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Sohu.com Inc. (NASDAQ:SOHU)

Q3 2006 Earnings Call

October 26, 2006 8:00 pm ET

Executives

Ingrid Shea - Investor Relations

Dr. Charles Zhang - Chairman of the Board and Chief Executive Officer

Carol Yu - Chief Financial Officer

Analysts

Safa Rashtchy - Piper Jaffray

Catherine Leung - Citigroup

Richard Ji - Morgan Stanley

Dick Wei - JP Morgan Technology Research

Ming Zhao - Susquehanna Financial Group

William Bao Bean - Deutsche Bank

Lu Sun - Lehman Brothers

Steve Weinstein - Pacific Crest Securities

Presentation

Operator

Good day, everyone, and welcome to the Sohu third quarter 2006 earnings release conference call. Today’s conference is being recorded. For opening remarks and introductions, I would like to turn the conference over to Ingrid Shea, Investor Relations. Please go ahead.

Ingrid Shea

Thank you, Operator. Thank you for joining Sohu.com to discuss our 2006 third 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 here-in, 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 statement. 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 for its revenues.

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

Thank you for your patience. Now, let me turn the call over to Dr. Charles Zhang, Chairman and CEO. Charles.

Dr. Charles Zhang

Hello, everyone, and welcome to Sohu’s 2006 third quarter financial results call. I am pleased to report a strong quarter of financial performance, backed by a record quarter of brand advertising revenues.

As we enter the final months of 2006, I am more than happy with what we have accomplished, and even more excited about what the future will bring, especially as the much-anticipated Beijing Olympics draws closer.

To appeal to the increasingly sophisticated Chinese user base and China’s growing online advertising market, we continue to deliver premium, differentiated and exclusive content. This strategy has been working well in expanding our core advertising business.

Now, I would like to discuss highlights for the third quarter.

We achieved yet another record total revenues of $35.4 million for the third quarter of 2006, growing 4% sequentially and 29% year-on-year, exceeding company guidance.

Let me discuss the progress of our many business lines. First, advertising. Overall, we experienced a good quarter in advertising, driven by our record-high brand advertising revenues. Advertising revenues for the third quarter were $23.9 million, up 5% quarter-on-quarter and 27% year-on-year, meeting our guidance.

Brand advertising revenues were $21 million, representing a sequential increase of 9% and a year on year increase of 35%, exceeding company guidance. For the first nine months of 2006, brand advertising revenue grew by 37% year on year.

Sponsored search accounted for $2.9 million, representing a sequential decline of 19%, and year on year decline of 10%. For the first nine months of 2006, sponsored search revenue grew by 9% year on year.

In brand advertising, revenues continued to be driven by heavy spending sectors, such as automobile, real estate, and information technology. The sectors that experienced the fastest growth for the quarter were e-commerce and online games.

During the quarter, we took significant steps to enhance our products, content, and the strategic partnership strategy in order to attract more users and extend the power of the Sohu brand.

More specifically, I would like to highlight the progress in three important areas.

First, Sohu has been focused not only on the development and the rollout of innovative products, and in fact web 2.0 community-based products, but also successful in integrating them with traditional text and pictures into a uniform platform.

We have developed enhanced products that come together nicely to create an entire Sohu community matrix, which currently includes chinaren.com, Sohu clubs, Sohu blogs, and Sohu commentaries and the SoGou maps report.

We also experienced great success in integrating our more traditional products with our newer web 2.0 products.

For example, across most channels, when a piece of controversial news is presented in the traditional text and picture format, we also provide relevant web 2.0 products, such as Sohu commentaries, next to the news. Accordingly, users can read the news, ask questions, express their own opinions, or discuss with other users.

The daily page view for Sohu commentaries alone increased 35% sequentially during the third quarter.

Another prime example of successful integration is our new blog product. Launched in September, with fun and new personalization features, Sohu Blog Plus version has been doing very well -- well received.

One of its unique features is that bloggers can customize the layout of their blog’s front page, and fill that with their favorite Sohu matrix products. In this way, this front page becomes bloggers’ personalized portals. Similar to MySpace, Sohu Blogs focused also on interactivity by allowing users to add commentaries to the blogs and links to other blogs, list all newly updated blogs and links to blogs of viewers who have recently viewed your blog.

