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Sohu.com Inc. (NASDAQ:SOHU)

Q4 2006 Earnings Call

February 5, 2007 8:00 pm ET

Executives

Brandy Piacente - Investor Relations

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

Carol Yu - Co-President, Chief Financial Officer

Analysts

Jason Brueschke - Citigroup

Dick Wei - JP Morgan

James Mitchell - Goldman Sachs

Wallace Cheung - Credit Suisse

Ming Zhao - SIG

Nat Schindler - Piper Jaffray

William Bao Bean - Deutsche Bank

Lin Chi - Lehman Brothers

Richard Ji - Morgan Stanley

Presentation

Operator

Thanks so much for holding everyone and welcome to the Sohu fourth quarter 2006 earnings conference call. Just a reminder, today’s conference is being recorded. And now, for opening remarks and introductions, I would like to turn the conference over to Brandi Piacente with the investor relations group at Sohu. Brandi, please go ahead.

Brandi Piacente

Thank you for joining Sohu.com to discuss our 2006 fourth quarter and fiscal 2006 results. On the call today are Dr. Charles Zhang, Chairman of the Board and CEO; and Ms. Carol Yu, Co-President and 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 are 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.

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Dr. Charles Zhang

Thank you, Brandi. Hello, everyone. Welcome to Sohu's 2006 fourth quarter financial results call. First, I would like to begin today by announcing some key executive management promotions.

Effective February 5th: Belinda Wang, Senior Vice President of Sales and Marketing, was promoted to Co-president and Chief Marketing Officer; Dr. Yu Gong, Senior Vice President of Focus.cn and Wireless, was promoted to Chief Operating Officer; and lastly but not least, Carol Yu, who is joining me today on this call, was appointed to the additional position of Co-President.

Each of these individuals have played a critical role in Sohu's success. Please join me in congratulating them on their achievements.

Next, I would like to comment on some monumental strides that Sohu took in 2006 that will set the stage for even more impressive offerings to come.

We have successfully reengineered Sohu into a technology-focused company. With a comparatively small technology team of 200 colleagues, our achievements have been extraordinary and they reflect our visionary leadership in our markets.

We are very proud of our launch of Sogou 3.0 enhanced version, which clearly positions Sogou as one of the best Chinese search engines.

Sohu is a recognized leader in online video content and we are reinforcing this leadership with our peer-to-peer streaming technology for both live broadcast and video on demand, and Sohu Blogs has also gained in popularity, due to its my space personal space nature.

To accelerate and bolster Sohu's technological advantages, I am also pleased to announce that we are in the final negotiations with Zhejiang University to establish a joint laboratory to develop even more advanced technologies to drive leading developments in China’s Internet space.

The next main point that I would like to address is Sohu's progress and outlook for our brand advertising. Brand advertising grew 35% year over year in 2006, attributable to China’s robust online advertising market and the heightened activity related to the World Cup last summer.

Our outlook in brand advertising remains bullish for 2007, and of course 2008, not only because of the continuing growth in traditional high-spend sectors, such as automobiles, along with accelerating conversion by sectors in fast-moving consumer goods that have traditionally focused on television advertising, but also our unique status as Internet sponsor of the Beijing 2008 Olympics, which I will highlight momentarily.

So stay tuned for more exciting developments with regard to Sohu's technological focus and brand advertising emphasis in the year to come.

Now, let me discuss the progress of our main business lines last year.

Beginning with advertising: overall, we experienced a good quarter, driven by high brand advertising revenues. Advertising revenues for the fourth quarter were $24.9 million, up 4% quarter on quarter and 23% year on year, meeting the high-end of our guidance. For fiscal 2006, advertising revenues grew by 29% year on year, meeting our guidance of 25% to 30% growth.

Brand advertising revenue was $22 million, representing a sequential increase of 5% and a year-on-year increase of 30%, meeting the high-end of our guidance. For fiscal 2006, brand advertising revenue grew by 35% year on year, exceeding our guidance of 30% growth.

Sponsored search accounted for $2.9 million, representing a sequential growth of 3% and a year-on-year decline of 14%. For fiscal 2006, sponsored search revenue grew by 3% year-on-year.

In brand advertising, Sohu continues to attract more high-profile advertisers, mainly due to our increased branding and penetration into sports and video content areas. In 2006 Q4, we increased our number of advertisers by more than 35% year on year to over 630 advertisers.

Revenues continue to be driven by heavy spending sectors such as automobiles, real estate, and information technology. The sectors that experienced the fastest growth for the quarter were education, clothing and accessories and financial services.

More specifically, I would like to highlight three key areas that are leading us to robust growth opportunities in our brand advertising business for 2007 and beyond.

First, Beijing 2008 Olympics is the most important differentiating factor between Sohu and other Internet companies. Everyone would agree that the Olympics is the single most significant factor accelerating the advertising market in China over the next few years. As the only Internet sponsor of the Beijing 2008 Olympics, Sohu is the sole authorized Internet company that can partner and execute joint marketing activities with other partners and sponsors. This is a huge catalyst for our advertising business, and one that will ensure our leadership position in the market.

