Sogou Inc. (NYSE:SOGO) Q2 2019 Earnings Conference Call August 5, 2019 7:30 AM ET
Jessie Zheng - IR Director
Xiaochuan Wang - CEO
Yi Zhou - CFO
Conference Call Participants
Elsie Cheng - Goldman Sachs
Alicia Yap - Citigroup
Xueru Zhang - 86Research
Alex Yao - JPMorgan
Ladies and gentlemen thank you for standing by, and welcome to Sogou's Second Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. After managements' prepared remarks, there will be a Q&A session. Today's conference call is being recorded and if you have any objections, you may disconnect at this time.
I would now like to turn the call over to your host today, Jessie Zheng, Investor Relations, Director of Sogou. Please go ahead.
Hello, everyone, and thank you for joining Sogou's Second Quarter 2019 Earnings Conference Call. On the call are CEO, Xiaochuan Wang; and our CFO, Joe Zhou, who will give an overview of the operations and the financial results.
In line with our practice on the previous earnings conference call, Xiaochuan's prepared remarks will be made in Xiaochuan's voice using personalized speech synthesis and style transfer learning technology, which was developed by the Sogou Voice Interaction Technology Center. Xiaochuan will join the Q&A question portion of the call in person.
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 measures 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 risk 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. For more information about the 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 our CEO, Xiaochuan Wang.
Thank you, Jessie, and hello, everyone. We are pleased to report that in the second quarter, we achieved steady growth across our core businesses with total revenues reaching US$304 million or over RMB 2 billion. We also recorded for solid profitability with non-GAAP net income of nearly US$28 million or RMB 189 million.
In Search, as of the end of June, Sogou maintained its position as China's second-largest search engine. At the same time, our Search revenue continued to grow faster than the industry average.
In Mobile Keyboard, we recorded 450 million DAUs in the quarter, up 17% year-over-year, which reinforced its position as the third-largest Chinese mobile app in terms of DAU, according to iResearch. With these expanded user bases for both Search and Mobile Keyboard, we have gradually built up our big data and recommendation service at a company level.
Revenues generated from this service have ramped up quickly and is on track to become our second growth engine. At this level [ph] with the support of our core AI capabilities, the smart hardware business has been progressing well with its ongoing upgrade and is delivering tangible results.
Now let me walk you through each of our core businesses. In Search, we are committed to building a more efficient and knowledgeable search platform that provides high-quality content, particularly in health care search and intelligent Q&A.
In the second quarter, we further expanded the authoritative content offering to better address user search intentions and content needs. This has resulted in a significant increase in the proportion of health care search queries as well as growth in the average number of clicks per user for health care search results. Moreover, we stayed significantly ahead of our peers in both the fulfillment and accuracy rate of our top direct answer results in the quarter.
In addition, we further built up our content ecosystem with Sogou Health, our content aggregating platform. During the quarter, we continued to broaden access to the authoritative health care and Q&A content of Sogou Health, allowing us to provide high-quality content as a consistent standard across all our platforms. All of these efforts have effectively boosted our organic traffic growth.
Our top [indiscernible] high-quality content, we have also been strengthening our service offering in Search. During the quarter, we partnered with the health care vertical and introduced initiatives to build a closed loop to better serve the demands of our users.
Specifically, we recently received an Internet hospital license that secured the permission to develop online diagnoses and treatment services. Of note, our independently developed Smart Wise technology, a core technology used in online diagnosis and treatment, was adopted by the regional health care platform in Shanghai Jing'an District in July 2019.
Turning to Mobile Keyboard. Thanks to a number of industry-leading product innovations, Sogou Mobile Keyboard continued to grow its user base. By the end of June, average daily voice requests made via Sogou Mobile Keyboard increased by 72% year-over-year with up to 680 million requests per day, thereby retaining its position as the largest voice app in China.
During the quarter, Sogou Mobile Keyboard launched the most advanced voice conversion technology, which is a voice industry, a strong testament to its leading-edge voice synthesis capability as well as its innovation strengths.
This technology allows users to convert their voices with selection of nearly 20 characters, such as celebrities and animated characters, as well as dialects as this enables our users to communicate in more expressive and entertaining ways. Voice conversion has become one of the most popular entertainment functions in our Mobile Keyboard.
