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Sohu.com Inc. (NASDAQ:SOHU)

Q2 2008 Earnings Call

July 28, 2008 8:00 am ET

Executives

Brandi Piacente - The Piacente Group

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

Belinda Wang - Co-President, Chief Marketing Officer

Dr. Gong Yu - Chief Operating Officer

Carol Yu - Co-President, Chief Financial Officer

Analysts

Jason Brueschke - Citigroup

Dick Wei - J.P. Morgan

Jenny Wu - Morgan Stanley

Eddie Leung - Merrill Lynch

C. Ming Zhao - Susquehanna Financial Group

Operator

Welcome to the Sohu second quarter 2008 earnings conference call on the 28th of July, 2008. (Operator Instructions) I would like to turn the conference over to Miss Brandi Piacente, Investor Relations. Thank you, Madam, please go ahead.

Brandi Piacente

Thank you for joining Sohu.com to discuss our second quarter results. On the call today are Chairman and Chief Executive Officer, Dr. Charles Zhang; Co-President and Chief Marketing Officer, Belinda Wang; Co-President and Chief Financial Officer, Carol Yu; Chief Operating Officer, Gong Yu; Vice President of Online Game Business, Wang Tao; and Senior Finance Director, Alex Ho.

Before management begins their prepared remarks, I would like to read you the Safe Harbor statement in connection with today’s 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 online advertising sales, online game revenues, and mobile phone related wireless revenue 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 CEO. Charles.

Dr. Charles Zhang

Thank you, Brandi. Hello, everyone. Thank you for joining us today. We are very pleased to report another strong quarter. The second quarter of 2008 was the fourth consecutive quarter in which we reported record total revenues, record revenues in each category, and record net income, [and we] exceeded the high end of company guidance.

For the second quarter of 2008, Sohu achieved another milestone in the company’s history, with total revenue exceeding $100 million. Our total revenues grew by 20% quarter-on-quarter and 162% year-on-year to $102 million. Brand advertising revenue reached $41.7 million, representing an increase of 26% quarter-on-quarter and 57% year-on-year. Online games revenue reached $47.9 million, up 17% quarter-on-quarter and 11.5 times year-on-year. Non-GAAP net income increased 69% quarter-on-quarter and 423% year-on-year to $42.3 million.

Now let’s take a closer look at Sohu's performance. For our portal business, the strong momentum we achieved in the second quarter was merely a result of our distinct portal strength, from execution on our Olympic strategy and marketing campaigns across China. For the second quarter, all of these efforts resulted in the 64% year-on-year increase in average unique visitors to the Sohu portal. A good example is our unmatched success on the Olympic torch relay project reporting in attracting both users and advertising dollars. According to iResearch, an independent research forum, 62.2% of all Internet users in China watched the Olympic torch relay through Sohu's website, and 83% of all the Internet users in China said that they will use Sohu websites to obtain information on the Olympic games, which will be 29% more users than our closest competitors.

The success surrounding the Olympic torch relay coverage also attracted heavy advertising spenders, such as Coca-Cola, Lenovo, and Samsung, to name a few.

In the second quarter, we conducted an all-out promotional campaign which included TV advertising, bus banners, billboards, and LED exposures in 26 first and second-tier cities in China. If you plan to come to China during the Olympic period, you will see first-hand the power and influence of the Sohu branding campaigns. The campaigns create a lot of buzz throughout China and enhance Sohu's brand value.

In addition, we expect to see the momentum of both traffic and the revenue continue into the third quarter.

The Beijing 2008 Olympic Games is a prime example of Sohu's successful media strategies to garner premium content and promote Sohu branding. Gong Yu, our Chief Operating Officer, will provide a review on this in a few moments.

We also expanded the interactivity of the Sohu matrix by providing users with alternative ways to access Olympic information. For example, Sohu bloggers can customize their blogs by adding their favorite Sohu features, such as news, photos, videos, and so on, making Sohu blogs an all-inclusive area where Chinese sports fans keep track of their favorite games, teams, and athletes.

In June 2008, Sohu blog has fully integrated with the largest online alumni club in China, chinaren.com, and launched its space feature. Similar to the [friends feeds], it allows bloggers to add tags and notes on friends and support for RSS reading.

