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Sohu.com Inc. (NASDAQ:SOHU)

Q2 2007 Earnings Call

August 1, 2007 8:00 pm ET

Executives

Brandi Piacente - Investor Relations

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

Carol Yu - Co-President, Chief Financial Officer

Analysts

Dick Wei - JPMorgan

Catherine Leung - Citigroup

Eddie Leung - Deutsche Bank

Wallace Cheung - Credit Suisse

Gene Munster - Piper Jaffray

Jenny Wu - Morgan Stanley

James Lee - WRHAMBRECHT + CO

James Mitchell - Goldman Sachs

Steve Weinstein - Pacific Crest Securities

Richard Ji - Morgan Stanley

C.Ming Zhao - Susquehanna Financial Group

Presentation

Operator

Thanks so much for holding, everyone. Welcome to the Sohu.com second quarter earnings release conference call. Just a reminder, today’s conference is being recorded and at this time for opening remarks and introductions, I would like to turn the conference over to Ms. Brandi Piacente. Please go ahead, Madam.

Brandi Piacente

Thank you for joining Sohu.com to discuss our second quarter 2007 results. On the call today are Dr. Charles Zhang, Chairman and Chief Executive Officer; and Ms. Carol Yu, co-President and Chief Financial Officer.

Before management begins their prepared remarks, I would like to read you the Safe Harbor statement in connection with today’s conference call. Except for the historical information contained herein, the matters discussed in this conference call are forward-looking statements. These statements are based on current plans, estimates, projections and therefore you should not place undue reliance on them. Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statements.

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

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

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

Dr. Charles Zhang

Thank you, Brandi. Hello, everyone. Welcome to Sohu's second quarter 2007 financial results conference call. I am pleased to report outstanding second quarter results for Sohu, exceeding our expectations in each of our revenue categories and earnings. We are encouraged that our Olympics strategy and technology efforts are paying off. Let me first begin by discussing Sohu's major achievements for the second quarter.

First, brand advertising -- we achieved another record high for brand advertising revenue of $26.6 million, exceeding the high-end of our guidance by over $1.6 million. Despite a comparison with a high advertising quarter last year with the FIFA World Cup during the same period last year, the year-on-year growth was 38%.

For the second quarter 2007, revenues were driven by heavy spending sectors such as automobiles, real estate, and online gaming. The fastest growth sectors year on year were online gaming, fast moving consumer goods, and financial services.

Our strong advertising revenues for the second quarter demonstrate: A, a robust momentum in advertiser spending as we draw closer to the Beijing 2008 Olympic Games; and B, an accelerating conversion of ad spending from offline to online.

For the Beijing 2008 Olympic Games, Sohu enjoys dominant advantages. Let me just recap our three most prestigious roles within the Olympic arena. First, official Internet Content Sponsor of the Beijing 2008 Olympic Games, which entitles us to operate the official website, beijing2008.cn; B, exclusive strategic partner of China Interactive Sports, or CI Sports, as backed by the China General Administration of Sports, which manages all sports associations, as well as the China National Athlete Team, or Team China; and finally, exclusive Internet Content Partner for Team China.

With these, we are able to provide the most authoritative and first-hand coverage surrounding the Olympic Games and Team China. For other media, including other Internet companies, due to limitations of their content sources, they have been reprinting or excerpting news or information from the official website. Our unmatched content strength in turn brings in further traffic and advertising income to Sohu.

In addition, the International Olympic Committee, IOC, and the Organizing Committee for the Beijing Olympics, BOCOG, have both been very supportive in defending partners and sponsors against attempts of ambush marketing. Their efforts have proven to be effective.

We also became a partner of choice for Olympic reporting with a large number of traditional media and have established cross-media alliances. Currently, the alliance comprises 15 major TV stations, including CCTV and Beijing TV, along with 35 print media across the country. Coverage through these alliances reaches nearly all of the 1.3 billion Chinese population and will provide Sohu with extensive exposure on their platform. Obviously this will greatly enhance Sohu's brand value.

We are also seeing increased interest in sports marketing across the board, even from non-Olympic sponsors. Sohu's premium sports content, such as NBA, China Basketball and China Football leagues, as well as a wide range of athletes’ official website on China Interactive Sports, CI Sports, has proven a very attractive advertising draw.

Sohu also benefits from the accelerating conversion of ad spending from offline to online. One example is the fast-moving consumer goods sector, which traditionally has heavy ad spending on TV platforms. For the second quarter, FMCG increased approximately 90% year on year, becoming our fourth largest revenue contributor, representing approximately now 10% of total brand advertising revenue.

