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Sohu.com Inc. (NASDAQ:SOHU)

Q1 2007 Earnings Call

May 1, 2007 8:00 pm ET

Executives

Brandi Piacente - The Piacente Group

Dr. Charles Zhang - Chief Executive Officer

Belinda Wang - Co-President, Chief Marketing Officer

Dr. Yu Gong - Chief Operating Officer

Carol Yu - Co-President, Chief Financial Officer.

Analysts

Jason Brueschke - Citigroup

Dick Wei - J.P. Morgan

Paul Keung - CIBC

Tian X. Hou - C.E. Unterberg, Towbin

Eddie Leung - Deutsche Bank

James Mitchell - Goldman Sachs

Gene Munster - Piper Jaffray

Lin Shi - Lehman Brothers

James Lee - WR Hambrecht+CO

C. Ming Zhao - Susquehanna Financial Group

Presentation

Operator

Good day, everyone and welcome to the Sohu first quarter 2007 earnings release conference call. Today’s conference is being recorded. For opening remarks and introductions, I would like to turn the call over to Brandi Piacente. Please go ahead.

Brandi Piacente

Thank you for joining Sohu.com to discuss our first quarter 2007 results. On the call today are Dr. Charles Zhang, Chairman and Chief Executive Officer; Ms. Belinda Wang, Co-President and Chief Marketing Officer; Ms. Carol Yu, Co-President and Chief Financial Officer; and Dr. Yu Gong, Chief Operating Officer.

Before the management begins their prepared remarks, I would like to read you the Safe Harbor statement in connection with today’s conference call.

This announcement contains forward-looking statements. It is currently expected the Business Outlook will not be updated until release of Sohu's next quarterly earnings announcement; however, Sohu reserves right to update its Business Outlook at any time for any reason.

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 statement. Potential risks and uncertainties include, but are not limited to, Sohu's historical and possible future losses and limited operating history, the 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.

Now let me turn the call over to Dr. Charles Zhang, Chairman and Chief Executive Officer. Charles.

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Dr. Charles Zhang

Thank you, Brandi. Hello, everyone. Welcome to Sohu's first quarter 2007 financial results conference call. First of all, let me tell you where I am and why I will speak very slowly.

I am at an altitude of 3700 meters high because I am on my way to Mount Everest because I am leading an Internet reporting team through beta testing the Olympic report, the Olympic torch relay, which the Olympic committee will put the torch on top of Mount Everest in 2008. This year, 2007 is a test, so I am taking advantage of the May holiday to go to Mount Everest. That is why, because of a lack of oxygen, I will speak really slowly.

I would like to begin by touching upon the role of the new members of our management team that will be joining Carol and me on today’s call. As our business continues to grow and the Beijing Olympic Games draw nearer, Sohu has a greater need for experienced senior executives to lead our key business segments.

Since announcing Belinda and Yu Gong’s appointments on our fourth quarter conference call, we have been integrating them into our investor relations efforts, thereby creating visibility to their roles as key members of our team, so please join me by welcoming them to our call.

I am pleased to begin this call and report Sohu achieved a record quarter for brand advertising revenue, exceeding the high-end of our guidance, even in this traditionally slow season.

Brand ad revenue increased 7% quarter on quarter, and 41% year on year. In total, advertising revenue for the first quarter was $25.6 million, up 3% quarter on quarter and 27% year on year.

With our progress in the first quarter and the trends we are seeing in the market, we believe we are well-positioned this year. The initiatives we have in place around increased brand advertising and online games revenue will begin to show its effects in the second-half of this year.

Let me discuss some of the initiatives that will drive our efforts.

First, brand advertising. Three key factors are driving our growth momentum and outlook in brand advertising: the encouraging Internet population growth in China, the acceleration trend in advertising spending away from international offline media to online advertising, and the approach of the highly anticipated Beijing 2008 Olympic Games.

Our expectation is that Olympic-driven brand advertising momentum will accelerate during the second-half of 2007 as pre-games activities heat up. Historically, statistics show that advertisers with Olympic budgets start to spend significantly in the six to 12 months lead-off to the games. Among our peers in China, Sohu will be one of the primary beneficiaries.

Second, online games; on April 4th, our self-developed 2.5 dimension massive multiplayer online role-playing game, Tian Long Ba Bu, entered final closed beta testing. We are pleased with the initial results of closed beta testing, which has had a more positive effect on online gamers than our previous games. We plan to launch open beta testing on May 9th. The commercial launch of Tian Long Ba Bu could come as early as June of this year and we look forward to updating you on the progress of this game on our second quarter conference call. Therefore, we will start full quarter financial impact of this game beginning in the third quarter of 2007.

