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Sohu.com Inc. (SOHU)

Q1 2006 Earnings Conference Call

April 26, 2006, 5:00 p.m. EST

Executives

Ingrid Shea, Investor Relations

Charles Zhang, Chairman of the Board and Chief Executive Officer

Carol Yu, Chief Financial Officer

Analysts

Jason Brueschke - Citigroup

Safa Rashtchy - Piper Jaffray

Dick Wei - JP Morgan

William Meade - Deutsche Bank

Richard Ji - Morgan Stanley

James Mitchell -

Lu Sun - Lehman Brothers

Chen Chu - Vertovic

Presentation

Good evening ladies and gentlemen, and welcome to SOHU’s first quarter 2006 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Ingrid Shea. Please go ahead ma’am.

Ingrid Shea

Thank you for joining SOHU.com to discuss our first quarter 2006 Results. On the call today are Dr. 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 online 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 Dr. Charles Zhang, Chairman and CEO. Charles.

Charles Zhang

Thank you. Welcome to SOHU's first quarter 2006 financial results call. I am happy to report that we have started fiscal year 2006 on a strong note, with our core advertising business experiencing solid growth, and our non-advertising business ramping up nicely.

Year 2005 was a year where SOHU experienced growing threats in China's online advertising sector, after placing a heavy emphasis on the core advertising business. 2006 has shown that this momentum has continued at a solid pace. We look to further grow our business, to expanding our content offerings with strategic partnerships and continue our developments and the rollout of our own innovative products and services to drive traffic and usage on the SOHU family of websites.

Now I would like to discuss highlights for the first quarter. Despite being a seasonally weak quarter, we achieved another record total revenue of $31.3 million for the first quarter of 2006, growing 3% sequentially and 32% year-over-year, exceeding the Company guidance.

Let me discuss the progress of our main business lines. First, advertising. Overall we experienced a healthy quarter in advertising. Advertising revenue for the first quarter was $20.1 million, down 1% quarter-on-quarter and up 35% year-over-year, exceeding our guidance.

The brand advertising revenue was $16.7 million, representing a sequential decline of 1% and year-over-year increase of 38%. Sponsored search accounted for $3.4 million, representing a sequential increase of 1% and a year-over-year increase of 26%.

In brand advertising, revenues were primarily driven by heavy spending sectors such as automobiles, information technology and real estate. We were pleased to see increased monetization of our new products. Revenue from ChinaRen and new community-based products such as message boards and the blogs, and the picture galleries increased around 60% sequentially. There has been growing momentum in the more recent quarters, and we expect this to continue going forward.

At SOHU we are always looking for new and innovative ways to attract more users to our sites, and expand the power of the SOHU brand. During the first quarter we made significant reinvestment to enhance our content offerings and also improve products, adding more differentiated content in the form of streaming media.

In connection with this, I would also like to highlight the following: first on the major international sports events front, we are taking strides towards becoming a leading online sports content provider in China. With SOHU's Olympics sponsorship role, and now with SOHU's partnership role surrounding the FIFA 2006 World Cup; all of this while still maintaining a higher gross margin than our major competitor.

As we move closer to the Beijing 2008 Olympics, we have increased our traction with the Olympic partnership and sponsorship community of potential advertisers, especially surrounding the recent Winter Olympics in Torino. We also provided extensive coverage of the event on our sports channel.

In our quest to further enhance our sports content, we have been investing aggressively and smartly to provide premium and differentiated content for the upcoming World Cup event. In March, we were chosen by SMGBB.cn a subsidiary of the Shanghai Media Group to be an exclusive portal partner in delivering exclusive 2006 World Cup broadband Internet video content to Chinese Internet users and football fans.

In addition, earlier this week we announced a partnership with Sony BMG which allowed SOHU.com to be able to exclusively offer a full range of music and video products of the 2006 World Cup official music via online and wireless capabilities.

We view both these relationships as SOHU's further commitment to providing the best and the most exclusive content to its growing user base, and also a testament to SOHU's leading global brand presence, capable of providing well-thought out content of extremely high profile international events.

It is to our expectation that the impact of the Olympics will become more fully magnified as the Beijing 2008 Olympics approaches. We expect the World Cup to be an important revenue contributor in the late second quarter and early third quarter, when the event takes place. That is on the sports event front.

Secondly, SOHU's family of sites and innovative products continue to attract more traffic, increasing stickiness and leading to more effective monetization with brand advertisers. With more than 1,000 content providers and a unique product, SOHU's combined family of websites continue to rank number one in page views amongst all Chinese Internet portal companies, according to Alexa.com.

