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Sohu.com Inc. (NASDAQ:SOHU)

Q2 2006 Earnings Conference Call

July 27, 2006 8:00 pm ET

Executives

Ingrid Shea - IR

Charles Zhang - Chairman of the Board and CEO

Carol Yu - Chief Financial Officer

Analysts

Jason Brueschke - Citigroup

Michael Zhang - ThinkEquity Partners

Matt Schindler – Piper Jaffray

Richard Ji - Morgan Stanley

James Mitchell - Goldman Sachs

Tian Hou - CE Towbin

Dick Wei

Presentation

Operator

Good afternoon ladies and gentlemen, and welcome to the Sohu Second Quarter 2006 Earnings Call. (Operator Instructions) I would now like to turn the conference over to Ingrid Shea, Investor Relations. Please go ahead.

Ingrid Shea

Thank you everyone for joining Sohu.com to discuss our 2006 second quarter results. On the call today are Dr. Charles Zhang, Chairman of the Board and CEO; and Ms. Carol Yu, Chief Financial Officer.

Before the management presentations, I would like to read you the 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 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.

Potential risks and uncertainties include, but are not limited to: Sohu's historical and possible future losses, limited operating history, uncertain regulatory landscape in the People's Republic of China, fluctuations in quarterly operating results and the Company's reliance on online advertising sales, mobile phone-related wireless revenue, and online games revenues.

Further information regarding these and other risks is included in Sohu's Annual Report on Form 10-K and other filings in the Securities and Exchange Commission.

Thank you all for your patience. Now I'd like to turn the call over to Dr. Charles Zhang, Chairman and CEO.

Charles Zhang

Welcome to Sohu's 2006 second quarter financial results call. I am pleased to report another quarter of strong financial performance led by our core advertising business. 2006 has so far proven to be an excellent year, which has not only demonstrated Sohu's ability to successfully execute on its content strategy in growing its core advertising business, but also Sohu's foresight in being able to anticipate where the online market opportunity is and in enhancing its business strategies to best capture this.

We have always remained in tune with online market dynamics, anticipating the need of the widening pool of online advertisers to best meet the ever-changing demand of the growing Chinese online user community. We look to further grow our business through expanding our offerings with premium, differentiated and exclusive content. We are also focused on continuing our development and the rollout of our own innovative, interactive community-based products and services.

Now, I would like to discuss highlights for the second quarter. We achieved another record total revenue of $34.1 million for the second quarter of 2006, growing 12% sequentially, and 36% year-on-year, exceeding company guidance. Let me discuss the progress of our main business lines.

Advertising. Overall, we experienced a very good quarter in advertising, boosted by 2006 FIFA World Cup. Advertising revenue for the second quarter was $22.8 million, up 13% quarter-on-quarter and 35% year-on-year, exceeding our guidance. For the first half of 2006, advertising revenue grew by 35% year-on-year.

Brand advertising revenue were $19.3 million, representing a sequential increase of 16% and a year-on-year of 39%. For the first half of 2006, brand advertising revenue grew by 38% year-on-year.

Sponsored search accounted for $3.5 million, representing a sequential increase of 2% and a year-on-year increase of 14%. For the first half of 2006, sponsored search revenue grew by 20% year-on-year.

In brand advertising, revenues continued to be driven by heavy spending sectors such as automobile, real estate, and information technology. The sector that experienced the fastest growth of the quarter was in consumer goods.

2006 FIFA World Cup, which officially kicked off on June 9 contributed nicely to brand advertising revenue during the second quarter. We were pleased to see World Cup, especially in video advertising form embedded in video clips, attract over a dozen new advertising customers, including first-time online advertisers.

Our enhanced content and strategic partnership strategy has proven to be successful in growing our advertising revenue and we continue to look for new and innovative ways to attract more users to our site and extend the power of the Sohu brand.

To further explain this, I would like to address a few key points:

First, Sohu has become a pioneer in delivering a video content through complementary partnership opportunities. This rapid uptake of broadband penetration throughout China and the availability of P2P streaming technology, online video content has been able to reach a wider online community and therefore attract more advertisers for video advertisements.

According to a recent research report issued by CTR Market Research, a leading market research firm and a subsidiary of CCTV, World Cup audience in China spend on average 217 minutes on the Internet. They highlight among all types of media. During the World Cup, we see this new rich media, more television-like form of advertising attracting a pool of advertisers from traditional forms of advertising.

It is important to remember that the long-term growth in Sohu’s online advertising business will come not only from gaining market share, but growing the overall pie of online advertising dollars and Sohu’s slice in that. For this reason, Sohu has taken the lead in leveraging its differentiated content from numerous sources and partnerships to show advertisers that advertising online is the most effective and efficient way to reach the target consumer market.

