage. Thank you.

Daniel Wu

Sorry about that.

Operator

Your next question comes from the line of Murthy Lee [ph] with Morgan Stanley. Please proceed.

Murthy Lee – Morgan Stanley

Hi, thank you for taking my questions. Hello?

Daniel Wu

Hi, yes. Go ahead. How are you, Lee?

Murthy Lee – Morgan Stanley

Hi, how are you? Well, I would like to ask about the rate card increase. Do you think that Focus Media is in a good position to raise its price in 2009, and by how much percentage? And I have follow questions.

Tan Zhi

We have not announced that plan yet. But we do have a rate card increase within our first 2009, we do have the plan. And but however we have not announced that yet. It will be similar or slightly smaller than the previous year. That’s also up to our – the result from the CCTV’s upcoming media conference for the announcement.

Murthy Lee – Morgan Stanley

Thank you. Also my second question is related to the margin trends. Could you give me some light about the margin trends both the gross profit margin and operating margin in both the fourth quarter and going into 2009? Because we see that you have made a big improvement in the margin and we’d like to know how the trend goes out in the future.

Daniel Wu

Sure. This is Daniel Wu; let me address the margin question. For the commercial location network, as you see, the margin continues to improve and of course this is relatively speaking in the near term is a fixed cost business, and because a lot of our major cost items are relatively fixed. So, in the long term, we expect the commercial location network margin to move towards 75% or above. In the fourth quarter, it really depends on the final actual results of revenue we deliver in the business. The margins may fluctuate up or down depending on the actually outcome of our fourth quarter revenue. For the in-elevator poster frame network, similar answer because it’s relatively a near term fixed cost business. We expect long term gross margin to be over 75%. For fourth quarter, it really depends on the actual performance of the business in terms of revenue. The in-store network, the gross margin, although improved, but still we are not making money, and that, Focus Media really doesn’t want to run a business that doesn’t make money. So, from our point of view, we are taking into consideration of this situation – taking into consideration of the expected macro-environment outlook for 2009, we want to restructure this business in a way that it can achieve profitability on net basis as well as growth in 2009. So, the outcome of the fourth quarter margin of our in-store advertising business really depends on the specifics of our restructuring plan and also in the long term we look at 55% to 60% gross margin for in-store network. That’s still our goal. For internet, really at this time we are restricted to make any forward-looking statement due to – because we are in the SEC filing process. So, at this time, that’s – our third quarter gross margin actually decreased a little bit from the second quarter.

Murthy Lee – Morgan Stanley

I see. Thank you. My last question is regarding the digital frame. What would you think that the digital frame – firstly, how many digital frame will be installed by the end of 2008? And where do you think the growth is coming from, from price increase, from distance, or utilization improvement? Thank you.

Daniel Wu

Okay, let me quickly try to answer your question. Not sure, I’ll give the whole picture. I think if you look at end of Q3, the digital frame in our residential network, we have approximately 30,000. We expect, given the overall slowdown of advertising environment, our deployment will be a little bit slower. So we expect by end of Q4, end of this year, we may have approximately 35,000 digital frames on a nationwide basis. Next year, we actually have already purchased additional 20,000, 30,000 digital frames for deployment in 2009. So, next year, we are really not going to make any additional purchase, but we continue to expect we will install maybe 1,000 to 2,000 units a month next year on an average basis. So, the network will continue to expand next year on a selective basis, but at a slower pace versus 2008. And –

Murthy Lee – Morgan Stanley

All right. Thank you very much.

Daniel Wu

Yes, sure.

Operator

Your next question comes from the line of Wallace Cheung with Credit Suisse. Please proceed.

Wallace Cheung – Credit Suisse

All right. Dr. Tan, Daniel, and David how are you?

Tan Zhi

Good.

Daniel Wu

How are you, Wallace?

Wallace Cheung – Credit Suisse

Great. Thank you. Thanks for taking my question. I think two quick questions. Number one is, I recognize the installed base of the LCD actually declined on a sequential basis. Give us a little more color on that. And second point will be – and also I find out the amortization expense of the intangible assets actually coming down. On the other hand actually we still have a pretty big amount (inaudible). Can you give me us more like the trend going forward? Thank you.

