Sogou's (SOGO) CEO Xiaochuan Wang on Q1 2018 Results - Earnings Call Transcript

| About: Sogou (SOGO)

Sogou Inc. (NYSE:SOGO) Q1 2018 Earnings Conference Call April 25, 2018 7:30 AM ET

Executives

Xiaochuan Wang - CEO

Joe Zhou - CFO

Jessie Zheng - Investor Relations

Analysts

Thomas Chong - Credit Suisse

Alex Yao - JPMorgan

Piyush Mubayi - Goldman Sachs

Natalie Wu - CICC

Jessie Zheng

Hello, everyone, and thank you for joining Sogou's First Quarter 2018 Conference Call. On the call, our CEO, Xiaochuan Wang; and our CFO, Joe Zhou, will give an overview of operations and financial results. Before management begins their prepared remarks, I would like to remind you of the company's 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 our current trends, estimates and projections, and therefore, you should not play 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 containing any forward-looking statements. Some more information about potential risks and uncertainties, please refer to the company's filings with the Securities and Exchange Commission.

With that, I will now turn the call over to CEO, Xiaochuan Wang.

Xiaochuan Wang

Thank you, Jessie, and thank you everyone for joining on our call. I will begin by providing an overview of our business progress during the first quarter of 2018. Joe will then represent our financial results for the first quarter.

In first quarter of 2018, we continued to steady business implement our twin-engine growth strategy driven by Sogou Search and Sogou Mobile Keyboard. Comprised despite slower growth in overall search markets, we posted a healthy business growth with core search revenues growing more than 50% year-over-year. According to iResearch data, at end of March, we have a mobile search market share of 18.2%, 3 percentage points higher than a year ago. The user base of Sogou Mobile Keyboard continue to grow rapidly with 382 million - 362 million DAU, up 41% from a year ago. According iResearch data, Sogou Mobile Keyboard will remain the third largest mobile application in China by DAU. In core search, we continued to differentiate - different [Indiscernible] our offering in key verticals. In healthcare, we have made significant strength in improving the quality of search results. Upon ages, healthcare-related content now covered [Indiscernible] of healthcare-related queries have significant increase from less than 10% just a year ago. And in education, our investments in industry-leading online education company in the first quarter gave us access toward a significant amount of [Indiscernible] in education. This move will enable us to a better need in increasing demand for education-related search. We will continue to limit incumbency with valuable content data and technology especially in the healthcare, legal and educational verticals. We continue to look for opportunities to build strategic partnerships through equity investments that help to solidify Sogou competitive edge and drive long-term growth of our cost benefit.

We also continued to innovate with Sogou Mobile Keyboard, started improving user accuracy in terms of both smart, interaction and text-based expressions. Sogou Mobile Keyboard is China’s most popular language input application with users spending an average of more than one hour a day using it. Moreover, Sogou Mobile Keyboard have interface with virtually all the application where users would require Chinese input in different use cases. This have created a solid foundation for us to look for new ways to provide this information and so that our user value.

In AI, our R&D investment remains focused on the technologies since our language voice consolidation, translation or Q&A. These investments are trading technological breakthroughs by allowing us to continuously optimize our core products. Another great example of our progress in AI was our participation in March [Indiscernible] international completion for conservation with the name [PASCAL VOC], where we fit a new word [Indiscernible] in terms of object detection. This fully demonstrated our leading [Indiscernible] space model for Advanced Image Processing. We are already leveraging our computer-reaching capabilities in our mobile keyboard and smart transmission devices. For example, this app automatically translates English, realize objects such as manual and those trends into Chinese, with improved accuracy in recognizing text with images.

We also made further progress in voice technology. As of March, Sogou Mobile Keyboard [Indiscernible] an average of 280 million voice secrets per day, making it the largest voice recognition application in China.

In March, we launch the Sogou’s Travel Translator, which was very well received by the market and both out on first page of launch, making it the best seller among clear products.

Now I will turn the call over to our CFO. Joe Zhou.