Third, let me talk about technology. Although our key catalyst for brand advertising and online games are strong near-term positives, a long-term driver of our business and its success will be our technology developments.

Our technology developments reflect Sohu's cutting edge position in the Chinese Internet space. Our technology has not only enhanced our own business success but has created an opportunity for us to continue to be a thought leader in the way new technologies change the Internet industry in China.

One example is the implementation of Sohu Passport. Sohu made significant progress in the integration of Sohu products and registration systems by implementing the Sohu Passport in order to further enhance the stickiness of Sohu websites.

Historically, we had a number of separated user registration systems for different products, such as Sohu Community, Mail-box, Blog, Alumni Clubs, Sohu message boards, and Music Box. Users have logged in to each website based on a separate profile for each platform.

At the end of March, we introduced Sohu Passport, which enabled users to seamlessly surf most of our products within the Sohu matrix. With Sohu Passport, users maintain one profile for all Sohu web processes and they can navigate from one site or channel to another under a single login.

This creates cross-selling and marketing opportunities and stickiness to expand the utilization rate of our various products.

In the first quarter of 2007, partially related to this new passport system, our total registered bloggers increased by approximately 50%, and our daily new registered bloggers increased by more than 40%. We expect this substantial enhancement of our user experience for the Sohu community will boost traffic growth across our portal this year.

Another example of our success in introducing new and unique technologies to the market was evidenced at the recent incident where Google copied Sohu's database of the propriety Chinese language input system, called Sogou Pinyin. This caused a lot of attention.

Almost a year ago, we launched the first version of Sogou’s Chinese character input method, called Sogou Pinyin. Sogou Pinyin enables users to type Chinese characters on a western style keyboard by using Pinyin, a phonetic system for translating English phonetics into Chinese characters. This product has pioneered the way a search engine and the Chinese character input method are powered together. In this way, Sogou Pinyin database is automatically updated on a real-time basis to reflect the latest trend of popular vocabulary used by netizens which significantly improves accuracy and speed. We are the first developer of this unique technology.

Now let me turn the call over to Belinda Wang, our Co-President and Chief Marketing Officer, for the business review of our brand advertising. Because of the high altitude, I will hang up the phone and I will leave the question-and-answer session to Carol, Belinda and Yu Gong of our management team. Thank you.

Belinda Wang

Thank you, Charles. Hello, everyone. I would like to take this opportunity to discuss our progress for brand advertising.

As Charles mentioned, Sohu achieved another record quarter for brand advertising revenue. We are excited about the trends we are seeing in ad spending. Revenues continue to be driven by heavy spending sectors, such as automobile, information technology and real estate, with continuing acceleration from fast-moving consumer goods, but pleased to see increased efforts driven by the encouraging Internet population growth in China. The accelerating trend in advertising spend away from traditional offline media to online advertising and the continued expanded user base brought by our innovation and product enhancement. We expect this to continue going forward.

I would also like to highlight a few other key areas. First, Olympic partners and sponsors advertising dollars; as we get close to the Beijing 2008 Olympics with the launch of more Olympic related events, such as the recent torch design and the torch relay route, we are pleased that certain Olympic partners and sponsors have increased their overall advertising budget for 2007 and we feel the impact of their increased spending will start to kick in during the second-half of 2007.

We are seeing different stages of budgeting that the Olympic partners and sponsors are moving through. There are still quite a number of partners and sponsors that are waiting on the site launch, while they pick and choose from the best possible events to participate in.

For those partners and sponsors that have completed this process, they have increased their 2007 advertising spending from 50% up to three times as compared to their 2006 advertising spending.

We are even able to sign up partners and sponsors who are new clients to Sohu. We are pleased with the progress and the indications of spending we are seeing for the second-half of 2007.

Second, multimedia -- we will continue to leverage our multimedia strategy such as we do and its competitive advantage to expedite the shifting of advertisers’ budget from transitional media, such as TV, to Sohu.

Sohu continues to add more premier and interactive content on our video channels and recognize the strong combined growth of 30% quarter to quarter in page views. One example occurred during Chinese New Year on our V-Channel, while we had CCTV to webcast the Spring Festival Gala, which was the first ever on the Internet, enabling Internet users to watch the program and participate real-time by using products such as the Sohu message boards.

Beginning in May, 2007, as video ads become more popular among advertisers, we will charge our embedded video advertising under a CPM model rather than on a timing basis. We expect this to be a preferable pricing model that will better reflect the value of Sohu's leading position in online video content and result in a more effective monetization of this product in the long run.

Now, let me turn the call over to Yu Gong, our Chief Operating Officer, for a business review of our online games.