During the World Cup period, we experienced first-hand increased from Internet users in China from our Sohu exclusive online video content on match highlights. According to CTR Market Research, daily rates of Sohu's World Cup website accounted for approximately 50% of all Internet videos in China. This achievement would not have been possible without our breakthrough proprietary P2P streaming technology and our exclusive portal rights for the World Cup video highlights.

To leverage our success in delivering World Cup video, we have continued to secure more premiere online video content such as Chinese Football Association Super League 2006 and the China Basketball Association Professional League 2006 and 2007 online video highlights; and a major European soccer, Soccer Live Internet video coverage. In addition, we are going to hold a press conference in Beijing this afternoon to announce that Sohu has entered into an exclusive partnership with Europe's leading multimedia sports platform, Eurosport, to launch eurosports.sohu.com in China. It features in-depth coverage, including certain video content and a sophisticated database of a wide range of major international sports events.

Furthermore, we also plan to offer more video content both purchased and self-developed on our entertainment channel.

Second, our Olympic sponsorship growth is leading to increase Sohu branding. We have additional partnerships amongst other exclusive Olympics sponsors and increase the publicity as the event approaches. We are executing well in our Olympics strategy. We are pleased to report that we will enter into a significant online marketing initiative with the ever-popular global sports brand and a fellow Beijing 2008 Olympic sponsor Adidas, in which Adidas will become the co-branded partner of Sohu's sports channel.

Adidas' sports-related resources can help make sports channel with even richer content and attract more traffic. This is a direct result of Sohu's membership in the exclusive Olympic sponsorship group.

In addition, we are also proud to announce that Sohu has been selected to be the exclusive Internet content partner for Team China from now through 2008 for the 15th Asian Games and the 6th Asian Winter Games and the Beijing Olympics 2008.

With the completion of FIFA World Cup 2006, the only mega international sports events which can make a large impact in China prior to the widely anticipated Beijing Olympics 2008 will be the 15th Asian Games to be held in late 2006 and the 6th Asian Winter Games to be held in early 2007.

The Chinese Government and the Beijing Organizing Committee of the Olympic Games is further increasing the publicity of Beijing 2008 Olympics throughout China by organizing various widely spread offline events and online activities.

For example, the Fourth Beijing 2008 Cultural Festival held during this past month received high publicity. As the exclusive Internet content sponsor of Beijing 2008 Olympics, Sohu had the privilege to be the only online platform to select the creation of the official Beijing Olympic song to the government for selection.

As the official sponsor of Beijing 2008 Olympics and official partner of Team China from now through 2008, we are seeing more exclusive co-marketing and co-branding opportunities arise as the excitement of Beijing Olympic continues to build in China as we approach 2008.

Third, we also continue to invest in product development to maintain Sohu’s leading portal position supported by an innovative product line. Our innovations in product developments and the continuous improvements of our existing products are key for us to achieve and sustain our leading portal position. Sohu has a history of providing popular community-based products such as China Alumni Club, message boards, picture gallery and blogs.

In the second quarter, we carried out an initiative to integrate all our community-based products into a uniform platform so as to further expand the interactivity of various groups of community within the Sohu matrix of websites, allowing us to better consolidate our products, facilities, user customization. For example, during the World Cup, we have been able to provide users with various gateways for the World Cup community from Sohu's family of websites and the channels. Users were served with the latest interactive World Cup discussion topics so as to freely express their views.

We have been continuously upgrading our Sohu blogs. Earlier this month, we began open beta testing for Sohu Blog Plus. The upgraded version, similar to MySpace.com, Sohu Blog Plus allow user customization and enhanced interactivity amongst the bloggers. It integrates our popular products such as Sohu Search, Music Box and Picture Gallery to improve overall blogger experience.

Compared to the previous quarter, the number of our registered bloggers was substantially increased by more than 250%. These enhanced products have not only generated more traffic but also added to our source of other content.

As our community-based products continue to gain traction and generate more traffic, we have experienced sequential increases in monetization over the past several quarters. I would like to point out that in the second quarter as advertisers allocated more advertising dollars to the World Cup and the sports channel, revenue from or community-based products remained relatively flat. However, we believe the community-based products will be an important revenue driver going forward.

In sponsored search, the 2% sequential growth and a 14% year-on-year was driven by continued improvements to fine-tune the Sohu search product. With the successful launch of Sogou version 2.5 in late 2005, based on our internal testing the relevancy, accuracy and the response time have been proved substantially, which attracted increased and users over the last few quarters. For 2005 Q4 and 2006 Q1, our internal statistics show that Sogou traffic increased by approximately 40% to 50% quarter-on-quarter.