Joe Zhou

Thank you, Mr. [Chang]. Hello, everyone. We step into 2018 with solid financial results. Our total revenues increased by 53% year-over-year to $248 million in the first quarter. Our non-GAAP net income witnessed a continued gross momentum with 56% year-over-year increase to $20 million. Overall, we are very pleased with this type of results. Going forward, we will continue to leverage our duo growth engines, Sogou Search and Sogou Mobile Keyboard, to further enhance our financial and operating performance. And now I will walk through our financial results.

Please note that, unless otherwise noted, all monitory amounts that I discuss are in US dollars. Also note that I will refer to some non-GAAP numbers. You can find the consolidation of non-GAAP to GAAP measures in our earnings release.

Total revenues in the first quarter were $248 million, a 53% increase year-over-year. On a constant currency basis, the exchange rate in the first quarter of 2018 had been the same as a year ago. Total revenues in the first quarter would have been $230 million, a 41% increase year-over-year. Search and search-related revenues were $220 million, a 55% increase year-over-year. The increase was primarily due to a strong growth in auction-based pay-per-click services, driven by continued traffic growth and improved monetization in mobile search. Auction-based pay-per-click services accounted for 83% of our search and search-related revenues compared to 81% in the corresponding period in 2017.

The number of advertisers for our auction-based pay-per-click service was approximately 75,000, an increase of 12% from the same period of 2017. The average revenue per advertiser for auction-based pay-per-click services was $2,430, an increase of 42% year-over-year. Other revenues were $28 million, a 38% increase year-over-year. The increase was primarily due to increased revenues from sales of smart hardware products and Internet value-added services.

Cost of revenues was a $154 million, a 76% increase year-over-year. Traffic acquisition cost, a primary driver of cost of revenues, was $112 million, a 94% increase year-over-year, representing 45% of total revenues compared to 36% in the corresponding period in 2017. The year-over-year increase was driven by price inflation as a result of increased competition. We believe it is important for Sogou to compete aggressively in traffic acquisition, because increased traffic enhances the scale [indiscernible] to advertisers and a benefits the bottom line.

Gross profit was $94 million, a 26% increase year-over-year. Non-GAAP gross profit was $95 million dollars, a 26% increase year-over-year. Both GAAP and the non-GAAP gross margin were 38% compared with 46% year-over-year. The decrease primarily resulted from traffic acquisition cost outgoing revenues. Total operating expenses were $80 million, returned to 8% increase year-over-year.

Research and development expenses were $47 million, and 41% increase year-over-year, representing 19% of total revenues, compared to 20% in the corresponding period in 2017. The increase was primarily due to an increase in salary and the benefits expenses, share-based compensation expenses as well as outsourced product development fees, reflecting our continued efforts to strengthen our AI capabilities.

Sales and marketing expenses were $27.1 million, a 9% increase year-over-year, representing 11% of total revenues, compared to 15% in the corresponding period in 2017. The increase was primarily due to an increase in both salary and benefits expenses for our sales and marketing staff as well as marketing and promotional spend for our mobile products.

G&A expenses were $6 million, a 38% increase year-over-year, representing 2.6% of total revenues, compared to 2.9% in the corresponding period. The increase was primarily due to an increase in professional service fees.

Operating income was $20 million, a 16% increase year-over-year. Non-GAAP operating income was $19 million, a 47% increase year-over-year.

Income tax expense was $2 million compared to an income tax expense of $1 million in the corresponding quarter of 2017. The effective tax rate was 12% compared to 8% in the corresponding quarter of 2017.

Net income attributable to Sogou was $15 million, a 25% increase year-over-year. Non-GAAP net income attributable to Sogou was $20 million, a 56% increase year-over-year. Basic and diluted earnings per ADS were $0.04. Non-GAAP basic and diluted earnings per ADS were $0.05.

As of March 31st of 2018, the Company had cash and cash equivalent and short-term investments of $1.1 billion compared with $1 billion as of December 31, 2017. Net operating cash inflow for the first quarter of 2018 was $56 million. Capital expenditures for the first quarter of 2018 was $13 million.

