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Sohu.com Inc. (NASDAQ:SOHU)

Q2 2010 Earnings Call Transcript

July 26, 2010 8:30 am ET

Executives

Tip Fleming – IR, Christensen

Charles Zhang – Chairman and CEO

Belinda Wang – Co-President and COO

Carol Yu – Co-President and CFO

Tao Wang – CEO, Changyou.com

Analysts

Alicia Yap – Citigroup

Eddie Leung – Merrill Lynch

Jenny Wu – Morgan Stanley

Wallace Cheung – Credit Suisse

Kathy Chen – Goldman Sachs

Wendy Huang – RBS

Steve Weinstein – Pacific Crest

Muzhi Li - Mizuho Securities (Asia)

Dick Wei – JPMorgan

Operator

Welcome to the Q2 2010 Sohu earnings conference call on the 26th of July 2010. On today’s recorded presentation, all participants will be in a listen-only mode. After the presentation, there will be an opportunity to ask questions. (Operator instructions) I would now hand the conference over to Mr. Tip Fleming. Please go ahead, sir.

Tip Fleming

Thank you, operator. Thank you for joining us today to discuss Sohu.com's second quarter 2010 results. On the call today are Chairman and Chief Executive Officer, Dr. Charles Zhang; Co-President and Chief Operating Officer, Belinda Wang, Co-President and Chief Financial Officer, Carol Yu; Chief Executive Officer of Changyou.com, Tao Wang; Chief Financial Officer of Changyou.com, Alex Ho; and Sohu's Senior Finance Director, James Deng.

Before management begins their remarks, I would like to remind you of the company’s Safe Harbor statement in connection with today's conference call. Except for the historical information contained herein, the matters discussed in this conference call are forward-looking statements. These statements are based on current plans, estimates, and projections, and therefore you should not place undue reliance on them.

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

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

Charles Zhang

Thank you. Hello, everyone, welcome to our call. I’m pleased to report another solid quarter. During the second quarter of 2010, we achieved a record total revenue and record revenues for brand advertising and online games. All such revenues exceeded our expectations. Total revenues were $146.1 million, up 15% year-over-year and 13% quarter-over-quarter.

Gross brand advertising revenue before business tax was $28.1 million. Net brand advertising revenue was $53.2 million, up 22% year-over-year and 35% quarter-over-quarter. Online game revenues were $77.7 million, up 17% year-over-year and 8% quarter-over-quarter.

Our results for the second quarter of 2010 surpassed our expectations as we established the record total revenues and set new highs in our brand advertising and online game businesses. For brand advertising business, we continue to place emphasis on online video and are convinced this will be an area of significant future growth.

We have successfully expanded and diversified our collection of licensed and in-house produced quality video content, and develop innovative applications that cater to various devices, including the most sought after iPad. We are very encouraged by the fast-growing user base and new advertisers.

For our online game business, Changyou demonstrated that the ongoing strategic release of feedback-driven content and a diverse portfolio of games are helping retain existing users, attract new ones, and reinforce the popularity of our games. We are optimistic about our ability to build on our momentum this year and add value over the long-term.

Moving on, I would like to provide some more color on specific areas of our business. During the quarter, we continued to execute our video strategy and are pleased to report that Sohu now maintains the largest online library of authorized high-definition video content in China with more than 100,000 episodes of local and global television dramas, movies and documentaries, TV show and cartoons.

A Korean TV drama has been the mostly welcomed overseen video content in China for years. We have recently secured from Korea top three TV stations, all of the hit shows from the past decade, as well as TV dramas for the next three years. Meanwhile, we created innovative applications that cater to various devices. One example is the application that automatically identifies users that are accessing Sohu video sites from an iPad and directs them to an iPad section that contains more than 200 select high-definition videos, specifically tailored to fit the iPad format.

In the second quarter, average daily video views of our high-definition video channel grew 63% compared to the first quarter of this year. Importantly, this growing traffic attracted more advertising spending. Advertisers who traditionally only advertise on local TV stations have increasingly turned for online video sites, and many of them have increased the spending.