Besides, Sohu's technological initiatives will continually attract new users to Sohu websites. For example, the Sogo Pinyin measure has been further expanding market share in the second quarter due to its product quality and the effective marketing campaigns. During the Olympic Games period, Sogo Pinyin will deliver the most updated Olympic information through Sogo Pinyin, which we expect will further attract users. Further, Sohu is riding the tide of the remarkable expansion of the overall China Internet industry.

After any historical event, Internet adoption in China tends to escalate to a higher level, followed by an expansion in the online advertising market. Sohu has leveraged such opportunities to the fullest extent. For example, after the tragic Sichuan earthquake in May, many non-Internet users turned to the Internet to get the latest news or information, as the Internet has been able to provide the most timely comprehensive and in-depth coverage of the event from all perspectives. This expanded the reach and traffic of the Sohu portal and the channel sustained after the earthquake.

We expect penetration of the Internet in China will rise again with the Beijing 2008 Olympic Games, which is only 11 days away from us. We believe that our achievements so far, the expanded user base, increased brand recognition, and the strengthened media influence will carry forward to 2009 and beyond.

Belinda will provide a review of our brand advertising business in a few moments but first, let me briefly discuss our online game business. For the second quarter of 2008, online games revenue increased 17% quarter-on-quarter and reach $47.9 million, exceeding the high-end of company guidance, despite the earthquake in Sichuan Province, which prior to the earthquake has contributed to 3% of our online game revenue and as well as a server shutdown during the three-day national mourning period.

Although Tian Long Ba Bu has entered its second year of commercial operation, it continued to gain users and perform well in China’s online game market, with revenue in Mainland China growing to $43.3 million, representing a quarter-over-quarter increase of 13%. This was made possible by periodical new content release designated to cater to changing user preferences and attract new players to our game.

We were glad to see that peak concurrent users continued to increase during the quarter, from 600,000 to 700,000. Registered accounts grew by 21% quarter-on-quarter from 27.9 million to 33.8 million people. After the three-day national mourning period from May 19th to May 21st, daily peak concurrent users bounced back to the level higher than for the pre-mourning period, and daily spending increased when compared to the same day in the week before the mourning period. We believe that this shows the stickiness of Tian Long Ba Bu.

In the second quarter, we have focused on enhancing users’ in-game experience, converting non-paying users into paying users, and reducing the launches of new virtual items, with a goal of expanding the lifecycle of the game. Active paying accounts increased by 21% quarter on quarter from 1.39 million to 1.68 million. Quarterly average revenue per active paying accounts, or ARPU, decreased by 10% quarter-on-quarter from RMB199 to RMB179.

Further, our early efforts to bring Tian Long Ba Bu overseas have started to bear fruit. In the second quarter, our overseas game licensing revenue increased by 4.7 times from $400,000 to $2.2 million U.S., now representing 5% of our total online game revenue. To date, we have licensed Tian Long Ba Bu in Taiwan, Hong Kong, and Vietnam. In April 2008, we commercially launched Tian Long Ba Bu in Taiwan and Hong Kong, and within three months Tian Long Ba Bu has become one of the most popular games in both regions. We may, on an opportunistic basis, expect to export Tian Long Ba Bu to other countries.

In early July, we launched a new expansion pack for Tian Long Ba Bu, which we believe will help to maintain the momentum of the game. Despite the potential negative impact of the summer holidays and the Beijing 2008 Olympics on online games usage, for the third quarter we expect our online games revenue to grow by 7% to 12% quarter-on-quarter.

Next on our game pipeline, development work is on track for both our new in-house game, Duke of Mountain Deer, and a licensed new game, Legend of Ancient Worlds. Our target to have closed beta testing of Duke of Mountain Deer by the end of 2008 and Legend of Ancient Worlds in mid-2009 remains unchanged.

For Duke of Mountain Deer, based on our internal evaluations and initial feedback collected on the China [July] festival, we are satisfied with the quality of the game.

I would now like to talk about the plan for confidential filing of the draft registration statement from IPO of the game business, Changyou.com. We also today announced that we plan to submit on a confidential basis to the U.S. SEC a draft registration statement for a possible initial public offering of American Depositary Shares, ADS, representing ordinary shares of Changyou.com Limited, Changyou, a recently-organized Cayman Islands company that is Sohu's online games business subsidiary. The number and dollar amount of ADSs proposed to be offered and sold have not yet been determined.