Dr. Yu Gong

Thank you, Belinda. Hello, everyone. Let me give you an update on our new game, Tian Long Ba Bu, which entered its final stage of closed beta testing on April 4th. Since October of 2004, we have established an in-house development team to build out this MMORPG. We believe having our own game development center allows us greater flexibility to modify our games to meet the demands of gamers. We are pleased with our initial results of Tian Long Ba Bu, as it was well received by gamers. The result is above our expectations.

On May 9, 2007, we will start open beta testing. Since it is only one month from date we entered into closed beta, we will monitor the game closely to decide the best timing of its commercial launch, which could be as early as June.

The pricing model of this game will be an items-based revenue model. In order to leverage on this business opportunity, we expect to invest about $1 million on server depreciation and bandwidth costs, and $1.3 million to marketing this year.

For the second quarter alone, we will invest around $1 million in those items. Our expectation on Tian Long Ba Bu’s revenue to be not less than our previous game, Blade Online, for the third quarter of 2007.

In addition, margin of Tian Long Ba Bu will also be better than our previous game, since there are no licenses paid associated with this game.

With that, I would like to turn the call over to Carol Yu, Co-President and Chief Financial Officer for a review of our Olympic effort and a financial review.

Carol Yu

Thank you. Hello, everyone. First, the Olympic effort; we are pleased to report our Olympic strategy is executing well. As mentioned by Belinda, we are in a unique and advantageous position to enjoy momentum associated with the brand advertising growth as the games draw near.

Our Olympic sponsorship brings us many benefits, one of them being local Olympic partners and sponsors can only have online advertisements using the joint Olympic logo on Sohu. Nonetheless, benefits of our Olympic efforts do not only come from monetization but also as a developer and operator of the official website of the Beijing 2008 Olympic Games, we are enjoying valuable content resources, the latest example being the first-hand information on the torch design and torch relay routes.

Other exclusive content includes privileged access to officials, national Olympics committees and star athletes, and providing the most authoritative and timely and comprehensive Olympic coverage.

We not only can report but we can also organize Olympic marketing activities to further attract users to our sites. Last but not least, our association with the Olympics brings us more working opportunities with government officials and helps further foster and strengthen our ties with the Chinese Government.

Second, financial review; I would now like to take this opportunity to discuss some key financials for the first quarter ended March 31, 2007.

Total revenues were $33.1 million for the first quarter, compared with $34.4 million for the preceding quarter and $31.1 million for the first quarter of 2006.

With total advertising revenues of $25.6 million, we achieved a sequential increase of 3% and a year on year increase of 27%. Brand advertising revenues were $23.5 million, exceeded high and the low guidance, representing a sequential increase of 7% and year on year increase of 41%.

Sponsored search was $2.1 million, down 29% sequentially and 40% year on year. The sequential decline in search revenue was mainly due to seasonality and the impact from the late Chinese New Year. The year on year decline was also attributable to the increased churn rate of losing customers and our enhancement of anti-fraudulent click mechanism during the second-half of last year. We are reviewing our sales and marketing strategies for this business line.

Non-advertising revenues were $7.5 million, a decrease of 21% quarter on quarter and 27% year on year. Wireless revenues were $5.6 million, down 17% quarter on quarter and down 30% year on year. Sohu is well positioned to minimize risk associated with this wireless sector, as it now only represents 17% of our total revenue.

For a breakdown of wireless revenue for the first quarter, [inaudible] revenues decreased 15% to $2.7 million compared to the previous quarter. The decrease is mainly due to ongoing negative impact of policies issued by mobile network operators in July, 2006.

WAP revenues were $1.7 million, down 26% from the previous quarter, mainly due to instability of operator system and the implementation of WAP premium select businesses, resulting in a decrease in subscription of our WAP services. MMS, IVR, and ring-back tone services combined were down slightly from $1.3 million for the previous quarter to $1.2 million.

In other revenues, online game revenues declined 23% sequentially and 22% year on year to $1.6 million. The decline is primarily due to termination of our game, Knight Online, which has come to the end of its product lifecycle.

Gross margins -- starting January 1, 2006, share-based compensation expenses are charged to costs of revenues and operating expenses due to the adoption of SFAS-123R. Total share-based compensation expense for the first quarter of 2007 was $2.5 million.

As we believe excluding the share-based compensation expense from our non-GAAP financial measure of net income makes a more meaningful comparison of Sohu's operation results and improves users’ understanding of Sohu's performance, we use non-GAAP measures to explain margin costs and expense items below.

Overall non-GAAP gross margin for the first quarter was 62%, down from 65% in the previous quarter and 66% in the first quarter of 2006.