We have also been able to further differentiate our blogs by focusing more on grassroots blogging, in comparison to other blogs centered on celebrities or high-profile personalities.

To promote Sohu Blogs Plus version and all it has to offer, Sohu hosted a Sohu Blog Forum in Beijing in late September, with a special focus on its front-end personalization features. This offline event was attended by more than 5,000 celebrities and grassroots bloggers.

Our combined product enhancements and the marketing efforts resulted in the number of page views for the Sohu Blog increasing over 160% here in the third quarter, and registered users increasing approximately 98%, compared to the previous quarter.

As a result of the successful integration of Sohu products, we experienced strong momentum in web 2.0 monetization, and saw revenues from these segments grow approximately 50% in the third quarter sequentially.

We expect the successful integration of traditional products and web 2.0 products will become one of the key drivers of our online advertising business.

Secondly, Sohu continues to expand its online video content portfolio, with new channels and exclusive content. With the development of our proprietary peer-to-peer streaming technology, and increased broadband penetration in China, there is a strong demand for TV-like content by the Internet users. This has been proven by our success to attract audiences with the exclusive video highlights for the 2006 FIFA World Cup.

In order to further capture this growing demand, we recently launched two online TV like channels, specifically geared for video content. They are V Channel for entertainment and S Channel for sports.

In addition to preset programs structured like TV stations having a certain broadcast timetable, users can also enjoy programs on an on-demand basis. Both channels have been well-received, despite being recently launched.

For example, earlier this month, V Channel hosted an online concert for the Top 10 winners of the 2006 Supergirl contest, which attracted over 170,000 online users.

Our S-Channel was launched on October 8th, and now features video highlights from China Football, China Basketball Competitions, and select European soccer matches and Eurosports.

In our recently announced, multi-year partnership agreement with NBA, we will be able to show 24 live regular season webcasts, along with nightly game recaps otherwise, unavailable on TV in China, beginning November 2nd, which we expect to funnel traffic to the S Channel.

We expect rich media revenue to continue to gain momentum, as advertisers increasingly allocate more enterprising dollars from traditional media to online advertising. We believe we have put the right strategy in place to best capture this changing trend in advertising spending.

Third, we continue to execute well on our Olympic strategy. We have built a comprehensive sports offering surrounding our role in the Olympics, and continue to add new, exclusive and exciting elements.

As the Beijing 2008 Olympics draws near, the anticipation and the excitement around this event continues to build throughout China. On November 7th this year, 2006, the first anniversary of Sohu winning Olympic sponsorship, we will launch our Olympic channel to serve the needs of the Internet population, as well as anxious Olympic fans throughout China.

One of Sohu's important initiatives during the third quarter is our strategic cooperation with China Interactive Sports, or CISports. For any sports event, the two most important resources are the matches and the athletes. CISports is in an extremely viable strategic position, as it owns substantial and significant resources relating to athletes.

CISports is backed by the China General Administration of Sports, which in turn manages all sports associations as well as Team China, which includes all the athletes we present in China in international sports events.

We have recently entered into a multi-year agreement with CISports to jointly manage and operate all its underlying websites, including sports.cn, sport.org.cn, and the official website of the China Olympics Committee, olympic.cn, and other official websites from various sports associations, as well as the official website and the blogs for famous athletes, such as Liu Xiang.

The upcoming Asian Games will also allow Sohu to leverage its exclusive sponsorship role for the Beijing Olympics in 2008 and Team China, as well as CISports resources and athletes.

We are extremely excited that Sohu is the only Internet company that has exclusive legal rights to interview athletes before each game, and interview gold medal winners after the games. With the combined resources of CISports and our role in the Asian Games and Olympics, we have garnered significant access to many athletes, which we will be able to fully utilize through online interviews and the videos to be made available exclusively on our S Channel.

As we move more fully into a two-year countdown period toward the 2008 Olympics, we are seeing an increased number of activities and programs by TV stations and sponsors. We have been working on numerous projects with these parties, which have resulted in increased PR and the media exposure for Sohu.

We will also be working with city TV, Beijing, Shanghai, and Guangdong TV stations to promote related programs such as Athlete Interviews.