Where we're attracting more users to Search and Mobile Keyboard, we're also building the big data and recommendation service to unlock its commercial value. And big data, based on our understanding of hundreds of millions of our users, we have developed accurate user profiling and have continuously improved the algorithms to make targeted recommendations. This has led a solid foundation for our recommendation service. Meanwhile, we have leveraged our own product matrix to provide our recommendation service to more users.
In particular, we enhanced content and service distribution capabilities with Mobile Keyboard. But remember, during the quarter, we improved this user interface and content format to make this recommendation feature more intuitive in tests.
Further our users, can receive and share content more conveniently. We're pleased that Mobile Keyboard is becoming an important driver for our recommendation service.
In the second quarter, revenues generated from the big data and recommendation service tripled year-over-year. The service consists of news feeds that leverage our various Search-related assets as a content recommendation within Mobile Keyboard, among other things. We expect the growth momentum to continue in the second half of 2019.
Moving now to AI. In the second quarter, we continued to implement our AI strategy of developing language-centric AI technology. We geared up our efforts to drive the innovation in technologies and applications and advanced our leadership in voice and computer vision with many industry-leading [indiscernible]
For example, we launched the world's first Russian-speaking AI news anchor named Lisa in partnership with ITAR-TASS, a news agency in Russia. We've also expanded the application scenario of our Sogou Vocational Avatars, moving into the legal industry. Jointly with the Beijing Internet court, we unveiled an AI judge, the first of its kind in the world.
With this jump [ph] to AI smart hardware, we have leveraged our core AI capabilities to drive the ongoing upgrade of the three major product lines: children, translation and voice. As a result, our AI smart hardware business made significant progress in the second quarter.
Let me provide just a few updates on the products. In May 2019, we launched JoyTube [ph] a new generation of children's smartwatch that integrates multiple AI-enabled functions such as intelligent Q&A, simulation of parents' bedtime storytelling and smart evaluation of children's spoken English level. All of the functions are significantly improving our product competitiveness. Also, our AI-enabled smart recorder, C1, has topped the best-selling list of several mainstream e-commerce platforms since its launch in March.
In addition, we have initiated R&D for high-end voice-enabled hardware products that are empowered with enhanced AI capabilities for more sophisticated use cases. As new AI products hit the market, we expect our hardware business to return to growth from the third quarter. In summary, it was a busy and productive quarter.
And now I will turn the call to Joe, who will walk you through our financials.
Thank you, Xiaochuan. Hello, everyone. In the second quarter, our total revenues reached $304 million, which, on a constant currency basis, would have booked an 8% increase year-over-year. Notably, we saw a larger revenue contribution from the big data and the recommendation service as we continued to tap into its monetization potential.
We also focused on improving operational efficiency and achieved a solid profitability in the second quarter. Although we anticipate the external environment to remain challenging in the second half of 2019, we expect to experience positive momentum from our new growth drivers, including the big data and the recommendation service as well as smart hardware.
I'd like to also point out one other key portion of our announcement today. Highlighting our solid balance sheet and the confidence in the company's long-term growth, our Board of Directors recently authorized a share repurchase program of up to US$50 million over the next 12 months. And please note that we will fund the repurchases from our existing cash balance.
Now I'll walk you through our financials in greater detail. Please note that unless otherwise noted, all monetary amounts that I discuss are in U.S. dollars. Also, note that I will refer to some non-GAAP numbers, which exclude share-based compensation expenses. You can find the reconciliation of non-GAAP to GAAP measures in our earnings release.
Total revenues in the second quarter were $304 million. On a constant currency basis, total revenues in the second quarter would have been $324 million, an 8% increase year-over-year.
Search and the search-related revenues were $276 million. On a constant currency basis, search and search-related revenues would have booked a 9% increase year-over-year. This increase was primarily due to the growth in auction-based pay-for-click services.
Auction-based pay-for-click services accounted for 88% of search and search-related revenues compared to 85% in the corresponding period in 2018. The number of advertisers for our auction-based pay-for-click service was approximately 87,000, up 5% year-over-year. The average revenue per advertiser for auction-based pay-for-click services was $2,800, up 1% year-over-year.
Other revenues were $27 million, an 11% decrease year-over-year. The decrease was primarily due to lower sales of smart hardware products as a result of continued efforts to upgrade our smart hardware strategy.