For the second quarter, traffic growth was approximately 10% sequentially. We believe that the total traffic of Sogou as of today now reflects the impact of the version 2.5 upgrades, especially given that our marketing investment in this area was minimal in the last few quarters.

Since the launch of Sogou 2.5, our engineers have been working on an even more advanced version, 3.0 which is expected to be launched by the end of 2006.

During the second quarter, we have increased our crawled web pages from 2.5 billion pages to 4 billion pages. We will further expand the crawled web pages to 10 billion pages by the end of 2006 with the versions 3.0 launch.

With the Sohu search technology together with our expanded database, we now have much more mature products which best position ourselves to become one of the leading search engines in China, and we can more aggressively compete for more users and traffic going forward.

Accordingly, we plan to enhance our product marketing efforts on Sogou in the next few quarters so as to further establish our presence in the competitive search market. We also have plan to monetize Sogou more aggressively in 2007 onwards.

Turning now to the outlook for advertising for the remainder of the year, with the first half of fiscal year 2006 behind us, we have been pleased to deliver solid results driven by the core advertising segments. With increased visibility for the remainder of fiscal 2006, we are revising our full year advertising revenues growth targets from our previously stated 25% to a revised range of 25% to 30% year-on-year as we see continued strong momentum. For brand advertising, we expect full year revenue growth to be 30%.

Turning to our wireless business, our focus remains on our core advertising business. We have been pleased to see a continuous pickup in our wireless business with 12% sequential and 41% year-on-year growth in the second quarter to $9 million. This represents the sixth consecutive quarter of growth in our wireless business, which has been achieved entirely through organic means with no substantial increase in promotional expenses.

As many of you know, the new policies recently announced by the mobile network operators will negatively impact our wireless revenue for the next few quarters. While we believe it is important for Sohu to maintain a presence on the wireless side, and more specifically in the WAP, in anticipation of the imminent launch of the 3G mobile networks in China, we are also mindful of uncertainty that exists in the wireless industry and we have strategically positioned ourselves so that wireless revenues represents only a modest portion of our total revenues.

In addition, we have been limiting any additional investments on this business line. Our primary focus is and will continue to be on our ad effectiveness. However, we do see complementary additional wireless revenue opportunities on the horizon which will allow us to capitalize on our core content strengths from our quarter and family of websites.

In June, we officially discontinued our e-commerce platform, exiting an unprofitable business segment, which is another testament to our full commitment and the dedication for our core business of brand advertising and sponsored search.

With that, I would like to turn the call over to our CFO Carol Yu for financial review.

Carol Yu

Thank you, Charles. I would like to take this opportunity to discuss some key financials for the second quarter of 2006.

Revenues. We are pleased to report strong record revenues of $34.1 million, which exceeded our guidance.

Advertising. With advertising revenues of $22.8 million, we experienced a sequential increase of 30% and a year-on-year increase of 35%.

Wireless. Wireless revenues were $9.0 million, up 12% quarter on quarter, and 41% year on year. Let me give you a breakdown of wireless revenues. SMS revenues increased 14% to $5.4 million, compared to the prior quarter. WAP revenues were $2.5 million, largely unchanged from the prior quarter. MMS, IVR and ringback tone services combined to increase 36% sequentially to $1.1 million, boosted by Sohu's exclusive wireless rights to the official song and music of the World Cup.

While we have been pleased to see a continued steady recovery for our wireless business, as Charles mentioned, in the next few quarters we expect to see some negative impact due to policy changes. As stated in our press release dated July 7, these new policies are expected to reduce Sohu's wireless revenue by approximately $1.5 million to $2.5 million per quarter for the third and fourth quarters of 2006.

Let me give you further details in this regard. In the second quarter, wireless revenues came from China Mobile amounted to $4.6 million, out of which about 1.6 is related to services of products, which are affected by the new policy. Similarly, wireless revenue from China Unicom amounted to $4 million, out of which $2.1 million will be affected.

Based on our current estimates, we expect such new policies will reduce our China Mobile revenues by $1 million to $1.3 million per quarter, and our China Unicom revenue by $0.5 million to $1.2 million respectively. We also expect these new policies to reduce Sohu's wireless gross margins by approximately 2% to 3% for the third and fourth quarters of 2006. Because of the expected downturn of wireless revenues on the coming quarters, we have been limiting any additional investments on this business line.

Other revenues. Our other revenues mainly included online game revenue, which grew 2% sequentially and 60% year-over-year to $2.1 billion.

Turning to our gross margins. Starting from January 1, 2006, share-based compensation expenses are charged to cost of revenues and operating expenses due to the adoption of SFAS 123 R. Sohu's share-based compensation expenses for the second quarter is %1.3 million. As we believe, excluding the share-based compensation expense from our non-GAAP financial measure of net income makes a more meaningful comparison of Sohu's operation results and improved user understanding of Sohu's performance, we use non-GAAP measures to explain margins, costs, and expense items.