And finally turning to guidance. For the second quarter of 2018, we expect total revenue in the range of $295 million to $305 million, representing a 40% to 45% increase year-over-year. Please note that for the second quarter of 2018 guidance, we have presumed an exchange rate of RMB 6.40 to $1.00 as compared with the actual exchange rate of approximately RMB 6.86 to the dollar for the second quarter of 2017 and RMB6.36 to the dollar for the first quarter of 2018.

That concludes our prepared remarks today.

Jessie Zheng

Operator, we are now open to the questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Thomas Chong from Credit Suisse. Please go ahead.

Thomas Chong

Jessie, thanks for taking my questions. My question is about our Sogou Mobile Keyboard. Given the fact that it is our second engine with a huge user base and it's our key applications, can you comment about our strategy for Sogou Mobile Keyboard in the future?

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So our strategy was about mobile keyboard is quite straight forward. First we need to expand market share; and second, we are looking for new ways for monetization.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So Sogou Mobile Keyboard has expanding its user base rapidly with DAU up 41% year-on-year. But I have still want to emphasize a few facts that you better bear in mind.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So Sogou Mobile Keyboard is essentially for app smartphone every 10 user that use Chinese Internet so actually they’re real. Half of them will real replace the naked keyboards on smartphones with Sogou Mobile Keyboard and will never enabled our mobile keyboard occupies half of the screen with daily time spend of over one hour, and it actually can interface with all kinds of application that requires Chinese input in different use cases. And we have a very large user base and we have a very strong user stickness. This allows us to be the undisputable leader in Chinese input method.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

We’re very confident that we can build upon this competitive advantage and to further expand our market share, first we will continue to innovate with our Sogou Mobile Keyboard to increase user retention and we -- in such a way our partners will become increasingly recognize our product quality and branding power, and building on that so we can - we are in a much better position to extend our partnership with - such OEM makers through pre-installation to allow more internet users to use - to allow more smartphone user to use Sogou Mobile Keyboard as a default keyboard.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

Turning to monetization. So first, we have actually generated a portion of revenue from the search suggestion function embedded in Sogou Mobile Keyboard and in the future look for new used cases to expand the user coverage. In the past, Sogou Mobile Keyboard had less than 50% of the market share and there was certain difficulty in rolling out a search suggestion function large scale. But with market share of over 50% still growing rapidly, we think it’s a right time for us to increase user coverage.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

And more importantly, we now see that users, while they type, they actually have great demand for information and services. We are looking to innovate with the product format on mobile keyboard and to create opportunities to deliver information and services that our users value without interfering with user experience.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So lastly, Sogou Mobile Keyboard has strong dictator capabilities which we have been talking about but actually which are not fully unlocked. Sogou Mobile Keyboard processed over 90 billion Chinese character inputs every day, and through that we can secure massive language data and capture user behavior and intention across different use cases. This helps us to improve accuracy of user profiling, which will help us to facilitate the developments of news feed and Internet finance business as a very good complement to our core business. For example, we have leveraged Sogou Mobile Keyboard data to build the user profiles for some Internet finance users, which have helped us to identify high-quality users and will minimize credit risk.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

These initiatives that we have been talking about will be steadily implemented within this year, and we will provide update when we see more clearer progress.

Thomas Chong

Thank you for the detailed answer.

Operator

Thank you. The next question is from Alex Yao from JPMorgan. Please go ahead.

Alex Yao

Good evening, Xiaochuan, Joe and Jessie. I have a couple of questions on the cooperation with the Tencent. Number one. We saw there has been some new changes to the WeChat search function. I just want to get your thoughts on how you think about the impact on Sogou search. For example, the current priority for many programs seems to be higher than before. Would that potentially affect Sogou’s general search usage within the WeChat search?

Secondly, can you give us a little bit update on the integration between WeChat search and Sogou’s general web search? If there’s any metrics you can share with us such as the traffic, coverage, click-through rate et cetera, et cetera, that’ll be very helpful.

And then lastly, how do we think about the potential for WeChat search?