With the new models launched and more in the pipeline, we expect hardware sales to return to growth in the third quarter of 2019. Cost of revenues was $196 million, a 9% increase year-over-year.
Traffic acquisition costs, a primary driver of cost of revenues was $146 million, an 8% increase year-over-year, representing 48% of total revenues compared to 45% in the corresponding period in 2018. The year-over-year increase was driven by price inflation, which has clearly moderated from a year ago.
As we continue to be selective with traffic acquisition and benefit from increasing contribution from organic traffic, we expect TAC growth to be well contained for the remaining quarters of 2019.
Both GAAP and the non-GAAP gross profit were $108 million compared to $132 million in the corresponding period in 2018. GAAP gross margin was 35% and the non-GAAP gross margin was 36% compared to 40% a year ago. The decrease primarily resulted from the growth of traffic acquisition costs outpacing that of revenues.
Total operating expenses were $96 million, largely flat year-over-year. Research and development expenses were $51 million, a 10% decrease year-over-year, representing 17% of total revenues compared to 19% in the corresponding period in 2018.
Sales and marketing expenses were $37 million, an 8% increase year-over-year, representing 12% of total revenues compared to 11% in the corresponding period in 2018. G&A expenses were $9 million, a 31% increase year-over-year, representing 3% of total revenues compared to 2% in the corresponding period in 2018.
Operating income was $12 million compared to an operating income of $25 million in the corresponding period in 2018. Non-GAAP operating income was $18 million compared to non-GAAP operating income of $30 million in the corresponding period in 2018.
Other income, net, was $4 million compared to $3 million in the corresponding period in 2018. Income tax benefit was $1 million compared to an income tax expense of $3 million in the corresponding period in 2018. The income tax benefit primarily resulted from a tax filing adjustment of income tax expense previously recognized.
Net income attributable to Sogou was $21 million compared to net income of $33 million in the corresponding period in 2018. Non-GAAP net income attributable to Sogou was $28 million compared to net income of $38 million in the corresponding period in 2018. Basic and diluted revenues per ADS were $0.05. Non-GAAP basic and diluted earnings per ADS were $0.07.
As of June 30, 2019, we had cash and cash equivalents and short-term investments of $1.1 billion compared to $1 billion as of December 31, 2018. Net operating cash inflow for the second quarter was $56 million. Capital expenditures for the second quarter were $12 million.
And lastly, turning to our outlook. For the third quarter, we expect total revenues to be in the range of $304 million to $314 million, representing a 10% to 14% increase year-over-year or an 11% to 15% increase year-over-year in RMB terms.
Please note that for the third quarter 2019 guidance, we have assumed an exchange rate of RMB 6.9 to the dollar as compared with the actual exchange rate of approximately RMB 6.81 to the dollar of the third quarter of 2018 and RMB 6.82 to the dollar for the second quarter of 2019.
That concludes our prepared remarks.
Thank you, Joe. Operator, we'd now like to open the call for questions.
Yes. Thank you [Operator Instructions] And the first question comes from Elsie Cheng with Goldman Sachs.
Thank you, management for taking my question. [Foreign Language] And I'll quickly translate my question. My first question is on industry where the overall advertising industry growth remained challenged this year. We also observed some other Internet companies with big amount of user traffic are actively launching search features in their apps. Well, is it still very early stage right now?
But I want to hear management's thoughts on whether you think there's any change in dynamics in competitive landscape in the search space. And how is Sogou strategically positioned to take on these challenges?
And my second question is on the growth outlook of Search business at Sogou. Is it fair for me to interpret the 3Q revenue guidance, which is a robust number of 11% to 15% in RMB terms, as the start of a normalized growth period for company and coming out of the growth bottoms on the second quarter, as we just did? And can management also provide more color on the short-term or maybe long-term growth drivers as well? Thank you.
Okay. So I'll take the first question. First, on online advertising, we believe that Toutiao's entry into the online ad sector has made the sector very competitive and actually has materially impacted the search advertising.
However, we believe that it and we are -- we'll continue to grow our own traffic and revenue. We believe our Search revenue is going to maintain a steady growth and continue to be -- grow faster than the industry average.