Our outlook for brand advertising for the remainder of the year is strong. With increased visibility for the remainder of the fiscal year 2007, we are revising our full year brand advertising revenue growth target to 35% year on year from our previously stated 30%.

Second, major technology breakthrough -- the initial success of our in-house developed game, Tian Long Ba Bu (TLBB), is an example of turning our technological achievement into enhanced business success.

On May 9th, we launched our self-developed MMORPG game, Tian Long Ba Bu. It is based on the famous Chinese novel, Eight Kinds of Demigod, written by Louis Cha, nicknamed Jin Yong. The game appeals to players of all levels and offers high quality graphics and in-game communities.

So far, the initial results are encouraging. Tian Long Ba Bu’s peak concurrent users (PCU), have exceeded 400,000 and 209,000 active paying accounts. On average, each paying account has generated total revenues of RMB 82, or $11 to Sohu during the period from May 10th to June 30th. As of June 30th, TLBB had more than 10 million registered users.

As Tian Long Ba Bu is still in its infancy stage, we are carefully monitoring its progress. Our goal for the second-half of 2007 is to gradually push up value while maintaining a good user experience.

For the third quarter, we will increase our marketing expense by about $1 million to further solidify our market position. With higher-than-expected peak concurrent users, we are adding more servers and bandwidth capacity and as such, we will increase depreciation and bandwidth expense by $200,000.

In addition, the debut of Sohu 3.0 proves our visionary leadership in the Chinese Internet market. Sohu 3.0 is a result of our three-year effort to reengineer Sohu into a technologically driven and product-oriented company.

The following features of Sohu 3.0 are available to users across the entire Sohu website matrix: first, Sohu blogs serve as the master gateway to Sohu's products and communities, including the web 1.0 and web 2.0 content and product. We aim to attract users to adopt this as their personalized portal space. Further, we upgraded Sohu Blog to a video version in July, where bloggers can upload their own videos and share with others.

For the second quarter 2007, we continued to acquire new bloggers at a fast pace. Our total registered bloggers increased sequentially by approximately 65% and we expect the growth of registered bloggers to continue to accelerate.

Two, Sohu Passport, which we introduced in the first quarter of 2007, enables users to surf all of our products within the Sohu matrix.

Third, Sohu web-based messenger enables users to freely communicate on a real-time or delayed-time basis with each other anywhere in the Sohu matrix.

Sohu 3.0 also provides users with other services and products, such as Sohu P2P streaming technology, Sogo Search Engine, and Sogo Pinyin input method, et cetera. We believe Sohu 3.0 will ultimately increase the overall stickiness of the Sohu matrix and grow our user base.

During the second-half of 2007, we plan to launch a comprehensive marketing campaign, including TV commercials and other advertisement, which will cost about $2.5 million to promote Sohu products. This included a $1.5 million of U.S. dollars of such expense in our Q3 guidance, with a balance in the fourth quarter.

With that, I would like now to turn the call to Carol, co-President and Chief Financial Officer, for an update for our second quarter financial performance. Carol.

Carol Yu

Thank you, Charles. Hello, everyone. I will now provide a review of our financial results for the second quarter ended June 30, 2007.

One, revenues: total revenues were $39.0 million for the second quarter, exceeding the high-end of our guidance, compared with $33.1 million for the preceding quarter and $34.1 million for the second quarter of 2006.

Advertising -- with total advertising revenues of $28.4 million, which exceeded the high-end of our guidance, we achieved a sequential increase of 11% and a year-on-year increase of 24%. Brand advertising revenues were $26.6 million, also exceeding the high-end of our guidance, it represented a sequential increase of 13% and year-on-year increase of 38%.

We are glad to see continuing momentum from Olympic partners and sponsors in setting their advertising budgets. In our conference call last quarter, we mentioned that certain Olympic partners and sponsors had increased their 2007 advertising spending by 50% for typical heavy spenders and up to three times for those who are relatively new to online advertising as compared to 2006. At the same time, some of them were on the sidelines.

As of today, we are pleased to report that about 60% of Olympic partners and sponsors have confirmed their 2007 ad spending with us, and some of them are new clients. On an overall basis, this group has increased their 2007 advertising spending on Sohu by more than 80% as compared to last year.

Sponsored search revenues were $1.7 million, down 16% sequentially and 50% year on year. The decline in search revenue was mainly due to our continued strengthening of our anti-fraudulent click policy, based on more sophisticated algorithms.