Specifically, the number of online video advertisers in the first half of this year increased 85% as compared to the same period of last year or up a small base. For the full year 2010, we believe revenues from video advertising will triple that of past year. Given that this business is only one year old, we pride ourselves as an especially strong choice.

Moving on, and before I pass the call over to Belinda, I’d like to take a moment to discuss our online game business. Our online game business, we have once again delivered record financial results and exceeded our financial guidance for the quarter and our flagship title Tian Long Ba Bu continues to grow and generate high profit for the company. According to Forbes Magazine, Tian Long Ba Bu was already one of the world’s top five most trustable game franchise in 2009.

What is more exciting than these positive financial results is the double-digit sequential growth we saw in game users for the quarter. The growth was mostly driven by players’ enthusiastic response to the Tian Long Ba Bu 2 major expansion pack that we released on April 2nd. For the second quarter, aggregate registered users grew 12% quarter-over-quarter to 98.2 million, up from 87.4 million last quarter.

Aggregate peak concurrent users, or PCU, which was determined using a new statistical method, grew 25% quarter-over-quarter to 1.14 million, up from 910,000 last quarter. In comparison, aggregate PCU under the previous statistical method grew 23% quarter-over-quarter to 1.28 million, up from 1.04 million last quarter. And aggregate active paying accounts, or APA, grew 17% to reach 2.79 million, up from 2.4 million last quarter.

Average revenue per active paying account, or ARPU, for the quarter was RMB 184, down 8% from RMB 201 last quarter. The lower ARPU level is in line with our persistent strategy of keeping our gains affordable for users in China compared to most other online games offered in the market today. More importantly, it reflects the dilutive effects of a large number of newcomers to our games during the quarter, since new users typically transact at the beginning.

Now I would like to give you an update on both our in-house developed MMO games that have received extensive attention, Tian Long Ba Bu and Duke of Mount Deer, DMD. During the second quarter, we gained a large number of new users with our flagship game Tian Long Ba Bu as a result of our April 2nd Tian Long Ba Bu 2 major expansion pack.

To build our game to momentum, we introduced a multi-content earlier this month that is aimed at encouraging user interaction and increasing the stickiness of our community. As we enter the second half of 2010, we plan to release another major expansion pack in the fourth quarter, focusing on further in reaching the end game experience of users and extending the game’s lifespan.

On our second in-house developed game, Duke of Mount Deer, DMD, our 160 game engineers continue to work passionately on finalizing details in a day. DMD will not only be the first in the industry to allow users to freely switch between multiple graphical modes, the game also features popular forms of social interactive game play for a wide range of people across different genders and nationalities.

In addition, the game will carry on original cartoonish graphical style created by our in-house artists with adorable elaborations of characters, visually attractive sceneries, and realistic weather effects. We believe the combination of all these features will make the game unique.

As our game engineers continue to touch up graphics on the visual side, fine tune the in-game economic premise and add more player tutorials, we have decided to push back the games open beta testing timeframe to beyond our initial plan, which was originally set for the third quarter of 2010. This is a difficult decision to make. And we believe that by doing so, DMD’s chance of success in this competitive environment will be enhanced.

Now I’m happy to pass the call over to our Co-President and Chief Operating Officer, Belinda Wang, who will give an update on our brand advertising business. Belinda?

Belinda Wang

Thank you, Charles. I’m pleased to report that we had strong performance in our brand advertising business. Brand ad revenues hit a record high, up by 22% year-over-year. For your easier comparisons with other peer companies, Sohu’s gross brand ad revenue before business tax was $58.1 million. Net brand ad revenues were $53.2 million. As expected, total revenues picked up with the World Cup and Shanghai Expo.