As we have previously reported, Sohu discontinued its e-commerce platform of physical consumer goods on June 20, 2006. While processing the disposal activity of its e-commerce business, Sohu is reporting the related business activities as discontinued operations. Sohu's income statement separates out discontinued operations for both current and prior periods in order to focus on continuing operations.

Accordingly, those margins discussed below have not included our of continued e-commerce business.

Overall, non-GAAP gross margin for the second quarter was 65%, a decrease from 68% in the previous quarter and 69% in the second quarter of 2005. Advertising non-GAAP gross margin was 71% in the second quarter, down from 75% in the previous quarter and 76% in the same period last year.

Brand advertising non-GAAP gross margin for the second quarter was 72%, down from 76% in the previous quarter in the same period last year. This gross margin decline was primarily due to an increase in the exclusive content expenses and bandwidth costs.

Sponsored search non-GAAP gross revenue for the second quarter was 65%, down from 69% in the previous quarter and 77% in the same period last year. This decrease was mainly because of the increase in depreciation expense for servers and bandwidth cost.

Non-advertising non-GAAP gross margin was 53% for the second quarter, a decline from 55% for the prior quarter and 56% in the second quarter of last year. The decrease was primarily due to a reduced price ceiling set by one of the mobile network operators on SMS fees and the increase of wireless content expenses.

Operating expenses. For the second quarter, Sohu's non-GAAP operating expenses totaled $14.4 million, up 12% from the previous quarter and up 37% year-on-year. The year-on-year increase was primarily because of the increase of marketing expenses, as well as increase in headcount and salaries.

Operating margins. Non-GAAP operating margin in the second quarter was 23%, down from 26% in the previous quarter and 28% in the same period last year. GAAP operating margin in the second quarter was 19%, a slight decrease from 20% in the previous quarter.

Other income. For the second quarter, Sohu's other income included a gain of $800,000 arising from our early redemption of convertible notes with face value of $15 million at a discount.

Income tax expense. Income tax expense in the second quarter was $300,000 compared to $400,000 in the previous quarter.

Net income. Non-GAAP net income for the second quarter was $8.4 million or $0.22 per fully diluted share. This compared to net income of $7.8 million, or $0.20 per fully diluted share for the previous quarter and $7.1 million, or $0.18 per fully diluted share for the second quarter of 2005. GAAP net income for the second quarter of 2006 was $7.2 million, or $0.19 per fully diluted share compared to $6 million or $0.16 per fully diluted share in the prior quarter.

Stock repurchase program. As we previously disclosed, in October 2005, the Board of Directors approved the company's stock repurchase program of $15 million. On July 25, the Board further approved to increase the total amount of the program from $15 million to $30 million. As of yesterday, Sohu has repurchased 284,000 shares under this program and $6.2 million has been utilized. We purchased another 135,000 shares today, bringing the total number of shares to 419,000 shares. Once again, management exhibits our strong confidence in the company's future.

Balance sheet. Let me now make a few comments on the balance sheet. As of June 30, 2006, after early redemption of $50 million convertible notes during the second quarter, Sohu's cash, cash equivalents and investment in marketable debt securities was $133 million compared to $137 million as of last quarter and $133 million as of the end of the last year.

As of June 30, face value of our outstanding convertible notes has been reduced to $60 million. As of June 30, 2006, out net accounts receivable balance was $23.7 million, a decrease of $1.1 million as compared to last quarter. This includes $16.1 million related to our brand advertising business and $6 million related our wireless business.

During the second quarter, we had record high collection of sales proceeds, totaling $24.6 million from our brand advertising business.

Our DSO for the second quarter was 68 days compared to 76 days for the previous quarter and 81 days for the second quarter of 2005. Second quarter brand advertising DSO was 69 days compared to 89 days for the previous quarter and 89 days for the second quarter of 2005. The successful reduction of DSOs by as much as 20 days demonstrates our efforts in closely monitoring our accounts receivable are paying off.

As of June 30, 2006, our bad debt provision amounted to $1.9 million compared to $1.5 million as of last quarter. While we consider this level of bad debt provision to be still relatively low as compared to a level of advertising sales, we continue to remain prudent in our revenue recognition policy and strengthening our credit extension.

Finally, our business outlook. You will find detailed guidance for the third quarter 2006 in our earnings release, but I would like to highlight:

We estimate total revenues to be between $32.5 million to $34.5 million, with advertising revenues of $23.5 to $24.5 million and non-advertising revenues of $9 billion to $10 billion.

In particular, we estimate brand advertising revenue to be between $20 million to $20.5 million.

Third, we estimate non-GAAP fully diluted earnings per share to be between $0.19 to $0.21.