From now until August, 2008, various activities surrounding the Olympics will heat up significantly, which include major events such as volunteer programs, torch relay, and billing of opening and closing ceremonies, and test games signifying completion of various stadiums.

By participating in such joint marketing activities, Sohu will not only significantly enhance its brand value but also drive advertising revenue from the more than 40 Olympic partners and sponsors.

Although other Internet companies can still report on Olympic events and will still be able to attract ad revenue, Sohu has three distinctive advantages over them: first, we will have first-hand access to exclusive content of this event through the operation of the Olympic official website; second, for the local partners and sponsors of Beijing 2008 Olympics, they can only use their joint Olympics logos on Sohu and not on other Internet companies; thirdly, our strategic cooperation with CIS Sports, a company under the National Sports Bureau, enable us to tap into the pool of elite athletes that play a critical role in the successful promotion of these marketing activities.

The power of this operation was proven during the Asian Games. Sohu produced a high-profile TV-like program called “From Doha 2008” in which Sohu was able to interview approximately 50 medal-winning athletes right after their matches.

Due to the critical importance of the Olympics, competitors have been aggressively trying to make in-roads into this area, but we are pleased to report that the Beijing Organizing Committee of the Olympic Games has been very supportive in defending our rights against attempts of ambush marketing, and the efforts have proven to be effective.

Second, Sohu's leading position in online video content is becoming increasingly well-recognized by Internet users and advertisers. The impact of online video is becoming one of the most profound factors in the Internet spaces in China.

According to a CNNIC report, Chinese broadband users in 2006 have exceeded 100 million and accounted for 74% of total Internet users. The increased broadband penetration has led to increased demand of video content as well as video advertisements. In 2007, we believe viewing entertainment and sports video content will increasingly become a routine activity for a large part of the Internet population.

As I mentioned earlier, with our pioneering proprietary peer-to-peer streaming technology, we have successfully provided video on demand and live broadcast in programs through our two dedicated video channels, B-Channel and S-Channel. Our superior technology supports an increasing number of viewers with less broad bandwidth. We are also providing viewers with a superior online experience.

Our B-Channel, launched in August, 2006, aims to integrate entertainment elements of traditional media, Internet, and TV platforms. We are building our own editorial team so as to provide users with unique original content in video format.

Our S-Channel, launched in October, 2006, continues to focus on games such as NBA and other game events. For a live NBA regular season webcast, along with nightly game recaps starting in early November, peak total viewers have exceeded 1 million per game with [inaudible] playing.

Page views of both video channels in the fourth quarter increased 30% sequentially.

For the fourth quarter of 2006, our rich media advertising revenue increased 40% quarter on quarter. Also, among all types of rich media advertising, video advertising has increased 150% quarter on quarter. Rich media ads attract high-profile advertisers who previously were heavy ad spenders in TV platforms, especially from auto, FM, CG, and IT sectors. A few select examples are Sony Ericcson, Microsoft, Intel, IBM, Toyota, and [Tsingtao] Beer.

We believe rich media ads, including video ads, will become an even more popular form of advertisement in 2007, and Sohu is well-positioned to take advantage of this growth opportunity.

Third, effective integration of Sohu's superior technology-driven product is a key driver of our online advertising business. In order to further enhance the stickiness of Sohu websites, we have been integrating our community-based products with our traditional content. An example is Sohu Blog, which has successfully been integrated with more Sohu products, such as photo albums and enhanced music box in order to provide a superior user experience with better and personalized features. Users now can customize their blog front pages by having more choices of their favorite Sohu products and enable this front page to become a personalized portal, similar to MySpace or My Yahoo!.

In the fourth quarter of 2006, page views of Sohu Blogs increased 70% sequentially and registered blog users increased about 50% sequentially. According to third-party statistics, we are rapidly bridging the gap with our major competitors. The user penetration of Sohu Blog increased from approximately 15% of the blog of our major competitor in June, 2006, to approximately 50% in December of 2006.

As a result of the seamless integration of Sohu product offerings, we are able to provide advertisers a total solution of Web 1.0 and Web 2.0. By providing advertisers these options, we continue to see a high rate of Web 2.0 monetization. The revenue from Web 2.0 products in the fourth quarter increased by 60% sequentially. We are pleased with the results of this metric of our business.

For 2007 outlook, based on our current visibility, we expect the full year brand advertising revenue to grow 30% year on year. We will periodically update this guidance in the year if necessary, when we have further visibility of the positive impact of the Beijing 2008 Olympics.

Turning to sponsored search, we experienced a 3% sequential revenue increase and a 14% revenue decline year on year. As I mentioned in my opening remarks, we successfully launched Sogou 3.0 on January 1, 2007. It is the first search engine with a database of 10 billion retrieved Chinese web pages. With expanded database capacity, faster updating speed and the enhanced search relevancy and accuracy, Sogou’s page-crawling speed has increased significantly to 500 million pages per day.