Most of the revenue growth is from general industry categories, including IT industry, automobile, telecom industry, FMPG, real estate, and online games. Auto advertising has started this quarter and will be able to grow along with auto sales in the second half of the year of 2010. In real estate, a series of new government recognitions on the property markets that were designed to deflate the possibility of a bubble did serve to decrease the construction volume in big cities. However, we have not seen a material effect on our business. And we have been seeing increasing revenue contributions from the second tier cities.

Recovered from the global financial crisis, we have seen manufacturers of IT industry and telecom industry, as well as mobile operators aggressively increasing their online marketing spending to promote new products and applications. Revenues from fast moving consumer goods experienced a solid growth in the second quarter, and we expect a steady full year growth benefited from marketing bursts around World Cup, Shanghai Expo, Asian Games, as well as online video growth.

In terms of the guidance, we expect gross brand ad revenue before business tax in the third quarter of the year of 2010 to reach approximately $62 million to $64 million and net brand ad revenues will reach approximately $57 million to $59 million, representing a 16% to 20% year-over-year growth.

Now I’d like to turn the call over to our CFO, Carol Yu, who will take you through the quarter’s financials. Carol?

Carol Yu

Thank you, Belinda. And hello, everybody. I would like to walk you through our financials for the second quarter. One, revenues. Total revenues were $146.1 million, up 15% year-over-year and 13% sequentially, and exceeded our expectations. Brand advertising revenues were $53.2 million, up 22% year-over-year and 35% quarter-over-quarter.

Online game revenues were $77.7 million, up 17% year-over-year and 8% quarter-over-quarter. Wireless revenues were $11.1 million, a sequential decrease of 17% and a year-on-year decrease of 26%. The decrease was mainly attributable to the full quarter impact of the implementation of several measures to tighten control over wireless value-added services by network operators.

Most of the remaining figures I’ll be discussing will be non-GAAP. The impact of share-based awards, including share-based compensation expense and related non-cash income tax expense, are charged to the quarter's cost of revenue, operating expenses and income tax expense. For the second quarter, the total share-based compensation was $6.5 million and the non-cash income tax expense was $0.6 million.

We believe excluding the impact of share-based compensation awards from our non-GAAP financial measures of net income makes a more meaningful comparison of Sohu's operational results and improves investors' understanding of our performance. So we will also use non-GAAP measures in this discussion to explain margins, cost, and expense items.

Two, gross margins. Non-GAAP gross margin for the second quarter was 74%, which compares to 75% last quarter and 78% in the second quarter of last year. Brand advertising non-GAAP gross margin for the second quarter was 60%, which compares to 59% last quarter and 68% in the same period of last year. The decline from the second quarter of 2009 was mainly due to increased bandwidth costs and amortized video content costs relating to our video strategy.

Online game non-GAAP gross margin was 91% for the second quarter, which compares to 93% last quarter and 94% in the second quarter of last year. Wireless non-GAAP gross margin for the first [ph] quarter was 48%, which was unchanged from last quarter and increased from 45% in the same period of last year. The year-on-year improvement was mainly due to our reduction of some distribution channels with higher revenue share.

Three, operating expense. Non-GAAP operating expenses for the second quarter of 2010 totaled $50.8 million, which was increase of 18% over the last year and 17% from the same period last year. The higher operating expense compared to last year was primarily due to an increase in marketing expenses. Operating margin. Non-GAAP operating margin was 39%, which was down from 42% last quarter and 43% in the second quarter of last year.

Five, income tax expense. Non-GAAP income tax expense was $5.7 million as compared to $7.4 million last quarter. Under US GAAP, we also recorded non-cash income tax expense of $0.6 million relating to share-based compensation awards for the second quarter.

Six, net income. Before deducting the share of net income pertaining to the Non-Controlling Interest, non-GAAP net income was $52.5 million, $2 million ahead of our expectation, up 9% as compared to last quarter and up 7% from the same quarter of last year. After deducting $15 million for the share of net income pertaining to our Non-Controlling Interest, non-GAAP net income was $37.5 million or $0.96 per fully diluted share, which was ahead of our expectations and representing an increase of 11% compared to last year.