Advertising non-GAAP gross margin was 64% in the first quarter, down from 66% in the previous quarter and a decline from 75% in the same period last year.

Brand advertising non-GAAP gross margin for the first quarter was 67%, down from 70% in the previous quarter and 76% in the same period last year, primarily due to the increase in content costs, bandwidth, and server depreciation costs.

Sponsored search non-GAAP gross margin for the first quarter was 25%, down from 43% in the previous quarter and 69% in the same period last year. The decrease was primarily due to a decrease in revenue as well as higher server depreciation expense in relation to the launch of Sogou 3.0 in late 2006.

Non-advertising non-GAAP gross margin was 56% for the first quarter, compared with 60% for the previous quarter and 51% in the first quarter of last year. The decline in non-advertising gross margin was primarily due to the decreased mix of higher margin revenues, a decrease in gross margin of certain wireless products, and the increased server depreciation costs for our game business.

Operating expenses -- for the first quarter, Sohu's non-GAAP operating expenses totaled $13.9 million, down 4% from $14.5 million for the previous quarter and up 9% year on year. The quarter on quarter decrease was mainly due to the decrease of our marketing expenses, while the year on year increase was primarily due to our increased reinvestment in R&D for technology projects and product development, and increased marketing expenses for branding.

Operating margin -- non-GAAP operating margin was 20% for the first quarter, compared with 23% for the previous quarter and 25% in the same period last year.

Income tax expense in the first quarter was $0.3 million, compared to $0.5 million in the previous quarter.

Net income -- non-GAAP net income for the first quarter was $7 million, or $0.18 per fully diluted share. This compares to net income of $8.1 million, or $0.21 per fully diluted share for the previous quarter and $7.8 million, or $0.20 per fully diluted share for the first quarter of 2006.

GAAP net income for the first quarter of 2007 was $4.5 million, or $0.12 per fully diluted share, compared to $6.1 million, or $0.16 per fully diluted share, in the previous quarter, and $6 million, or $0.16 per fully diluted share, for the first quarter of 2006.

Now I will make a few comments on the balance sheet. As of March 31, 2007, Sohu's balance of cash, cash equivalents and investments in marketable debt securities, was $97.5 million, compared to $129.7 million as of December 31, 2006, and $137.5 million as of March 31, 2006. The reduction in cash reflects the purchase of our Beijing headquarters at a purchase price of approximately $35.3 million. Following this transaction, we continued to maintain sufficient cash resources for our operational needs.

As of March 31, 2007, our net accounts receivable balance was $27.7 million, an increase of $3.9 million as compared to $23.8 million as of December 31, 2006. This includes $22.2 million related to our brand advertising business and $4.2 million related to our wireless business.

Our DSO for the first quarter was 72 days, compared to 62 days for the previous quarter and 76 days for the first quarter of 2006.

First quarter brand advertising DSO was 76 days, compared to 58 days for the previous quarter and 89 days for the same quarter last year.

We are continuing to closely monitor our accounts receivable and are pleased with the outcome. As of March 31, 2007, our bad debt provision totaled $1.6 million, compared to $1.6 million as of December 31, 2006, reflecting our change in revenue recognition and credit extension policies.

Finally, turning to our business outlook. For the second quarter ending June 30, 2007, Sohu expects: total revenues to be between $35.5 million to $37.5 million, with advertising revenues of $26.5 million to $27.5 million, and non-advertising revenues of $9 million to $10 million.

Brand advertising revenues will be between $24.5 million to $25 million.

As mentioned by Yu Gong, we expect to invest approximately $1 million for server depreciation costs, bandwidth and marketing on our new online game, Tian Long Ba Bu.

Sohu estimates non-GAAP fully diluted earnings per share to be between $0.17 to $0.19.

Assuming no new grants for 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 to reduce fully diluted earnings per share under U.S. GAAP by approximately $0.06.

In conclusion, with the new products introduced to enhance our user portal experience, the rapidly approaching Beijing 2008 Olympic Games, and the potential contribution from our new online game, Tian Long Ba Bu, we are well-positioned to have a good year and look forward to keeping you updated on our progress in the months to come.

This concludes our prepared remarks for today. We will now open the floor for questions. Operator, please go ahead.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from Jason Brueschke with Citigroup.

Jason Brueschke - Citigroup

Thank you. Good morning, everyone. Maybe I will just do three quick questions and then get back in the queue. The first one is for Carol. Carol, it looks like the investment in the exclusive content is paying off with respect to our seeing good revenue on the advertising side. However, the gross margins continue to trend down. Could you give us some color about when we expect to see some leverage on that? How much more do you expect the advertising gross margins to drop in ’07 and ’08? And the same question for non-advertising gross margins in ’07 and ’08. Thanks.