As of March 2006, total family traffic was 102% of our major competitor in terms of page views. Traffic from our portal site, SOHU.com, represented 72% of our major competitor. We also continue to have higher stickiness with approximately 11 page views per user, versus our competitor's 10.

As an integral part of our strategy, we are focused on developing our community-based products such as China Net and China Alumni Club, message boards, picture galleries and blogs. This has proven to be successful, as traffic to these products has increased nicely since the launch of this product. We continue to invest and broaden our new product portfolio, such as Photo Album, in order to grow on an already existing solid base, and increasingly monetize this product going forward.

Now let me talk about sponsored search. In sponsored search, the 1% sequential growth and 26% year-over-year growth was driven by continued improvements to the Sogou search product itself, and a more concentrated effort in marketing and promoting the Sogou brand. We have followed the successful launch of Sogou v. 2.5 in November 2005 with an additional product and a feature enhancement. We launched a new feature search capability in February 2006, and added an improved seamless map search function in 2006, both of which will further enhance the overall search experience.

In addition, our innovative Sogou marketing campaign such as Sogou Super Girl contest, and our national photo dog search continues to generate buzz throughout China. Those events are cost effective and creating marketing initiatives to promote the Sogou brand in the most meaningful way to reach the mass Chinese online population. We strive to make Sogou the search engine of choice. Customer tailored, key to the needs of the Chinese community.

With the continuous product improvements combined with an effective marketing campaign, SOHU has continued to experience a robust traffic growth in the first quarter, increasing over 50% from the previous quarter, according to our internal data.

Overall, we remain confident that there will be strong growth to our core advertising business over the next few years. The branding effect from the Olympic sponsorship and other high profile international events such as the World Cup will have an increasingly significant impact on our ability to attract more enterprises as the online advertising market in China grows.

We are also continuing to focus on developing and fine tuning our search product, given the increasingly competitive search environment in order to best position SOHU as one of the leading search engines in China.

For the full physical year of 2006, we remain confident in reaching our full year advertising revenue growth target of 25% year-over-year. We see continued healthy growth in brand advertisers and the sponsored search.

Now let me turn to our wireless business. Well, our focus remains on our core advertising business, we have been pleased to see a continued pick up in our wireless business with 10% sequential and a 34% year-over-year growth in the first quarter to now $8 million. This represents the fifth consecutive quarter of growth in our wireless business, which has been achieved entirely through organic means, with no substantial increases in promotional expenses or reinvestment.

During the next quarter we will be able to leverage our content partnerships such as the Sony BMG partnership, to allow us to offer a full range of music and video products of 2006 World Cup Official Music through wireless services, which will contribute more to our ringback tone and WAP revenues.

We will also be working more closely with China Mobile to jointly promote our efforts in integrated marketing of ringback tone and WAP services for the World Cup Official Music. Through these partnerships, we believe we will be able to more effectively promote SOHU' s World Cup Music products through China's mobile user population.

In early April, one of our mobile network operators issued a new policy, applicable for all ISPs in which it set price ceilings for SMS monthly fees or per message subscription fees. This became effective on April 17th and is likely to reduce our SMS revenue from this mobile network operator. However, for the second quarter 2006 we expect the negative impact of this new policy on SMS revenue to be offset by the positive contributions resulting from the World Cup event.

As we have previously stated, we believe it is important for SOHU to maintain a presence on the wireless side and more specifically in the WAP, in anticipation of the eminent launch of the 3G mobile network in China and the burgeoning market that it will bring.

Our WAP portal launched in December, 2005 continues to see strong sequential traffic growth of 30% in the first quarter and we will continue to capitalize on SOHU's comprehensive content streams from our web portal and family of web sites so that we can take full advantage of complementary wireless revenue opportunities. In short, our business divisions are well-aligned and well-positioned to achieve our growth objectives.

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

Carol Yu

Thank you, Charles. I would like to take this opportunity to discuss some key financials for the first quarter 2006. First, revenue. We are pleased to report strong record revenues of $31.3 million for the first quarter, which exceeded our guidance. Advertising. With advertising revenues of $20.1 million, we are experiencing marginal sequential decline of 1% and a year-over-year increase of 35% from search revenue. Bid listing revenue accounted for 30% of our total search revenue, unchanged from the previous quarter.