Seven, net margin. Non-GAAP net margin before deducting the share of net income pertaining to the Non-Controlling Interest was 36%, which was a slight decline from 37% last quarter and 39% in the second quarter of 2009.

Eight, moving over to the balance sheet and cash flow statement, we continued to maintain a debt-free balance sheet for the second quarter. We generated $57.6 million in operating cash flow. As of June 30, 2010, our cash balance was $599 million. Our net accounts receivable was $62 million. The brand advertising DSO for the second quarter of 70 days is compared to 73 days in the previous quarter and 73 days in the second quarter of 2009. Receipt in advance and deferred revenue within the online game business totaled $34.3 million, which compares to $27.4 million as of the end of last quarter.

Nine, our outlook for the third quarter of 2010 is as follows. We expect total revenues to be between $153 million to $158 million, with advertising revenues of $61 million to $63 million. Brand advertising revenues to be between $57 million to $59 million. This implies a 8% to 11% quarter-over-quarter growth or a 16% to 20% year-over-year growth. Online game revenues to be between $80 million to $83 million.

Before deducting the share of non-GAAP net income pertaining to the Non-Controlling Interest, we estimate our pro forma non-GAAP net income to be between $54.0 million and $56.5 million as compared to $52.5 million for the second quarter, as mentioned before. After deducting the share of non-GAAP net income pertaining to the Non-Controlling Interest, we estimates non-GAAP net income for the third quarter of 2010 to be between $39 million to $41 million, and non-GAAP fully diluted earnings per share for the third quarter of 2010 to be between $1.00 and $1.05.

Assuming no new grants of share-based awards, we estimate compensation expense and income tax expense relating to share-based awards for the third quarter of 2010 to be between $6.5 million and $7.5 million, which includes $1.5 million to $2.0 for Changyou. Considering Sohu's shares in Changyou, the estimated impact of this expense is expected to reduce Sohu's fully diluted earnings per share for the third quarter of 2010 under US GAAP by $0.16 to $0.18.

In conclusion, we are pleased with our second quarter results and are optimistic about the remainder of the year. Both of our core businesses are developing well. Traction in our brand advertising business is picking well, as we increasingly provide higher value advertising solutions to our advertising partners around China.

With the growing Internet user base in China, including the 255 million people watching online video, we believe the opportunities are limitless for us given the strong balance sheet, widely known brand name, and comprehensive platform. Changyou performance is encouraging, as new feedback-driven content updates help to retain existing users and attract new ones to diversified portfolio updates. All in all, we have no doubt that we will be able to achieve sustainable growth and deliver value to our shareholders over the long-term.

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

Question-and-Answer Session

Operator

Thank you, madam. (Operator instructions) The first question comes from Alicia Yap from Citigroup. Please go ahead.

Alicia Yap – Citigroup

Hi. Yes, good morning and good evening. My question is related to the online video. So can you share with us the traction which you have seen on the online video initiative? Particularly, any color you could give us on the percentage of brand ad revenues coming from online videos? And what percent of contribution do you expect the video to grow into by the end of this year? What are some of the industries that are attracted to advertise on the videos? And lastly, how much do you plan to invest in video content cost for the rest of the year?

Carol Yu

Actually we expect our online advertising revenue from video contents will triple this year compared to the revenue last year. So in terms of the advertisers, we see a lot of the revenue growth and even the new budget allocation from the advertisers in different industry categories, especially in FMCG, auto – yes, and even in some high-tech [ph] advertisers.

Charles Zhang

We won’t be able to give out the percentage of advertising amount coming from online video part.

Alicia Yap – Citigroup

What about the cost that you plan to invest for the rest of the year?

Charles Zhang

You mean the spending?

Alicia Yap – Citigroup

Yes, the spending.