Sohu’s and Changyou’s purposes for conducting the IPO, if commenced, is to provide Changyou a sharper focus on the online games business and related strategic opportunities, with Sohu remaining Changyou’s majority shareholder.

The IPO is expected to commence as market conditions permit and is subject to Changyou’s filing with the SEC a registration statement on Form F-1 in compliance with the U.S. Securities Act of 1933 as amended, or the Securities Act, and the SEC’s declaring such registration statement effective.

This announcement is being made pursuant to and in accordance with Rule 135 under the Securities Act. As required by Rule 135, this announcement is not intended to and does not constitute an offer of any securities for sale.

Thank you for your attention. I would like to now turn the call over to Belinda Wang, Co-President and Chief Marketing Officer, for a brief discussion of our progress in Sohu's brand advertising business.

Belinda Wang

Thank you, Charles. For the second quarter of 2008, we are excited about another quarter of record brand advertising revenue. It was mainly attributed to number one, over-extension of China’s Internet market, as mentioned by Charles; number two, continuous shifting of advertising budgets from offline to online; and number three, robust momentum.

In advertising spending as the Beijing 2008 Olympic Games draws nearer; and last but not least, further increase in the overall effectiveness of advertisers’ marketing campaigns on the Sohu platform due to expansion of our unique visitors.

For the second quarter, the top three industries in brand advertising were automobile, real estate, and online games. The fastest growing sectors were IT, real estate, and online games. For the IT sector, starting with the torch relay, advertisers have been expanding their ad spending to capture consumer attention and enhance brand value by leveraging the Olympic Games. For real estate, the growth is mainly due to developers that increased their promotion to compete for limited proxy buyers, given the slow proxy market in certain regions of China. And the strong growth of online games is due to the rich pipeline of the industry, despite speculation as to a slower Chinese economic growth due to the expansion of Internet reach with the advertisers in industries experiencing headwinds nevertheless increase their advertising spending on the Sohu platform even more than before to maximize the cost efficiency of their marketing campaign.

So with that, I would like to turn the call over to Gong Yu, our Chief Operating Officer, for a review of website operations.

Dr. Gong Yu

Thank you, Belinda. During the second quarter, we continued our strategy of offering premium content to attract more users to our websites and [challenged] the portal of choice for the Beijing 2008 Olympics, Sohu has been well-prepared to provide the most comprehensive, authoritative, and first-hand coverage of the Olympics and Team China, not to mention few [inaudible]. In June, Sohu was awarded new media rights to Internet broadcasting for the Olympics. Our strategy partner, CCTV.com, as a [inaudible]. Sohu will offer live webcasts and video-on-demand of competition together with the opening and closing ceremonies of Beijing 2008 Olympic Games. Sohu will have 3,800 hours of Olympic video content and we can jointly produce Olympic related video programs together with CCTV.com. Sohu as the sole Internet platform featuring the [Info 2008] system, which provides real-time live goals and delivers first-hand Olympic Games news. With this feature, Sohu will be able to provide comprehensive Olympic coverage ahead of any other website.

According to China Internet Network Information Center, the state network information center of China, as of June 30, 2008, China has 253 million Internet users, an increase of 46.2% year-on-year, and has become the number one Internet nation in the world. As Charles mentioned earlier, for the second quarter average unique visitors to the Sohu portal increased by 64% year-on-year. This has proven that our initiatives and improvement resulted in our game marketing share of Internet users and reinforcing Sohu as the leading position among China Internet companies.

With that, I would like to turn the call to Carol, Co-President and Chief Financial Officer for a review of Sohu's financial results. Carol.

Carol Yu

Thank you, Gong Yu and hello, everyone. I will now provide a review of the financial results for the second quarter of 2008.

One, revenues -- starting with the top line results, total revenues hit a record of $102 million, representing an increase of 20% sequentially and 162% year-on-year. Not only did each of the revenue categories exceed our expectations but all surpassed all-time records.

One, advertising -- total advertising revenues reached $43.4 million, as we achieved a sequential increase of 25% and a year-on-year increase of 53%. Brand advertising revenues totaled $41.7 million, representing a 26% sequential increase and a year-on-year increase of 57%. Sponsored search revenues were $1.7 million, representing a 5% sequential increase and a 3% decline year-on-year.