Two, non-advertising revenues -- non-advertising revenues were $10.6 million, exceeding the high-end of our guidance, an increase of 42% sequentially and a decrease of 6% year on year. This mainly represents revenues for wireless and online games.

Wireless revenues were $6.6 million, a sequential increase of 18% quarter on quarter, and down 27% year on year. Sohu is well-positioned to minimize risk associated with the wireless sector as it now represents only 17% of our total revenue.

For a breakdown of wireless revenues in the second quarter compared with the first quarter of 2007, SMS revenues increased 33% to $3.6 million, compared with $2.7 million from the previous quarter, mainly due to revenue of $0.8 million generated from SMS voting platform for certain TV programs.

WAP revenues were $1 million, down 42% from the previous quarter. The decrease was because a mobile operator started promoting its own WAP portal and introduced a new fee reminder for WAP services.

MMS, IVR, and ring-back tone services combined increased to $2 million, up from $1.2 million for the previous quarter. The increase was mainly due to our more timely release of new songs.

Online game revenues increased 137% sequentially and 8% year on year to $3.8 million, led by the commercial launch of Tian Long Ba Bu on May 10th. Tian Long Ba Bu generated revenue of $2.3 million for the second quarter.

Gross margin -- starting January 1, 2006, share-based compensation expenses are charged to the cost of revenues and operating expenses due to the adoption of SFAS-123R. Total share-based compensation expense for the second quarter of 2007 was $2.4 million. As we believe excluding the share-based compensation expense from non-GAAP financial measure of net income makes a more meaningful comparison of Sohu's operation results and improves the user’s understanding of Sohu's performance, we use non-GAAP measures in this discussion to explain margin, cost and expense items.

Non-GAAP gross margin for the second quarter was 62% compared with 61% in the previous quarter and 64% in the second quarter of 2006. Advertising non-GAAP gross margin was 64% in the second quarter, basically the same as the previous quarter and a decrease of 71% in the same period last year.

Brand advertising non-GAAP gross margin for the second quarter was 67%, again unchanged from the previous quarter and down from 72% in the same period last year. The year-on-year decrease was primarily due to increased content costs, bandwidth and server depreciation costs.

Sponsored search non-GAAP gross margin for the second quarter was 22%, down from 25% in the previous quarter and 65% in the same period last year. The quarter-on-quarter decrease was because although revenue decreased 16% sequentially, some costs are fixed in nature. The year-on-year decrease was due to lower revenue but higher server and depreciation expense in relation to the launch of Sogo 3.0 in late 2006.

Non-advertising non-GAAP gross margin was 56% for the second quarter, up from 52% in the previous quarter and 50% in the second quarter of last year. The increase primarily represents contribution of Tian Long Ba Bu.

Three, operating expenses -- for the second quarter, Sohu's non-GAAP operating expenses totaled $16.7 million, up 22% from $13.7 million for the previous quarter and up 19% year on year. The increase was primarily due to our continued investment in product development, Sohu branding, as well as additional expenses for Tian Long Ba Bu of $1.3 million, including marketing, server depreciation, and personnel expenses.

Four, operating margin -- non-GAAP operating profit margin was 19% for the second quarter, compared with 20% for the previous quarter and 23% in the same period last year.

Income tax expense -- income tax expense in the second quarter was $0.2 million, compared to $0.3 million in the previous quarter, due to effective tax planning efforts undertaken by management.

Six, net income -- non-GAAP net income for the second quarter was $8.1 million, or $0.21 per fully diluted share. This compares to net income of $7 million, or $0.18 per fully diluted share for the previous quarter and $8.4 million, or $0.22 per fully diluted share for the second quarter of 2006.

Please be reminded that in 2006 second quarter, we included a one-time gain on early redemption of convertible notes of $0.8 million. Excluding such gains, non-GAAP net income for the second quarter of 2007 increased 17% sequentially and 6% year on year.

GAAP net income for the second quarter of 2007 was $5.7 million, or $0.15 per fully diluted share, compared to $4.5 million or $0.12 per fully diluted share.

Seven, balance sheet -- now, I will make a few comments on the balance sheet. As of June 30, 2007, Sohu's balance of cash, cash equivalents, and investments in marketable debt securities was $113.1 million, compared to $97.5 million as of March 31, 2007 and $129.7 million as of December 31, 2006.

As of June 30, 2007, our net accounts receivable balance was $29 million, an increase of $1.3 million as compared to $27.7 million last quarter.