Carol Yu

We intend to spend, from a cash flow standpoint, about $15 million to $20 million of cash. But that would not be hitting our profit and loss entirely for the whole year because there could be some purchases that will be forward buy into next year. For example, like what Charles has said, we will be buying Korean TV drama series out of Korea for the next three years. So for the amortized cost this year, it won’t be a lot.

Alicia Yap – Citigroup

I see. Can I actually just add one more question? Can you update us in terms of any plans of your cash use, any other interesting areas that you plan to build or some strategic investments?

Carol Yu

No. I think we would be very cautious when we look at how do we use our cash, and we don’t have any specific plans in mind yet. But it will be all surrounding the media and the Internet platform.

Alicia Yap – Citigroup

Thank you so much.

Operator

Thank you. The next question comes from Eddie Leung from Merrill Lynch. Please go ahead.

Eddie Leung – Merrill Lynch

Good evening. Thank you for taking my call. I have two questions. The first one is related to online video as well. What would be the competitive advantages for you guys over the pure-play in online video?

Charles Zhang

Well, I think we are – we offer proprietary – I mean, we offer contents with copyrights. And we fight piracy so that – this is the – you know, we have this high standard, a moral standard, and also high standard for the technology – for the high-definition technology. So you will see a more clear picture and also stable bill rate because of our infrastructure buildup. And also we offer – because we are broadcasting copyrighted content, we are able to – we have the best quality content, means that the picture will be very clear because we’ve bought it instead of stealing from somewhere, and also not only domestic content, but also international content from Hollywood with very accurate subtitles.

So basically it’s – our video strategy will be to provide quality, copyrighted, good content that is long and very clearly defined categories for users to navigate and to use so that Sohu video already forming this brand. And if you want to see the latest TV dramas, episodes and with high quality, then you go to Sohu, you turn on Sohu. This is already – this brand has already been formed. On pure-play, probably more – I mean, more chaotic and also very experienced and also facing a lot of lawsuits, legal lawsuits, and also advertisers will have a second thought about whether to advertise because it’s the intellectual property issue.

Eddie Leung – Merrill Lynch

Thank you, Charles. And then just another question on the capital expenditure, could you share with us your capital expenditure schedule related to the new office in DC as well as in the upcoming couple of years? Thanks.

Carol Yu

You mean the office building that we bought?

Eddie Leung – Merrill Lynch

Yes, Carol. Thanks.

Carol Yu

It’s about $110 million. I think up till now, we’ve probably paid 40% – 40%, 45% of that, and then with the remaining depending on the progress of the building over the next two years.

Eddie Leung – Merrill Lynch

Got it. Thank you very much.

Operator

Thank you. (Operator instructions) The next question comes from Jenny Wu from Morgan Stanley. Please go ahead.

Jenny Wu – Morgan Stanley

Thank you for taking my call. We've had a lot of surveys about the impact from World Cup. Just wanted to hear the highlights from you such as how Sohu has been impacted by World Cup, such as how many advertisers you secured and how much is the advertising revenue and traffic you have generated, and what kind of products –?

Carol Yu

Jenny? Jenny, we can’t hear one word from you.

Jenny Wu – Morgan Stanley

Okay, let me repeat again. Is it better now?

Charles Zhang

Yes. Speak louder and slowly.

Carol Yu

Slowly because the line is cutting in and out.

Jenny Wu – Morgan Stanley

Oh, sorry about that. Okay. It’s about the World Cup. Basically, I just want to hear your highlights about how much you were impacted by the World Cup, such as how many advertisers you have secured, how many advertising revenues and profits you generated, and what kind of online products are most popular and what kind of traffic growth, something like that. Thank you very much.