In July 2006, we granted approximately 420.000 restricted stock units to its employees and directors. Assuming no other grant of new share-based awards, we estimate share-based compensation expense to be between $1.9 million to $2 million. The estimated impact of this expense is expected to reduce Sohu's fully diluted earnings per share of US GAAP by about $0.05.

In summary, we are more than satisfied with our 2006 second quarter results. While we look into the remainder of the year, we continue to see strong momentum in online advertising. We have begun to see the direct impact that our Olympic sponsorship growth and World Cup partnerships can have in growing our advertising revenues; and more importantly, building the Sohu brand. We expect this kind of momentum to only pick up going forward as we make more strides to further cement our leading position as a top online international sports content provider and global online news and entertainment provider.

We look forward to providing every one of you with more update of our successes for the remainder of 2006. Thank you all for your ongoing support.

That concludes my presentation. I would like to now open the floor for questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Jason Brueschke - Citigroup. Please go ahead.

Jason Brueschke - Citigroup

Thank you. Charles and Carol, good morning and congratulations on really a fantastic quarter.

Carol Yu

Thank you, Jason.

Jason Brueschke - Citigroup

I will just maybe ask two questions and I will get back in at the end of the queue. So, my first question of discusses the exclusive content relationship that you have as well as your streaming video initiative.

I understand that we are early in the broadband rollout and effectively therefore you are in the investment stage of these businesses and it is clear by the new partnerships that you have announced. What I wanted to do is look forward maybe two or three years from now, when we have much broader broadband penetration, we may have 3G networks and maybe could you discuss first of all what the pricing that you are going to be able to command in a more wired China than compared to today? And maybe qualitatively what the margins would like then given the greater pricing than what you are seeing today during the initial build out of this strategy?

Carol Yu

You are basically asking, what will be the pricing in the gross margin be like looking down two, three years down the road with all these video clips, right?

Jason Brueschke - Citigroup

Right. And all the exclusive content that you are basically assembling today.

Charles Zhang

First of all, I think the broadband penetration is already pretty 50%; even more. And also with the P2P technology, the bandwidth and server costs are very low, almost like no additional cost for video content versus text-based content because of the P2P technology.

The advertising format partially looks like the traditional TV forms; embedded 15 second clips, TV commercials. So that will compare with the traditional TV. Then there is also a roaming tax, but the price we will have to be very creative and also closely monitoring the click-through rates to determine the price.

Carol Yu

I think two to three years down the road like what Charles has said, it will be more like a TV. As far as pricing is concerned we should be approaching the TV rate in terms of viewership and the like. Of course embedded with the CPM model, because by then I would assume that that model will be a lot more widely accepted than what we are seeing today.

I think Charles raised a very good point too that we would have added advantage over television because we will be able to not only sell in the video clips but also the surrounding text, and people will be viewing all these -- it's almost like video-on-demand, because we have this technology that would be able to effectively deliver the ad from that mode.

We will be able to integrate all the interactive part of that we have with promoting. So, it would be a combined package of tax, video, and interactive products surrounding that topic. So, I would be disappointed if I see my ad rates below that. Return as reflected in gross margins, lower than what TVs are seeing today.

Jason Brueschke - Citigroup

Okay. That's actually very helpful. Let me switch gears to the wireless. You have about a month now since the new policies have gone into effect, and in your prepared remarks you discussed what the financial impact is.

What I am kind of curious is to may be the what's, where, and the how these new policies are impacting? Are we seeing a greater impact on the existing subscriber base that you have so it is increasing churn? Is it making the securing of new customer that that was really being impacted? Is it a combination?

You are really the first company that really be able to address these things with a month behind us, and I would just love to get some color on exactly how you are seeing the implementation of these policies impact this sector?

Carol Yu

The policies are actually different for China Mobile and China Unicom. I think the China Mobile rules are more negative than the China Unicom rules, and that's the reason why I specifically segregate those two items in my speech. The China Mobile rules would affect your subscriber base and the ability to get new subscribers. So, it's the entire subscriber base that is at risk.

Going back to what I have just discussed, out of the $4.6 million that we earned from China Mobile today, about $1.6 million are related to services and products that are being affected, and I am actually expecting the reduction could be as much as $1 million to $1.3 million.

So the worst-case scenario is out of the $1.6 million, I may only have $300,000 left from my China Mobile revenue; they are affected by the rules. It is affecting the subscriber base and the ease of acquiring new subscribers.

Turning to the China Unicom rules, it's basically just turning the per message space subscribers to a monthly subscription. So, it is more like applying or imposing on us another price ceiling. The switch from the per message space to the monthly subscription base is automatic. So you don't need positive subscriber confirmation. So, basically it's just another price delay, it does not affect the subscriber base.