According to our internal data, the traffic in the first month of launch grew by 20%. We believe this does not yet fully reflect the merge of Sogou 3.0 upgrade.

In China, most of the Internet subscribers use Chinese language for their daily computing activities. It is essential to install the desktop software in order to type Chinese on English keyboards.

By leveraging our Sogou search technology, we have launched our Sogou Chinese Character input method software, Sogou Pinyin Version 2.0. On January 29, 2007, a vocabulary database of Sogou Pinyin was tied to the search query database of Sogou, and thus it can capture the latest Chinese words used by Internet users.

This application has been well-received by Chinese Internet users. After this launch in June, 2006, active daily users increased by 60% to 100% for the third and the fourth quarter of 2006. Sogou Pinyin Version 2.0 was launched on January 29, 2007.

We will continue to carefully control our monetization rates and plan to monetize Sogou more aggressively only when its traffic levels significantly increase.

Turning to our wireless business, we experienced a decline of 24% quarter on quarter and 7% year on year. The decrease was mainly due to the full quarter impact of regulatory implementation of double confirmations on the SMS monthly subscriptions and further strengthening of a billing process and procedures by certain provincial mobile network operators.

We would like to reiterate that although the wireless services environment in China continues to be volatile, it is important for Sohu to maintain our presence in this industry, and more specifically in WAP, so that we are well-positioned for the much-anticipated imminent launch of the 3G mobile networks in China.

By leveraging our core content strengths, we believe we can effectively maintain enough of a presence to capture the future growth in key wireless segments. In addition, Sohu is well-positioned to minimize the risks associated with this sector and it only represented 20% of our total revenue in the fourth quarter of 2006.

Lastly, on the corporate side, we have purchased seven floors of the Beijing headquarters, totaling about 18,000 square meters, for $35.3 million, by utilizing the cash on our strong balance sheet. We believe this strategic purchase will not have a material impact on our net profit and will enhance our operating cash flow going forward. We expect this purchase to further boost the sense of belonging of our staff and to facilitate our recruitment of talent.

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

Carol Yu

Thank you, Charles. Hello, everyone. I would like now to take the opportunity to discuss some key financials for the fourth quarter and fiscal 2006. One, revenues. We are pleased to report total revenues of $34.4 million for the fourth quarter, which is in range with our guidance.

Advertising: with advertising revenues of $24.9 million, we experienced a sequential increase of 4% and year-on-year increase of 23%. In fiscal 2006, total advertising revenue of $91.8 million grew 29% year on year.

Brand advertising revenues were $22 million, representing a sequential increase of 5% and year-on-year increase of 30%. For fiscal 2006, brand advertising revenues grew 35% year on year to $79 million.

Two, wireless: for the fourth quarter, wireless revenues were $6.8 million, down 24% quarter on quarter and down 7% year on year. For fiscal 2006, total wireless revenues were $32.6 million, growing 24% year on year.

Let me give you a breakdown of wireless revenues in the fourth quarter. SMS revenues decreased 39% to $3.2 million as compared to the previous quarter. [inaudible] revenues were $2.3 million, down 9% from the previous quarter, and MMS, IBR, and ringback tone services combined were slightly up at $1.3 million, which is slightly up from the previous quarter.

Three, other revenues: other revenues mainly included online game revenues, which declined 5% sequentially and grew 24% year on year to $2.1 million.

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-123R. Total share-based compensation expenses for the fourth quarter 2006 were $2 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 user understanding of Sohu's performance, we use non-GAAP measures to explain the low margin, cost and expense items.

Overall, non-GAAP gross margin for the fourth quarter was 65%, relatively stable from the 66% in the previous quarter and down slightly from the 68% in the fourth quarter of 2005.

In fiscal 2006, overall gross margin was 66%, down from 69% in fiscal 2005.

Advertising non-GAAP gross margin was 66% in the fourth quarter, down from 71% in the previous quarter and a decline from 74% in the period last year. In fiscal 2006, advertising gross margin was 71% compared with 75% in fiscal 2005.

Brand advertising non-GAAP gross margin for the fourth quarter was 70%, down from 73% in the previous quarter and down from 75% in the same period last year, primarily due to increased content costs, headcounts, bandwidth and server depreciation costs.

Sponsored search non-GAAP gross margin for the fourth quarter was 43%, down from 58% in the previous quarter and 68% in the same period last year, primarily due to the increase of revenue sharing to website alliances, bandwidth and server depreciation costs.

Non-advertising non-GAAP gross margin was 60% for the fourth quarter, an improvement from 57% for the previous quarter and 55% in the fourth quarter of last year. The improved gross margin was primarily due to the increase of margin of online game and an increase in wireless gross margin due to control of content costs. For fiscal 2006, non-advertising gross margin was 56%, flat from fiscal 2005.

