Sohu.com Limited (SOHU) Q2 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and good evening. Thank you for joining Sohu's Second Quarter 2017 Earnings Conference Call. [Operator Instructions]. Today's conference call is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the conference over to your host for today's conference call, Mr. Eric Yuan, Investor Relations Director of Sohu. Please go ahead, sir.

Thanks, operator. Thank you for joining us today to discuss Sohu's second quarter 2017 results. On the call, our Chairman and CEO, Dr. Charles Zhang; Acting CFO, Joanna Lv. Also with us today are Changyou's CEO, Dewen Chen; CFO, Jasmine Zhou; Sogou's CEO, Xiaochuan Wang; and CFO, James Deng. 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 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 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, including its registration statement and the most recent annual report on Form 10-K. With that, I will now turn the call over to Dr. Charles Zhang. Charles, please proceed.

Thank you, Eric. Thank you, everyone, for joining the call. Sohu delivered better-than-expected revenue growth in the second quarter, driven by solid performance from Changyou and Sogou. Group revenues totaled $461 million, up 10% year-over-year and 23% quarter-over quarter. The highlight of the quarter was Legacy TLBB, our new mobile game that is a big hit and ranked as one of the top grossing games in China between its launch in mid-May and end of the quarter. Sogou's financial results exceeded our prior guidance as its mobile search growth maintained strong momentum. Our Brand Advertising business performance was relatively soft largely due to a lackluster video and ad sales. Nonetheless, for Sogou Video, we have been shifting our content focus to self-developed dramas. We expect the move to generate substantial cost savings and improve our bottom line results in 2018. Before I give more details about our key businesses, let me summarize our financial results for the second quarter. Total revenues were $461 million, up 10% year-over-year, 23% quarter-over quarter. These results were largely negatively affected by the depreciation of the RMB. On a constant currency basis, total revenues would have been $23 million higher or an increase of 15% year-over-year. Net brand advertising revenues, $86 million, down 24% year-over-year and up 6% quarter-over quarter. Sogou revenues, $211 million, up 20% year-over-year and 30% quarter-over quarter. Online game revenues, $122 million, up 23% year-over-year and 43% quarter-over quarter. Non-GAAP net loss attributable to Sogou.com Inc. was $72 million or a loss of $1.85 per fully diluted share. Now let me go through some of our key businesses. First, our media business. For our media portal business, Sohu News APP and Sohu H5 Portal, our 2 key mobile products for us, we strive to continuously upgrade their features and enrich the content offering in order to grow our user base in a very competitive market. In the latest version of Sohu News APP, we introduced a greater number of short-format video clips into the main information stream and improved the functionality so that users can more easily interact with third-party writers. We have also applied machine learning technology to refine the algorithm to push more targeted and relevant stories to our users. In terms of monetization, revenues from large brand advertisers remained soft, while demand for our small medium enterprises content customers have started solid. We expect that SME segment will be a key growth driver as we continue to develop a more sophisticated advertising system that specifically serves their needs. Now moving to Sohu Video. In the beginning of 2017, we made a critical decision to overhaul our content strategy that we would focus on self-developed dramas going forward in the time when the price of premium TV dramas, the head content, keeps escalating. We believe the traditional ad-supported model doesn't work since the revenue -- ad revenues don't keep up with the pace of the cost inflation. We decided to pursue a different approach that we will nearly expand our resources, our original content and drive our subscription base. And production cost of our original shows is on average only about 20% to 30% of top-tier ad TV content, TV dramas. This is partly because we don't need to pay very expensive stars in original shows to attract audience. Instead, we can focus on selecting superior screenplays, hiring young and talented directors and actors and reaching a standard of production, quality of filming. In many cases, the popularity of our original dramas have been as good, if not better than TV dramas which costs us much more additionally because original dramas are exclusive for our platform. We cannot only generate ad sales, but also bolster our subscription-based revenue. In the first half 2017, we broadcasted top original dramas, of this, The Souls Teacher; and Men with Swords; and, Reborn a Monk, were quite popular. We have stronger lineup in the pipeline for the second half, like Dear Prince, and The Monster Killers; and Campus Beauty. So for 2017, the total number of original dramas will reach nearly 30 which is about 20% more than last year. The growing library of our original content should lay a solid foundation for expanding our user subscriber base. Financially, since early this year, we have stopped taking expensive domestic TV dramas that are scheduled to release next year. Consequently -- confidently, we expect our overall content costs will be meaningfully lower in 2018. This savings, combined with the ramp-up in subscription revenue will help cut the losses of Sohu Video. Next, moving to -- moving over to Sogou. In the second quarter, Sogou search traffic and revenue growth were healthy. We continue to invest heavily in various artificial intelligence related, AI-related initiatives for current product portfolio and also for our long term ambitions. Xiaochuan will update you on more details in his remarks. Lastly, let me talk about Changyou. In the second quarter, Changyou's financial results were quite solid, helped by the success of our new mobile game, Legacy TLBB. Since its debut in mid-May, legacy TLBB is consistently ranked among the top-grossing games in the market, demonstrating Changyou's ability to develop top-quality MMORPG mobile games. In the meantime, we're aware that the life span of mobile games are shorter compared with PC games. To maximize the longevity of Legacy TLBB, we'll continue to invest in plays and social systems. In terms of overall mobile game strategy, our main focus is still on MMORPG games and advanced casual games and SLG games. We'll soon be presenting to the market a more diversified portfolio centered on these 3 genres. In the pipeline, we plan to launch mobile game Blade Online, at end of the year which is another game that we have adapted from PC to mobile. PC -- Blade Online PC game was launched as early as 2004 and enjoyed very loyal following along the way. In addition, new MMORPG games such as and are planned to hit the market by late 2017 or early next year, 2018. So now let me pass the call over to Xiaochuan Wang for an overview of our Sogou business. Xiaochuan?

