SOHU.com Q4 2005 Earnings Conference Call Transcript (SOHU)

SOHU.com (SOHU)
Q4 2005 Earnings Conference Call
February 6th 2006, 8:00 PM.

Executives:

Ingrid Shea, Investor Relations
Charles Zhang, Chairman of the Board and Chief Executive Officer
Carol Yu, Chief Financial Officer

Analysts:

Katherine Lange, Citigroup
Safa Rashtchy, Piper Jaffray
Frank Shi, CLSA
Dick Wei, JP Morgan
Ming Zhao, SIG
Lu Sun, Lehman Brothers
Wallace Chung, Credit Suisse First Boston
Michael Zhang, INC Equity Partners

Presentation

Operator

Good day ladies and gentlemen, and welcome to SOHU's First Quarter and 2005 Fiscal Year Earnings Conference Call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. If anyone needs assistance at anytime during the conference, please press the star followed by the zero. As a reminder this conference is being recorded today, Monday, February 6, 2006. I would now like to turn the conference over to Ms. Ingrid Shea, Investor Relations. Please go ahead ma'am.

Ingrid Shea, Investor Relations

Thank you for joining SOHU.com to discuss our Fourth Quarter and Fiscal 2005 Results. On the call today are Charles Zhang, Chairman of the Board and Chief Executive Officer, and Carol Yu, Chief Financial Officer.

Before the management presentations I would like to read you the Safe Harbor statement in connection with today's conference call. Except for the historical information contained herein, the matters discussed in this conference call are forward-looking statements. These statements are based on current plans, estimates and projections, and therefore, you should not place undue reliance on them. Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. 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 on-line advertising sales, mobile phone related wireless revenues, online games and e-commerce for its revenues. Further information regarding these and other risks is included in SOHU's Annual Report on Form 10-K and other filings with the Securities and Exchange Commission. Thank you for your patience.

Now I would like to the call over to Charles Zhang, Chairman and CEO. Charles?

Charles Zhang, Chairman of the Board and Chief Executive Officer

Thank you all for joining our conference call today. To start there is one key message that I want to emphasize on our call today. And that is our commitment for our core advertising business. SOHU's brand and research, we managed firm and the growth that we have seen this past quarter and throughout 2005 is representative of our growing strength in China's online advertising market. We look to further drive our business through continue development and the rollout of our own innovative products and the services to drive increased traffic and the usage on our sites.

Now I'd like to discuss highlights for the quarter. We reported record total revenue of $30.5 million growing 8% sequentially and 27% year-on-year exceeding company guidance. Let me discuss the progress of our main business line. Advertising, overall we have seen a healthy fourth quarter and 2005 fiscal year in the advertising business. Advertising revenues for the fourth quarter were $20.3 million, up 8% quarter-over-quarter, which exceeded our guidance. For the full fiscal year 2005, Advertising revenue grew 27% year-over-year also exceeding our guidance of 20% to 25% year-over-year growth.

Brand advertising revenue were $16.9 million, and the sponsored search accounted for $3.4 million, a sequential increase of 8% and 7% respectively in a traditionally weak quarter, and a year-on-year increase of 28% and 27% respectively. I'd like to give an overview of brand advertising first. In brand advertising, the 8% of sequential revenue growth was primarily due to heavy advertising spending sectors such as information technology, automobiles and real estate. On the other hand sectors that have experienced the fastest growth for the quarter has been financial services, travel and healthcare. More specifically, there are two very important and underling sectors which are as a core of our brand advertising strength and the strong future growth outlook.