Operating expenses for the fourth quarter, Sohu's non-GAAP operating expenses totaled $14.5 million, down 6% from the previous quarter and up 4% year on year. The quarter-on-quarter decrease was mainly due to a decrease in bad debt, expenses and professional fees.

The year-on-year increase was primarily due to our increased reinvestment in research and development, increase in marketing expenses and branding, and increase in headcount and salaries, particularly for research and development.

Operating margin: non-GAAP operating margin in the fourth quarter was 23%, unchanged from the previous quarter and up from 21% in the same period last year. GAAP operating margin in the fourth quarter was 17%, flat from the previous quarter.

Income tax expense: income tax expense in the fourth quarter was $0.5 million, as compared to $0.4 million in the previous quarter.

Six, net income: non-GAAP net income for the fourth quarter was $8 million, or $0.21 per fully diluted share. This compared to net income of $8.5 million, or $0.22 per fully diluted share for the previous quarter, and $8.9 million, or $0.23 per fully diluted share for the fourth quarter of 2005.

GAAP net income for the fourth quarter of 2006 was $6.1 million, or $0.16 per fully diluted share compared to $6.6 million, or $0.17 per fully diluted share in the previous quarter.

Seven, balance sheet: let me now make a few comments on the balance sheet. As of December 31, 2006, Sohu's balance of cash, cash equivalents, and investments in marketable debt securities was $130 million, compared to $120 million as of September 30, 2006 and $133 million as of December 31, 2005.

After purchase of our Beijing headquarters by utilizing our cash surplus, our cash and cash equivalent balance will be reduced to $95 million. We believe this is adequate for our operational needs. Nonetheless, we did not exclude the possibility to obtain certain stand-by financing if such is available on attractive terms.

As of December 31, 2006, our net accounts receivable balance was $23.8 million, a decrease of $2.1 million as compared to last quarter. This includes $15.2 million related to our brand advertising business and $7.1 million related to our wireless business.

During the fourth quarter, we had a record high collection of sales proceeds for our branded advertising business totaling $27.6 million. Our DSO for the fourth quarter was 62 days compared to 72 days for the previous quarter and 62 days for the fourth quarter of 2005. Fourth quarter brand advertising DSO was 58 days compared to 66 days for the previous quarter and 77 days for the fourth quarter of 2005. This demonstrates our efforts in closely monitoring our accounts receivable are paying off.

As of December 31, 2006, our bad debt provision amounted to $1.6 million, compared to $1.8 million as of September 30, 2006. While we consider this level of bad debt provision to still be relatively low compared to our level of advertising sales, we continue to remain prudent in our revenue recognition policy and stringent in our credit extension.

Nine, finally, our business outlook. You will find detailed guidance for the first quarter 2007 in our earnings press release, but I would like to highlight several key metrics.

Sohu estimates total revenues to be between $32 million to $34 million, with advertising revenues of $25 million to $26 million and non-advertising revenues of $7 million to $8 million.

Sohu estimates brand advertising revenues to be between $22.5 million to $23 million. Assuming no effect of new accounting standard FIN 48, which just became effective on January 1, 2007, Sohu estimates the non-GAAP fully diluted earnings per share to be between $0.18 to $0.20, and assuming no grant of new share-based awards, Sohu estimates share-based compensation expense to be between $2.3 million to $2.4 million.

The estimated impact of this expense is expected to reduce Sohu's fully diluted earnings per share under U.S. GAAP by $0.06.

In conclusion, Sohu continues to deliver premier differentiated and exclusive content that appeals to the increasingly sophisticated Chinese user base, but we are also a premier technology innovator in China, with deep intellectual capital, proprietary infrastructure, and powerful search engine. We have a clear competitive advantage all across the industry: in brand advertising with our Olympic content sponsorship, in video content leadership, and with highly innovative product integration between community-based and traditional content. Our strategies have been successful in expanding our core brand advertising business and in leading the market in terms of both innovation and integration value.

We are excited about the future, as the highly anticipated Beijing Olympic Games draw closer and related pre-Olympic activities speed up in our region.

That concludes our presentation. Thank you. I would like now to open the floor for questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions)

We will go first today to Jason Brueschke at Citigroup.

Jason Brueschke - Citigroup

Thank you, and first of all, let me say congratulations, Carol, on your promotion to Co-President.

Carol Yu

Thank you, Jason.

Jason Brueschke - Citigroup

Let me just give three quick questions and then I will get off. The first one is, could you give us some more color on what exactly happened to the gross margins for advertising in the fourth quarter? The second one is regarding the wireless value-added services. What happened in the quarter that you guys did not anticipate when you gave us the guidance for the fourth quarter? Then the final, the third question is regarding the online video advertising. It seems like there is a tremendous amount of interest that is growing in China, as well as the rest of the world. Do you see ’07 really as a year where traffic and interest will happen, and then advertising revenues maybe follow more in 2008, or should we expect significant advertising revenues around the online video more in 2007? Thanks.