Our DSO for the second quarter was 63 days, as compared to 72 days for the previous quarter and 68 days for the second quarter of 2006. Second quarter brand advertising DSO was 70 days, compared to 76 days for the previous quarter and 69 days for the same quarter last year. We are continuing to closely monitor our accounts receivable and we are pleased with the outcome.

As of June 30, 2007, our bad debt provision totaled $1.4 million, compared to $1.6 million as of March 31, 2007, reflecting our stringent revenue recognition and credit extension policies.

According to the terms of our serial coupon convertible notes, in July 2007 we redeemed $58.5 million of such notes at par. After the redemption, our cash balance is now around $55 million and we believe this is adequate for our operational needs.

Finally, turning to our business outlook, for the third quarter ending September 30, 2007, Sohu expects: one, total revenues to be between $45 million to $47 million, with advertising revenues of $30 million to $31 million and non-advertising revenues of $15 million to $16 million; brand advertising revenues of $28.5 million to $29.5 million. We estimate non-GAAP fully diluted earnings per share to be between $0.25 and $0.27.

Assuming no grants of new share-based awards, we estimate share-based compensation to be between $2 million to $2.1 million. The estimated impact of this expense is expected to reduce fully diluted earnings per share under U.S. GAAP by $0.05. And, as mentioned by Charles, we are now raising our 2007 full year advertising revenue, brand advertising revenue target to 35%.

In conclusion, we are very pleased with our second quarter results and we look forward to accelerating momentum during the run-up to the Beijing 2008 Olympic Games with our technology breakthroughs, plenty of content, enhanced branding, and benefits associated with our Olympic strategy.

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) We will go first today to Dick Wei of JPMorgan.

Dick Wei - JPMorgan

Good morning, Charles and Carol. Congrats on a good quarter. My first question is on the -- I think one of the hopes that investors hope to see is Sohu to become the destination site for Internet users leading to the 2008 Olympics. I guess in the earlier remarks, you guys mentioned that many of the exclusivity and excitement regarding the Olympics, yet I guess looking at Alexa, I haven’t really seen any traffic pick-up from the 2008.Sohu.com, which is your Olympic channel. Can you give us some confidence that Sohu will actually become the destination site when going into the Olympics time, actually from now until the Olympics?

Dr. Charles Zhang

Well, I think from our internal data, we’ve seen overall traffic growth related to sports. We don’t view the Alexa data as any concrete evidence because that is -- I mean, that data is easily maneuverable and it is not -- but internal data is showing that sports related content has been getting more and more popular as we draw closer to the Olympics.

Dick Wei - JPMorgan

Could you give us some, if you can, give us a strategy how you are going to drive the Internet users to Sohu? That would be very helpful too.

Carol Yu

You mean from now until the -- in the one-year time span or during the Olympics?

Dick Wei - JPMorgan

I guess from now until the Olympics, driving the Internet users to use Sohu to look at the Olympics content. As a result, page views come up and advertisers will come to Sohu.

Carol Yu

Okay. I think the content strength has proven itself. As you can see, as we mentioned that the advertisers have already come, so I answered that part of the question.

On the traffic side, we have been -- first, we have a lot of exclusive information and news. It is first published on the official website, Beijing2008.cn, simultaneously on Sohu, so that is everything about the games.

Let me give you an example. For example, in April, BOCOG released the design of the torch and the torch relay route. Such information was given simultaneously to Sohu before-hand, so we have -- well, actually, zero hand information, not first-hand. So what Sohu could do is prepare a lot more interesting content on Sohu simultaneously with the release of such previously confidential information.

For example, we have a very detailed description of the route and the design concept behind the torch relay design. We invited the design team to have a chat with our users and so on.

While the other media could only do a very dry press release and certain copy/paste from our official websites. So that is the difference in terms of the content. So I am very confident that during the run-up to 2008, more and more users will be converted to come to Sohu to read the Olympic news.

And also during the games, because we will have exclusive interviews with athletes through CI Sports and their association with the national sports bureau and the like. All these would be very, very attractive to advertisers.

Dr. Charles Zhang

I want to comment about the recent launch of Sohu 3.0, which includes blogs and the web 2.0 products. With that product, we have China Interactive Sports resources. For example, a very well-known athlete, [inaudible], has opened his blog on Sohu. So Sohu blogs growth, technology-driven products, and also with the sports resources and Olympic related resources will drive users further to our site.