Going forward, we plan to organize and host such activities and programs to not only further increase Sohu's exposure, but also grow our advertising revenue base.

Due to the boundary-less nature of Internet space, official partners and sponsors of Beijing 2008 Olympics, except for those top partners, traditionally were not allowed to place their Beijing 2008 Olympic joint company logos on any online advertisement, even for their own company website, because of the geographical constriction.

I am very pleased to announce that because of Sohu's exclusive Internet content service sponsorship status on the Beijing 2008 Olympics, the Beijing Organizing Committee of Olympic Games has recently approved its local partners or sponsors to advertise with their joint company logos in Sohu websites.

As we are moving closer to the Olympics, we expect more local partners and sponsors who would like to advertise with their respective joint logos, and in order to do so, they can only do so on Sohu.

In sponsored search, we experienced a 90% sequential and 10% year on year revenue decline, mainly due to further enhancements on the anti-fraudulent click mechanism, and decrease of revenues from a fixed fee paid listing.

We continue to invest in product development in anticipation of the SoGou 3.0 version launch. During the third quarter, the number of page views remained flat, while the number of crawled web pages increased from 4 billion to 5 billion pages.

With the launch of SoGou 3.0 targeted for the current fourth quarter, SoGou will be able to further increase the number of crawled web pages to an even more impressive 10 billion pages, and produce more relevant, accurate search results in a shorter response time.

We believe our unwavering focus on developing a solid search product is exactly what is needed to be one of the leaders in the competitive search market in the long run.

With the upcoming launch of SoGou 3.0, we will also be unveiling a marketing program in the fourth quarter, with an optimal search product backed by strategic marketing efforts. We believe we are on track to more aggressively monetize SoGou when we first enhance our traffic.

In our wireless business, while our focus remains on core advertising business, we are pleased to see our wireless business continue to exceed guidance. Despite the widely anticipated negative impact of new policy changes by the mobile network operators, our wireless revenues only experienced a marginal sequential decline of 2% quarter on quarter, and was still up 31% year on year.

This follows six quarters of sequential, steady revenue growth. We have been able to achieve this due to our vigilance in managing the wireless business and then minimizing the risks of uncertainty, and identifying new revenue sources.

We believe it is important for Sohu to maintain a presence on the wireless side, and more specifically, in WAP, in anticipation of the imminent launch of the 3G mobile network in China.

While our primary focus is and will continue to be on our advertising business, we continue to carefully monitor the wireless industry and believe that we are well-positioned to minimize the risks associated with this sector. We are also maintaining enough of a presence to capture growth in key segments through leveraging our core content strengths.

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

Carol Yu

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

We are pleased to report strong record revenues of $35.4 million for the third quarter, which exceeded our guidance.

With advertising revenues of $23.9 million, we experienced a sequential increase of 5% and a year on year increase of 27%.

For the third quarter, wireless revenues were $8.8 million, down 2% quarter on quarter and up 31% year on year. Let me give you a breakdown of wireless revenues for the third quarter:

  • Advertising revenues decreased 4% to $5.1 million compared to the prior quarter;
  • WAP revenues were $2.5 million, up 5% from the prior quarter;
  • MMS, IBR, and ring-back tone services combined were slightly up from the prior quarter, at $1.2 million;

Given the widely expected negative impact of new policy changes by mobile network operators, we view the marginal sequential decline in the third quarter as a positive. We have continued to limit our investment in this segment, and have also been prudently identifying additional revenue sources.

During the quarter, we generated $0.5 million from the SMS voting platform we provided for My Show, a television music program through a partnership with Sprite, Shanghai Media Group, and Universal Music Group.

Our other revenues mainly included online game revenues, which grew 4% sequentially and 55% year on year to $2.2 million.

Starting 2006, share-based compensation expenses were charged to cost of revenues and operating expenses due to the adoption of FAS-123R. Total share-based compensation expenses for the third quarter 2006 was $1.9 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 operation results, and improves users’ understanding of Sohu's performance, we use non-GAAP measures to explain the gross margin, cost and expense items.