Carol Yu

Let me answer your second question first. What we didn’t expect when we gave out the guidance is really the actual implementation of the wireless, the regulations of the rules on the wireless side when we actually gave out the guidance. You remember last quarter, the rules actually hit us a lot less than we originally expected, so we are a little bit on the optimistic side and continue to expect a flat quarter for the fourth quarter, after looking at our Q3 results.

Unfortunately, the actual detailed implementation rules became more and more stringent as time went by, as the MII become very, very serious about those rules and operators implement those rules on a very stringent side. So that is what we did not anticipate. That is your question number two.

On the advertising gross margins, what we actually do is we actually continue to launch more and more video products, as Charles explained in his script. That actually brings us more -- we have hired more editors on both the sports side and the entertainment side, and also although with our streaming technology, peer-to-peer streaming technology, there is some savings in terms of the bandwidth and server depreciation costs, but nonetheless, that is an entirely new business for us, so that actually increased the content cost as well.

Sorry, what was your third question?

Dr. Charles Zhang

I think the first question is about the gross margin on advertising. You talked about that, gross margin on advertising.

Carol Yu

Yes, I just talked about it.

Dr. Charles Zhang

The gross margin, why it is lower?

Carol Yu

Yes, I --

Dr. Charles Zhang

You didn’t talk about the wireless, but the advertising side.

Jason Brueschke - Citigroup

It was on the rich media. Is ’07 going to be the year to really monetize rich media in a really mature way, or will we see that more in ’08?

Dr. Charles Zhang

I think the defining moment is really 2006, the World Cup and later, the NBA broadcast that basically announced the coming of age of the video media on the Internet space in China. I think maybe the traffic popularity on a much larger scale will happen in the middle of 2007, maybe in six months of accumulation because we already see a lot of traffic for our B-Channel and S-Channel. And then, I think the advertising will follow not too late.

Carol Yu

So the full year impact of these increasing advertising revenue on the video side, you will see a much more vivid impact in 2008.

Jason Brueschke - Citigroup

Okay, great. Thank you.

Operator

We will take our next question now from Dick Wei at JP Morgan.

Dick Wei - JP Morgan

Hi, good morning, Charles and Carol. I just have a quick question on the top line guidance for first quarter. Basically, it looks like for brand advertising, the guidance is going to be up 37% year over year, or sequentially up about 4%, which is quite strong compared with typical negative seasonality in Q1. Also, in addition, the Chinese New Year is late this year, so that typically causes advertising growth to be slower in Q1.

I wonder, your strong guidance, does it suggest some one-time contribution to first quarter when I compare this with your full-year guidance of only 30% year-over-year growth? Could you provide some more color on the guidance?

Carol Yu

We have better visibility for Q1 as we are already in it. Two factors leading to the relatively strong quarter, especially on the advertising side. One is, well, that’s the two factors that we keep talking about like parrots. One is the Olympics. The Olympics heat up, so we are seeing more and more activities between ourselves and other sponsors, and two is the video side. NBA was launched, the season started in November. Revenues started coming in thereafter, and so we are seeing a full quarter impact of NBA advertising in Q1.

Dick Wei - JP Morgan

Are you able to break down in Q1 Olympics-related advertising or video site-related advertising, roughly?

Carol Yu

No.

Dick Wei - JP Morgan

All right. I will let someone else ask a question. Thank you.

Carol Yu

Thank you.

Operator

Ladies and gentlemen, we politely ask that you please try to keep your initial questions to one, and we go next now to James Mitchell at Goldman Sachs.

James Mitchell - Goldman Sachs

Hi, congratulations on your promotion. The G&A costs looked very low in the fourth quarter of ’06. I know in the MD&A, you stated that was due to lower bad debt and professional fees than in prior quarters, but was there any kind of contra items that reduced the G&A? Or should we expect the G&A to start again from that base level as we move into ’07?

Carol Yu

We will continue to increase, or we will continue our investment, like what Charles has said, both premier content as well as on the R&D, so we will step up those investments starting 2007 as well. It is very seasonal, so it’s not like it’s flat from here or there. A lot of the expenses, for example, [sell-through] marketing, are very optional, so we may want to do it once more here or there.

James Mitchell - Goldman Sachs

Okay, but the G&A line item was down I think 40% Q-on-Q, and it was actually down year on year as well, ex stock-based compensation. So I am just wondering whether G&A will be closer to $2 million a quarter.

Carol Yu

Oh, you are talking about just that line item?

James Mitchell - Goldman Sachs

Yes.

Carol Yu

I will get Jackie to get back to you.

James Mitchell - Goldman Sachs

Okay. Thank you.

Carol Yu

Thanks.

Operator

We will take our next question now from Wallace Cheung at Credit Suisse.