Wireless. We have been pleased to see a continued steady recovery of this business. Wireless revenues were $8 million, up 10% quarter on quarter and 34% year-over-year. Let me give you a breakdown of wireless revenues for the first quarter. SMS revenues increased 13% sequentially to $4.7 million after certain technical problems with one of the operators which we solved in the previous quarter. WAP revenues grew 12% sequentially to $2.5 million, mainly due to product enhancements and better ranking on the Monternet platform. MMX, IVR and ringback tone services accounted for $0.8 million in total, as compared to $0.9 million in the previous quarter.

Other revenue. Our other revenues mainly included online game revenues which grew 23% sequentially and 54% year-over-year to $2.1 million. The growth was primarily driven by the increase of sales of [virtual goods] in the games.

Turning to our growth margin. Starting from January 1, 2006 share-based compensation expenses are charged to cost of revenues and operating expenses following the adoption of FAS 123R. Total share-based compensation expenses for the first quarter was $1.7 million. We believe, excluding such expense from our non-GAAP financial measure of net income makes a more meaningful comparison of our operational results, and improved users understanding of our performance. Hence, we use non-GAAP measures below to explain margins, comps and expense items.

Overall non-GAAP growth margin for the first quarter was 66%, unchanged from 66% in the previous quarter, but down from 68% in the first quarter of 2005. Advertising non-GAAP gross margin was 75%, up from 74% in the previous quarter but down from 78% in the same period last year. Brand advertising, non-GAAP gross margin was 76%, up from 75% in the previous quarter but down from 77% in the same period last year.

Sponsored search non-GAAP gross margin was 69%, up from 68% in the previous quarter, but down from 82% in the same period last year. Non-advertising, non-GAAP gross margin was 51%, an improvement from 50% from the prior quarter, but down from 52% in the first quarter of last year.

Operating expenses. For the first quarter, SOHU's non-GAAP operating expenses totalled $13 million, down 9% from the previous quarter but up 20% year-over-year. The quarter to quarter decrease was primarily due to a one-time accounting adjustment recording an accrual of sales commissions during last quarter. Year-over-year increase primarily related to costs associated with our Olympic sponsorship and personnel costs.

Operating margin. Non-GAAP operating margin for the first quarter was 25%, up from 19% in the previous quarter and 23% in the same period last year. GAAP operating margin for the first quarter was 19%.

Income tax expense. Starting in 2006, the applicable PRC income tax rate for most of our operating entities in the PRC have increased to 7.5% due to the expiration of certain income tax covenants. For the first quarter, income tax expense totalled $0.4 million.

Net income. Non-GAAP net income for the first quarter was $7.8 million or $0.20 per fully diluted share. This compares to net income of $8.9 million or $0.23 per fully diluted share for the previous quarter and $5.7 million or $0.15 per fully diluted share for the first quarter of 2005. GAAP net income for the first quarter of 2006 was $6 million, or $0.16 per fully diluted share.

Balance sheet. Let me now make a few comments on the balance sheet. As of March 31, 2006 SOHU's cash, cash equivalents and investments in marketable debt securities was $137 million as compared to $133 million as of the end of last quarter, and $129 million as of last year's first quarter. As of March 31, 2006 our net accounts receivable balance was $24.9 million, an increase of $5.6 million as compared to last quarter. This included $17.8 million related to our advertising business, and $7.1 million relating to our wireless business.

During the first quarter, we collected sales proceeds of $15.5 million for our advertising business. Our DSO for the first quarter was 76 days as compared to 62 days in the previous quarter. First quarter advertising DSO is 89 days compared to 77 days for the fourth quarter. Because we typically receive advertising sales proceeds from third-party advertising agencies in the second and fourth quarters, based on agency contracts. We normally have higher advertising DSOs in the first and third quarters. We continue to closely monitor our accounts receivable.

As of March 31, 2006 our bad debt provision amounted to $1.5 million compared to $1.2 million as of December 31, 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 our credit extension.

Finally, our business outlook. You will find detailed guidance for the second quarter 2006 in our earnings release, but I would like to highlight:

SOHU estimates total revenues for the second quarter of 2006 to be between $31.5 million to $33.5 million with advertising revenue of $21.5 million to $22.5 million and non-advertising revenues of $10-11 million.

SOHU estimates non-GAAP fully diluted EPS for the second quarter to be between $0.20-$0.22.

Assuming no new grants of share-based awards, SOHU estimates the share-based compensation expense for the second quarter of 2006 to be between $1.2 million to $1.3 million. This expense will reduce SOHU's fully diluted GAAP EPS by $0.03 to $0.04.