So we will now turn to our gross margins. Overall gross margin for the third quarter was 66%, remained at similar levels compared with 65% in the previous quarter and 67% in the third quarter of 2005.

Advertising gross margin was 71% in the third quarter, unchanged from the previous quarter and a decline from 74% in the same period last year.

This year on year gross margin decline was primarily due to an increase in exclusive content expenses and bandwidth cost.

Brand advertising gross margin for the third quarter was 73%, up from 72% in the previous quarter and down from 74% in the same period last year.

Sponsored search gross margin for the third quarter was 58%, down from 65% in the previous quarter and 74% in the same period last year. This is primarily due to increased server depreciation and bandwidth costs.

Non-advertising gross margin was 57% for the third quarter, an improvement from 53% for the prior quarter and 54% in the third quarter of last year. The improved gross margin was primarily due to an increased mix of higher margin revenues and an increase in gross margin of certain SMS products.

For the third quarter, Sohu's operating expenses totaled $15.4 million, up 7% from the previous quarter and up 39% year on year. The year on year increase was primarily because of our increased reinvestment in research and development, increase of marketing expenses on branding, and increase in headcount and salaries.

Operating margin for the third quarter was 23% on a non-GAAP basis, flat from the prior quarter but down from 27% in the period last year. GAAP operating margin in the third quarter was 17%, slightly down from 19% in the previous quarter.

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

Non-GAAP net income for the third quarter was $8.5 million, or $0.22 per fully diluted share. This compares to net income of $8.4 million, or $0.22 per fully diluted share for the previous quarter, and $8 million, or $0.21 per fully diluted share for the third quarter of 2005.

GAAP net income for the third quarter of 2006 was $6.6 million, or $0.17 per fully diluted share compared to $7.1 million, or $0.19 per fully diluted share in the previous quarter.

As we previously reported, on August 2nd, we announced the completion of a $15 million stock repurchase program. As of today, we have another $15 million stock repurchase program approved by the Board of Directors, which is still ongoing. We will continue to execute this program and repurchase shares on an opportunistic basis going forward.

Let me now make a few comments on the balance sheet. As of September 30, 2006, Sohu's cash, cash-equivalents, and investments in marketable cash securities was $120 million, compared to $133 million as of June 30th, and $133 million as of December 31, 2005.

As of September 30th, our net accounts receivable balance was $25.9 million, an increase of $2.2 million as compared to last quarter. This includes $16.5 million related to our brand advertising revenue, and $7.3 million related to our wireless business.

During the third quarter, we had a record high collection of sales proceeds, totaling $24.8 million for our brand advertising business.

Our DSO for the third quarter was 72 days, as compared to 68 days for the previous quarter, and 82 days for the third quarter of 2005.

Third quarter brand advertising DSO was 66 days, down from 69 days for the previous quarter, and significantly down from 105 days for the same period last year. This demonstrates our efforts in closely monitoring our accounts receivables are paying off.

As of September 30, 2006, our bad debt provision amounted to $1.8 million, as compared to $1.9 million as of June 30, 2006. While we consider this level of bad debt provision to be still relatively low as compared to our level of advertising sales, we continue to remain prudent in the revenue recognition policy and strengthening of our credit extension.

Finally, our business outlook. You will find detailed guidance for the fourth quarter 2006 in our earnings release, but I would like to highlight. Sohu estimates total revenues to be between $34 million to $36 million, with advertising revenues between $24 million to $25 million, and non-advertising revenues of $10 million to $11 million.

For brand advertising business in particular, Sohu estimates that to be between $21.5 million to $22 million.

We also estimate our non-GAAP fully diluted earnings per share to be between $0.20 and $0.22.

Lastly, Sohu estimates the share-based compensation expense to be between $2.1 million to $2.2 million. The estimated impact of this expense is expected to reduce Sohu's fully diluted earnings per share, under U.S. GAAP, by $0.05 to $0.06.

In summary, we are pleased with our financial results to date and, as we move towards the end of 2006, we are confident in the strength of our core online advertising business and the strategy we have developed to further brand Sohu as the portal of choice for advertisers. We have built a comprehensive and unique sports platform, and continue to add strategic content partnerships as we gear up for the Olympics.