First, SOHU's Olympic sponsorship growth is a near-term and long-term growth catalyst for our brand advertising business. The fourth quarter was the first quarter of our constructing operating and hosting official Beijing 2008 Olympics website. The website www.beijing2008.com is now up in running in three languages: Chinese, English and the French. We are very excited about our role in the Olympics and this has been felt throughout the entire organization at SOHU. This is the point of extreme pride for myself and also for the entire unit. Our Olympics sponsorship role is also an important recognition by the Chinese Government that SOHU is the premium internet portal company and has enhanced our overall relationship with government agencies. The overall impact is the increased SOHU brand awareness and we have already seen the impact SOHU branding power coming through from 14,100 advertisers. In Q4 2005, we already beginning signing new Olympics related deals with 14,100 advertisers such as Lenovo and Audi China. We expect in fact to become even more magnified as the Beijing 2008 Olympics approaches.

Second, SOHU's family of sites and innovative products continued to attract more traffic, increased strictness and lead to more effective monetization for its brand advertisers. SOHU's has more than 1,000 corporate partners and has unique products such as Chinaren, Alumni Club, and new products such as message boards, picture galleries and the blogs. Traffic of our community products, example message boards and picture galleries are increasing at a monthly rate of over 10% during Q4 2005. As a result, SOHU's combined family website has achieved the number one ranking of page views among Chinese internet companies according to Alexa, and SOHU has widened its lead against its major competitors. Based on Alexa as of mid-January of 2006, SOHU's family of website traffic have increased with more than 120% of our major competitors in terms of page views.

Turning to portal site, SOHU.com, we have narrowed the GAAP quite significantly compared for our major competitors, just in the past few months with SOHU traffic on the rise from representing 72% of that of our major competitors at the end of September of 2005 to 87% as of mid-January 2006. We're also making pleased kind of higher thickness with it to certain pages per user versus our competitor 10 to 11. I would like to again emphasize despite above payoff in investment, SOHU has been able to maintain a higher gross margins of 74% versus our competitors 68%.

In addition, we've also seen increased monetization of our new products, in Q4 2005 revenue from Chinaren and its old new products such as message boards and the Picture Bar increased by over 60% sequentially. Although, this was off relatively small base, we expect retailers continue to gain momentum going forward. In sponsored search, the 7% sequential growth was driven by a significant increase in bid listing revenues, which accommodated for 30% of our total sponsored search revenues, compared with the 23% in the third quarter. This shift is revenue mix of managed utility expansion of our website client networks and the growing acceptance of the pay-per-click concept in China.

In late November 2005, we also successfully launched sogou version 2.5, which increased the search database to 2 billion retrieved pages and 800 million index pages. In addition, sogou 2.5 is the more intelligence version in terms of crawling, selecting and ranking for search results, thus providing users with more relevant, accurate and up-to-date web pages. Sogou 2.5 improves analysis capability to more effectively minimize dead links and repetitive links.

According to our internal data SOHU's traffic in the fourth quarter will close to 40% compared with the third quarter and we believe this does not yet fully reflect the sogou 2.5 upgrade, as the new product did not fully ramp-up on to the end of December. In addition, we will continue to look for new and innovative ways to promote sogou brand via our Sogou Supergirl contest and National Dog Search. The Dog search has sparked great interest especially given that this year 2006 is a Year of the Dog. It is important for us to brand Sogou and the search engine's choice customer tailored to the needs of entire community.

We remain confident that there will be strong growth for our advertising business over the next few years. The brand impact from the Olympics sponsorship will continue to have a significant impact on our ability to drive our advertising business going forward. We will also continue to focus on developing and fine-tuning our search products given the increasingly competitive search environments in order to position Sogou as one of the leading search engines in China. For 2006, we're targeting full-year advertising revenue to grow 25% year-on-year as we see continued healthy growth in brand advertising and more significant contributions from sponsored search advertising.

Turning to our wireless business. Though our focus remains on our core advertising business, we happened to see a continuous steady recovery in our route wireless business with 7% sequential growth and 65% year-on-year growth in the fourth quarter to $7.2 million. In addition, the growth of our wireless business was achieved with no substantial increase in promotional expenses or revenue sharing percent exchange.