And on the product front, our observation so far is that Sogou Search is intended to meet the user demand for consuming a variety of content. Remember, Sogou is pretty much labeled as a content aggregator, and very naturally, it's search would be serving the content by having to match the user consumption appetite.
So in contrast -- so as Sogou, we do general search, and general search is more about helping users find the right information, answer or develop an understanding of things. It's not a use case for consumption or consuming content.
So for us, we will focus more on leveraging our AI technologies, such as knowledge computing, to enhance the search quality and raise the mind share of Sogou Search among users so that we can be very differentiated from our competitors and continue to grow our market share.
In addition, we have been focusing on developing our big data and recommendation service. With the expanded user bases for both Search and Mobile Keyboard, we have gradually built our big data and recommendation service at company level to unlock its commercial value, and we have seen a very solid momentum on that front.
And second, we made very good progress with the business, upgrading across our smart hardware categories, including children, translations and voice. So we believe these new growth drivers will continue to experience positive momentum and help Sogou grow its business for the longer term.
This is Joe. I will take second question regarding the guidance of Q3. So for Q3, total revenues in RMB expected to increase by 11% to 15%. So take the middle end, that implies a 13% increase year-over-year in RMB terms. So I want to remind you that in Q3 2018, we did have a low base as we suspended 10 days of online ad business due to the Douyin incident.
So on an apple-to-apple basis, if there was no Douyin incident, the -- I think Q3 guidance, I mean, for the middle end would imply 8% growth year-over-year in RMB terms. So basically, that means comparing to Q2 is also 8% growth year-over-year, the growth in Q3, and continuing into the Q4 will be steadily at around 8%.
Looking to next year, with the enlargement of our big data and the recommendations service and the accelerated growth from smart hardware, we expect the revenue growth in 2020 will accelerate.
Okay. Got it. Thank you very much.
Thank you. And the next question comes from Alicia Yap with Citigroup.
Hi. Good evening. [Foreign Language] Thanks for taking my questions. I have a couple questions. Number one is that could you elaborate a bit the increase in the traffic acquisition cost, which I think you mentioned was due to the increase in pricing? So are you able to share with us what is the magnitude of the increase in pricing? And also, how should we expect that to trend in the second half and if you have any early colors into the 2020 on the TAC costs?
Second question is how do you quantify the latest demand outlook, especially on the medical customer? You -- it seems to be commanding. You are gaining some shares. So I wonder if you are able to quantify the percentage of the share gains from your peers. And also related to the health care, I wonder if Sogou has plans to move the medical search queries into the structured data platform like your peers.
Okay. I'll take the first question regarding the TAC increase. So as percentage to total revenue for Q2, TAC accounted for 48% of total revenues comparing to last year's 45%. So the increase is mainly due to the price inflation.
So for 2018, unlike previous years, there is a midyear price inflation in 2018. So for the first half of 2019, the price inflation is about, say, 30% to 40%. But for the second half, the price inflation will slow down to 10% to 20%.
So with our efforts to drive up the organic traffic and be more selective on traffic acquisition, so in the second half, TAC as percentage of total revenue will continue to decrease in the Q3 and Q4.
So overall, for full year 2019, TAC as a percentage to total revenue will be -- increase just a little bit, say, 1 or 2 percentage points, I mean, as percentage to total revenue comparing to the last year's 47% of total revenue.
So in terms of our demand outlook for the health care sector, we haven't seen a significant impact from our vertical peers. And in -- still in sectors, our health care is very fragmented compared to other sectors. So it's very difficult for vertical apps to just satisfy the -- all users' demand.
Second, in terms of structured data, we are doing the same thing as our competitors do. We are moving our search queries related to health care into a more structured platform so that we can increase the mind share of total search among all the users and improve our search quality.
Thank you. And the next question comes from Xueru Zhang with 86Research.
Good evening, management. Thank you for taking my question. I have a quick question on the Mobile Keyboard. Can management help us understand better how recommendation works on the Mobile Keyboard and how Sogou to monetize through this feature? And what is your long-term revenue target regarding this business? Thank you.
In terms of the monetization potential for Mobile Keyboard, we are building actually the big data and recommendation service. So in big data, actually we have a very good understanding of our users from our various search assets so that we can develop accurate user profiling and improve the algorithm to make targeted recommendations. Also in Mobile Keyboard, we believe a lot of users are trying to search with Mobile Keyboard whether it's general search or e-commerce search.