We look forward to updating everyone on our progress on Sohu's many exciting initiatives over the next few quarters. Thank you all for your ongoing support.

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

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from Safa Rashtchy, Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Good morning, Charles and Carol, and congratulations on a great quarter. A couple of quick questions. You mentioned I believe the two categories, or two areas that advertisers that were strong, e-commerce and games. Could you give us a little bit more color as to what was driving that strength, whether it was new product launches, or new advertisers? Also, how is the strength in other sectors? What should we expect would be driving growth in the coming quarters? Maybe you could give us some sort of a piece of qualitative weight of those two sectors --

Carol Yu

Sorry, Safa, the line does not come out very clear. Could you just repeat your question?

Safa Rashtchy - Piper Jaffray

I will try. I am in a land line, but I will try to speak louder. I was asking about the strength in different sectors of the advertising. You mentioned e-commerce and games were strong. Could you tell us what drove that strength? Were there any new product launches? Also, how was the strength in the other sectors?

Carol Yu

Real estate is a little bit fast. Real estate, automobiles, and IT continue to be our three major streams of advertising revenues. E-commerce and online games, because there are many online game launches and there are many new sites for e-commerce that are also being launched. In general, the Internet sector is very bullish in China. They need to do advertising on our platform, so I think that drives it.

Up and coming, like what Charles has mentioned, we will launch the Olympic channel on November 7th. That is a core part of our Olympic strategy, and the fact that CISports, we will co-operate and co-manage those sets of websites. We believe that all these new assets of inventories will contribute to continued strength in our advertising business.

Also, the two new channels that Charles has mentioned, S and V, the two video channels, which we are very, very excited about. We believe that would lend on the success of our World Cup videos. Advertisers are very pleased with the results that they saw on the World Cup video clips, and I think that will continue to be a very exciting part of our business.

Safa Rashtchy - Piper Jaffray

That is a perfect segue for my follow-up, if I may. The video and sports related sites, as well as your blogging and social networking as you group them, web 2.0 initiative, which you said have had good success, are they bringing any new type of advertisers? I am especially thinking of any consumer packaged good companies, which may be more interested in those types of sites. Are you seeing any interest from new advertisers because of those channels?

Dr. Charles Zhang

Yes, especially the V, the entertainment channel, is getting good feedback and response from consumer goods companies, because the entertainment channel is reaching a wider, younger user base.

Carol Yu

Yes, we are seeing interest from advertisers who were not as keen as they were before, so they are more keen today, for a wider population of advertisers.

Operator

Our next question comes from Catherine Leung, Citigroup.

Catherine Leung - Citigroup

I just have a question on the wireless segment. It was much better than we expected, and I was wondering if you could help us understand better whether this was because the policies themselves did not have as great an impact as expected, or was it due to some proactive measures that Sohu has been taking? Thank you.

Dr. Charles Zhang

I think, as I said, it is due to our vigilance in managing our business, and also identifying some new opportunities. So it is really, without any additional marketing or spending whatever, by fine-tuning, manage the team well, and minimize the loss due to the policy change, and also identify new opportunities, like the My Show, the TV show. So there is some kind of creativity.

Carol Yu

Catherine, it is all our execution.

Catherine Leung - Citigroup

Thank you.

Operator

Our next question comes from Richard Ji, Morgan Stanley.

Richard Ji - Morgan Stanley

I have a couple of questions. First, regarding your brand advertising, could you comment on the advertising pricing trend, especially given that you most likely will increase advertising price at the beginning of next year? That is my first question.

Carol Yu

It is going upwards.

Richard Ji - Morgan Stanley

Okay. When are you going to give us more concrete color?

Carol Yu

But Richard, I think more importantly, other than the pricing trend itself, it is the creation of additional inventories, like what I have just mentioned. We are now able to offer our advertisers a much broader range of products and inventories, otherwise unavailable before or by our competitors. I think that will be a more important revenue growth driver.

For example, these new inventories, nothing to be compared like to like, and we do expect, for example, as we approach 2008, the Olympic channel’s pricing, as you can imagine, will just -- I mean, there is only one way. The trend is up.

While we still maintain our previous practice of raising prices 20%, 25% on a year on year basis on our hard resources, I think these additional inventories, both the fact that these inventories are available and second, and more importantly, is that these inventories will be very, very attractive to a much broader range of advertisers.