Dick Wei - JPMorgan

Great. Finally, if you can just give me an update on the new media broadcasting rights.

Carol Yu

This is still under negotiations between the IOC and CCTV in China.

Dick Wei - JPMorgan

Okay, great. Thanks.

Operator

We’ll go next now to Catherine Leung at Citigroup.

Catherine Leung - Citigroup

Good morning. Congratulations on a very strong quarter. I have two questions. First, on the Olympics, can you please give us your thoughts on the Olympic alliance that was recently formed by Sina, NetEase and Tencent? We view this as a confirmation or an affirmation of your strong position. Would you agree?

Also, can you give us any thoughts on how your recently announced partnership with CCTV will benefit you, especially as you mentioned CCTV is currently under negotiations with the IOC for the video rights to the Olympics.

Secondly, on the Tian Long Ba Bu game, could you please let us know how the user statistics have trended so far in July and August? Well, mainly in July. Thank you.

Dr. Charles Zhang

I’ll answer part of this question and then let Carol go ahead. Yes, of course that alliance confirms the strength and the position that Sohu is enjoying with the Olympics and overall sports reporting.

We are, as I said in the previous remarks, not only with the official website, Sohu as a sponsor but also with the China Interactive Sports, the alliance and the cooperation with China Interactive Sports, so we have more resources than just the Olympic official website. So that CI Sports manages all the sports associations and Team China. These resources will prove to be very valuable because, as I just said, the interactive products like Sohu blogs and Sohu 3.0 will have a lot of athletes on Team China who will open their blogs to have interviews with us.

So I think it is really a very -- it is a very powerful Olympic related resource combination, so that I think our competitors just really felt very threatened. I think it is a PR strategy rather than a real concrete, any concrete effect.

Carol Yu

If I may add, I concur with what Charles said. I think our competitors have given us a strong vote of endorsement of our entire Olympic strategy and I am pretty happy with that.

Turning to your second question regarding Tian Long Ba Bu, -- sorry, CCTV. Charles.

Dr. Charles Zhang

Well, CCTV I think, as I said, I won’t comment about the video rights but the alliance with CCTV is really a very complete and broad range, including --

Carol Yu

Technology, cross promotion.

Dr. Charles Zhang

Technology, especially our streaming technology application to CCTV platform and also with a broad array of CCTV programs. Sohu will participate and be responsible for the interactive part together with CCTV.com. For example, the recent Olympic --

Carol Yu

The countdown, the one-year countdown coming in less than a week.

Dr. Charles Zhang

And that is one of the many projects included in the alliance framework so that I watched CCTV 5 and it mentioned Sohu and CCTV, so we also get exposure on the TV audience of Sohu.

Carol Yu

The example is, for example, we did a survey on the Internet asking users for their anticipation on the opening ceremony, which is a very hot topic among the Chinese people within China right now as to what will the opening ceremony of the Olympics look like. So we did a survey as to what they want to see, whom they want to see and so on, topics and the like. And this survey is done on Sohu but with very high TV exposure on CCTV, so this is what we get and we’ve got a very strong brand association on the Olympics topic.

Turning to Tian Long Ba Bu, we are seeing continued momentum on the ARPU side. Our current strategy is to maintain the users at the current level. We do not want to expand it to a much higher level than the current level but we are trying to increase ARPU while maintaining users at the current level. I think our efforts are -- we are seeing good results from the current efforts and you can see that from the guidance as well.

Catherine Leung - Citigroup

Thank you very much.

Operator

We’ll go next now to Eddie Leung at Deutsche Bank.

Eddie Leung - Deutsche Bank

Good morning, Carol and Charles. I would like to learn more about your game strategy, your factory release on the pipeline. Could you tell us how many engineers you have in your game division and what are they working on, any new games, et cetera? Thanks.

Carol Yu

Our game strategy is pretty new, which is -- I mean, Tian Long Ba Bu was only launched less than three months ago. We are seeing some initial success at the infancy stage. We are now trying to build a pipeline, which is underway so we don’t have any concrete answers for that. We have a very strong development team consisting of about 70 people and we are trying to expand that as well.

Dr. Charles Zhang

I’ll comment that our games, Tian Long Ba Bu’s initial success, it is not a surprise or something out of the blue. It is consistent, it is a result of really Sohu's technology driven and product-oriented strategy over the past few years, so that we tried and tried and tried. We tired [Nygo] online and Blade online and finally we got it right.

So online games will be Sohu's long-term strategy and it is important to really have a good team, technology and product team, that can generate more and more good games.