Non-advertising revenues -- non-ad revenues totaled $58.6 million, representing an increase of 17% sequentially and 452% year-on-year. Online games revenues were $47.9 million, an increase of 17% quarter-on-quarter and 11.5 times year-on-year, due to the continued strong performance of Tian Long Ba Bu. For the second quarter, revenues from Tian Long Ba Bu and Blade Online were $45.5 million and $2.4 million respectively.

Wireless revenues were $9.2 million, a quarter-on-quarter increase of 7% and year-on-year increase of 39%, despite our making of a one-off tax provision of $2.1 million, which was net of against wireless revenues. Sohu is well-positioned to minimize risk associated with the wireless sector, as it now only represents around 10% of our total revenue.

Two, gross margins -- under SFAS-123R, share-based compensation expenses are charged to the quarter’s cost of revenue and operating expenses. Total share-based compensation expense for the second quarter of 2008 was $2.2 million. 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 investors’ understanding of Sohu's performance, so we use non-GAAP measures in this discussion to explain margins, cost, and expense items.

Non-GAAP gross margin for the second quarter was 76%, flat with the previous quarter and increased from 62% in the second quarter of 2007. Non-GAAP advertising gross revenues were 65% in the second quarter, compared with 64% in the previous quarter and the second quarter of 2007.

Brand advertising non-GAAP gross margin for the second quarter was 67%, flat with the previous quarter and the same period last year. Sponsored search non-GAAP gross margin for the first quarter was 6%, flat with the previous quarter and down from the 22% in the same period last year. The year-on-year decrease was mainly due to higher bandwidth costs to support the increased traffic. Non-advertising non-GAAP gross margin was 84% for the second quarter, compared with 85% in the previous quarter and up from the 56% for the second quarter of last year.

Online games non-GAAP gross margin for the second quarter was 93%, up from 92% in the previous quarter and 64% in the same period last year. The increase correlates to the increase in TLBB's revenue.

Wireless non-GAAP gross margin for the second quarter was 40%, down from the 54% in the previous quarter and the 52% in the same period last year. The decrease was primarily due to a once-off tax provision which was net of against wireless revenue mentioned earlier. Excluding such provision, wireless non-GAAP gross margin for the second quarter was 51%.

Three, operating expenses -- for the second quarter, Sohu's non-GAAP operating expenses totaled $35.4 million, up 15% from the $30.8 million for the previous quarter and up 111% year-on-year. The year-on-year increase was primarily due to the continued investment in product development, marketing expenses for Sohu's branding, as well as an increase in bonuses to reward employees for their contribution to Sohu's good results. The quarter-on-quarter increase was mainly due to Olympic related marketing spending.

In the first and second quarter of 2008, we incurred Olympic related marketing expenses and content costs of $0.5 million and $6.5 million respectively. For the third quarter, we expect Olympic related marketing expenses and content costs to be around $17 million. All these costs and expenses will be non-recurring for the fourth quarter of 2008 and beyond.

Four, operating margins -- non-GAAP operating profit margin was 41% for the second quarter, up from 40% in the previous quarter and 19% in the same period last year.

Five, income tax expense -- income tax expense in the second quarter was $0.6 million, compared to $9.2 million in the previous quarter and $0.2 million for the same period last year. In the first quarter of 2008, Sohu accounted for its PRC income tax based on its Q3 tax rate of 25%. Given Sohu's technological-centric business with strong research and development capabilities, in the second quarter we were informed by the relevant tax bureau that some of our operating entities will be entitled to certain tax holidays and be subject to a zero income tax rate for the full year of 2008 and 12.5% for 2009 through 2011. Accordingly, in the second quarter, Sohu adopted a 0% income tax rate for these entities and reversed a $4.1 million related income tax provision that was made in the first quarter of 2008. Excluding such reversal, the effective tax rate for the second quarter was 11%. We expect our overall effective income tax rate for the rest of 2008 to be in the low teens.

Six, net income -- non-GAAP net income for the second quarter reached a record high of $42.3 million, or $1.07 per fully diluted share. Non-GAAP net income increased by 69% sequentially and 423% year-on-year.