Richard Ji - Morgan Stanley

That is very good. The second question is, by our observation, I noticed an interesting development in your company, and that is you are among the first few search company that took serious measure to attack the fraudulent click problem, which I think is a prevailing issue in the industry. Could you just help us understand a little better what measures you have taken, and what do you think of the trend going forward, especially for your new SoGou search engine?

Dr. Charles Zhang

We rewrote the software that is managing our, you know, the search business, and basically --

Carol Yu

For example, if the same IP comes out with more than X number of clicks, it would be disregarded, so this is the mechanism behind, but technologically, I cannot explain how we wrote those programs, but this is the mechanism behind as to how we excluded or strengthened the measures on fraudulent clicks, and we believe that we have the responsibility to make sure the industry is growing on a very healthy basis.

Operator

Our next question comes from Dick Wei, JP Morgan.

Dick Wei - JP Morgan Technology Research

Good to see another very nice brand advertising growth for the quarter. My main question is on the Olympic side. I was talking with a media, ad agency the past two weeks. They are already talking about adjusting their budget for Olympic advertising, probably going to start in the second-half of ’07. I guess for the World Cup, you guys probably did not really realize the full potential. How has the Olympic sales effort been going? Has there been having any -- probably not during the Olympic weeks, but probably the three months before, or six months before the Olympics actually take place, do you have any rate cards or any sales to the Olympics channel already? Some comments on that would be great.

Dr. Charles Zhang

Before Carol gives a more detailed explanation, I want to re-emphasize the one that I just said, about the privilege. Because of the geographical restriction, a non-top advertisers, non-top partner of the Olympics, basically local advertisers, we can advertise with their Olympic logo on a billboard or on any non-Internet properties, but once they advertise on the Internet properties, then immediately, people anywhere in the world can see. It has this problem, basically the boundary-less nature of the Internet. That is why it was restricted.

But because Sohu, as a sponsor of the Olympic website, and also through technological matters, we are able to resolve that problem by the IT identification, so the Olympic Committee awarded our rights to allow the local sponsors of the Olympics to advertise on the Sohu Olympic channel and the website.

This provides a very unique opportunity and a privilege for those many, many local advertisers who are starting to accelerate their Olympic advertising in 2007, to have their Olympic logo to appear on the Internet and the Sohu properties are the only place they are allowed to, so this is a very important opportunity that probably is not fully comprehended by the industry yet.

Carol Yu

Dick, you really are ahead of time, really forward-looking because we are now very busy talking about budget allocations from advertisers for 2007 and you start asking me about questions about 2008, so maybe -- let me just give you some color as to what makes us very excited about 2007 first.

In 2007, there are a few key events which we believe will help drive the ad budgets, add traffic and everything. The first event is the torch relay, the members participating in the torch relay. The torch relay itself will only start in 2008, but next year, sponsors and partners will all get their respective holders, for example, Sohu and other sponsors and partners will get their respective holders for such members, participants in the torch relay.

All of these companies will be very busy using different methods to help promote their images and branding by selecting these participants, including Sohu. We already have been approached by many of these sponsors who are looking forward to working with Sohu on the Internet to pick up these torch relay participants, which would be a very, very high profile event next year. This is the first item.

The second item is all the stadiums will be ready, obviously, before the games and a lot of them will be ready next year. In order to make sure that all these stadiums function properly, there will be a series of test games. It is called [Market] Beijing, is a total of 40-something. The first two have already been done in 2006, during September and October, and it has drawn a lot of local interest and international interest as well.

There will be another 40-something of these test games next year. CISports is responsible to host the official website for all of these 40-something test games, and we believe that will be a very good platform for both sponsors and non-sponsors of the Olympic Games to take part in these very exciting sports events.

Just to give you two examples as to what makes us very bullish as to our overall Olympic Strategy.

Dick Wei - JP Morgan Technology Research

Carol, if I may have a follow-up question on that, have you been showing those Olympic specific related channels already? I understand that the Olympics outlook is really good. You guys are really well-positioned, but I just want to make sure that the sales efforts is actually going on.