In summary, we are pleased with our first quarter 2006 results and believe we are well-positioned for future growth. Our healthy brand advertising business, combined with a steadily improving search product, further complemented by stable growth on the wireless side, are all positive factors as we look ahead.

We view the World Cup as a near-term growth driver and the Olympic sponsorship as a longer-term growth catalyst. We strive to brand SOHU as a leading online international content provider, and global online news and entertainment provider.

We look forward to providing everyone with more updates of our successes for the remainder of 2006, and take this opportunity to thank everyone for their interest and continued support in SOHU's vision.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jason Brueschke - Citigroup.

Jason Brueschke - Citigroup

Thank you. Good morning, Carol and Charles and congratulations on another fine quarter.

Carol Yu

Thank you, Jason.

Jason Brueschke - Citigroup

I have a question about the advertising business and then one about the wireless business. The advertising business is off to a remarkably strong start for Q1. Can you comment whether you are seeing more of a fundamental change in the amount of advertising across the industry that is moving from offline sources to the online? And maybe comment on some of the efforts that you need to do beginning early in the third quarter to specifically expand and grow the number of advertisers, and when that might be happening? Then I will come back and ask a wireless question. Thanks.

Carol Yu

I think you are right, Jason. The online advertising market in general is seeing a lot of momentum, continued shifting from offline to online general GDV growth in China, and so on and so forth. You see it in everything that is happening in this industry.

More specifically relating to SOHU, I think there are a few things worth noting. The first is, the Olympic sponsorship continues to prove to be a very powerful weapon in terms of branding SOHU as the premier destination for advertisers. I think that is becoming more and more evident.

The second point is SOHU's consistent strategy is to continue to invest in these strong sponsorships like the World Cup, and probably more to come; to reinvest back into the business to build and give users very differentiated and premier content. I think you can see us differentiating from the rest of our peers. So hopefully the momentum will continue and we will be seeing more growth to come.

Jason Brueschke - Citigroup

Great. Regarding the new policy with [Vivanet] could you help quantify exactly what is happening there? What is their review process for [inaudible - technical difficulty]

Carol Yu

They put a number of caps on a per message basis and on the monthly subscription, but all in all we expect if the volume doesn't change, I mean if it is not price elastic, then it would probably reduce our revenue by $0.5 million in Q2.

Jason Brueschke - Citigroup

It is actually quite minor, the relative impact you are seeing there?

Carol Yu

Right, but instead of projecting growth, I mean hopefully -- we are now on the downside. So the [two way] impact, to us, is quite -- we don't like to see that, let's put it this way. It is not significant, but it is not something that we like to see. But as Charles has said, we do expect our investment in World Cup and the Olympics and the other organic efforts that we are putting into the wireless business will be able to offset this impact.

Jason Brueschke - Citigroup

Have you started to aggressively monetize that yet? Or are we still in the pre-monetization phase? Can you give us an update on that?

Charles Zhang

We are still in the pre-monetization of Sogou. Driving traffic and developing the product technology is the focus of 2006.

Jason Brueschke - Citigroup

Thanks and congratulations.

Carol Yu

Thank you, Jason.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Good morning Carol and Charles. Congratulations on a good quarter. A couple of questions. Charles, I believe you if I heard you right, your guidance for the year or your broader outlook of 25% outlook growth; yet you grew much faster this quarter and you mentioned that not only you are seeing an overall [acquisition] in the market, that some of your initiatives, including World Cup, are helping and you expect to [measure] your impact on World Cup.

I am trying to reconcile the two statements. If you think it is such a good trend, why wouldn't you be able to increase that outlook of 25% growth for advertising?

Carol Yu

I will take that question, Safa. Yes, we are seeing a lot of momentum but we are still only in the second quarter of the year and we still feel more comfortable with the 25% than any high-end numbers. But just to clarify, we are not seeing any bad news at this stage.

Safa Rashtchy - Piper Jaffray

The second question is on search. Can you give us some color on what kind of progress you have made in market share from users, as well as if you can give some color on the revenue market share?

Charles Zhang

Let me first off talk about the traffic market share, and then let Carol talk about the revenue side. I think first of all the traffic growth, 60% over last quarter, which basically we have been maintaining this rate of growth over the last few quarters; I think Sogou is among the fastest-growing search engines in traffic market share, of all of the search engines in China. I don't believe any other search engine can grow quarter on quarter 60% in terms of page view traffic.