Daniel Wu

Sure. Let me address that question. So, if you look at the number of screens in the in-store adverting base, it’s come down a little bit because we actually, given – now, today we are the only provider for the in-store digital adverting business in China. We are making effort to optimize the network coverage. So, certain spots which we feel did no or little economic value, but was covered prior to the acquisition of CGEN by (inaudible) Focus Media, right now we are in the process of terminating those areas of coverage, which we feel did no economic value, you know China is a big country. And given our focus on revenue and growth we want to make sure our cost structure is aligned in certain area, which we don’t believe there is any efficiency, we want to cut back to optimize the network. So, that’s why you see the numbers showing decrease. And given as we discussed that we are looking at potential options to restructure CGEN’s business, if we’re actually doing the restructuring plan, terminate additional locations towards [ph] continue to optimize the network, the number of screens for in-store network may continue to decline based on the restructuring plan. So, for the intangible assets, we have about $177.8 million on the book, or really decreased from the previous quarter. This is due to our continued amortization of intangibles. Once those amortizations are complete – you know typical amortization life is three to five years. And once those amortizations are complete then we don’t have this particular item for amortization as we’re not going to make any additional acquisitions in the near future. We do not expect this actual number to change materially. So, it’s the amortization of the acquired intangibles which, as you know, includes items such as location contracts, employment agreement, non-compete customer contracts varies. So, amortizable item actually have a different life depending on the analysis by an independent third party appraisal firm.

Wallace Cheung – Credit Suisse

Thanks for the answers Daniel. Just one follow-up. Regarding the commercial location LCD TV sign, how much further down is the number of installed base going forward in the next two quarters time. And also you did have a reason why you provided a relatively weak fourth quarter guidance? Thank you.

Daniel Wu

I am sorry. Can you repeat your question again?

Wallace Cheung – Credit Suisse

I recognize the commercial location side, the LCD TVs are still going to move installed base actually down on a sequential basis from 123,000 in the second quarter to 120,000 in third quarter. So, do we expect further decline in the fourth quarter and going forward?

Daniel Wu

Actually, the decrease is not the reason why we have expected slowdown in fourth quarter for commercial location network, because as Dr. Tan said earlier, the conservative expectation for fourth quarter is based on demand picture. As you know our network cover – nationwide we cover more than 50 cities directly and all those networks sometimes we need to optimize those networks, some efficient spots, we need to reduce that and convert that to a different coverage. So, for example, maybe previously we had two small screens and maybe we changed to one large screen. Or maybe previously in some spots we used LCDs, now we’re changing some of the spots to digital frame. So, there is a continued effort made in optimizing the network and generating additional growth in our commercial location network. So, the slight reduction of number of screens really is not an indication of any particular reason which leads to our weaker revenue projection in Q4 of 2008.

Wallace Cheung – Credit Suisse

Okay. Thank you very much.

Operator

Your next question comes from the line of Jason Helfstein with Oppenheimer. Please proceed.

Jason Helfstein – Oppenheimer

Hi, thanks. Few questions, sir, can you clarify a few things you said earlier. Did you say that Allyes revenues were impacted during the Olympics? And then with respect to the Beijing area etcetera, are clients in Beijing – the business then did not recovery but then remains strong in other areas. I’m just wondering if I heard that correct.

David Zhu

In third quarter, I guess, in August we see a little bit decline of the (inaudible) something. And in September, we see them come back. So, we don’t see that in future. We didn’t see any decrease specifically in Beijing area. Thank you.

Jason Helfstein – Oppenheimer

Okay. And I’ve got three others. Just to clarify, for CGEN, did you say that fourth quarter in-store revenues could be down 50%, did I hear that correct? Is that possible?

Daniel Wu

It could be. It’s possible because it really depends on what exactly included in the restructuring plan. So, the restructuring plan has not been finalized at this stage, it still needs to be discussed and negotiated. So, at this time, we take a conservative approach when we issued the guidance, potentially we may see 50% revenue to our in-store advertising business. It’s particularly in Q4 because Q4 is the quarter where we expect to have this restructuring complete.

Jason Helfstein – Oppenheimer

Okay. And then just two more quick ones. With respect to Allyes, does the company having to turn-away client business with respect that people are not paying their bills, which is impacting DSOs. So, in another words, as the management of Allyes is trying to reduce DSOs, are they turning any clients away who are not paying? Is that part of the issue here?

David Zhu

It’s David. It’s not. The payment term is longer, so we don’t do business with them, no. So we get to see that during Q3, during the Olympics we did not have too many Olympic official sponsors. So, at that moment, the preferred to pending the advertisement at that moment because at that time most of the TVs or internet were official sponsors. So, that’s not because of the payment terms changing. Thank you.