Here I also want to mention although the same efforts are put into search engines, although this quarter the business side is not doing well but we will continue to try to have a strong -- we have a very good search engine technology and then we have the products and continue to try and I think we will be rewarded some day, just as we are getting the success with our game strategy.

Carol Yu

Just to supplement what Charles said, Sogo traffic grew by 30% year on year and in July, traffic further increased by another 40%.

Eddie Leung - Deutsche Bank

That’s good. Thank you very much.

Operator

We’ll go next now to Wallace Cheung at Credit Suisse.

Wallace Cheung - Credit Suisse

Hi, Charles and Carol. Congratulations on a great quarter. Just a very quick question on can you give revenue guidance, brand advertising revenue guidance? You are projecting to grow at around 35% but just by the first two quarters grow as well as the third quarter revenue guidance grows, that may imply your fourth quarter growth could be lower than 35%. Am I correct?

Second question also related to brand advertising revenue guidance, actually -- what are the key growth areas in terms of customer sentiment that you are seeing much stronger growth in the third quarter? Thank you.

Carol Yu

Well, we are now having more visibility in Q3 and obviously less in Q4, so this is -- our guidance represents what we are seeing today, so that answers your first question.

On the second question, factors remain, the same old group of customers. Charles mentioned about the fast-growing, the online gaming sector being one of the highest growth and then other sectors such as IT and automobiles are also showing strong momentum.

Wallace Cheung - Credit Suisse

Thank you. Good to hear that conservative guidance.

Carol Yu

I didn’t say that. Thank you, Wallace.

Operator

We’ll go next now to Gene Munster at Piper Jaffray.

Gene Munster - Piper Jaffray

Good morning and congratulations. I guess just a follow-up on the previous question is that clearly the business is doing well. Is there any reason, I know it is still early -- we’ve always thought of really the inflection point of the spending from advertisers going in the Olympics to be in the March, June and September quarters. Is there any reason for our takeaway that things are good and they should get increasingly better? Is that a good takeaway from the strength that you’ve seen in the business today?

Carol Yu

I mentioned in the call that we are actually signing up more and more advertisers and more and more advertisers are firming up their Olympic marketing strategy, so yes, we are seeing that momentum coming and we are so far very pleased with whatever we are seeing.

Gene Munster - Piper Jaffray

Okay, and just to confirm, did you guys break out the dollar value of Olympic-branded advertising in this quarter?

Carol Yu

No, we just gave an indication as to how much we signed up. We did not break it out because a lot of the sponsors and partners are our existing customers, so it is very difficult to break that out. So what we give is to just give a year-on-year comparison for whatever they have spent with us last year and whatever they intend to spend with us this year.

Gene Munster - Piper Jaffray

Okay, so for example last year during the World Cup, you talked about a $2 million increase in spending. There’s not an easy, neat number for us to go out with as far as the increase in spending you are already seeing. Is that correct, there’s not a number or there is a number that we can go out with?

Carol Yu

I don’t understand your question.

Gene Munster - Piper Jaffray

Last year during the World Cup, you talked about World Cup added $2 million in incremental branded ad revenue. My question is, is there -- can you say how much in branded -- I think the answer is no. I think you just said no but just to confirm, you have not --

Carol Yu

No.

Gene Munster - Piper Jaffray

Okay, and just finally the increased spending on the gaming side or increased spending in general, obviously your revenue growth is phenomenal. It is essentially all for the gaming side, the increase -- it’s infrastructure, marketing and spending. Is that the takeaway?

Carol Yu

I did mention in the call that the incremental on Tian Long is $1.3 million for Q2.

Gene Munster - Piper Jaffray

Okay, great. Thank you.

Operator

We’ll go next now to Jenny Wu at Morgan Stanley.

Jenny Wu - Morgan Stanley

Hi, Charles and Carol. Congratulations on a great quarter. I have two questions. The first one regarding the margins, given all the effort, we expect all the expenses might go up. Would you please give us some guidance on the margin trend?

Carol Yu

We expect margins to stabilize at the current level, at least at the gross level. Net margin will be at least at the current level.

Jenny Wu - Morgan Stanley

Thank you. The second question is regarding the Olympics sponsors advertising strategy. Would you please elaborate more on the terms of their advertising contract with Sohu? For example, are they mostly monthly-based or quarterly-based, or through the year contracts, something like that? Thank you.