Belinda Wang

Yes. Actually we are pleased to see World Cup addressed over 40 countries and advertisers to our World Cup side in the sports channel. Our past sponsors I think are clearly China Telecom, Unilever, Dongfeng Auto, Adidas and Lenovo. So I think the World Cup proves again the importance of the hot sports events in terms of driving the number of users traffic and then revenue. So we actually will not give out the exact revenue numbers. However, I think it was the second biggest sport event only after the 2008 Beijing Olympic Games in terms of revenues and the number of sponsors and advertisers. Regarding your question about the new content, actually in the World Cup – in our coverage on the World Cup, there were some interactive events like blogs, writing blogs, report of World Cup by Twitter, something like that possibly attracted by the users. Mini blog.

Charles Zhang

Yes, the mini blog.

Jenny Wu – Morgan Stanley

Okay. How about the traffic growth and how much the momentum that you think it will sustain in the third and fourth quarter?

Belinda Wang

It’s very impressive, but we won’t disclose that for competitive reasons.

Jenny Wu – Morgan Stanley

Okay. Just on your feedback profile, how many advertisers you secured from that event will stay for the rest of the year?

Belinda Wang

Actually we are pleased to see some new advertisers allocate some products that we could contract [ph] for the World Cup and we will see to sustain the investment for the rest of this year.

Jenny Wu – Morgan Stanley

Okay. Thank you very much.

Operator

Thank you. The next question comes from Wallace Cheung from Credit Suisse. Please go ahead.

Wallace Cheung – Credit Suisse

Hi, good evening. Thanks for taking my questions. Just a quick question on the balance sheet items, it seems like –

Charles Zhang

Could you speak louder?

Wallace Cheung – Credit Suisse

Sorry about it. Okay. Just quickly on the balance sheet items, first of all, on a quarterly basis, the cash balance is relatively flat. Is this because of the investment in the new building? And also it seems like the other assets also jumped by quite a lot. Is that also related to the new building as well [ph]?

Carol Yu

Yes. That’s the prepayment that we made – contract payment that we made on the new building.

Wallace Cheung – Credit Suisse

Okay, thank you. Just quickly, let’s say, within 2010 how much further of the $110 million that are we going to spend for this year?

Carol Yu

For this year? Maybe another $10 million, $20 million, depending on the progress.

Wallace Cheung – Credit Suisse

Okay. So the remaining part will be spent (inaudible) as well?

Carol Yu

I can’t hear you.

Wallace Cheung – Credit Suisse

Sorry. The remaining part of the investment will be spent in 2011?

Carol Yu

Yes. The balance will be over the next two years.

Wallace Cheung – Credit Suisse

Okay, great. Just the final more quick one is, can you update on search business? It seems like it’s growing easily at around 30% something, but still a little bit maybe into the growth rate behind Baidu. Can you give us a further update about this?

Carol Yu

The search is a very small part of our business. The uptick in Q2 is primarily due to seasonality. There is nothing special about it. And obviously it’s not yet competitive or comparable to Baidu.

Wallace Cheung – Credit Suisse

Okay. Thank you.

Operator

Thank you. The next question comes from Kathy Chen from Goldman Sachs. Please go ahead.

Kathy Chen – Goldman Sachs

Hi, thanks for taking my question. I had a question on the branded advertising revenues. Could we just check if the four-year outlook is still around 20% revenue growth? And then related to that, specifically on the property segment, in the prepared remarks you said that you haven’t seen any impact so far from the policy changes. Can you just share if you’ve seen any slowdown in the recent months and what are the expectations for the second half for that particular segment? Thank you.

Belinda Wang

You are asking about the real estate vertical, right?

Kathy Chen – Goldman Sachs

Yes.

Belinda Wang

Actually in the real estate, as we mentioned in the earlier script, in terms of new government regulations on the proxy market was designed to try to deflate the possible bubble. And it’s did decrease the transaction volume in big cities, especially in the first tier basis. However, we have not seen a material impact on our revenue, our real estate ad business. That (inaudible) our focus is going to be more proactive in the second tier cities.

Kathy Chen – Goldman Sachs

Okay. And then can I just track what the updated total branded advertising revenue guidance is? I think the previous guidance was 20% for this year. Is that still the same?

Carol Yu

We don’t have any plans to change that guidance, at least not yet.