So, the impact is a lot more easy to quantify and it is a lot less persuasive in a sense. So, like what I said in my speech just now, we have $4 million from China Unicom total, out of which $2.1 million got affected. My estimate is that the reduction will be just $0.5 million to $1.2 million. So, you can see that the impact is a lot less than those from the China Mobile side.

Jason Brueschke - Citigroup

Great. Thank you.

Carol Yu

Have I answered your question, Jason?

Jason Brueschke - Citigroup

Yes. You did answer because you've kind of touched on both the new subscribers and the existing ones. So, that's great. I will just jump in the back of the queue again. But congratulations again guys on a great quarter.

Carol Yu

Thank you, Jason.

Operator

Thank you. Our next question comes from Michael Zhang - ThinkEquity Partners. Please go ahead.

Michael Zhang - ThinkEquity Partners

Hi, good morning guys. Great quarter. Just two questions. Number one is that the year-over-year growth for the sponsored search was rather low compared to the past few quarters. Can you add little more color on that?

Carol Yu

Well, we have been saying that we are now still very much emphasizing on the product development stage. We actually have not been even promoting the product as aggressively as some of our other competitors. We're planning to do so pretty soon because we now view that the products are now ready. We did not actually monetize the products very aggressively because we believe that if we monetize the product too early or too prematurely, we actually would be losing creditability to customers, because the user experience would not be good. The customer experience would not be as good. So, we rather want to hold back a little bit and be able to do so at a more opportune time.

Charles Zhang

So, by the end of the year with version 3.0 retrieved pages will be reaching 10 billion pages and so in the later half of the 2006, we feel that the product will be much mature in 2007 that the year when we're going to aggressively monetize the search. You may remember that a large part of the search revenue are based on the triggered Sogou search.

Michael Zhang - ThinkEquity Partners

Yes, but from now on to the launch of version 3.0, the growth rate, do you expect to be in the mid-teens or be higher as you reported in the past few quarters?

Carol Yu

You are saying this year or next year?

Michael Zhang - ThinkEquity Partners

This year.

Carol Yu

This year will probably in mid-teens – mid-to-high teens.

Michael Zhang - ThinkEquity Partners

Okay. Yes, that's very helpful.

Carol Yu

When Charles gave out the revised annual guidance, we specifically said that on an overall basis, including search, overall ad revenues will grow by 25% to 30% whereas we just pointed out that brand advertising will grow by 30%.

Michael Zhang - ThinkEquity Partners

Okay. Yes, that's very helpful. My second question is related to the World Cup. We have seen the World Cup related revenue in the news, ranging from 30 million RMB to 50 million RMB. Could you provide a little color on that? In other words, how big the contribution from the World Cup was in the second quarter?

Carol Yu

I think that incremental revenue, I would decline to give out the absolute number, but the incremental revenue divided between Q2 and Q3 is roughly about 2 million according to GAAP numbers because everything you see on the news, those are actually non-GAAP numbers. These are gross of rebates and tax. It's PR numbers, these are not like IR numbers.

So, the incremental extra amount in addition to the framework contract that we have signed at the start of the year is probably about $2 million on a GAAP basis.

Charles Zhang

Incremental means that, without World Cup, advertising anyway, and then the amount that is completely due to the World Cup.

Michael Zhang - ThinkEquity Partners

Yes, that's great. Thank you very much.

Operator

Thank you. I apologize, we are having some technical difficulties on the Hong Kong side, but now we have it up and running. Our next question comes from Hong Kong, Mr. Safa Rashtchy with Piper Jaffray. Please go ahead.

Matt Schindler – Piper Jaffray

Hi, this is Matt Schindler calling in for Safa Rashtchy. I just want to check if I heard that correctly. The incremental World Cup numbers, additional advertising dollars in Q2 were $2 million?

Carol Yu

No, it's total. It's Q2 and Q3 because the World Cup runs from June 9th to July 9th.

Matt Schindler – Piper Jaffray

Okay, can you give us a little color on where that's coming from? Is it specifically from price increases that you can get or is it selling more real estate ?

Carol Yu

It is new inventory, because we created a World Cup channel, which didn't exist before the World Cup, as you can imagine. So, it is new inventory attracting advertisers to put money on that bet.

Charles Zhang

And a new form of inventory.

Carol Yu

Right.

Matt Schindler – Piper Jaffray

Of those 12 new advertisers that, I think you mentioned a 12 dozen new advertisers attracted to the video side, are you seeing any of them signing or showing interest in longer-term contracts beyond the World Cup site?

Carol Yu

Yes, we do. Typically, when new advertisers, when they try it out they would start small and then would typically grow to be more substantial over the coming few quarters.