Seven, net margins -- non-GAAP net margin for the second quarter was 42%, compared with 13% in the previous quarter and 21% in the second quarter of 2007.

Eight, balance sheet -- as of June 30, 2008, our cash and cash equivalents were $226 million, 72% of which were denominated in RMB compared to $160 million as of the end of the first quarter.

As of June 30, 2008, our net accounts receivable balance was $36.6 million, an increase of $0.4 million as compared to $36.2 million last quarter. Our DSO for the second quarter was 31 days, as compared to 37 days for the previous quarter. Second quarter branding DSO was 52 days as compared to 60 days for the previous quarter.

As of June 30, 2008, our bad debt provision totaled $2.2 million, flat with $2 million as of March 31, 2008.

Nine, finally that brings me to our business outlook. For the third quarter of 2008, Sohu expects: one, total revenues to be between $112 million to $116 million, with advertising revenues of $48.5 million to $50.5 million and non-ad revenues of $63.5 million to $65.5 million; two, brand advertising revenues of $47 million to $49 million; three, online games revenues of $51.5 million to $53.5 million; four, after adjusting the $17 million of Olympic related marketing and content costs, we estimate non-GAAP fully diluted earnings per share to be between $1.00 and $1.05, compared to non-GAAP fully diluted earnings per share for the second quarter of $0.97, as adjusted for the one-time income tax reversal mentioned earlier; and lastly, assuming no grants from new share-based awards, we estimate share-based compensation expense to be between $2.5 million to $3 million. The impact of this expense is expected to reduce fully diluted earnings per share under U.S. GAAP by about $0.06 to $0.07. We expect to maintain profitability for the fourth quarter of 2008 at a similar level with Q2 and Q3.

We are delighted with Sohu's many great achievements in the second quarter and believe we are well-positioned for future success. While we continue to invest for long-term growth, we believe that the organic expansion of our businesses, combined with savings from the non-recurring Olympic related cost will result in continued growth of our earnings next year.

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) And the first question comes from Mr. Jason Brueschke from Citigroup. Please go ahead with your question.

Jason Brueschke - Citigroup

Thank you, and good morning or good evening, everyone at Sohu and congratulations on another record quarter. Carol, the results for Q2 and I think the outlook kind of speak for themselves in some ways. I’m going to maybe ask a question that looks out a little bit further, which I think is something on investors’ minds. And what I want to ask about is maybe looking at 2009 in a general sense. On the one hand, there’s a lot of positives. There’s the lapping effect of the Olympics, there’s more Internet users in China, there’s the increasing budget shifts from offline to online, all on the positive side. And then there is maybe on the other side of the equation some growing macroeconomic concern about the state of the Chinese economy. Could you maybe talk a little bit more about what your expectations are with respects to brand advertising and how those two things might very well balance each other off, or what the relative rate is -- excuse me, weight is going to be in 2009?

And then secondly as part of that, if you could comment on how you see the enhanced competitive positioning that Sohu will have in that market in 2009 as a result of your branding campaign, as a result of the benefits of you being the Olympic sponsor this year, that would be helpful. And then I have one follow-up question. Thanks.

Dr. Charles Zhang

So first of all, I think because of the campaign, the brand exposure of the Olympics, after the Olympics, during the Olympics there will be more users visiting Sohu to watch the Olympics. When they visit Sohu, they find that Sohu is not only about Olympic reports but also a better news channel, a better video content and also a more powerful blog and space product, community products, and also the Sohu Pinyin is already used everywhere. So our goal is to really retain or let these users who stay onto Sohu after the Olympics, so you will see -- we’ve observed in the past six months the increase of stickiness of our users so people -- more users will visit Sohu and spend more time on Sohu after the Olympics. That will translate into the click-through rate of the banners and the brand advertising, so that’s why we believe that after the Olympics, there will not be a major slow down for our brand advertising business. Instead, actually just because of the brand exposure, we’ll have more users and more click-throughs to our banner, to our advertising. This is for the overall matrix traffic and the [trends into] advertising. But I think the overall competitive advantage is really Sohu's continued technology and product driven culture that you continue to use better products and also our media-driven strategy to have the best reporting on the portal.