Jason Helfstein – Oppenheimer

Okay. Daniel, can you comment on the tax rate. It was sequentially lower. What drove that and then what’s the right tax rate for ’04 and for next year – I sorry for fourth quarter and for next year? Thanks.

Daniel Wu

Tax is a very complicated exercise in China nowadays because there are so many new rules and new regulations that are put in place in 2008 due to the change of tax law. Tax rate is a little bit lower because it looked like about 14%, but if you take into consideration the tax rebate, it’s even lower. The reason why our tax provisioning quarter from quarter varies it depends on the process or the stage of certain analysis regarding our tax planning, and also depends on approval stage of certain certificates we are applying for the government for tax exemption. So in 2008, we still expect the full-year tax rate to be 15% on an effective basis taking into consideration of any tax rebate we receive from the local Chinese government. There may be some – if this is a conservative expectation, we are still in the process of obtaining certain exemptions for our income tax. If those exemptions are approved in Q4, in the early next year, we may see some tax benefits from those new exemptions, but we cannot take that into consideration at this moment, because the situation is still unclear. For 2009, we expect our tax situation to be similar to 2008, of course with certain – we try to make our best effort to plan and apply for the optimal tax structure for the company. So, at this moment, given all those initiatives are actually still in the process of being complete, we expect our 2009 income tax to be similar to 2008, which is 15%, taking into consideration of any potential tax rebate or subsidy from the local tax authorities. So, that is where we are.

Jason Helfstein – Oppenheimer

Thank you.

Daniel Wu

Thanks, Steven.

Operator

Your next question comes from the line of Eddie Leung with Merrill Lynch. Please proceed.

Eddie Leung – Merrill Lynch

Good morning, guys. Couple of questions. The first one is, could you elaborate more or give us more color on the free cash flow situation going forward, given the pending restructuring et cetera? Thanks.

Daniel Wu

Sure. Let me answer that question first; and later on, if Dr. Tan wants to add anything. I think as we said in the press release, Dr. Tan mentioned that Focus Media going forward, our main focus is on free cash flow generation. We want to generate additional margin, we want to generate free cash flow; we want to grow our free cash flow. To achieve that, there are two things which are important. Actually, if you look at this quarter, our free cash flow – if you look at the operating cash flow minus CapEx minus any acquisitions, we have achieved positive free cash flow. Our cash balance, excluding the share buyback we have implemented, our cash balance actually increased slightly. Going forward, first of all, the CapEx expectation for 2009, as we said, will actually come down dramatically because we don't have any material investments in new equipments in 2009, which we feel are – which we are expecting at this time. So, in 2009, our digital frame network will continue to expand because based on the current inventory of digital frames we have and also we will continue to optimize the networks, both in our commercial and installed networks, but all, we don't expect to incur material CapEx. The CapEx will be significantly down from the current level, this year we expect about – now it is $65 million, Q4, very minimal. So, next year, it will drop from approximately $65 million towards maybe below $20 million next year. So that is one way to control how we look at our cash flow going forward.

The second is, of course we will focus on better management of working capital. If you look at the key problems we're facing now, is some accounts receivable issues. And we are – actually management, although we have made a lot of effort on that, still a lot of things need to be improved. So, going forward, we do expect we will continue to make further efforts on improving our accounts receivable situation. Of course, also as we mentioned earlier, we don't expect any acquisitions in the near future for the next 12 months at least. So, we do not expect acquisition will take additional cash flow except earn-out payment obligations relating to historical acquisitions, which as we already announced, we expect to be approximately no more than $100 million in 2009. So with that, the business will focus on generating more operating cash flow to improve our free cash flow and hopefully those cash flows we can use for shareholder value enhancing exercise.

Eddie Leung – Merrill Lynch

Daniel, just a quick follow-up on this one. In the fourth quarter, how much cash earn-out we should be looking at?

Daniel Wu

At this stage, we expect no more than $50 million.

Eddie Leung – Merrill Lynch

Got that. And my second question is regarding advertising demands. Could you also comment on the demands you see in the top tier cities versus in the lower tier cities?

Tan Zhi

This is Tan Zhi. The advertising demand, overall in China is basically across the board from major cities to secondary cities, it’s almost in similar pace there.

Eddie Leung – Merrill Lynch

Understood. Thank you.

Tan Zhi

Thank you.

Operator

Your next question comes from the line of Ming Zhao with SIG. Please proceed.