Kathy Chen – Goldman Sachs

Okay. Thank you.

Operator

Thank you. The next question comes from Wendy Huang. Please go ahead.

Wendy Huang – RBS

Hi, thanks for taking my question. Charles, can you maybe give us some color on your mini blog searches? How do you view the potential of this media platform? And what’s your view on the recent government crackdown on some mini blog service providers? Thank you.

Charles Zhang

For Sohu’s mini blog, we are a latecomer, with our competitor actually launching the product almost more than six months ahead of us. So we started to offer small base, but with our historically strong blog user base, we actually have some advantage, and also with technology – in Sohu’s technology-driven culture. So we are actually able to pick up quickly. But the Twitter-like products in China, it’s – we hope that it will – more into a technology-driven and social network-oriented products instead of a strong media offering. So it’s – so we actually basically stopped our – closed our search function and made sure that all the new members developed are through this connection, migration or basically a gradual development.

So I think – and also we emphasize the application with mobile phones. So that’s also an area that heavy development undergoing. So we look at the Twitter-like products, which is the mini blog in China, Sohu has a strong advantage because of our team has a history of giving the blog with strong technology. And we view the mini blog as a long-term battle, and we will take a long-term view about it and we believe that this product will have a long – very good return but with proper management. And also basically the – let it grow in a very steady and solid way with user acquisition, with this organic growth of our user acquisition, new position [ph] and a Sohu network type development rather than it’s a media aspect.

Wendy Huang – RBS

So what’s the user base of your mini blog services? And what do you think should be a meaningful user base for you start monetizing from it?

Charles Zhang

We actually start off with a small base and we – so I’m not ready to release the mini blog data. It’s still in early stage and still not comparable with our competitors, but it’s a good future. And in terms of business model, I think it’s not going to be – I don’t think it is advertise-based. I think it’s probably – but we will search for the right business model (inaudible) but I think it will definitely increase the stickiness of the overall Sohu portal and also a strong application for mobile phones. So it will probably in the future a mix of advertising and by mostly subscription based business model, but we don’t know. We are still exploring. And it’s too early to talk about business model right now.

Wendy Huang – RBS

Thank you.

Operator

Thank you. (Operator instructions) The next question comes from Steve Weinstein from Pacific Crest. Please go ahead.

Steve Weinstein – Pacific Crest

Great. Thank you for taking my question. Two things. First, can you tell us what exchange range you used for Q2 and what’s implied in your Q3 guidance? Also, I’m curious if you can give us some context around what’s going to cost you to kind of promote a major game. So if you look at Duke of Mount Deer, when you do take that game for launch, what do you think your marketing budget is going to need to be to make that successful? Can you put any context with maybe what you’ve spent on TLBB just a few years ago? Thanks.

Carol Yu

For the exchange rate, the rate will be from 6.83 to 6.76 to where we are today and based on the timing of the transactions. And obviously the exchange rate that we use for Q3 guidance would be 6.76 as of today. And your second question regarding Duke of Mount Deer, I will turn it over to Wang Tao to answer.

Tao Wang

In terms of the marketing cost of the major games nowadays in China, obviously when you compare with (inaudible) quite significantly. On one hand, as the – because of online advertising grew up, of course that grows up along together with the growing of the user base of the overall online gaming industry as well. But strategically, for DMD in terms of talking about a concrete budget, as we are now formulating the overall marketing strategy for the DMD, so right now it’s still early for us to comment on that. But since DMD is our second in-house developed game, so we believe it would work well for us to spend those relevant marketing dollars to that, given the fact that we have already impacted (inaudible) in terms of the R&D level and be competent on the game. Thank you.

Steve Weinstein – Pacific Crest

Okay, thanks.

Operator

Thank you. The next question comes from Mr. Muzhi Li from Mizuho Securities. Please go ahead.