Carol Yu

And Jason, taking up the first part of the question regarding the outlook for 2009 advertising market, and you know that we will not be giving out 2009 advertising guidance yet. I mean, it’s still more than nine months before we probably do that but with the -- like what Belinda has said, we are very bullish about our competitive position, the overall Internet market, and we do believe that we -- like what I said in my concluding remarks that with the savings that we’ll be taking out from our profit and loss accounts on the Olympic related expenses, even though it is like just a so-so growth in our revenue, we’ll still be showing pretty decent earnings growth. So I think that’s comforting. Thank you, Jason.

Jason Brueschke - Citigroup

Absolutely, and I was just -- I’m more interested just qualitatively. I’m wanting to know maybe in the discussions you’ve had with advertisers, because the expectations are that the Olympics probably have already been very successful to brand advertising, it will be next quarter, are you guys hearing or sensing that even if kind of the -- let’s just say the macro advertising environment in China next year, let’s say it’s not as strong for various reasons but that the Internet advertising might be stronger because we expect to see an acceleration in shifting from offline to online. Just really qualitatively, is that something that that trend, do you expect that to be accelerated or enhanced in any way by the success that’s expected from the Olympics? I mean, it’s really qualitative I’m just trying to understand.

Carol Yu

The first thing is that nobody -- I don’t think anybody’s focus will be post Olympics yet, to start with. And second, like what Belinda has mentioned in her script, that even in industries where people are seeing -- the industries themselves are seeing a slowdown, such as auto and real estate; because of the strong media strength of our portal and Internet in general, we’re not seeing any slow down yet.

Dr. Charles Zhang

Basically the correlation between the macroeconomic situation and the online spending is not a direct correlation. If the economy slows down, it doesn’t necessarily translate into a slowdown in the online spending because people may find the Internet to be a more cost-effective marketing tool platform. Actually demonstrated in a recent real estate online advertising, where you have actually more real estate developers find the Internet a better tool to market. So it’s not a direct correlation. It’s hard to say. So really a composite effect that we don’t know yet, but as the Internet user base, as China becomes the largest Internet user base in the world, especially the post 1980 generation, I think the Internet for them is the most -- probably the primary platform to get information and to make friends. And they are really probably a large consumer group where they spend a lot of money. So this generation, a lot of advertisers target.

Jason Brueschke - Citigroup

Great, and then maybe I can ask one quick question about your gaming business -- you had a record performance in the second quarter and I’m just wondering, did you see any effect from the Euro 2008 football or soccer tournament? A big sporting event sometimes can impact the online gaming sector in general, and what would be any of the takeaways from either the effect or lack of effect on TLBB that you could maybe share with us with respect to what your expectations are from any positive impact that the Olympics may have on the game in the third quarter? Thanks.

Carol Yu

We don’t see any impact during the Euro Cup period, and we don’t expect there will be much impact from the Olympics. As we previously explained, because we are a portal, we will drive a lot of news onto the games page as well, so the user can continue to play the games while knowing all the live scores of the hit games. So we don’t believe that there will be much impact. Despite the fact that it’s actually the summer holidays, so we actually see the PCUs staying at the current level instead of going further up because of the summer holidays. I think that impact is more than the Olympic.

Jason Brueschke - Citigroup

Great, thanks, and congratulations again.

Carol Yu

Thank you, Jason.

Operator

The next question comes from Dick Wei from J.P. Morgan. Please go ahead with your question.

Dick Wei - J.P. Morgan

Hi, everyone. Thanks for taking the questions and congrats on a really strong quarter. I’ve got two questions; the first question is after the Olympics, what are the key initiatives for Sohu, maybe the top three key initiatives going forward? Is it more of the content technologies or is it the communities, for example?

And secondly, you currently have more than $220 million of cash right now and I guess the potential IPO would inject more cash into Sohu as well, so what are the plans for cash use going forward? Thanks.

Dr. Charles Zhang

The post-Olympic initiatives, definitely we will stay on course basically to continue to execute our strategy, which is continue to execute our media driven strategy, where we will continue to improve our reporting news and different channels, and also certain vertical industries like the business channel, the entertainment channel and others. And also to experiment with more forms of content, especially video content. So this is one, it’s really the media continues to become the most influential media platform, which is an opportunity that only the Internet in China has, that Internet in the U.S. never had this opportunity to become a major media platform.