We are pleased that our wireless business has become increasingly stable in fiscal year of 2005. We certainly believe it is important for SOHU to maintain a presence on the wireless side, and the more specifically in WAP in anticipation of the eminent launch of the 3G mobile network in China and the burdening market that it will bring. 3G license is expected to be awarded this year and the commercialization of the technology by 2007.

With this in mind we recently launched our WAP Portal, now WAP version of our existing portal in a simplified format in December 2005. And we have been seeing fabulous increase, 80% in the subsequent to two months. We have been able to capitalize on the SOHU’s broad content strength from our portal and the family of website. We belive that we will be able to continue to leverage our content strength strategy in this area. Now I'd like to turn the call over to our Chief Financial Officer, Carol Yu for financial review. Carol?

Carol Yu, Chief Financial Officer

Thank you, Charles. I would like to take this opportunity to discuss some key financials for the fourth quarter and 2005 fiscal year. One, Revenues: We are pleased to report strong revenues of 30.5 million for the fourth quarter, which exceeded our guidance. Revenues for fiscal 2005 were 108.3 million, a record in SOHU's corporate history. One, Advertising. With advertising revenues of 20.3 million, we experienced a healthy 8% sequential and 28 year-on-year improvement. In fiscal 2005, total advertising revenues of 70.9 million grew 27% year-on-year. Two, Wireless. For the fourth quarter, wireless revenues were 7.2 million, up 7% quarter-on-quarter and 55% year-on-year. In fiscal 2005, total wireless revenue were 26.3 million, declining 28% year-on-year, reflected those strategy of shifting revenue mix to the core advertising business.

Let me give you a breakdown of the fourth quarter wireless revenues. SMS revenues declined 3% to 4.2 million, which was a result of technical problems with one of the operator's network. These issues have already been result by the end of the fourth quarter. WAP revenues were up 8% despitely impacted by China Mobile's new policy. In late November, soliciting all askings from remoting paid services or any WAP networks except on China Mobile's mode in that platform. MMS, IBR and ring back tone services accounted for 0.9 million in total, that’s compared to 0.5 million in the previous quarter. Despite certain challenges, wireless revenues has experienced full consecutive quarter of cautious recovery. Three, other revenues. Our other revenues mainly include online game revenues which grew 19% sequentially and 42% year-on-year to 1.7 million.

Two, turning to our gross market. Overall gross margin for the fourth quarter was 66%, up from 65% in the previous quarter and down from 68% in the fourth quarter of 2004. In fiscal 2005, overall gross margin was 66%, down slightly from 67% in fiscal 2004. Advertising gross margin was 74% in the fourth quarter, relatively flat from the previous quarter, and down from 81% in the same period last year. In fiscal 2005, advertising gross margin was 75% compared with 78% in fiscal 2004. Non-advertising gross margin was 50% for the fourth quarter, an improvement from 47% from prior quarter and 42% in the fourth quarter of last year. In fiscal 2005, non-advertising gross margin was 50% compared with 54% in fiscal 2004.

Three, operating expenses. For the fourth quarter, SOHU's operating expenses totaled 40.2 million, increasing 25% from the previous quarter and 37% year-on-year. The increase in expenses quarter-on-quarter primarily relates to cost associated with SOHU's exclusive Olympic sponsorship role and additional advertising sales commission payable to our sales team totaling 1.4 million.

More specifically, the increase of 1.4 sales commission can be attributed to two factors. First, consistent with SOHU's previous policy, commission expenses payable to our sales team will recorded upon actual cash collection of advertising revenue. During the fourth quarter, actual cash collections was much higher than that of last quarter. Related sales commission increased by 0.7 million. Second, as of December 31, 2005, in view of the company’s implementation of tighter credit control and an increase in overall credit worthiness of its customers, the company determined that sales commissions should be recorded upon recognizing advertising revenue. As a result, we recorded an additional accounting adjustment of $0.7 million of sales commission relating to revenue recorded but not yet collected as of December 31, 2005.