To achieve that, it is basically a maturing of the Sogou v2.5 that we launched last November. A lot of rough edges, trying to smooth it out and making it more user friendly and more powerful. Now we already have 2.5 billion pages achieved and we indexed 800 million pages. The user experiences are improving gradually, every week, by the week.

Also, we will have launched some featured search. We launched a picture search which we didn't have a proper picture search before, but now it is a very user-friendly picture search. Also the completion of the integration of the [Go To] map with Sogou, so now a very powerful Sogou map search. That map search also integrated from day one to the SOHU properties, so that if you have news reporting anywhere, you immediately have a location and the Sogou map would help you point out that location. All of this integration with the SOHU family of websites.

Also, continued improvement of our music search and the music box, and the music box integration with other parts of SOHU's blogs and others. So I think in terms of traffic and the product side, it is page search development and the feature search, picture search and music box search and the map search, and also the integration of Sogou search with all of our other SOHU properties, the matrix of portals. These later points, the integration with others, is something our competitors do not have. They do not have that kind of portal matrix resource.

Carol Yu

On the revenue side, we just want to talk about the revenue mix. It remains pretty much the same, [inaudible] versus paid is about 30%. I think it is a typical business as usual quarter for search.

Safa Rashtchy - Piper Jaffray

One last question if I may. Do you expect to grow at the same rate of your overall online advertising market in 2006 or do you think it will grow faster?

Carol Yu

We expect to be slightly faster, but not by a huge margin because of the relatively low base.

Charles Zhang

The search is always traffic first, and the revenue second. I think 2006 is really a year we dramatically ramp up our traffic to a significant level. Then we will look at 2007 to have revenue growth.

Safa Rashtchy - Piper Jaffray

Thank you. Great quarter.

Carol Yu

Thank you.

Operator

Our next question comes from Dick Wei with JP Morgan.

Dick Wei - JP Morgan

Good morning, Carol and Charles. Congrats on a good quarter.

Carol Yu

Thank you, Dick.

Dick Wei - JP Morgan

I have a question on the advertising as well, basically as related to the growth. I wonder how much of World Cup related advertising revenues have been factored into the second quarter? Do you think those revenues are one-time only in the second quarter? Do you think advertisers, are they pulling in their second half advertising to the first half for the Olympics, or is that additional to what they spend?

Carol Yu

We don't want to give the amount, as you can appreciate, for competitive reasons. What we see is you remember we always tell people that the advertisers sign framework contracts with us at the start of the year. We are actually quite pleased to see -- we are quite pleased to see that close to 50% of the advertising dollars flowing into World Cup are one side of the framework that we sign, so these are pure additional ad dollars that people are pulling either from cutting their other expenses or from other media into online advertising and onto SOHU. This is a very good indicator, as far as we are concerned.

Dick Wei - JP Morgan

Lastly, can you comment on the revenues, [Focus and 173]?

Carol Yu

[Focus and 173] altogether would be close to $4 million, just below $4 million.

Dick Wei - JP Morgan

The growth is pretty much in line with the rest of the segments?

Carol Yu

Not really. These are typically very slow seasons for Focus and 173. So we are actually seeing a down quarter for these two segments. Last quarter was about $4 million, so we actually see growth coming from the other sections to bring the sequential decline to only 1%.

Dick Wei - JP Morgan

Great, thanks a lot.

Carol Yu

Thank you, Dick.

Operator

Our next question comes from William Meade with Deutsche Bank. Please go ahead.

William Meade - Deutsche Bank

Hi, I know it is a small segment, but could you talk a little bit about your games business and the number of items sold, the number of users? Average price they paid, things like that? What games are driving the item sales? Thanks.

Carol Yu

The number of users is probably about 30,000 so it is pretty much unchanged from the previous quarter. Our strategy during Q1 was because we actually have quite a bit of fall in terms of users from last year from play, so we were anticipating that during Chinese New Year as well. But the fall did not come as expected and for the sale of virtual goods in both games, we did quite heavy promotion on the virtual goods and that is why we have quite a decent increase as compared to last quarter.

Charles Zhang

For two games.

Carol Yu

Yes. Hello?

William Meade - Deutsche Bank

Yes -- sorry, I thought you were going to say something. Could you just comment a little bit on your user generated content? The content business, community blogs, just some metrics there in terms of perhaps the revenue generated off of that?

Charles Zhang

That is also a focus of not only SOHU but all of the Chinese Internet. We have continued to build the communities based on the two largest communities we have, which are the SOHU message boards and also the China Alumni Club and community.