Thank you, Charles. In the second quarter, benefiting from strong mobile traffic growth and a reviving search advertising market, Sogou saw its growth back to the fast lane. Revenues totaled RMB1.45 billion, up 26% from a year ago, exceeding our prior guidance and continuously outpaced the industry growth. As of June, aggregate search traffic grew by 24% from a year ago, of which mobile traffic jumped over 50% and represented nearly 80% of the overall traffic. This kept our market share in an upward trajectory. On Sogou Mobile Keyboard, our market-leading Chinese input application, our user base continued to expand rapidly. According to iResearch, the user base of Sogou mobile keyboard increased by more than 70% over the past year, solidifying our position as the #3 mobile application in China in terms of DAUs. During the second quarter, we continued to promote AI-empowered technology and product innovation. We integrated our proprietary AI technologies like question-and-answer, words and machine translation into our core product, including Sogou search and Sogou input method. Our strong Q&A-based search capability which caters to the increasing amount of search queries in question format provides direct answers to users instead of only displaying links. This has greatly improved user experience on mobile search. For voice, in the second quarter, Sogou Mobile Keyboard supported 260 million voice inputs on a daily basis, up more than 80% from a year ago. For machine translation, our Sogou English search channel, we're able to fully translate English web pages into Chinese. And on Sogou Mobile Keyboard, we can convert user's voice into text input from Chinese to English. In May at WMT, Workshop on Machine Translation international academic competition, Sogou won the global championship for Chinese-to-English machine translation. Our partnership with Tencent on product cooperation also progresses well. For example, Sogou Baike, one of the largest online encyclopedias in China, now provides exclusive content for search function within Weixin. Sogou's machine-based Q&A capability also provides technical support to Tencent Cloud Xiaowei, a smart device -- a services open platform. Financially, our total revenues in the second quarter reached $211 million, up 20% year-on-year and a 26% increase in RMBterms. Mobile search revenues accounted for 76% of total search revenues compared with 49% last year. GAAP net income was $23.5 million, compared to $33 million net income, excluding a one-off item from the same period in 2016. I will now turn the call over to Joanna, who will walk you through financials.