Four, operating profit margins. Operating profit margins in the fourth quarter was 19%, down from 25% in the previous quarter and 25% down in the same period last year. Operating profit margin in 2005 was 23%, down from 33% in fiscal 2004, before the inclusion of the newly required stock-based compensation expense we estimate operating profit margin will resume back to the mid-20s level for the first quarter of 2006.

Five, other income. For the fourth quarter, SOHU’s other income totaled $2.4 million. This included a gain of $1.2 million arising from the repurchase of convertible notes with face value of $15.22 million as a discount. In addition, due to an exception regarding payment of certain taxes, and receipts of tax refunds by our China subsidiaries, we have also recorded approximately $1.2 million gain of other income.

Six, net income. Net income for the fourth quarter was $8.9 million or $0.23 per fully diluted share. This compares to net income of $8 million or $0.21 per fully diluted share for the previous quarter and $6.5 million or $0.17 per fully diluted share for the fourth quarter of 2004. For fiscal 2005, net income was $29.8 million, or $0.77 per fully diluted share, compared to net income of $35.6 million, or $0.89 per fully diluted share in fiscal 2004.

Seven, balance sheet. Let me now make a few comments on the balance sheet. As of December 31, 2005, SOHU’s cash, cash equivalents and investments in marketable debt securities was $134 million compared to $132 million as of end of last quarter, and $141 million as of December 31, 2004. During the year, the company completed a $13.8 million stock repurchase program and the above-mentioned repurchase of convertible notes. As of December 31, 2005, our net accounts receivable balance was $19.3 million, reduced by $4 million as compared to last quarter. This includes $14.3 million relating to our advertising business and $3.5 million related to our wireless business. During the fourth quarter, we managed to collect sales proceeds totaling $23.3 million for our advertising business. Such collections resulted in a drop in our DSO for the fourth quarter to 62 days, compared to 82 days in the previous quarter.

Fourth quarter advertising DSO was also reduced to 77 days, significantly down from 105 days for the third quarter. This demonstrates our efforts in closely monitoring our accounts receivable are paying off. As of December 31, 2005, our bad debt provision amounted to $1.2 million, compared to $1.7 million as of September 30, 2005. While we consider this level of bad debt provision to be still relatively low as compared to our level of advertising sales, we continue to remain prudent in our revenue recognition policy and strengthening of our credit extension.

Eight, and finally, our business outlook. You will find detailed guidance for the first quarter 2006 in our earnings release, but I would like to highlight. One, SOHU estimates total revenues to be $28 to $30 million, with advertising revenues of $19 to $20 million and non-advertising revenues of $9 to $10 million. Two, SOHU estimates first-time stock-based compensation expense to be $1.7 to $1.8 million. In addition, starting from January 1, 2006, the applicable PRC income tax rate of SOHU has increased from 0% to 7.5%. SOHU estimates PRC income tax expense to be between $0.5 to $0.7 million for the first quarter. The total impact of these two expenses is expected to reduce SOHU’s fully diluted earnings per share by $0.05 to $0.06. And, third, after deducting the above-mentioned stock-based compensation and PRC income tax expense, SOHU estimates fully diluted earnings per share for the first quarter of 2006 under US Generally Accepted Accounting Principles to be between $0.14 to $0.16.

In summary, we are pleased with our fourth quarter and fiscal 2005 results and believe we are well positioned for growth in 2006. Our healthy brand advertising business combined with the steadily improving search product further supplemented by cautious recovery on the wireless side are all positive factors as we look ahead into 2006 and beyond. We view the Olympic sponsorship as a strong growth catalyst, and affirmation of SOHU’s long-term leadership in this dynamic online environment. We remain confident that our positioning and forward strategy contains the optimal mix of what is needed to drive results and increase shareholders value.

That concludes my presentation. Thank you for your attention. I would now like to open the floor for questions. Operator?

Questions & Answers

Operator

Thank you. Ladies and gentlemen, at this time we will begin the question and answer session. If you have a question, please press the '*' followed by “1