Wallace Cheung - Credit Suisse

Good morning, and congratulations on Carol’s promotion. Just one quick question, a follow-up on James’ question. Do you expect the brand advertising market growing at a similar rate as what you project on your annual growth guidance?

Carol Yu

Say that again, sorry?

Wallace Cheung - Credit Suisse

I’m sorry. Do you expect your brand advertising revenue growth at [inaudible] for the year, may be, from my perspective, a little conservative. Do you expect the overall market to grow the same?

Carol Yu

What we are seeing right now is we have been in talks with the 40 sponsors and partners for the Olympics. I think this is the group of people who are going to spend the bulk of their money, or the most significant portion of their budget during 2007 and ’08. When we talk to this group of people, what we are hearing from them is they want to spend money they have in marketing budgets but what they are waiting to see is to pick and choose which activities they would like to invest in. They would like to see some cross-media integration, for example, between Internet and TV and traditional text media.

So they are more like planning right now. So while I would say that the guidance right now is reflective of what we are seeing today, but as time goes by, they may decide to spend more on this front.

Wallace Cheung - Credit Suisse

Okay, great. Just a clarification, Carol: your answer is actually you are seeing a potential that there could be more budget to dispense, but based on what your discussion with most of the customers, this is what you get, but potentially there are more events happening, there could be more potential allocation. Am I correct?

Carol Yu

Yes.

Dr. Charles Zhang

We will update our guidance as the Olympic picture becomes clearer.

Carol Yu

James, just to get back to your question, yes, you can take it as the base line, the G&A expense in Q4, as the base line going forward.

Wallace Cheung - Credit Suisse

Thank you very much, both Charles and Carol. Thank you.

Operator

We will take our next question now from Ming Zhao at SIG.

Ming Zhao - SIG

Good morning, everyone. Just one question: could you comment on major advertisers from sectors like real estate, gaming, and some other sectors that you see interesting?

Carol Yu

We can provide that list to you, because real estate and game advertisers are mostly local companies, so I do not have that list ready for you.

Ming Zhao - SIG

No, I am not asking for a list. I am asking do you see any trend in the real estate business? How is the trend of them spending online? Do you see an increase or a deceleration, or do you see in FM CG sector growing faster? Any comments on that?

Dr. Charles Zhang

Yes, I think the FM CG sector is definitely picking up, accelerating, and also financial services is also an area that is getting very popular as the Chinese stock market continues getting very hot, and also Sohu's business channel is getting a lot of traffic. That is why we think because of the up rise of FM CG, we have been immersed and developed a very strong and powerful entertainment channel which is targeting to all this younger generation, and where a lot of FM CG products like to advertise on those channels.

For real estate, I think that --

Carol Yu

Well, real estate is kind of flattish, but one point I would like to make is that out of the big sectors, which traditionally are automobiles, real estate, and IT, automobiles actually we are seeing very, very impressive growth, so that will be one of the key factors for us in 2007.

Ming Zhao - SIG

Great, thank you.

Dr. Charles Zhang

Adding 1,000 cars per day in Beijing.

Operator

We will take our next question now from Safa Rashtchy with Piper Jaffray.

Nat Schindler - Piper Jaffray

Hi, this is actually Nat Schindler calling in for Safa. Quickly, I just wanted to know if you can give us any sort of metrics or data that you have seen since the launch of Sogou 3.0 that would give us some indication of how well you are being able to keep up with your rather entrenched competition in the search market.

Additionally, any new things you have been doing on the sales and marketing side to compete with the aggressiveness of SINA on its marketing on the sales side of it, the business in branded.

Dr. Charles Zhang

In branded, okay. So first of all, on the search side, we have seen, after the launch of 3.0, Sogou 3.0, we have seen the traffic grow 20%. Also, on one hand, we are going to launch some marketing campaign as we did in 2005 and 2006, and now with a much better product. Also, online we have a network of websites, Sohu.com and other China websites to integrate the Sogou search intrinsically at a user level, at a registered user level, on every website pages of the Sohu site, Sohu websites, so that using that leverage of the Sohu websites to let users to readily use the search all over the Sohu websites.

Also, to use the Sogou search engine to power the Sohu website so that to use the Sogou search engine for organizing Sohu news retrieval and delivery better. So this is the advantage we have as a portal over our competitors.

Of course, there is also a very powerful Sogou technology-related product, which I just described, which is the Sogou Pinyin input method, which is getting extremely popular and it is actually a new direction for input method, and its input method is used anywhere, for when people are chatting and typing blogs and writing e-mails and writing Word documents, everywhere. So it is a very -- it needed the boost of the Sogou brand name.

Some small mistake was made in our marketing of Sogou last year as the toolbar was considered to be intrusive, so that is why traffic suffered a little bit. Now the Sogou Pinyin input method is getting Sogou a very good brand name now. People really love it, so this will be another very powerful helping hand for the Sogou traffic.