Carol Yu

The sales efforts -- actually, like what I said, our sales team is very busy getting budget allocations from advertisers over the next couple of months. They started this lately, so we do expect to be able to give more color on our next two calls.

Operator

Our next question comes from Ming Zhao, Susquehanna Financial Group.

Ming Zhao - Susquehanna Financial Group

Thank you. Good morning, Charles and Carol. First question is, can you explain what is the increase in the fixed asset line?

Carol Yu

Those are mainly servers for getting ready for the SoGou 3.0.

Ming Zhao - Susquehanna Financial Group

My second question is on the search. You guys talked about monetization for ’07, and now you mentioned the anti-fraudulent clicks, is that suggesting you are going to change the business model from paid directory listing to a pay-for-performance dominated model next year?

Carol Yu

We will continue to offer both models, and we will probably switch the emphasis more to what is pay-for-performance, yes.

Ming Zhao - Susquehanna Financial Group

Final question is you mentioned there is some softness in the real estate advertisers. On a sequential basis, has that revenue portion declined quarter over quarter?

Carol Yu

Q3 is slightly lower than Q2, but Q4 is mainly flat.

Operator

Our next question comes from William Bean, Deutsche Bank.

William Bao Bean - Deutsche Bank

Could you just talk a little bit about the advertising on the real estate side, just give us an update on what happened there and whether things are back to normal?

Carol Yu

Like what we explained to the group of investors that you brought to Beijing, new policies came out, developers put some of their promotional campaigns on hold. Once the detailed rules are out, the developers come back and do their promotional campaigns again, so there is a slight drop during Q3, but it came back to more normal towards the end of Q3.

William Bao Bean - Deutsche Bank

Great, and can you give us a sense of the timeline in terms of starting to monetize SoGou, and what sort of pattern we should expect, or what you are expecting in terms of how you see the revenue ramping up? Is it going to be more gradual, or do you think you see an early spike?

Dr. Charles Zhang

I think traffic first. We are looking at launching SoGou Version 3.0, which we believe, in terms of a search quality database size and relevancy, accuracy, response time, everything, will surpass any competitor and become the leading search engine in terms of quality.

Only through this way that SoGou is not only better a little bit but better by a lot, that SoGou can have a traffic -- I think a -- not gradual, but almost like a dramatic increase, if we have the proper, right marketing efforts with it. We first hope that the traffic will dramatically grow in the first-half of 2007, and then the monetization follows.

Now it is still that we have the case where we are really growing traffic by launching the best, the far best search engine, because it takes time for search engine technology to accumulate and to mature.

I think the reason we adapt the SoGou 2.5 as version 2.5 because we believed in the beginning of the year, we think that SoGou 2.5 is a version that will transition into a more final 3.0 version, we believe with much broader and different architecture to lay the foundation for our future platform for a long time to come, so we are really excited about this version 3.0.

I think monetization will follow, maybe once we achieve the high traffic growth and the sizable market share in the first half of 2007.

William Bao Bean - Deutsche Bank

Great, and just one last quick thing. Could you just give us the number of blog users and page views in the quarter?

Carol Yu

No, we are not giving out those numbers right now.

Dr. Charles Zhang

The page views grew 160% compared with -- in the third quarter, and now into, starting the fourth quarter, the first month in the fourth quarter, page views and registered users continued to grow, especially benefiting from this newly launched version, the Sohu Blog Plus. So the page views continues to grow and the registered users continue to grow.

Operator

Our next question comes from Lu Sun, Lehman Brothers.

Lu Sun - Lehman Brothers

A question on search sponsored traffic. You mentioned that the page views remain relatively flat. I understand you are trying whatever you can to improve on the technology side, but other than that, we noticed that your blog traffic is tracking up very nicely and you have this radio content and other stuff, web 2.0 initiatives.

Is there any way that you can leverage the traffic growth on your other channels to search, or whatever campaign you can do to boost the usage on search sites?

Dr. Charles Zhang

Definitely. Search engines -- our SoGou search engine is not only a standalone product itself, but it is the engine to drive many applications through the Sohu matrix. The blog search and the future video search and now, we are streamlining the Sohu portal to give users a more relevant reading experience by utilizing the search technology.