Then we launched our blogs. Blogs, we've already completed the recent technological upgrade for the software layer, so now we are ready to market the blogs as a second attempt, a second phase of blogs. Also, to look at how to integrate the blogs with the two large community offerings SOHU has. Also, the SOHU music box.

So we have been seeing traffic growing very nicely in these web 2.0 products, although we suffer a little bit as other Internet companies in China, given the recent government regulation cracking down on Internet pornography and other policies.

There is a slight drawback recently, but overall the new products are getting a lot of attention. More importantly, SOHU is probably one of the few companies able to monetize this traffic. Our web 2.0 products, the revenue on selling these products grew by 60% in Q1.

William Meade - Deutsche Bank

Is that quarter over quarter?

Carol Yu

Yes, quarter over quarter.

William Meade - Deutsche Bank

Can you just give a sense of how many users there are using the blog services?

Charles Zhang

Now it is 200,000 bloggers and page views are about, daily page views, is between 5 million to 10 million.

Carol Yu

And BBS is around 30 million page views.

Charles Zhang

The two message boards are very big; about 30 million page views per day for the SOHU message boards, and the China Alumni Club, the ChinaRen community generates another I think 25 million page views. The China Alumni Club has 18 million. So total is about 55 million to 60 million page views with the SOHU message boards and the ChinaRen.com. That product combined alone, which basically make up the largest online community in China. On the web side, web-based -- I mean the Internet Explorer side, not the client end user side.

William Meade - Deutsche Bank

Okay.

Carol Yu

Thanks William.

Operator

Our next question comes from Richard Ji with Morgan Stanley. Please go ahead.

Richard Ji - Morgan Stanley

Hi, Charles and Carol.

Charles Zhang

Hi, Richard.

Richard Ji - Morgan Stanley

I had two questions. The first question is regarding the strategy of acquiring differentiating content, especially I am very much interested in the revenue sharing in the Olympics and for your FIFA World Cup content, what the revenue sharing arrangements are.

Carol Yu

It is not a revenue sharing, it is a straight purchase.

Richard Ji - Morgan Stanley

Can you elaborate a little bit more?

Carol Yu

We won't go over the detailed terms, but basically we signed a contract with SMGBB. They got the exclusive rights for the Internet and wireless video clips from FIFA. We are in cooperation with them that we will be their only portal partner. In return, we pay them a fee. So that is basically it.

Richard Ji - Morgan Stanley

My second question is regarding the ChinaRen revenue. Again, I estimate the ChinaRen is one of the top two or top three communities. What is the revenue? Can you quantify for us, what is the revenue contribution from wireless [inaudible - technical difficulties] from that community?

Carol Yu

We don't really use ChinaRen as a base for our wireless business. The monetization comes from the advertising side. Again, we don't disclose the dollar amount but as Charles has said, quarter to quarter our revenue from all of these, what we call the new community-based products grew by 60% quarter to quarter in Q2.

Richard Ji - Morgan Stanley

My final question is regarding advertising sales; dealing with very strong growth year-over-year. How much of that first quarter growth is related to the Olympics? I remember fourth quarter last year you already generated some revenue from the Olympics.

Carol Yu

I think it is not relating to Olympics as it is the branding impact that the Olympics is bringing us that we see a general increase in advertisers in SOHU. So I mean, there is not much Olympic-related event in Q1. I mean, the only thing we have is the winter Olympics, which is not a very high profile event in China.

But the general increase of advertisers interest in SOHU actually helped us to deliver the results that we see.

Richard Ji - Morgan Stanley

Thank you.

Carol Yu

Thanks, Richard.

Operator

Thank you. Our next question comes from James Mitchell. Please go ahead.

James Mitchell -

Good morning Charles and Carol, I have three questions; one big and one very micro. You've obviously mastered the art of guidance which is all good. If I look at your very strong branded advertising revenue growth, I think that in '05 you reduced the number of advertisers. For the first quarter of '06, was your growth driven more by higher spend per customer or a larger number of customers?

Carol Yu

We are actually seeing both.

James Mitchell -

Okay, so after shrinking your customer base a little bit in '05, it has expanded again in '06?

Carol Yu

I would say that we are actually -- I mean, it is very difficult to say whether it is expanding the customer base, because let's take financial services as an example. When they first advertised with us, they would come with RMB 100,000 to start with, but with all of the positive things that we have mentioned, they may now increase it to RMB 1 million per year.

What I am trying to say is, the new customers, when they first started, would be very, very small and they may just do it in one quarter or a month or a week or whatever; and then they may now turn to a year round customer.