Secondly, we will continue to execute our strategy on the space and SNS product, the community space project, like our blogs, which actually -- the kind of Facebook type of service, integration with our China alumni club and all these continue to expand our good momentum that started since 2007 with the base project, the instant messaging, the web instant messaging, the Sohu 3.0 passport, all these we’ve been talking about over the quarters.

And to do that, we continue to have this product-driven culture and more importantly, the technology driven culture where we focus on each product and really make sure it’s the right product for the users.

Of course, we will, as Internet search is an integral part of the Internet usage, we will continue to leverage to develop Sohu search engine and leverage the Sogo Search Engine market with our desktop shopper products, which is Sogo Pinyin to develop, and actually to have basically another major attack on the battle that we’ve been doing for the few years, which is the Sogo Search Engine, we never give up. So this one basically on Sohu media site, the initiatives, the media, the blog space project, and the search.

Of course, on the wireless side, we’ll continue -- we’ll consider how this -- you know, the merge of the mobile phone Internet with the PC-based Internet that tries to experiment with different ways that people to browse Sohu with their mobile phone. Of course, finally, the online games that continue with the launch of Duke of Mountain Deer and basically to continue to build a solid team that are innovative and really effective.

Dick Wei - J.P. Morgan

Great, and the cash question, please?

Carol Yu

We don’t have any immediate plans and we’ll let you know when we figure that out.

Dick Wei - J.P. Morgan

Okay. Thanks a lot.

Operator

The next question comes from the line of Jenny Wu from Morgan Stanley. Please go ahead with your question.

Jenny Wu - Morgan Stanley

Hello. Congratulations on another good quarter. I have two questions; first one, please give us some color on advertising spending by Olympic sponsors, and also the revenue contribution in second and third quarter? Thank you.

And secondly, if it is possible, can you give us some color on generally how long advertising contracts do they usually have with Sohu? Should we expect them to become long-term clients of Sohu going forward? Thank you very much.

Belinda Wang

Regarding your first question, we are unable to give you the exact number from the budget allocation from the Olympic sponsors but Carol just gave you the number, the guidance of our Q3 brand advertising that will be ranged from $48.5 million to $50.5 million, so you can see a nice growth of 155%, so I think you can get the signal from this number to see the trends of the budget allocation from the sponsors.

Dr. Charles Zhang

That’s 65% over last year. And also I think those advertisers have been, even before the Olympics, they have been our long-term advertisers but due to the Olympics and also in the future, they probably allocate more advertising dollars to us.

Jenny Wu - Morgan Stanley

Okay. My second question is regarding your online gaming. For this quarter, we see the ARPU per active paying accounts actually decline. And so first of all, could you give us some color on what is the reason behind this? And secondly, can you give us some color on your future gaming development strategies? Thank you.

Carol Yu

The strategy we used for Q2 is really to grow the active paying accounts and trying to convert more of the non-paying accounts into active accounts. And on top of that, we try to extend the life cycle of the games and trying not to grow ARPU too much. So in fact, the launching of virtual items during Q2 has been slowed down, so that explains the decrease in the ARPU. I think that’s a strategy that we adopt to extend the life cycle of the game.

Dr. Charles Zhang

Actually, that’s our intended -- we intended to do that. It’s like growing crops over the field. You don’t want to harvest too much to deplete the landfill.

Jenny Wu - Morgan Stanley

Okay. Thank you very much.

Operator

The next question comes from Eddie Leung from Merrill Lynch. Please go ahead with your question.

Eddie Leung - Merrill Lynch

Good evening, everyone. I have two questions; the first one is if [inaudible] [to hurt us], you guys have some plans on ’09 [inaudible] going forward. However, when we look at this space, it seems like the so-called pure play online video companies have enjoyed certain first mover advantages in terms of branding and traffic. So what are the advantages over these pure play online video sites that you think Sohu has and how you can play a catch-up game? Thanks.

Dr. Charles Zhang

First of all, Sohu's video traffic is also pretty large, so it’s not really a catch-up game. We are all on the same starting line. Definitely there are lots of [venture capital funds]. I mean, you invest heavily into those online video pure play, so they’ve made a lot of name and -- but I think just like -- remember what happened with the blogs field. There are many, many pure play blogs but later the portals actually reaped the benefits and really become a major player.