Carol Yu

They are no different from our typical ad contracts. They sign a framework contract with us and then they will do it on project on project or a month-by-month basis, unless it is, for example, like the Adidas sponsoring of the sports channel. That would be an annual contract.

Jenny Wu - Morgan Stanley

Okay, so currently most of them are on a monthly basis and you will expect more advertising dollars will come in in the later quarter?

Carol Yu

As the Olympics build up, the momentum, yes, we will see increased ad spending from the advertiser group as a whole.

Jenny Wu - Morgan Stanley

Thank you. That’s all my questions.

Operator

We’ll go next now to James Lee at WR HAMBRECHT.

James Lee - WRHAMBRECHT + CO.

Thanks for taking my question. Good morning, Charles and Carol. Can you just remind us a little bit, because last quarter, Carol, I remember you mentioned that you signed a number of Olympic sponsors on to your platform. I don’t remember specifically what that number was. Can you remind us what that number was versus after 2Q what that number is? And also, Carol --

Carol Yu

We didn’t actually mention that, but up until now we have signed up a higher number.

James Lee - WRHAMBRECHT + CO.

A higher number, okay. Also, can you guys talk about maybe how you are doing in terms of enforcing your rights? Last time you talked about the joint logo, people can only put the Olympic logo along the company logo on your Internet site only. Can you talk about any of the enforcement that you did during the quarter? Did you actually take down some of the advertisements in other websites that may have the joint logo? That being the first, and if you did, can you talk about how were the sponsors reacting to those kinds of actions?

Carol Yu

Well, yes, we did -- well, it is not actually us. It is BOCOG enforcing all ambush marketing to protect the entire group of partners and sponsors, and they have reinforced that many times. So I think so far, BOCOG has been very effective in terms of defending the rights of partners and sponsors. That’s number one.

What was your second question? What was the sponsor reaction? I think again, to us the sponsors and other partners, it is really the content strength and the strength of the Internet media itself, so if you see -- if we do possess that they like to see and you can’t see it elsewhere, we become their choice of partner in terms of having their ad. I think that is the response that we have been getting so far.

James Lee - WRHAMBRECHT + CO.

So there wasn’t any pushback from sponsors, they were very supportive of your rights to enforce, of your rights as the Olympic sponsor of the Internet, right?

Carol Yu

I think it is the media strength, it is the content strength.

James Lee - WRHAMBRECHT + CO.

If I can ask a last question regarding TLBB, I was curious; can you guys talk about the traffic pattern a little bit after the open beta? I am sure there was an initial surge in terms of traffic as you open up more servers, right? Can you talk about the traffic pattern a little bit, after you start monetizing, i.e. introducing virtual items into the game, how that traffic pattern flowed after that? And talk about maybe what you learned from looking at other free-to-play games in terms of introducing virtual items so the user experience will not be impacted? And maybe going forward into 3Q, how do you expect the traffic patterns? How do you plan to balance introducing a more virtual items versus traffic going forward?

Carol Yu

Well, as I have already mentioned, you are right. Traffic surged to over 400,000, just above 400,000 PCUs soon after the commercial launch. It is now maintaining at the 350,000 level and after the introduction of the virtual items and whatever monetization we have been doing to date, so I think we are learning from the industry as a whole and also, we think we have been, as I have said, tasting initial successes.

And as I have mentioned, we will try to have more monetization by introducing more virtual items for sale so that to increase ARPU. At the same time, we will try to maintain the traffic at the current levels, between 350 to 400.

James Lee - WRHAMBRECHT + CO.

Can we get a sense of how big is your virtual store now, i.e. how many virtual items do you have in your virtual store?

Carol Yu

I can give it to you later.

James Lee - WRHAMBRECHT + CO.

Okay, great. Thank you so much.

Carol Yu

Thank you.

Operator

We’ll go next now to James Mitchell at Goldman Sachs.

James Mitchell - Goldman Sachs

Congratulations, Sohu 3.0. A quick question for you, the sales and marketing figure for the third quarter, it sounded like you were going to spend $1 million more on Eight Kinds of Demigod and then $0.5 million more on general marketing for the portal, and those numbers would be incremental to the second quarter sales and marketing budget?

Carol Yu

Almost, yes.

James Mitchell - Goldman Sachs

Right, so we should -- but basically if you take the second quarter marketing budget, which already had some amount for Eight Kinds of Demigod, and then we add $1.5 million for these two marketing campaigns in the third quarter?

Carol Yu

Sorry, James, you lost me.