On the branded side --

Carol Yu

Again, like what I said, how do we --

Dr. Charles Zhang

Olympics and --

Carol Yu

Yes, so it is how do we react to our competitors’ aggressive sales efforts. Again, it is something that is like the most important differentiating factor between ourselves and our competitors, and all of our competitors, is the Olympics opportunity that we are having right in front of us.

Dr. Charles Zhang

Also, as I described, Sohu is now very technology and product focused, so that Sohu is much more innovative than our competitors, so that we are leading in the video content, which our competitor does not have, or does not have the technology to deliver the kind of content, so this will differentiate ourselves so that there will be more traffic and more users and also advertisers.

Also, even in the blogs, Sohu Blog is very different. It is not only reading some journals written by users, but also it is really a personal space, so the Sohu Blogs user accumulation is much faster. That will get a lot of traffic to the blogs and to add registered users. And these users will, at the same time because the blogs are integrated so well with Sohu's different common channels, the blogs will bring a lot of new users to the different channels, like our business channel, our entertainment channel, and other channels.

All of these are basically content marketing, with better content, better technology, so that -- actually, over the last few years, the technology focus now has come to its fruition, and shows up in all these Sohu content delivery. These are the, besides the Olympic opportunity, the technology-driven products, innovative products in blogs, interactive products and also in the video content are the powerful marketing tools marketing measure for users as well as for advertisers.

Advertisers want to see the effect. Now, advertisers really want to look at the effectiveness of their advertising, so with traffic and the click-through increase and then they will continue to advertise with us.

Nat Schindler - Piper Jaffray

Charles, just to follow-up on that, have you increased your sales force size recently to get this message out?

Dr. Charles Zhang

Well, on the sales side, no. It was basically gradually grow as -- it is really the PR and the marketing side to broadcast to the world about our new product, like we did in September at the Sohu Blog conference with 5,000 bloggers to attend and write articles, write journals about the event. This spring, we are going to launch some other content and product-related marketing.

On the sales force side, no, we have not significantly increased the headcount.

Nat Schindler - Piper Jaffray

Okay. Thank you.

Operator

We will go next now to William Bean at Deutsche Bank.

William Bao Bean - Deutsche Bank

Could you dig down a little bit deeper for me into the rich media and video? Maybe give us a sense of some numbers or metrics we should think about, like percentage of ad sales from those areas now and in the future?

Dr. Charles Zhang

On the metrics, first of all, I can tell you about the traffic side. After we launched the B-Channel, basically the entertainment channel for video, and the S-Channel, we have now regularly every day we have over 1 million viewers per day, either broadcast or video on demand. That will add up to 30 million per month of viewers. So this page view is a high-quality page view because each view represents let’s say three or five minutes of viewing, much more valuable than the traditional text-based page.

Within this -- before the video, there will be a 15-second TV like advertising. Also, on that video page, there will be surrounding text and some other. So as I said in the previous remarks, the video advertising has increased 150% quarter on quarter, and this rich media will -- now rich media appearing on other text-based pages, but you will see more and more of the 15-second TV commercials of advertising on our B-Channel and S-Channel.

Carol Yu

William, on the dollar amount side, it is still off a very low base. We just want to give investors and analysts a sense of the trend that we are heading towards. Right now, it is still a relatively small amount, so when it gets to like say 10% of our total brand advertising revenue, I will report that, okay?

William Bao Bean - Deutsche Bank

Okay, and could you just talk a little bit about the regulatory risk? I think the government recently used the word purify and that kind of makes me nervous. Could you give some color there on your thoughts, especially on the user-generated side?

Dr. Charles Zhang

Well, I think it has always -- well, you should not be terrified because it has been a gradual interactive process over the years. I think what the government is doing is right, because there are so many websites and so many individuals that now have the right to write anything. I think the company should be responsible. A corporate citizen has a responsibility to make sure the youngsters do not get exposed to problematic, pornographic content. That is one area where it is really for -- I think on the political side, it is not much area that we cannot -- so we already have a very good mechanism, have an interactive process with the corresponding government agencies to make sure that our sites are good and responsible.

William Bao Bean - Deutsche Bank

Great, so no problem so far, then, great. Then, just last quick --

Dr. Charles Zhang

I think what the government is doing is right. I think it needs some cleaning.

William Bao Bean - Deutsche Bank

Then just the last thing, a clarification on Sogou 3.0. You said up 20% since launch. Is that month on month or year on year?

Dr. Charles Zhang

It is only the first month.

Carol Yu

Month on month.

Dr. Charles Zhang

Yes, the first month.

William Bao Bean - Deutsche Bank

Okay, thanks.