Thank you, Xiaochuan. I will walk you through the key financials on our 4 major segments for the second quarter of 2017. The profit and loss numbers mentioned below are all on a non-GAAP basis. You may find a reconciliation of Sogou and Changyou's non-GAAP net income result to GAAP measures on Sogou's IR website. For Sohu Media Portal, in the second quarter, revenues were $42 million, down 12% year-over-year. The quarterly loss was $10 million compared with net loss of $50 million in the second quarter of 2016. For Sohu Video, in the second quarter, revenues were $43 million, down 5% from a year ago. Of this, advertising revenues were $22 million. The quarterly loss was $103 million compared with a net loss of $69 million in the same quarter last year. In the second quarter of 2017, we recognized impairment charges of around $45 million in video content cost as a result of faster-than-expected video advertising sales performance. For Sogou, total revenues in the second quarter were $211 million, up 20% year-over-year and 30% quarter-over quarter. Of this, online search related advertising revenues were $187 million, up 17% year-over-year and 31% quarter-over quarter. Sogou posted net income of $24 million compared with net income of $6 million in the same quarter last year. For Changyou, for the second quarter, total revenues, including 17173, were $150 million, up 16% year-over-year and 25% quarter-over quarter. Changyou posted net income of $61 million, compared with net income of $36 million in the second quarter last year. For the third quarter of 2017, we expect total revenues to be between $480 million and $510 million, brand advertising revenues to be between $70 million and $80 million. This implies an annual decrease of 28% to 37% and a sequential decrease of 7% to 19%. Sogou revenues to be between $230 million and $240 million. This implies the annual increase of 39% to 45% and a sequential increase of 9% to 14%. Online game revenues to be between $120 million and $130 million. This implies an annual increase of 22% to 32% and a sequential decrease of 2% to a sequential increase of 6%. Non-GAAP net loss attributable to Sogou.com Inc. to be between $39 million and $49 million and non-GAAP loss per fully diluted share to be between $1 and $1.75. Including the impact of aforementioned share-based awards and netting of approximately $1 million of Sohu's economic interests in Changyou and Sogou, GAAP net loss attributable to Sogou.com Inc. to be between $42 million and $52 million and GAAP loss per fully diluted share to be between $1.08 and $1.34. For the third quarter of 2017 guidance, the company has adapted a presumed exchange rate of RMB7 to $1 as compared with the actual exchange rate of around RMB6.66 to $1 for the third quarter of 2016 and RMB6.86 to $1 for the second quarter of 2017. Lastly, I will briefly update you with the divestments related with Changyou's privatization proposal. On May 22, the Board of Directors of Changyou received a nonbinding proposal from Dr. Charles Zhang for the acquisition of all outstanding shares in Changyou, including shares represented by American depositary shares by an acquisition vehicle to be formed by Mr. Zhang. On June 3, Sohu performed a special committee consisting of 3 independent and disinterested directors to review and evaluate the proposal. And on July 14, Sohu announced that the special committee has retained Citigroup as its financial advisor and Shearman & Sterling as its legal counsel. Changyou also formed a special committee consisting solely of independent and disinterested directors to review and evaluate the proposal. And on July 27, it announced that Changyou's special committee has retained Duff & Phelps as its financial advisor and Skadden, Arps as its legal advisor. That's all the information the company is able to provide at this time. Therefore, there won't be questions regarding the proposal in Q&A section of this call. This concludes our prepared remarks. Operator, we would now like to open the call to questions.

[Operator Instructions]. The first question comes from the line of Eddie Leung from Merrill Lynch.

The questions to perhaps Xiaochuan. Congratulations on a very good quarter. So just wondering, the strong revenue in the same quarter. How much of that was driven by an increase in number of advertisers and how much of that is driven by cap, like the spending of individual advertiser? And along the lines, could you also talk a little bit about the key advertiser segments in the quarter? And how is medical trending in the quarter?

So I think that strong Q2 performance is driven both by the increase in the number of advertisers and ARPU. The number of advertisers in Q2 increased by 13% year-over-year to over 75,000 and ARPU increased by 18% year-over-year to $2,200. The top 5 verticals remained roughly the same as in the past. The health care, e-commerce, gaming, business services and merchant services was each contributing 10% to 20% of search revenues.

The next question comes from the line of Natalie Wu from CICC.

Two questions here. The first one is about the Sohu Video. Charles, you mentioned that now ads revenue of Sohu Video will surpass ad portion by the end of this year. So just wondering if the guidance still holds. And second one is about Sogou. Just to clarify, did the management mention that the net profit of Sogou this year is like $22 million? Just not sure whether I got the wrong number.

Profit, right? Profit for Q2?

It's $23.5 million GAAP net income.

But for last year, the number is higher, right?

Yes. It's $33 million net income, also in GAAP, but that excluding one-off items related to the joint AI research institute with Tsinghua University.

So without -- with -- okay. So even better last year?

Yes.

Yes, because we're really for the market share and the traffic and also the revenue. Profit is actually secondary. It's really other stage for growth for Sogou.

I see, okay. So about the Sohu Video?

And for Sohu Video, I think it depends on whether we have some or few of the hit self-produced dramas or not. It's -- whether it's -- the subscription revenue will surpass the advertising revenues, it's not clear yet, still 6 months to go. And also, the advertising is kind of soft. So -- but...

But for the first quarter, you...

It's not that important. Other...

Yes, for the first quarter, you mentioned that advertising revenue accounts for about 60% of the total revenue for Sohu Video, is that right? So just wondering what is the right...

Yes. So now for this quarter, it's about actually 50%, right? So it's like 45%, 43% or 45%? And then on top of them are advertising. And the other half are from subscription and also live broadcast, live channel live and also from some of the OTT, right? So it is already -- the advertising earning already half of the total revenue. But nonadvertising is also the live channel live. So the subscription business, it's -- by the end of the year, it probably will not surpass and become half of it. But definitely now it's already less than half of the advertising revenue.

So you mean that the majority of ads revenue comes from the live broadcasting, right?

No, not the majority. But it was just a combination of the 3. But mostly, actually from subscription. The drama -- yes, drama subscription.