I would say that, expansion is from this very small, even negligible amount, now they are becoming a major source of income.

James Mitchell -

Your interest income seems to be down a little bit QonQ and down a little bit year-over-year, [slightly off cash balance] -- is there anything adversely impacting interest income during the quarter?

Carol Yu

It is actually the overall strategy of cash management. Interesting enough, RMB is generating lower interest income than U.S. dollars, especially within China with the anticipation of further Yuan appreciation, we choose to keep more of our cash in Yuan, so that explains it.

When we did all of the stock buyback and bond buyback and the acquisitions, mostly that these are offshore U.S. dollars. The higher interest income cash is being depleted without us replenishing it in anticipation of a further Yuan appreciation.

James Mitchell -

So you benefit from the exchange rate depreciation in the interest rate?

Carol Yu

That's right. But then, because our functional currency is in U.S. dollars, the exchange rate benefit actually goes into the balance sheet instead of the P&L. Despite the accounting treatment, we see real dollars, real benefits instead of just accounting benefits.

James Mitchell -

With what the various interest rates were that you need to take a balance sheet gain rather than the P&L -- okay.

Carol Yu

Thank you.

Operator

Our next question comes from Lu Sun with Lehman Brothers. Please go ahead.

Lu Sun - Lehman Brothers

Hi, Charles. Hi, Carol. Actually I have two questions. One is a follow up on your web v2.0 products. What is the revenue contribution in the first quarter? You mentioned that it is up 60% quarter on quarter. Also, I would be very curious to find out what would your way of monetizing these products? What kind of advertising you are putting on to this?

Charles Zhang

Lu, we are not disclosing the distribution of our advertising revenue. Normal, traditional web properties and the web 2.0 properties. Also, very often we combine the contracts, packaged contracts. We design a package of marketing initiatives for the advertisers with front page exposure and major channel media property exposure, plus some message boards and Alumni Club and ChinaRen and web 2.0 products. So it is very complicated. It is a package.

For competitive reasons and also for the reasons that it is not very easy to separate, we are not disclosing this number.

Lu Sun - Lehman Brothers

On your R&D expense, it seems to have grown in the first quarter? What are the major products that you are working on? Is it games or search functions? Can you elaborate a little bit. And also give us guidance for your full year?

Charles Zhang

Let me first describe it qualitatively. It is definitely, we continue to invest in the Sogou search. We need more servers and more bandwidth as the traffic continues to grow. Also, we are now in the phase to integrate and to leverage the Sogou technology to the overall SOHU web properties. I think costs are definitely bandwidth and servers are one part of the cost. Maybe Carol can comment qualitatively about the cost increase in R&D.

Carol Yu

I think it is really manageable, I mean we are investing aggressively but we still; engineers in China are not that expensive, so I think overall cost increases are really manageable.

Lu Sun - Lehman Brothers

Do you think it will be stable throughout the year or will you continue to see it at the rate of the first quarter for the remainder of the year?

Carol Yu

The way we manage our business is really to look at things net bottom line; if I spend more here, I spend less elsewhere. So I would just say that we just said in the past that the overall operating margin remained pretty stable at the mid-20 level. I mean, if I need to spend more this quarter, I will cut spending on the other expense items. We didn't really manage the business just by looking at individual line items.

Lu Sun - Lehman Brothers

For R&D, other than search, are there any other products that you think you need to spend a lot of money? Do you think that it will be generating revenue going forward?

Charles Zhang

A further comment about costs in R&D -- I think as we continue to grow the search traffic, actually grow much faster than our competitors, our server costs are not growing at a similar rate, because we just have a more, smarter -- the server quality and technology, architect design. These read-outs and the I/O, just better designed. So this is something that I want to point out.

Besides the page search technology that by itself has already amassed very deep research and a lot of effort, not just a one-word search but behind search there is a whole technological achievement and thrust.

Besides search, we also are developing streaming technologies which will turn the SOHU portal from a text-based media into both text-based and also streaming media with the World Cup video content exclusive rights, and with more and more motion picture streaming media content available, both through partnership or through some in-house development, TV technology and streaming media technology are very critical to the overall SOHU media property growth.

That will immediately be translated into advertising revenue, which will be able to attract beyond into the TV commercial area. I mean, the advertising dollar that was spent on TV commercials now find the Internet to be a very good streaming media platform to advertise.

Lu Sun - Lehman Brothers

Thank you very much.

Operator

Thank you. Our next question comes from Chen Chu with CEI Vertovic. Please go ahead.