Carol Yu

On the advertising gross margins, I think search is more difficult to predict because that is very much driven by the volatility in terms of the revenue based on a very small revenue base, but as I have to deal with the brand advertising side, Q1 is traditionally a slow quarter, but we choose to make additional investments, mostly on the video side and bandwidth and server depreciation because of the increased traffic as compared to the previous quarter and last year.

So taking into consideration seasonality, Q2 and Q3 would be upward trends for our brand advertising revenues. I would expect gross margins will not continue to trend down for our brand advertising business for the rest of the year. This is the first question.

For the non-ad part, again we are dealing with firstly very volatile wireless revenues and any change in mix of that revenue would have an impact on the gross margin side, so I would avoid answering that question. But looking beyond Q2 with the additional contribution from our new game, Tian Long Ba Bu, considering what Yu Gong has said, that is an in-house developed game. We do not have any revenue-sharing on that part, so I would expect gross margins to improve starting Q3 onwards, when we have a full quarter impact of that game.

Jason Brueschke - Citigroup

Great. Two quick other questions; you mentioned or I think it was mentioned that you guys are going to try to push CPM-based pricing, at least on your video. Could you give us an update on how those efforts are going? Are they being well-received by the market? Are you only planning on introducing CPM-based pricing around the video aspect, or is this something that you would extend across the entire spectrum to all of your brand advertising based contracts?

Carol Yu

I will direct this question to Belinda.

Belinda Wang

First of all, I think the overall Internet circumstance in China is very helpful to drive more online budget to the video format because there are over 10.4 million broadband users in China, representing a penetration rate of over 76% of the overall Internet users.

Secondly, we launched our entertainment video channel and our sports video channel, that is V and S channels, on Sohu for almost six months and it really drives a lot of traffic from the traditional text-based users. So far, we have over 1 million unique visitors for these two channels.

And the third, our design team has created a lot of creative new video ad formats in the first quarter of 2007. Because of these three reasons, I think the video advertising really draws a lot of attention from the traditional online advertisers.

For example, we just signed a deal with [inaudible], pharmaceutical company, which is one of the traditional pharmaceutical manufacturers in China, and they just signed up a deal with us for three months cooperation on the video program, which is called Super Voice. Recently, we are also in discussion with Intel to design a new video ad format on our V Channel.

So this indication and this is a very good indication and signals for a brighter future for the video ad formats on Sohu.

As you mentioned, we will charge our video online ad format under a CPM model, rather than on the time basis, because the user habits on the video program is quite different from when they are viewing the text-based content. They will stay longer on the video program rather than on the text-based format.

That is the underlying reason why we will charge it on the CPM model rather than on the timing or fixed place basis. Sohu will adopt the CPM model only for the video program. For other text-based or the picture-based content, we will continue to use the timed and fixed place format. Some of the hardest ads on the text-based content, we will think about choosing a kind of a balanced format between the CPM and the timed basis.

Jason Brueschke - Citigroup

Great. Carol, a quick last question for you; could you maybe give us an update on the exclusivity surrounding the Beijing Olympic sponsorship? There have been some questions as to whether the IOC can somehow open up streaming video or something else to a tender offer at the end of March. Maybe just let us know where that situation stands and what you think the implications are if there have been any changes. Thanks.

Carol Yu

Sohu is the exclusive Internet content provider sponsor for the Beijing 2008 official website, so we are the operator of Beijing2008.com or .cn, for that matter, and all content on that website is provided by Sohu.

The new media rights is a separate matter and that is closely tied into with the TV broadcasting rights, so yes, there was a tender but that is separate and distinct from the official website that we operate. So it is almost like TV broadcasting rights in the eyes of the IOC. The outcome of the tender will be known probably -- it not during Q2, it will be early Q3. So it is separate and distinct.

Jason Brueschke - Citigroup

Does that tender just deal with the actual streaming of the live events, or is there an Internet marketing campaign leading up to the event, et cetera, that can be built around that, or is it just -- it seems like to me it is more of an impact on CCTV than on you.

Carol Yu

It is the 16 days broadcasting rights of those games.

Jason Brueschke - Citigroup

All right. Thanks.

Operator

Next we have Dick Wei with J.P. Morgan.

Dick Wei - J.P. Morgan

Just two quick questions; the first question is for the games investment for $1 million. Is that all going to be expended in Q2 or is it going to be amortized over a period of time?

Carol Yu

It is all expense and all the development costs of this game has all been expensed in the previous quarter, and for the Q2 $1 million, it will also be expensed.