Dr. Charles Zhang

We have also seen the Sogou-related products, not only Sogou version 3.0 is a webpage search but based on that search, there is also some other progress on the Sogou-related products, as I mentioned the Pinyin input method and also we have seen the Sogou maps also gaining additional traffic. Also, we have seen -- you remember, the Sogou map is really the company we acquired two years ago, the Go to Map, and they really integrated the Sogou technology to make the Go to Map now become a consumer-based map service. Also, we have the Sogou-related message boards are also gaining much more traffic. Also, the Sogou Music Box that is well-integrated into the blogs, and others.

So there is a variety of Sogou-related products.

William Bao Bean - Deutsche Bank

Thanks a lot. I’ve taken enough time. Congratulations again. Thanks, bye.

Operator

We will go next now to Lin Chi with Lehman Brothers.

Lin Chi - Lehman Brothers

Hi, thanks for taking my questions. A question on search. Your Q1 guidance seems to suggest that search revenue probably have to decline Q-on-Q, but Q-on-Q and year on year. I just wonder how should we look at the monetization of your search effort?

I should also mention, you have changed the revenue sharing arrangement with the -- are you seeing that as a defective measure? What other measures are you taking to promote the monetization side of Sogou? Thank you.

Dr. Charles Zhang

I think, as I said, it is because the traffic is still small compared to our major competitor, so the first and most important thing now is to increase traffic, to get traffic, and then monetization later. So it takes, for Sogou’s technology to mature, we use three years. With version 1.0, 2.0 and now 2.5 and now 3.0, and finally the market, we had a blind test and the market is telling that finally Sogou 3.0 actually is better than our main competitor by the blind test.

So now, we still view 2007 as the year of traffic growth, because with a small traffic, then the monetization really does not, it is not -- it is very hard. For the monetization side, we now re-write our software that manages our channels. Also, we are reorganizing the department to build a more effective organization.

So 2007, we still see a year of traffic growth and not much on the monetization side as we had expected before.

Lin Chi - Lehman Brothers

Okay, understood. As for Sogou, the brand building, and besides that Sogou Pinyin and other related services, would you carry out anything nationwide, a brand-building campaign, et cetera, to build up the brand name?

Dr. Charles Zhang

Yes, previously we had the Sogou mountain climbing activity in 2005 and in 2006, we had the Sogou Supergirl Contest. In 2007, we will have the 2007 Supergirl contest as well. Also, other marketing campaigns -- as we announce, you will see it.

In 2005 and 2006, it was basically much more towards the brand building side, but in 2007, you will see the marketing will be integrated with the product more tightly to really drive traffic.

As I mentioned, in 2006, the Sogou traffic suffered some set-backs because the toolbar was considered to be intrusive client-end software that allowed virus killing -- I mean, it was considered to be spam, which the strategy was some problem. Now we terminated that strategy and continually think in terms of the users’ experience.

Lin Chi - Lehman Brothers

Great, one last question, if I may. For the non-advertising revenue, it seems like we are expecting a weak quarter for Q1. Can you comment a little bit on in which particular business line are you seeing the weakest performance? Is it online game, SMS, or MMS, et cetera?

Carol Yu

We talked about the wireless side. The bulk of the decrease on a quarter-to-quarter basis comes from the wireless side. We expect the wireless to be lower in Q1, go further down from the existing Q4 level. Also, we expect games, because we have now terminated one of our two online games back in Q4, towards the end of Q4, which is Knight Online, due to the maturity of that game.

Also, we turned Blade Online from a time-charged basis to an item-charged basis starting the end of December. So those two impacts would also draw online games revenue to be lower as well.

We expect the online games side would probably be, the impact of that would between $0.5 million, around that. The rest would be relating to wireless.

Lin Chi - Lehman Brothers

Okay, that is very helpful. Thank you.

Carol Yu

Thank you.

Operator

We will go next now to Richard Ji at Morgan Stanley.

Richard Ji - Morgan Stanley

Hi, Charles and Carol. I have some questions. First is regarding advertising rate increase. When do we expect the next round of advertising rate increase and by what magnitude?

Carol Yu

We are now processing our pricing strategy going forward, and again, for us, the bulk, the key revenue driver would be what we have said to draw more budget allocation and to expand our advertiser base, rather than price increase. But we do expect to have another round of price increase probably early second quarter. The rate would be similar to what we are seeing in past years. It would be 15%, 20%.

Richard Ji - Morgan Stanley

The second question regarding your mobile service. When do you think the mobile service operation will stabilize?

Carol Yu

I really don’t know, Richard. You will have to ask the MII when they will stop coming out with new and negative policies.

Richard Ji - Morgan Stanley

Or the operators.

Carol Yu

Yes, so it is -- I mean, we have been preaching to the street that this is a very volatile business, subject to regulatory risk and unfortunately, we are correct.

Richard Ji - Morgan Stanley

Okay, thank you.

Carol Yu

Thanks.

Operator

At this time, Brandi, I would like to turn the conference back over to you.

Brandi Piacente

Great. 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 very much.

Carol Yu

Thank you.

Operator

Again, that will conclude our conference. Thank you all for joining us and we wish you all a great day. Good-bye.

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