Ming Zhao – SIG

Thank you for taking my question. Good morning. I just wonder on the cash flow question, mainly the AR question. So, if you look at your revenue this year, second quarter, third quarter and your typical AR days are touching 122 now to 135 days range. So, we should expect a lot of the revenue generated in the second quarter starting to come in now. My question is, have you seen that happening or could you give us a color maybe fourth quarter accounts receivable versus 3Q accounts receivable, is that going to be down or going to be up?

Daniel Wu

Ming Zhao, I really cannot give you – I do not have a crystal ball to give you the exact number at the end of Q4, but if you look at our actual accounts receivable end of Q2 versus end of Q3, the percentile increased as much our revenue increased. So, we do see our collection – as we said, collecting cycle in our commercial and poster frame network to be consistent with our historical levels. The only area which we see a negative trend at this moment for our accounts receivable cycle is relating to our Internet division. In Q3, the accounts receivable DSO for Internet division is 155 days, which are above the Q2 level.

Ming Zhao – SIG

Okay, thanks for that. Second question is about the Internet business. Maybe David, could you give us some color about – in the second and third quarters, what is the percentage of the revenue from CGEN and Sohu were from Allyes Agencies?

Daniel Wu

Yes, Ming. I think actually – for business reasons, we actually not going to discuss specific business transactions with specific clients.

Ming Zhao – SIG

Okay, my last question is still about the overall ad market. (inaudible) slow down in outstanding in this market, did you feel the slowdown comes from the multinational companies or domestic companies? Also, do you feel the pressure come from the foreign agencies or from the direct sales force?

Tan Zhi

This is Tan Zhi. As I said before, we do not see particularly from any industry or any kind of customers, just basically across the board from all industry or region and all kinds of – whether agent or whether direct customer, we did experience almost similar pace there.

Ming Zhao – SIG

Thank you very much.

Tan Zhi

Thank you.

Operator

(Operator instructions) Your next question comes from the line of Clark Wong with Needham & Co. Please proceed.

Clark Wong – Needham & Co.

Hi, good morning and thank you for taking my questions. I have two of them and the first one is regarding the Internet business. I was wondering if there was certain types of Internet inventory that was particularly affected in the third quarter, whether it was a performance-based marketing or whether it was from large site or smaller sites; and also, what percentage of your operating costs would that be the G&A lines and sales and marketing lines? And to what extent are those costs variable? Thanks.

David Zhu

Hi, it is David Zhu. The big portals in Q3, I think it gets some benefits from the Olympics like – I cannot specifically say which Web sites. The smaller ones, especially for the word cost [ph] is impacted a little bit more rather than those big Web sites.

Clark Wong – Needham & Co.

Thank you.

Daniel Wu

Your second question is – sorry. Hello?

Clark Wong – Needham & Co.

Hi. The second question is, what percentage of the operating costs – or how should we look at the operating costs in terms of how variable they are in the G&A and the sales of marketing lines?

Daniel Wu

Sales marketing is always a variable cost. This is for the whole company, right?

Clark Wong – Needham & Co.

The whole company, yes.

Daniel Wu

Yes. So sales marketing has historically – if you look at it, it has always been a sort of variable cost. So historically, the sales and marketing cost, as a percentage of revenue fluctuates between – in recent quarters, between 12%, 13%. So, we continue to expect 12%, 13%, 14%; so we continue to expect sales and marketing to be a variable cost as relatively speaking to revenue between 12 to 14%, it depends on the quarter. The G&A relatively speaking is more of a fixed. The reason why the G&A cost is higher this quarter, actually in the last quarter it was 9.8% of revenues, this quarter at 11.8% of revenues. It is because as previously James Mitchell pointed out, we took some additional bad debt provision, we have already given you the reason for that, and also we had to incur some additional G&A cost because the IPO process of our Internet advertising division. So we need to put in the right team as well as the right cost structure and also professional cost as well for preparation for the IPO of our Internet division.

Clark Wong – Needham & Co.

Thank you.

Daniel Wu

Sure.

Operator

Your next question comes from the line of James Lee with Stern, Agee Capital Markets. Please proceed.

James Lee – Stern, Agee Capital Markets

I'm hoping to get more color on the Allyes business and I'm hoping to find out whether was there any sales turnover happened at Allyes, maybe that is causing you to lose market share and given the fact that your DSO at Allyes is 155 days so to indicate that the average aging is like five months, I was wondering what is the general credit term you give to customers and given the current DSO situation, what steps are you taking to sort of stepping up the collection process to make sure you get the money you earn? Thanks.