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So first, Tencent is one of our biggest shareholders. Since we established a strategic partnership in 2013, we have been giving our cooperation and now to waiting search. So we’ve noticed that mini-programs seems to be ahead of -- on top of the search results, but according a discussion with Tencent, which has search that’s not a prioritized that search results from particular source such as the mini-programs or other Tencent parties, the results are displayed based on multiple factors, including user search needs, our relevancy and timeliness. At the same time, WeChat team has definitely corporation with us to cater or users’ search needs. We have heard from Tencent that the integration has significantly enhanced user engagement with WeChat platform. So there is something I can share here. Users are actually responding very positively to Sogou’s general search results, which have over 30% pick-through rate in every 100 times when users see them.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So WeChat has still fine-tuned search function handy and smart take monetization as the top priority. They still focus on improving user experience. For example, WeChat has recent been beta testing some of the news search functions, including the tax and search box, which enable users to switch content in different verticals we can know WeChat echo system. This is something we have talked to Tencent. These new changes actually provides a more intuitive and a convenient user interface making it easier for users to find content within a WeChat echo system, including moments, official accounts, mini-programs, videos, music and so on. The new changes also allows more space for Sogou by core and the Sogou general search without to be displayed. So in summary, reaching is due in testing the search function mandates.

Alex Yao

Can you talk about how do you think about commerciality of our general search within WeChat search? Thank you.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

As regard to the monetization potential Sogou general search, we believe, only after WeChat search draft monetization, then monetization goes to Sogou. So I think it still takes time.

Operator

Next question is from the line of Piyush Mubayi from Goldman Sachs. Please go ahead.

Piyush Mubayi

Just looking at the cost side, how should we think of the high TAC in Q1 as well as the lower SG&A in the quarter? Are these levels indicative of what we could expect for the rest of 2018? And on the revenue side, if you could just take us through how the trends in traffic has been split between organic the Tencent component and Tencent drivers as well as what you've been able to get from OEMs?

Joe Zhou

So first on the cost of side. So we've TAC increase a 9 percentage points as percentage of revenue comparing to a year ago. So the gross margin decreased, say, 8 to 9 percentage points accordingly. So that trend will continue during the rest part of the year. So we expect tag us percentage after the revenue for 10 to 18 to be say 8 to 9 percentage points higher comparing to that of 2017. So we compete aggressively for traffic acquisition so that we can offer larger scale of prioritizing the service to our advertisers. That will benefit us both top line and the bottom line. So for traffic mix, so for this quarter, 24% organic and 38% from Tencent and 38% OEM. That didn’t change much comparing to last quarter. So for the rest of the year, we do expect our organic channel will be the faster -- will see the fast growth about the straight channels. This contribution in another term will go out from current say 24% to close to 30% in a two-year timeframe. So for OEM channel, we expect the percentage will keep stable, and for Tencent channel also stable for the rest of the year.

Piyush Mubayi

And on that, if I may just interject and ask. It appears that the TAC on the non-organic component of the revenues is almost -- is north of 60%. Is that a correct calculation?

Joe Zhou

Piyush, would you repeat your question?

Piyush Mubayi

The traffic acquisition cost for the stream of revenues that is not organic, that appears to be around 60%, which seems quite high. Why would it be that high?

Joe Zhou

If you compare the TAC as a percentage of acquired traffic, the ratio is close to 60%. So with competition, the price was up substantially this year. So we need to share most of the revenue to OEM channels, I mean for our acquired traffic.

Piyush Mubayi

Okay. Sorry continue.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So I just want to add some, provide some additional color on price inflation. Actually starting from this year, some smaller players were motivated by short-term initiative to bid aggressively for acquired traffic. That is there acquiring the traffic had a huge loss. We don’t believe this is a sustainable approach to traffic acquisition.

Operator

Thank you. The next question is from Natalie Wu from CICC. Please go ahead.

Natalie Wu

Hi. Good evening. Thanks for taking my question.

Operator

I’m sorry to interrupt you. Can you speak up a bit loud? Your voice is a bit fibble.

Natalie Wu

Is that better?

Operator

Yes, much better. Thank you. Please continue.