Dick Wei - J.P. Morgan

Okay, great. The next question is just in general, the preparation for the Olympics. I don’t really notice any advertisement in, for example, your 2008.sohu.com channel. I am wondering how is the preparation going for the Olympics and how is the pre-selling coming along for the Olympics? I understand Belinda was talking about some advertisers have increased spending by two or three times, but how it is affecting Sohu from what you can see right now? Thanks.

Carol Yu

The advertisements right now are being carried mostly in other channels. For example, in the sports channel, on the news channel, on the front page and the like. We are actually building up momentum and traffic for 2008.sohu.com.

Dick Wei - J.P. Morgan

And in terms of any other pre-selling related to the Olympics, anything like that? Any data that we can get?

Carol Yu

We are actually, like what Belinda has said, we are signing our framework contracts for some of these sponsors and partners, but the bulk of them are taking a wait-and-see approach, so we will actually be able to give you more updates on the next call.

But we are very confident the that 33 sponsors and partners will eventually have advertising budgets announced. It’s a matter of timing, but out of those that have already signed with us, we have seen very encouraging signs.

Dick Wei - J.P. Morgan

Great, thanks.

Operator

Next we will take Paul Keung with CIBC World Markets.

Paul Keung - CIBC

Good morning. Do you believe you are getting your fair share of online advertising budgets? In particular, has the Olympic sponsorship allowed you to get any new accounts, and if you could give some examples on that.

Carol Yu

Yes, I think we are getting our fair share. Year on year increase of 40% is definitely something that we are pleased to see. Second is the Olympic sponsorship, like what I just told Dick, we are seeing very positive signs, especially for those that have already signed the contracts, but we will expect to continue to update the market on more news as we move closer to the second-half of the year.

Paul Keung - CIBC

To follow up to that question, the partners that are you signing up, are some of those new accounts or is it mostly more spend by the existing accounts?

Carol Yu

It’s a mixture. For example, for new accounts they may start it off spending RMB2 million, RMB3 million with us to start with, but for existing accounts, especially those worldwide top sponsors, we are seeing their contracts increasing by -- because they already have very big advertising budgets with us in previous years, we are seeing those budgets increasing by about 50%. For those medium-sized accounts which previously signed up, for example, RMB2 million, RMB3 million with us, now doubling or even tripling their budgets with us.

Paul Keung - CIBC

Thanks. I’ll get back in the queue.

Operator

Next we have Tian X. Hou with Unterberg.

Tian X. Hou - C.E. Unterberg, Towbin

I have a question. It’s in the wireless value-added services area. I know you guys are downplaying that area, but since I pay a lot of attention to the market, I would like to get your insight about what is happening now in this area. I sense that your guidance for Q2 in this area is better, so does this growth come from your new game or does this growth come from wireless value-added services?

Carol Yu

We are expecting a pretty modest growth for wireless in Q2, as we are hoping that things will stabilize a little bit because we see some better trends in March and April. A very small contribution from the new game because even up to now as we speak today, the new game was only in its final closed beta stage, and only for less than a month, so we are not anticipating much in terms of revenue for Q2 for the new game.

Tian X. Hou - C.E. Unterberg, Towbin

Okay. The other question is related to the industry of online advertising. Certainly everybody is expecting ’07 online advertising is going to experience a rapid growth. Your year on year growth is 41%. Is that fair to say full year, we should expect some growth between 35% to 40%?

Carol Yu

Well, my guidance for the year is 30%. You have to remember that 2006 is a very high comp with World Cup on it. No matter how bullish we are for the Olympics, it is still not the year for the Olympics. It is still the preceding year. 2006 is a very difficult comp.

Tian X. Hou - C.E. Unterberg, Towbin

Okay. That concludes my questions. Thank you.

Carol Yu

And Sina’s guidance is 30% to 35%.

Tian X. Hou - C.E. Unterberg, Towbin

Yes, I know that one, yes. Thanks.

Operator

Next we have Eddie Leung with Deutsche Bank.

Eddie Leung - Deutsche Bank

Good morning. Could you tell me a little bit more about your strategy on the online game side? Will you continue to develop new games? What kind of games will be in the pipeline?

Carol Yu

Yes, we will continue to develop new games, but this first of its kind new game by Sohu is still in its infancy stage, so I think it is way too early for us to say what we are going to do next. Let us first do the open beta on May 9th and then the commercial launch hopefully sometime in June. Then we will update the market on our next call.

Eddie Leung - Deutsche Bank

Okay, great. Thanks.

Operator

Next we have James Mitchell with Goldman Sachs.