Chen Chu - Vertovic

Congratulations, Carol on a good quarter. I have a couple of questions. The first one will be in terms of the online advertising, do you see the growth come strongly from one or two particular industries, or is it pretty much evenly allocated?

Carol Yu

It’s pretty much evenly allocated, like what we have said. I mean, the general impact brought by Olympics, the up-tick in revenue from new products, new community-based products, and I think advertisers are now paying a lot of attention to what SOHU is doing because we have been aggressively investing in the high quality premier differentiated content that they would come and ask us, do we have more to come and they want to book resources, that sort of thing. So the momentum is there.

Chen Chu - Vertovic

Another question would be, World Cup is a one-quarter event, so is that…

Carol Yu

It’s two.

Chen Chu - Vertovic

Okay.

Carol Yu

It’s two quarters. It’s between Q2 and Q3.

Chen Chu - Vertovic

Okay, so it is a two-quarter event, can I say this -- you have to develop some new growth drivers, or like a near-term growth?

Carol Yu

Well, I mean, that’s always the case, Chen. I mean, like what we did in 2004, after we had the Athens Olympics, we have to find something else. That’s our day-to-day business.

Chen Chu - Vertovic

Is it fair to say that the World Cup is a pretty much an industry event, is not only driving SOHU’s online advertising revenue, but also will drive other portal’s advertising revenue?

Carol Yu

Yes, that’s true, but Chen, the fact that we have the video clips from FIFA, the official video clip, is the very differentiated content. It fits very well into the broadband trend of China, and it’s very, very different from the typical SOHU type of content. I mean, I can find 2,000 newspapers that supply news content, but that’s only one official video clip.

Chen Chu - Vertovic

Okay.

Charles Zhang

Yes, as Carol was saying, it’s a broadband penetration and also streaming media technology carried China’s Internet from a text-based stage, era, to this multimedia era. Compared with four years ago, the World Cup, the video clips are more essential than four years ago when China’s Internet was still basically a text-based Internet.

Also, for any independent sports event, people especially want to see a moving picture versus just a text-based description. So this is very essential, very important for SOHU to benefit from the World Cup more, because we have this exclusive video clip content.

Chen Chu - Vertovic

So another question will be router in wireless value-added services. I know you were participating for wireless rights for the song of the World Cup. Last week, there was news and talk about China Mobile had a conference with music labels and wanted to have a centralized platform for music downloads, and so ringtones even will be consolidated by China Mobile. Down below, what do you think about your focus on music, on songs, and what do you think about this policy will impact on other SP’s?

Charles Zhang

I think definitely in two areas, one is that we look at certain areas where we kind of have music copyrights, labels that we own or we have. Also the Supergirl contest, Sogou's Supergirl Contest, is a part of the marketing initiative for the Sogou search engine, but also it’s going to be an annual talent contest to generate and to make stars, singers; so that’s also part of our original content efforts. That’s one area that we’re definitely looking to more independent musical content through either by self-creation or by working with some other partners.

Secondly, to be different from other standalone SP’s, SOHU has the web portal with over 250 million page view downloads, and the mobile phone will become a more and more Internet-like, because IP networks with 3G will have a more seamless connection and do more functions that the people are doing on the Internet, so people who prefer to do the similar things, their emails, their music box, and the kinds of groups they visit. all these,

The mobile phones and the PCs are not as separated as before. People want to do similar things because the bandwidth and the memory and the storage and the pixels, everything are almost ready.

Because of this, SOHU has an advantage over other standalone SP’s because we already have the SOHU music box, and the toolbars and other software engineered, and entertainment devices that can be extended to the mobile phone.

Also, the web is the ideal, I would say the second interface for people to interact with the Internet, the web and the WAP and the mobile phone, two interfaces. Besides the mobile phone operators as a first interface, and the web and the WAP from the portals are the second interface.

Also, together with the first point I mentioned, where we get into some original musical content. I think we have an advantage as an Internet portal over standalone SP’s, and we believe that we will continue to grow our artist list nicely.

Chen Chu - Vertovic

Thanks so much.

Operator

Thank you. Ladies and gentlemen, we are at the end of our time for question and answers. I would now like to turn the conference back to management for closing remarks.

Carol Yu

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

Operator

Ladies and gentlemen, this concludes the sohu.com First Quarter 2006 Earnings Conference Call. You may now disconnect. Thank you for your participation.

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Source: Sohu.com Inc. Q1 2006 Earnings Conference Call Transcript (SOHU)
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