Natalie Wu

You know that Sogou has always differentiated yourself by the extraordinary AI capability, but we can see that there is very large gap in terms of R&D expenses between you and your competitor. So just wondering how do you and what kind of the math you actually apply to insure your leading concession in the AI-related area going forward? Thank you.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So unlike some of our competitors who invested -- R&D investment in AI is quite is less focused, Sogou actually has a clear-cut roadmap and focuses on natural language understanding. It’s not about autonomous driving or OS. We are looking to focus what our advantage are best leveraged, such as voice translation and transformation and Q&A technologies. So this enables us to stay at the forefront of what we are really good at.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So actually, our AI capabilities can be instantly applied to our core products and in different use cases such as search, [indiscernible] and the smart hardware. For example, we recently launched the Smart Travel Translator, which leverages our voice and the machine translation technologies, those being the core technologies of natural interaction. And also on service side, so the search actually - just in the afternoon we launched a marketing campaign showcasing actually [We Can], index international healthcare -- authoritative healthcare information on a Sogou search platform. So we look to secure the future gateways to smart hardware and closing the loop from technology capabilities to smart hardware instead of just simply a provision of AI technologies.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So from technology to application, we are actually among few. We’re actually among - in actually the leading position in the industry. On the technology side, we have a lot of new users and we have industry-leading capabilities in terms of AI technology. And in terms of applications, we are among the first to roll out simultaneous translation and almost first to index global healthcare information and also and on the first to launch the up-to-date translation devices that leverages our priority machine translation technologies. So in terms of both technology capabilities and applications, we believe we are in a industry-leading position.

Operator

The next question is from [Jill Zhang] from 86Research. Please go ahead.

Unidentified Analyst

I have two questions. One is regarding to core search and one is on the Smart Travel Translator. So for the core search business, can management elaborate more on the Q1 revenue growth? Its way into traffic and monetization, how much of that growth was driven by traffic growth and how much is driven by the improvements on monetization? And the second question is on the Smart Travel Translator. We noticed that recently launched Travel Translator now can be both and much importantly comes back on. I’m wondering can management share some data on sales volume since release and what is the annual sales target for this product? How should we look at this business? When you launched new smart hardwares in the second half, any indications on financial impact in June '18? Wnd what is the long-term growth strategy for smart hardware business?

Joe Zhou

Okay. I’ll take the revenue one and Xiaochuan will take the translator one. Okay. So for Q1, if I look at R&D revenue, so total revenue increased by 41% year-over-year. Among that, core search revenues increased by 47% year-over-year. So that’s driven by high single-digit traffic growth and about 30% improvement on monetization.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So as compared to smartphones, actually our Smart Travel Translator can be used in different use cases, such as when you are in plane or when you are shopping abroad. Our Smart Travel Translator is known for its offline translation capabilities, which actually leverages a strong algorithm, and CPU capabilities. And it’s equipped with microphone array that is very rare in such smart hardware.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So in March, we launched the Sogou Smart Travel Translator, which was very well received and so sold out on the first day of its launch, making the back seller among peer products. We target sales volume of less than 1 million units this year. Actually we have a team of [Indiscernible] as smartwatch product which has sold out 1 million units in, and we have leveraged our R&D capabilities accumulating from developing a smartwatch to apply it to the development of our translation devices. So from industry -- at industrial design to product party, we are actually in a leading position. And in the future we are going to launch a flew of smart hardware products that caters the needs of ordinary people. In this way we met -- so our strategy on smart hardware is actually to look for new gateways to information and services and focus on different use cases, such as travel, family and in-vehicles and building our gateway while adding to our car businesses. And on the technology side, smart hardware actually is also the best place where we can leverage our different AI capabilities, especially in interaction to be applied in different use cases and to bring the technology to be more programmatic.

Xiaochuan Wang

[Foreign Language]

Jessie Zheng

So we status smart hardware runways to contribute increasing percentage to the revenues and with improving margin profile, but we are not looking for a huge profit contribution. Instead, we’re trying to use what we have gained from a sales of the smart hardware to improve our R&D capabilities.

Operator

Thank you. Ladies and gentleman, this concludes our question-and-answer session. I would like to turn the conference back over to Jessie Zheng for closing remark. Over to you.

Jessie Zheng

Thank you, everyone, for joining today’s call and for your continued support for Sogou. We look forward to speaking to you again in the future.

Operator

Thank you very much.

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