Matt Schindler – Piper Jaffray

Okay, thank you very much. Great quarter.

Carol Yu

Thank you.

Operator

Thank you. Our next question comes from Mr. Richard Ji with Morgan Stanley. Please go ahead.

Richard Ji - Morgan Stanley

Hi, Charles and Carol.

Charles Zhang

Hi, Richard.

Richard Ji - Morgan Stanley

I have two questions. The first question is regarding your content strategy. Obviously you have been actively building your content library or content pipeline over the past several quarters, especially with all of these leading franchises. Can you just help us understand little better about the economics of this use and also how many of these are account-specific in nature?

Carol Yu

Richard, you are cutting in and out, can you repeat the question?

Richard Ji - Morgan Stanley

Okay. I am just interest to find out what are the economics for this new content, with this leading sport franchise, including whether it is a fixed fee base or a revenue sharing base. How many of these --?

Carol Yu

To start with, for the bulk of the deals that we have signed after the World Cup up to now, those that were discussed by Charles, which I will repeat here, it was mainly on a per case basis. The CBL, the China Basketball League matches and the China Soccer League matches are on an exclusive portal, so it would be an arrangement very similar to the FIFA deals.

For some of the major European soccer that we just signed, that would be on a non-exclusive basis, Eurosport that Charles mentioned as exclusive, all of these are on a purchase basis.

Richard Ji - Morgan Stanley

The other question, your current split between video-based advertising format and your so-called traditional advertising format. What is the rough breakdown?

Carol Yu

Because the video formats just happened during the World Cup, so that would be still a very small percentage among the total brand advertising revenue. That is what is really making us very excited because they are so successful that advertisers have been asking about the same question that you asked, what is our product pipeline? How can they do more? There is a lot of general interest aroused from advertisers, and I mean we are talking to them very diligently as we speak.

Richard Ji - Morgan Stanley

Sorry. My final question is regarding the pricing structure for your video-based advertising format. Would that differ substantially from your traditional brand advertising.

Carol Yu

Up to now, it is still on a fixed-fee basis based on time and the slot. We are selling both the embedded video clips, it has been embedded within the clips, as well as the frame, that is the TV frame that it is showing the video. Of course the embedded video, it is more expensive, but everything is still on the time basis.

Charles Zhang

The advertiser is TV commercial. They don't need to do it again. Produce it again, just do the TV commercial on the embedded clip, 15 second clips.

Carol Yu

And you can't fast forward that.

Richard Ji - Morgan Stanley

Great, thank you.

Carol Yu

Thank you.

Operator

Thank you. Our next question comes from James Mitchell for Goldman Sachs. Please go ahead.

James Mitchell - Goldman Sachs

Thank you Carol for taking my call. Two questions, one is how would you see the effective tax rate working through the rest of the year with second quarter performance.

The second question is if you look at your advertising cost of sales in the third quarter, very broadly speaking, should I expect it to be lower than in the second quarter, because there is less World Cup activity in the third quarter coming through? Or should I expect your advertising sales to be higher?

Carol Yu

I'm not sure if I hear you correctly James, but just let me answer that. The tax rates will be similar to that of Q2. Then for the gross margin, you are basically asking about gross margins for our ad business, right?

James Mitchell - Goldman Sachs

Yes, exactly.

Carol Yu

It would be pretty similar to that of Q2 as well. That is on the branded side. We do expect search will slip a little bit going forward, because for the remaining two quarters, our primary reason is because due to the added servers in order to support the 10 billion of crawl pages we do expect, with relatively not increasing the search revenue, we do expect a sight margin squeeze on a search side.

But the search revenue and the cost as well doesn't account for a material number as far as the total sector is concerned. So, I mean if you just look at the branded side, it would be pretty flat as of Q2.

James Mitchell - Goldman Sachs

If I can just pick you up on the search issue, I am really surprised you are not monetizing sooner search sooner. I can see that it's branded, you always have to trade off the amount of advertising you carry with the amount of content you carry. So, with the search business, since the natural results and the sponsor results are different, I am surprised you are not really pushing hard on selling the sponsored results?

Carol Yu

Well, like what I have said, it is really whether you are selling a very credible product. I mean, if you go on talk to your advertisers and try to monetize it aggressively and then the advertisers experience you find out that you don't really have a good products and good traffic supporting it, you are actually losing creditability among advertisers.

So, we have been consistently telling the Street that we would first do products, then with credible products, we will go and to aggressive marketing which we intend to do in the next two quarters, as far as product marketing is concerned. Then we will be doing more aggressive monetization next year.

Charles Zhang

Yes. Let me elaborate. So, it always goes in three steps. The first, technology and products. Then traffic, and then monetization. So, 2006 is really a year that we focus on growing traffic. Now with a product that is becoming increasingly better and better with the relevancy and all these parameters.