James Mitchell - Goldman Sachs

Good morning. Thank you for taking my question and taking the call, particularly those of you on Mount Everest. A couple of questions. First, if I look at your branded advertising revenue, I think the seasonality seems a little bit different this year than prior years. I think in previous years, the first quarter of the year would be flat on the fourth quarter in terms of branded advertising and then the second quarter would be up double-digits on the first quarter. This year, the first quarter was up I think 7% Q-on-Q, and then you are guiding for mid single digit growth Q-on-Q in the second quarter. Is there anything in particular driving that or it is just each year is a different year?

Carol Yu

Well, this year on brand advertising because of the late Chinese New Year, we are seeing people doing more advertisements prior to Chinese New Year and also partially because of the countdown to Olympics on the 500 days. So these two events added together help the seasonality a little bit for Q1.

Belinda Wang

In answer to your question, we just increased our price in January and this is one of the very important reasons for the increased revenue for Q1.

James Mitchell - Goldman Sachs

Okay, and then just following on from Tian’s question about other revenue. It looks from my model as if your other revenue was about $7.5 million, other being non-advertising in the first quarter, and your guidance is close to $10 million in the second quarter. I could not figure out where the extra $2.5 million was coming from, if wireless is up a little bit and if Tian Long Ba Bu is only marginally contributing.

Carol Yu

For wireless, we are expecting about a 15% to 20% increase on wireless, so that is what I mean by marginally up. So that accounts for a good portion of the $2.5 million. And then on the games part, Blade, our existing game, because we actually changed the revenue model in late December, 2006, so Q1 is actually in transition. So we are seeing an upward trend for Blade as well in Q1.

James Mitchell - Goldman Sachs

However, you’re far too conservative. 15% to 20% growth is better than marginal. Maybe a final, tougher question. I think in the past you had indicated you would try and protect your net income margins in the low 20%. It seems like for the second quarter, you are guiding for around 19%, 20%. Now, I appreciate there’s a sort of one-time hit from Tian Long Ba Bu marketing and server and bandwidth and other costs, but going forward, would you still be seeing low 20% as your target range for the net income margin?

Carol Yu

Yes. I would expect that number to improve from Q3 onward, as we talk about the contribution from Tian Long Ba Bu as well as the up-tick of our online advertising business.

Operator

We’ll take our final question from Jenny Wu with Morgan Stanley. Ms. Wu, your line is open.

Carol Yu

Operator, maybe we should switch to another? We’ll have one on one with Jenny.

Operator

Okay, just one moment. We’ll take Gene Munster with Piper Jaffray.

Gene Munster - Piper Jaffray

Thanks for taking my question. I know you have kind of touched on this but in terms of the branded advertising, obviously that was very strong in the quarter, much better than we were looking for. Was it price or was it click-through and sell-through? Can you give us some ideas about the sustainability of that and what really drove that? Thanks.

Carol Yu

On branded?

Gene Munster - Piper Jaffray

Yes.

Carol Yu

Three reasons we just talked about; price increase in January; second is late Chinese New Year, we saw more ads coming in. Third is some Olympic events, such as the countdown to 500 days on March 27th.

Gene Munster - Piper Jaffray

Do you think you could have future price increases or is this the new level going forward?

Carol Yu

We have some price increases in contemplation but it has not been finalized yet.

Gene Munster - Piper Jaffray

Thank you.

Operator

Our last question is from Lin Shi with Lehman Brothers.

Lin Shi - Lehman Brothers

Good morning, everyone. Thank you for taking my questions. On the Sohu brand advertising on the sales and marketing side, I understand you yourself are an Olympic sponsor as well, so what is your budget for your branding expense? When do you expect to incur the costs?

Carol Yu

We do not have any specific budget for that because we -- our source is the media, so for us to do branding for the Olympics is pretty low cost. Also, we are tagging along with a lot of the other sponsors and marketing partners, so all in all, the budget for that would be very, very minimal.

Lin Shi - Lehman Brothers

Okay, another question is on your investment in the brand advertising side. We understood in 2006, you put in quite an investment in bandwidth, servers, et cetera and content. For Q1, the gross margin, how much can be attributable to the costs that you incurred as an extra investment? How would it be in 2007 with your continuous investments, how the gross profit margin will be trending?

Carol Yu

Like what I mentioned before, I expect gross margin to stay at the current level, if not improving, during Q3 and onwards. I think Q2 will be stabilized and for Q3 onwards, we should have a slight margin expansion.

Lin Shi - Lehman Brothers

Okay, and I have a final question on your online game. For Blade Online, last quarter you turned the game to an item-bidding model. How do you see the user traction trending after the business model transition? It would be great if you could share some data points regarding your ARPU and total paying accounts.