Muzhi Li - Mizuho Securities (Asia)

Hello, thank you for taking my questions. I would like to follow up on the search. Would you please tell – would you please give some color on the current market share for the Sogou browser?

Carol Yu

Sogou browser right now is around 10%.

Muzhi Li - Mizuho Securities (Asia)

Okay. And how much does Sohu invest in the Sogou platform from the Pinyin to the search and to the browsers each year?

Charles Zhang

I think we have the benefit of a very popular Sogou Pinyin input so that based on that we are able to achieve – we are able to achieve a 10% dollar market, I mean, rich. Probably people make not necessarily only using that 10% – users to only use Sogou browser. They may be using other browser at the same time, so what I mean by the rich 10%. So the – we are still forming our search strategy. We are still in the state of forming our search strategy. And I think we are not clear – we are not sure how much will invest in marketing, but basically our Sogou Pinyin method is a good platform to launch browser and then eventually including the search – I mean, as a gateway for people to use Sogou search.

Muzhi Li - Mizuho Securities (Asia)

Okay. Thank you very much.

Operator

Thank you. (Operator instructions) The next question comes from Dick Wei from JPMorgan. Please go ahead.

Dick Wei – JPMorgan

Hi, thanks for taking my questions. My question is on the video content spending. Earlier you mentioned that the cash spending is around $15 million to $18 million per quarter. I wonder how it would track –

Carol Yu

Not per quarter, for the whole year, Dick.

Dick Wei – JPMorgan

Okay. That’s for the whole year. Okay. And so what about the content cost? Has there been any stabilization in terms of content cost? And from accounting margin-wise, how should we look at later this year and next year about margin trends?

Carol Yu

The $15 million to $20 million is from a cash flow standpoint. Amount cost to the current year is very acceptable compared to the revenue that we are bringing in. The impact of higher costs is coming from the bandwidth because we are seeing very good traffic for that. (inaudible) we expect something stable from the current level.

Dick Wei – JPMorgan

Okay. Great. And as a quick follow-up, in terms of the video revenue, how much would you quantify as coming up from the new advertisers, or how much would you say that is more from the cannibalization of their systems kind of brand advertising?

Carol Yu

That’s roughly a calculation. I think the 40% comes from the new advertisers and the 60% from the, yes, mature advertisers.

Dick Wei – JPMorgan

Okay, great. Thank you.

Operator

Thank you. We have a follow-up question from Wendy Huang from RBS. Please go ahead.

Wendy Huang – RBS

I just wonder how will you compare the Pinyin client software with IM software and what’s the long-term potential of that (inaudible) penetrate into the home PC. Thank you.

Carol Yu

I can’t hear you.

Charles Zhang

Speak louder.

Wendy Huang – RBS

Yes. I just wonder how you compare the Pinyin client software versus IM, instant messaging client software, which was targeting the home PC users. And obviously you already have the high penetration for your Pinyin services.

Charles Zhang

I think input basic needs for people to use a PC and it’s very basic. I think it’s probably more basic than IM. But IM is more sticky. Once you have the IM and you have the groups, it’s very hard to make – to switch. The user has a high switching cost. So each has its advantages and disadvantages. So definitely Sogou Pinyin is one of the very important platform for Sohu matrix in the future.

Wendy Huang – RBS

Okay. And Carol, can you maybe expand why your online advertising gross margin rebounded 2 percentage points sequentially in Q2? That’s all. Thank you.

Carol Yu

Because a lot of the cost effects and with the growth with the rebounding revenue, the increase or rebound of gross margin is expected.

Wendy Huang – RBS

Okay. Thank you.

Operator

There seems to be no more further questions. Please continue with any other points you wish to raise.

Tip Fleming

Thank you all for joining the call today. If you have any further questions, please don’t hesitate to contact the management team directly. Thank you for joining.

Operator

This concludes the Q2 2010 Sohu earnings conference call. Thank you for participating. You may now disconnect.

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Source: Sohu.com Inc. Q2 2010 Earnings Call Transcript
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