So, the next step is really to dramatically increase its traffic. The traffic for the second quarter is after 2.5, it reached a plateau, and then we expect we will regain the momentum of traffic growth. So, it's really the focus of traffic.

So, only when you have a sizeable traffic market share, you can effectively monetize in a scalable way, which will be the focus of 2007. We are really counting steps because if you talk about product technology, we developed a Sogou technology only within a period of 2.5 years.

So, for any technology to mature, it takes time compared with our competitors which are like six or seven years, we achieved the quality and the quality we believe that it's better and also with some specialized search is much better. So, it's really the steps.

James Mitchell - Goldman Sachs

Okay. I can understand you want to get the product optimized first. I just think that you can build the traffic monetization with branch experience. But thank you for answering the question.

Carol Yu

Thank you, James.

Operator

Thank you. The next question comes from Tian Hou with CE Towbin. Please go ahead.

Tian Hou - CE Towbin

Hi, Charles and Carol, this is Tian. How are you? Good quarter.

Carol Yu

Hi, Tian.

Tian Hou - CE Towbin

Hi. Good quarter. First question with margin and follow on what James just asked. If you look at the second quarter margin, margin was lower than the first quarter and the same quarter last year. I almost feel it was due to the high account expense and bandwidth. I would expect it was a two-quarter event, however, as what you said, using exclusive content to generate revenue and traffic is part of your strategy.

So, shall I expect down the road next year the margin will pretty much stay where it is right now? Should we see any rebound?

Carol Yu

To give you a short answer, I would expect it to be pretty stable. But like what I have always told The Street is, when we manage the business, we don't really just – especially for the branded side of the business, we don't really just look at margins, but we actually look at the net margins instead of gross margins because a lot of money is fungible. We can move it from opex to cost of revenues and vice versa. So, just looking at the gross margin line is a little bit misleading.

We are managing the business by looking at the bottom line. If you look at the net margins, here that we are talking about still very comparable, the 25% as compared to the last quarter. So, this is how we look at the business.

Tian Hou - CE Towbin

I see that you manage your business by managing bottom line. So down the road, even though you increase your exclusive content costs, you may still manage your bottom line. So your bottom line margin may still stay at 25% or make some improvement, is that correct?

Carol Yu

The reason for that is for example, like the World Cup video, yes, it is exclusive, it is strategic, it is more expensive than the traditional local content costs that we have been seeing in the past but because the content is so good, that the product is so good that it almost sells itself. So, I can actually reduce on a lot of promotional expenses that I would otherwise need to spend.

Tian Hou - CE Towbin

Okay I got it. Thank you. The other one is regarding the incremental World Cup advertisers, how many of them actually stayed? What portion of them expressed the interest to continue to advertise with you?

Carol Yu

I can't give you a concrete number because it is very dynamic. The 12 advertisers that we are seeing and whether they stay or they go, we just finished World Cup less than a month ago. So we are all in discussion with it. But whether they stay, again it is a matter of the budget allocation. We are really delighted to see it after World Cup, people are willing to allocate a much higher budget on to online video, especially with Sohu, and content owners are a lot more comfortable in talking to Sohu about giving us their content.

So, we have a pipeline of products and a pipeline of advertisers interested in that video, in that advertising format. That's what is making us really, really excited.

Charles Zhang

I have to tell you that advertisers are very happy because on all the video technology Sohu’s technology demonstrated that that's probably the most leading, advanced technology that ensures ease of use and flow of the picture. I am very happy.

Tian Hou - CE Towbin

Okay. Thank you.

Carol Yu

Thanks.

Operator

Our next question comes from Dick Wei, please go ahead.

Dick Wei

Charles and Carol, just a quick question on the guidance, It seems that for the third quarter, revenue is down about --

Carol Yu

We can't hear you. Can you just speak up?

Dick Wei

I have a question on guidance, the third quarter revenue is going to be flattish, if I look at the mid points. But, EPS is going to be down about $0.02 from this quarter, What is the reason for the decline in margins, is this sequential?

Carol Yu

Yes. It is primarily because of drop in the wireless margins and the fall in the search margins.

Dick Wei

All right. So, advertising will stay the same?

Carol Yu

Branded will stay pretty much the same.

Dick Wei

Okay. That is great. Thanks.

Operator

Thank you. At this time, I would like to turn the call back over to Ingrid Shea, please go ahead.

Ingrid Shea

We would like to thank everyone who participated in today's call, please feel free to contact us with any additional questions that you may have. Thank you all for your patience and your time.

Carol Yu

Thank you.

Operator

Ladies and gentlemen, this concludes the Sohu second quarter 2006 earnings call and you may now disconnect. Thank you.

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