So Mobile Keyboard has also generated a lot of data so that we can improve our recommendation service. In the future, Mobile Keyboard is going to be operated like a channel for us to push various information and various content and services. It will be more like a VPI kind -- VPA kind of services that we can recommend various content and services to an increasing number of users. And this is going to be an add -- a value-added service for millions -- hundreds of millions of our Mobile Keyboard users.
The service -- the recommendation service is going -- not only going -- not trying to keep users within the Mobile Keyboard. It's trying to leverage that user profiling to develop other services like newsfeed, which is still at a -- counts for a very low proportion of total revenue and also other services like Internet finance.
That’s very helpful. Thank you.
Thank you. And the next question comes from Alex Yao with JPMorgan.
Good evening, management. Thank you for taking my question. I have two questions. Number one, Joe, you talked about the advertising growth outlook in 2020 will be better than 2019. Can you walk us through what is the underlying assumption behind this statement for the -- or are you seeing the macro impact on advertiser sentiment or budget allocation, well, diminishing? Or are you seeing the pricing pressure from Douyin-relating inventory is going down? Or are you seeing traffic contribution -- meaningful kind of traffic contribution from the keyboard software?
And then second question is the recent Toutiao's search engine launch. I think you guys already talked about it already, if you -- the impact on operation. My question is how do you see the next 2 to 4 quarters. Are you seeing a possibility the user will increasingly make more search or take the platform gradually from content sourcing to general sourcing? Should we expect increasing competition pressure from a new entrant to search engine marketing?
Okay. For 2020 outlook for Search revenue, we expect it will be quite stable in 2020. So the acceleration is coming from, number one, with the development of our recommendation service, we expect revenue from that will continue to ramp up in 2020. And the second, with new products launched this year and more in the pipeline, we expect smart hardware sales will accelerate in 2020.
So in terms of the question with regard to expand from content search to general search, we believe that Toutiao -- it depends how users recognize Toutiao as to whether it's a general search engine or it's a content consuming platform. I think so far, I'll mention that Toutiao is pretty much labeled as a content aggregator. Having said that, we will keep an eye on how things are going to develop going forward.
Okay, thank you. And the next question comes from Natalie Wu with CICC.
Hi, thanks management for taking my question. This is [indiscernible] representing Natalie. So we noticed that the recommendation experienced [closing] in second quarter. So what do you think are the like major drivers behind? And what do you think are your like major competitive advantage compared to the industrial peers? And what is your like strategy and expectation for this kind of -- for this business going forward? [Foreign Language]?
As compared to our peers, I think we have a competitive advantage in providing the recommendation service because we have a massive user base. We are actually the #4 largest internet company in terms of by user base only after BAT. And second, we have a very good user profiling capability because we understand our users from Search and Mobile Keyboard. That's where our strength is.
In terms of revenue contribution, I think it's a bit too early to tell because this recommendation service is not only about online advertising. It's more about other services, including feed and financial services, which we expect higher ARPU from these innovative services, leveraging all the big data capabilities of the recommendation service.
Next question comes from Thomas Zhang [ph] with Jefferies.
Hi. Thanks, management for taking my questions. I'm not sure if my questions have been answered in previous questions. I just want to get an update about our cooperations with Tencent in terms of the monetization of general search.
And my second question is about our hardware initiatives. Can management give us some color about the profit profile over the long run, if there's any? Thank you.
In terms of our cooperation with Tencent, I think it's progressing well as planned, whether it's WeChat search or collaboration with QQ mobile browser. We have extended relevant agreements, and we believe there is a chance that we can expand our cooperation going forward.
In terms of our hardware, our most recent product, AI smart recorder, C1, is a strong testament to our AI technology capability. It's a very good use of our natural interaction and knowledge computing strategy. For example, it has a wonderful sound picking capability with very high accuracy. And in the future, we're going to leverage our advantages in Search and Mobile Keyboard. Search, which means you actually are outputting -- which means output and Mobile Keyboard which means input. So in the future, we are going to develop other categories of products that can leverage this output/input capabilities. And that -- those products are intended for much more mainstream market.
Okay. Thank you.
Thank you. And so this is the end of the question session. I would like to turn the floor to management for any closing comments.
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.
Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.