David Zhu

Hi, it’s David Zhu, Lee. So, we didn't see any – we don’t have some management or the managers are leaving impacted the money collection and for the payment terms, actually we're taking some actions above the credit for different customers in different credit levels where the segments, the agencies and direct clients would be of a different payment credit in the procedure of collecting money. Thank you.

James Lee – Stern, Agee Capital Markets

Thank you. And David, can you just clarify the terms you're giving to agency versus non-agency?

David Zhu

Really we cannot discuss specific items of our business relationship with customers. Sorry.

James Lee – Stern, Agee Capital Markets

Okay. And David, maybe you can help us understand the customer base a little bit; can you give us may be a reminder what that bases like, is it mostly major plan advertisers or at least small to medium size businesses that are mostly purchasing inventory from Allyes? And also from the supply perspective, maybe you can give us a better understanding, are your – most of your inventory coming from the portals or are they coming from small and medium Web sites?

David Zhu

Most of the inventory is coming from the major portals.

James Lee – Stern, Agee Capital Markets

And the customer?

David Zhu

That actually is – (inaudible) is major of my customers.

James Lee – Stern, Agee Capital Markets

All right. Thank you.

Operator

Your next question comes from the line of Tian Hou with Pali Capital. Please proceed.

Tian Hou – Pali Capital

Good morning. I have two questions; one is for Dr. Tan, and you are saying from the end of Q3, the beginning of Q4, you start to see a sharp decline in advertising. I just wondered if you could give us some specifics such as, when did you start to see the weakness for Q4 and when did the customers start carting or delaying their contracts? That is the first question.

Tan Zhi

I don’t [ph] believe the terminal cost shapely declined, it is not as shapely declined. Of late it experienced some decline that would come from basically it start from almost a month ago or so, when some markets are getting nervous everybody. At that time we have – in normal day, normal year, this time of the year we should be discussing some of next year’s budget with our customers. But this year, we do feel that – at the same time, when we discuss next year’s budget, we always discuss that at the end of this year how to close this year and then what is the leftover for customers’ budget to spend on this year. At every year in last three years we have experienced almost similar pace. That's why we see – in the September when we had the Analyst Day we have seen some visibility. However, early month also ago, we did experience some difficulties on the Q4 because many customers are concerned in their next year's budget, all their sales numbers. Therefore, many customers start to call us, discuss with us to delay their contract. They are not canceling contracts, but most of them delay their contracts, delay to next Q1, delays to – from November delays to December, to those kinds of postpones. That's why we did experience the drop for that.

Tian Hou – Pali Capital

Okay. So the other follow-on question will be what percentage of your revenue – have you seen the commitment yet?

Daniel Wu

I think, Tian, as we said historically our revenue booking is not based on contract signing. It's based on how the time we actually aired the commercial or we posted commercial. So under the contract our visibility for the remaining quarter is very, very high, because, we typically don't book a lot of revenue in the last month of the year and book in the year. So I think to answer your question in short, we do have very good visibility for the remaining of the quarter, barring any material change of event in the Chinese economy or any political event or whatsoever or natural disaster we are pretty comfortable with the current guidance we are providing to the market. We believe it's a conservative guidance taking into consideration the potential restructuring outside in-store advertising business. So we will make our best effort to do better. So that's where we are.

Tian Hou – Pali Capital

Okay. And then my next question is really related to your earn-out provisions. I guess the earn-out provisions apply to most of your acquired companies. So I just wonder in the past when an acquired company couldn't meet their earn-out provision would you quit them?

Daniel Wu

We don't pay.

Tian Hou – Pali Capital

You don't pay. And then they will leave you. You will terminate relationship?

Daniel Wu

No, no, no. If you think about – earn out typically has a range, right? And earn-out is typically 2 years to 3 years. So if they don't – if they are in the range of their earn-out, if they are within the range we would pay them based on whatever they achieved. If they exceed their earn-out we pay them the maximum. If they are not meeting their earn-out depends on how the acquisition structured maybe in the next year they can do some catch up or maybe next year if you have opportunity to make some money, but if the earn-out expires, if the acquisition agreement expires, then during the – the reason why we have two years to three years because we have enough time to install old management or maybe we just hire the current management to be part of Focus Media's management to run that business. So the business gets integrated. So if you think about Focus Media, when we started our commercial location network in 2003 we only had six cities. Now we cover more than 50 cities. Majority of those additional 50 cities in between those additional cities, commercial location network are through acquisitions which we have done in 2004 and 2005. And majority of those acquisitions already exceeded earn-out per se.