Even the existing product, you can look at Sohu blogs, the text is actually, behind the text, it is our search engine technology.

The Sohu matrix, by utilizing the search technology, it does drive traffic to SoGou, so the SoGou traffic growth is -- internally driven traffic is growing steadily. It is due to some counter effects that the overall traffic remained flat, because of some of our -- we stopped some toolbar-related spamming of pop-up windows, because it is cost -- a lot of the virus killing software regards the SoGou toolbar as a virus. That is something that is, you know, the counter effects to cancel the traffic growth.

We believe that SoGou traffic is now becoming more healthier and more quality traffic.

Lu Sun - Lehman Brothers

About that toolbar thing, do you think that can be resolved in the near-term, or do you have any good idea how to boost the external growth?

Dr. Charles Zhang

I think the toolbar is the important strategy, but at one time, the toolbar is not properly used. Now, I think it is already -- it dropped back. I think it has stabilized, a stabilized level. With the toolbar to be more, a really good functionality, like providing people, for people to really enjoy using the toolbar. I think it has already stabilized and I think it will gradually grow back, because there are so many toolbars by so many other companies, and toolbar really now is a very bad name. But in the long run, people will realize that the SoGou toolbar is a toolbar that can really help users have direct access to the various quality content and activities on the Sohu matrix, together with our team input measure, I think it will bring a lot of good will name to SoGou related desktop software.

Lu Sun - Lehman Brothers

Another question, if I may, on the games side. They are like 5% Q-to-Q growth -- what was the main driver of all this growth, and what is your expectation for your new game, [inaudible]?

Carol Yu

[inaudible] will launch, it is still in closed beta. The commercial launch is next year. Q-to-Q growth is just we do more promotional activities. It is nothing very, very important.

Operator

Due to time constraints, we will take our final question from Steve Weinstein, Pacific Crest.

Steve Weinstein - Pacific Crest Securities

Thank you very much. I was just hoping to get a little better understanding of what is happening in the search business. You called out two factors that influenced the growth in the quarter, one was attacking click fraud, and then one was removing some of the fixed fee type of listings. I am wondering if you could quantify for us or give us proportionately the impact that had on the business?

Then, on the fixed fee component of it, I assume the goal is to transition that into a cost-per-click type of model. I am wondering how that transition works from a modeling perspective, like how long you think it takes to get to basically revenue-neutral as you make that transition.

Carol Yu

I believe that we would expect to see revenue impact from those pay-per-click models, would come in probably the second-half of next year, because as we have always been telling the street, that we are still in a product development phase. Now, with SoGou 3.0, we are eventually pretty happy with the product, and we are now ready to move into the product marketing phase, which we expect to do in the next two, three quarters, and then we will start aggressive monetization the second-half of next year, or more meaningful monetization. With that, then we can move over to the pay-per-click model more credibly.

On the fraudulent click side, it probably hits us for about $2,000, $3,000 for now, per quarter.

Steve Weinstein - Pacific Crest Securities

I’m sorry, could you say that one more time?

Dr. Charles Zhang

I think the decline for the SoGou search business is that most of our paid for listing services has been related to [SoGu] search, the old search, and also with our alliance network of website.

What is really the driving engine for growth is really to have good listing, pay-per-click search on SoGou search traffic. So it is only when we have a really sizable webpage search from SoGou search, and also effective monetization of SoGou traffic, we will start to see a gradual growth pattern similar to competitors in the U.S. in China.

Before we make this transition, it is a transition not only from a paid listing to a bid listing, but also from the SoGou search and alliance network links to SoGou traffic, because a [SoGu] search, it is really, the traffic is facing off. We are not developing. We are not leading traffic, and to guide people who do use the [SoGu] search, it is the old search engine.

It is really the transition, transitioning in two areas.

Operator

At this time, I would like to turn the conference back over to Ingrid Shay for any additional or closing remarks.

Ingrid Shea

We would like to thank everyone for participating in today’s call. Please feel free to contact us with any additional questions that you may have. Thank you.

Operator

Once again, ladies and gentlemen, that does conclude today’s conference. You may now disconnect.

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Source: Sohu.com Q3 2006 Earnings Call Transcript
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