So our focus, our initiatives for online video has been very strong focus. We have a few types of video content. We signed with now probably 100 TV stations to carry TV news and TV content and also we have Sohu's original production -- actually, recently we launched a Sohu Beijing report as part of our original production. And certainly we have the -- basically the upload, basically the YouTube type of user generated video, which is probably the one you were talking about, the pure play, providing that service. And also number four is that we have this P2P technology that some of the pure plays don’t have.

Because of the media platform that our videos are a lot of news and reporting, which really provides quality content and useful content, so that in terms of monetization, advertisers tend to try with the Sohu video because they think that their advertising is appearing on quality content rather than on those, you know, not good content that tarnish their brand.

So the problem with the pure play is that first of all, as I just said, is that the content sometimes is not that decent, so that advertisers tend not to spend money, so their income is a problem.

Secondly is the too much pirated content, so that actually a lot content original owners will start to sue them, so that also provides a major obstacle to those pure plays. I think we are very confident that Sohu will fight a winning battle in this newly emerged media and content opportunity, video, online video.

Eddie Leung - Merrill Lynch

I understand. Another tough related question is from your tracking of your own -- you can say media inventory’s traffic as well as the industry traffic, do you see the verticals taking share from portals in terms of traffic, user traffic?

Dr. Charles Zhang

Well, for certain vertical industries, it has its share and also -- for example, also they have their not only the online share, taken but also we have some offline industry events and industry operations that help them to boost the revenue. So for that, yes, it is but the taking away is limited because it’s only certain industries and Sohu's matrix is really providing 80% -- I mean, providing most of the people with most news information, so it is -- it’s a reasonable distribution of traffic but our goal is to really the most openly used activities, like the blogs, the communication, the instant messaging, the news retrieving, everything -- we have the largest per share and for that general activities, the verticals cannot compete with us because this needs a strong technology and a community and the overall platform effect.

And also we are -- our matrix also has certain verticals like focus and [inaudible], so we actually have some verticals [that perform].

Eddie Leung - Merrill Lynch

Okay. Thank you.

Operator

Thank you. The next question comes from C. Ming Zhao from SIG. Please go ahead with your question.

C. Ming Zhao - Susquehanna Financial Group

Good evening. Thank you for taking my question. One question about the Duke of Mountain Deer; you commented on that game very positively in your prepared remarks, so what gives you the confidence when evaluating Duke of Mountain Deer? How does that compare to TLBB before that game was launched?

Carol Yu

After the launch of TLBB, we actually set out a very powerful call center to, or service center to collect feedback from players, so with that we can rechannel all the feedback from the players and get back into the games and make it a very successful and welcomed game by the users, by the gamers. We use all this feedback to build Duke of Mountain Deer as well.

C. Ming Zhao - Susquehanna Financial Group

Okay. All right, second question on the advertising business, if we look at the branded advertising gross margin, the gross margin actually was higher this quarter. Can you explain if this is still going to be the trend going forward? And also, a follow-up question to what has been discussed in the previous quarters, can you talk about the businesses with Focus Media related ad agencies? What’s the change there on the discount rate and percentage of revenue contributed from Focus Media?

Carol Yu

I’ll take the question on the gross margin; on the gross margin part, in the long run we probably will maintain at the present level. There could be some margin squeeze for the next quarter because of a lot of the content costs that we put in for Q3 but the sustainable long-term margin would be at the present level, and I’ll leave the second question for Belinda.

Belinda Wang

We cannot disclose the Deer structure with [subsidiaries] and we can see that it does not make a big impact on our revenue [growth].

Dr. Charles Zhang

Not disclose but not comment on because it’s not our deal -- we cannot comment on the deal that they have but with Focus Media, we have -- we cannot disclose our business cooperation with Focus Media but right now, we don’t think that they have any pricing leverage over us.

C. Ming Zhao - Susquehanna Financial Group

Thank you very much. Congratulations.

Operator

Ladies and gentlemen, we have no further time for any further questions. I will now hand the conference back to Brandi Piacente for any comments or closing remarks.

Brandi Piacente

We would like to thank everyone for participating in today’s call. Please feel free to contact us with any additional questions you may have. Thank you very much.

Operator

Ladies and gentlemen, thank you very much. You may now disconnect.

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