So that's why if you look at Framedia as well, right, if you follow it for a long time; we acquired Framedia in the end of 2005. Framedia earn-out was only for 12 months period. So in the beginning of 2007, the earn-out of Framedia already expired, and we actually issued because they have done extremely well, we have issued a share to them, and we have integrated their business to our business and now Dr. Tan previously was the CEO of Framedia, now is the CEO of Focus Media. And Framedia is one of the bright spots of our operations. So it really depends on outcomes. This is really no difference for any acquisitions people do in the U.S. This is a very typical how capital market transactions are completed.

Tian Hou – Pali Capital

Okay. So my follow-on question here is, in the next year or next two years, given the concern of worldwide economy, and also Chinese economy, I guess most of the earn-outs agreements you have established with the companies you acquired may have a difficulty to accomplish. So do you envision your earn-out payment will be declined?

Daniel Wu

Depends on the situation. I cannot answer specifically, because at this time we have not finished our 2009 budgeting process. We have not issued the 2009 guidance to the street, but logically speaking what you said makes sense. For example, for the in-store advertising business, we have two year around in 2008 and 2009. Given the current performance of Sheethan [ph], based on their performance in the first three quarters of 2008, the likelihood of exceeding their earn-out target in 2008 is very, very minimal. So basically, we actually – because of the acquisition structure of Sheethan, initially the total potential maximum consideration is $350 million. And we actually paid those $350 million in three installments. We only paid the first installment which is $150 million. So in the future if the performance of Sheethan is not up to par, not within as you know the earn-out target in 2008 is $9.6 million on the lower end, $20 million on the upper end. If they don't achieve that minimal, then we don't have to pay them based on the acquisition agreement. So we will not be issuing additional shares or paying them additional cash if they don't reach those targets. So as we said, it's really depends on actual performance of the business. I cannot give you a particular expectation at this time for how much exactly we are going to pay in 2009, but I do agree with you, the maximum potential earn-out in 2009 we expect to be approximately $100 million, and it may decrease if some of those entities in the tier two, tier three cities, but not perform as good as in a very robust economy environment.

Tian Hou – Pali Capital

My last question –

Operator

Okay, okay. Everyone, for time limit…

Tian Hou – Pali Capital

– this is my last question.

Daniel Wu

This is last question. We will cut it off.

Tian Hou – Pali Capital

It's a follow-up question. This is really for Dr. Tan. Based on what we just said, regarding earn-out provision payments, I sense some potential problems. I just wanted to point out. And like if I am in the management, I couldn't accomplish the earn-out provision, not because I didn't try my best, and I didn't get my payment. So I am not going to be happy. So what's the management – like you and Daniel is going to face is a lot of people are going to think about leaving. So you may face a high turnover for the management. So how (inaudible) and what you're going to do about it?

Tan Zhi

I hear you that – in fact what do we do? We are very experienced in the integration for all the acquired companies. In the most time you would – acquisition is a – earn-out base is three years. We always have negotiated terms that the second year we will introduce some management into the company. So we are how good a transition team will work on that. That's why we have had – we have many companies that are this year in the second year we are working hard with the current management and making sure we have the team that stay there. And also we also issue some of the stock options to those acquire the company when they reach to the second year. If one year before they expire the earn-out period. So we have introduced managed mechanism to make sure we have the management team, all the sales team stays with the company as long as possible. So for those entities who cannot achieve their earn-out certainly, we are also in the period evaluating whether this business makes sense over this region or this team makes sense. At that time we certainly will have some method to cover such a kind of disappointment situation. So that they – we the management in the first priority to think about our transition for the after the earn-out period expires.

Daniel Wu

Let me add a quick point. If you look at other side of a coin, if we actually pays a full amount without earn-out, the risk of the management leaving is actually more dangerous versus three year earn-out period, because the three year earn-out period allow us to have at least two to three years time to make the transition and put the right management team in place. To do that – so if you just look at Sheethan, if at the time, end the last year, when the capital market was very good and they were going through IPO, if we actually pay them the full $350 million, today we are looking at a much more difficult situation than versus where we are right now. We actually saved, relatively speaking, the future earn-out payment for the next year and the year after. Does that make sense to you?

Tian Hou – Pali Capital

Sure. Okay, thanks for answering my question.

Daniel Wu

Thanks.

Operator

Okay, thanks. For time limit, we don't take more questions. And that concludes today's conference cal. Thank you all and see you next quarter.

Daniel Wu

Thank you.

Tan Zhi

Thanks, guys.

Operator

Thank you for our participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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