James Mitchell - Goldman Sachs

Okay. So in the second quarter of sales and marketing spending, there was some amount already for the Eight Kinds of Demigod open beta testing. And then I think in the introductory comments, you said that there would be $1 million incremental spend for that game, and then there would also be -- I think it was $0.5 million spending on marketing the portal in general.

Carol Yu

No, we would have about $1 million incremental for Tian Long Ba Bu as marketing spend, and $1.5 million on Sohu in general, including the 3.0.

James Mitchell - Goldman Sachs

Right, and that 1.5 is for the third quarter or for the second-half of the year?

Carol Yu

For the third quarter.

James Mitchell - Goldman Sachs

Okay, and that 1.5 we should view as on top of what you are already spending in the second quarter?

Carol Yu

Yes.

James Mitchell - Goldman Sachs

Okay, great. Thank you.

Operator

We’ll go next now to Steve Weinstein at Pacific Crest Securities.

Steve Weinstein - Pacific Crest Securities

Thank you. I just wanted to get a little better understanding on the branding side. You put up some pretty impressive numbers in terms of what the Olympic advertisers are doing. I think you said up 80% year over year. But the whole segment of brand advertising is growing a little under 40%, which is still healthy but I am wondering, is there any sort of crowding out effect coming from the Olympic advertisers maybe taking up more of the inventory of the space and preventing the other advertisers from growing as quickly? Or are there any sort of inventory constraints when you think about going forward that can limit the potential upside from that business? Is there a cap that says no matter how strong the Olympic spending is, you just couldn’t get over 40% growth?

Carol Yu

Well, first thing is if demand is really high, we can always have price increases, so that answers your first question.

Second, I think we have been very diligent in terms of setting up new platforms. For example, the CI Sports platform is completely new inventory that we added this year, so we are not worried about that. And if that comes, it would be a very nice problem to have.

Hello?

Steve Weinstein - Pacific Crest Securities

Okay, thank you. That answers my question.

Operator

We’ll go next now to Richard Ji at Morgan Stanley.

Richard Ji - Morgan Stanley

Good quarter. Two questions; number one, given the strong demand related to the Olympics, what was the advertising rate hike the middle of this year and what will be the rate hike guidance going forward?

And the second one is regarding your Olympics website. You are the official Internet content provider for the Olympics website, so do you in principal, do you own all the advertising inventory for the Olympics website and is there any revenue sharing arrangement with the Olympics committee? Thank you.

Carol Yu

First question, rate hike, we already have an increase of 37% on average for the second and the third quarter, so it is already in placed. We haven’t finalized the rate cards from fourth quarter onwards. It really depends on the market situation.

The second question is the official website, beijing2008.cn, there is no ad space on it right now so it really depends on the IOC and BOCOG whether they want to open up any of those spaces on the official website. Right now it is very, very clean.

Richard Ji - Morgan Stanley

Thank you, Carol.

Operator

We do have time for one final question and we’ll take that question now from Ming Zhao at SIG.

C.Ming Zhao - Susquehanna Financial Group

Good morning. Two quick questions; first question, can you break down the revenue from Blade online and Tian Long Ba Bu for the quarter? And do you see the Blade online revenue declining in the future quarters?

Second question may be a little bit early but what is your strategy after the Olympics? Thank you.

Carol Yu

Online games revenue is 3.8. Tian Long Ba Bu is 2.3, so Blade is 1.5. Going forward, we expect Blade to be more or less at the current level. It would not have any material change impacting the total games revenue.

On the second question, I’ll leave it to Charles.

Dr. Charles Zhang

Well, I think the Olympic strategy is only one of our two or three strategies. I think Sohu 3.0 and also Sohu as an engineering powerhouse, that we’ll continue to push out new products that are gaining users and traffic and also our matrix strategy, our web 3.0 strategy and our search engine strategy -- everything will enable us to become the major presence for the hundreds of millions of Chinese Internet users and provide them with the most relevant mainstream applications. That’s our goal, so I think the Olympics is just one propeller for a -- a mid-term propeller or engine, but for the long-term it is really the technology and the products and the media that enable us to dominate.

Operator

Did you have anything further?

C.Ming Zhao - Susquehanna Financial Group

No further questions. Thank you very much.

Operator

Carol or Charles, did you have any further or closing comments today?

Carol Yu

No, thank you.

Operator

That will conclude our conference call for the day, ladies and gentlemen. Thank you all so much for joining us and we wish you all a great day. Goodbye.

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Source: Sohu.com Q2 2007 Earnings Call Transcript
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