Carol Yu

I don’t have the detailed ARPU and the like right in front of me, but I can tell you that the users, the number of players have tripled since we turned the game into a free playing model, and that is the reason why we have increased bandwidth costs and server depreciation because we are adding more investment on that front.

We are seeing that pretty stable. There’s improvement from January until March and then pretty much stabilized at the March level, so if you look at the entire quarter, that is why I explained to James earlier, that we will be seeing an increase in the games revenue for Blade as well.

Lin Shi - Lehman Brothers

Thank you.

Operator

Next we have James Lee with WR Hambrecht.

James Lee - WR Hambrecht+CO

Thanks for taking my call. A quick question; can you just clarify -- we spoke with a bunch of advertisers recently in China. They were saying that there are certain programs that, marketing wise, they could spend on your platform relating to the Olympics that they cannot spend on other platforms, such as Sina. Maybe Carol or Belinda, can you just clarify what exclusivity in terms of marketing advertisers can come and spend on your platform versus other Internet media platforms?

Carol Yu

Okay, there are two fronts to that. The first one is on the joint logo. For marketing partners and sponsors, as you can imagine, they spend tons of money in getting their Olympic sponsorship, so obviously they would like to advertise with the joint logo, which means the company logo plus the Olympic logo.

For local partners and sponsors, such as China Mobile, China Telecom, Sinopec, China Petroleum and so on and so forth, in order for them to use the joint logo online, they can only do it with Sohu. That is the first point.

The second point is they can only do joint marketing efforts with Sohu. For example, if China Mobile wants to do -- for example, they just launched a new marketing event called the Olympic family. They want to solicit people to submit their applications to enroll to their marketing program. They can only use the Sohu platform. They cannot use the Sina platform. They can still advertise with Sina in terms of just plain vanilla type of advertisements, but they cannot utilize Sina’s platform as part of the activity itself.

Have I made it clear?

James Lee - WR Hambrecht+CO

Yes, can you just explain is China Mobile -- just use China Mobile as an example, doing an Olympic family event, why can they only spend on you? Can they not do an Olympic family event with another media platform, such as Sina? Is it because purely you are the Olympic Internet sponsor? Is that why? I just don’t understand that.

Carol Yu

Yes, because we are the only Olympic sponsor. Let me twist it the other way around -- if Sohu runs our own marketing campaign, if we said we run Olympic family, we can’t use China Unicom as the wireless platform to submit applications. So it is the same token.

James Lee - WR Hambrecht+CO

Can I use another example, in Lenovo, which is also one of the Olympic sponsors, they decide to do anything relating to the torch relay. Maybe they want to attract people to sign up to be, for example, a torch bearer for the relay. In that case, can they only advertise with you and not with Sina, using that as another example?

Carol Yu

Again, I am differentiating between plan vanilla advertisements versus using the platform itself as part of the activity. So taking your example, yes, Lenovo is working with us, is using Sohu as their Internet platform in terms of torch relay.

James Lee - WR Hambrecht+CO

Okay, great. Thank you, Carol.

Operator

And we have Ming Zhao with Susquehanna Financial. Mr. Zhao, your line is open.

Carol Yu

Operator, I think --

C. Ming Zhao - Susquehanna Financial Group

Good morning, this is [Hia] on behalf of Ming Zhao. We just have a quick question. On your branded ad revenue side, we’re just wondering which industry sectors are contributing to the good growth? It seems your business channel is doing very well on traffic.

Belinda Wang

In terms of the industry categories, I think the automobile, IT, and telecom and real estate contributed a lot to the Q1 revenue. In terms of the channel contributions, because of the financial channels, the financial channels is really blooming in Q1. We really attract a lot of budget from the transitional advertisers on this channel.

Also, we see great signals for more budget on V Channel and S Channel.

C. Ming Zhao - Susquehanna Financial Group

So is this business channel benefiting from the stock market and why has it become the number one channel on the portal?

Belinda Wang

Are you talking about the financial channel?

C. Ming Zhao - Susquehanna Financial Group

The business channel, yes.

Belinda Wang

I think the major reason for the heavy traffic on the financial channel is because of the blooming stock markets happening in Q1.

C. Ming Zhao - Susquehanna Financial Group

Thank you.

Operator

That does conclude our question-and-answer session. I will turn the call back over to you, Ms. Piacente, for any additional or closing remarks.

Brandi Piacente

Thank you, Operator. 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

That does conclude our conference call for today. We do thank you for your participation.

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Source: Sohu.com Q1 2007 Earnings Call Transcript
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