The next question comes from the line of Alicia Yap from Citigroup.

I actually have questions regarding your 2Q profit or the loss. It seems that your expenses and loss meets your revised guidance which we saw a bigger-than-expected cost of advertising expense. So can you share with us, were any of you spending unexpectedly and you -- that you did not factor into the guidance earlier? Or was that related to impairment write-off that you have? And then related to 3Q guidance, how should we think about the video revenue it trend versus the portal within the brand advertising?

I think you're right. The -- actually, the expense increase is because of the impairment, right? Yes, it's a $45 million hit on Q2 and that means in the third quarter, definitely, we'll not have that because we changed our strategy of the [indiscernible] strategy. So we're not going to spend that much money because this year, it was still -- this year's head content purchase was committed last year. That's why we're still spending money, but because of the soft advertising sales. That way, if there's another reason, we actually accelerate the amortization, right? So that -- of the content cost. That's why it's so crowded into Q2. And in Q3, we will not have that. So you see an improvement on a narrower loss for the video business.

Yes, what about revenue guidance between Video and the Portal for 2Q?

Revenue guidance, the -- it's kind of flattish. We -- first of all, I think the -- I would say the head advertiser, the brand advertiser is kind of soft because those are -- and the spending money is -- it's just advertisers have many choices. They have their social networks or videos and other places to put advertising. But it's really -- the growth part is really the small medium enterprises that advertise on the Sohu News APP and the H5 Portal. And also after the synergy to cross-selling into the all-time frame location on the Sohu Video APP. Basically, you don't have -- it's not this preload video advertising. But actually, in the Video APP, you have other places to sell to the Portal, advertisers, small medium enterprises. So there's a lot of innovation that need to be done with advertising system. We're working on it. So the small medium enterprises, other than the synergy between Sohu Media Portal and the Sohu Video APP, we'll provide some of the growth for the future. definitely, we need to -- technology, innovation, algorithm improvement, user interface and others so that we have a robust growth of our Sohu News APP user base. That means the inventory will increase. And then [indiscernible] we have the inventory then we're -- we can sell it with our -- with any SME.

The next question comes from the line of Thomas Chong from BOCI.

I have a couple of questions on Sogou. And my first question is about -- do we have any pen on news feed initiative like what our peers are doing? And secondly, how should we think about the AI benefits to our click-through rate? Any trend that we can see or the acceleration in click-through rate going forward? And my second part of the question is about Online Video. Can management give us some big picture about how many video subscribers do we have in the second quarter?

On news feed, so we believe news feed is a good complement to search advertising, so we're making some trials on that front. In terms of CTR and the CAR reach, we have elaborated deep learning and big data analytics to improve ad algorithm and we managed to improve ad relevancy. So as such, we saw CTR and CAR reach have significantly improved.

We're not giving out the Sohu Video subscriber user base, right? No, we're not giving out, sorry. The -- yes, we expect -- there's -- but there's -- it's -- a good trend is that once we have a hit show, then it will boost the user base to a higher magnitude, a higher number. And then it may, after this hit show is over, the number actually does not -- the number does not fall back to where it was. Actually, level off a little bit, but stay at a higher level because once users subscribe in, they found that there's a library that is being mounted, accumulated because every new dramas and after 1 month of free broadcasting then, people have to pay. So we see a gradual growth of user base. That's a good phenomena for this kind of business. This adds on the user base, gradually grow. So we need -- which is our key is really to produce one hit show after another to boost the user base numbers to higher and higher level. And no, we're not giving our number.

The next question comes from the line of Chi Tsang from HSBC.

This is Wayne Wang speaking on behalf of Chi. So I have a question regarding with the strategic cooperation with Tencent and Sogou. So I remember last quarter, you mentioned that 40% of mobile traffic is from Tencent. So in this quarter, any updates on that? And secondly, about the potential IPO maybe for Sogou. So what kind of valuation level do you expect for the IPO and maybe any potential schedule for the IPO?

So to your first question, as of the end of second quarter, traffic from Tencent contributes less than 40% of our total traffic.

[Foreign Language]

No comments. No comments on IPO-related question -- cost valuation.

The next question comes from the line of Han Kim from Deutsche Bank.

I have two questions on Sogou. The first one is conceptual. So my understanding of Sogou IPO was that we would continue to invest into it this year but -- and will consider IPO when we felt like we could get good valuation on it and when I think the business have a lot of momentum. So I just wanted to get a perspective of why the consideration now and what has perhaps changed? That's my first question. And then maybe I'll move to the second one later.

Yes, unfortunately, we're not in a position to comment on IPO-related questions.

No, we just decided -- so IPO, right? We decided to go to IPO. It's because Sogou is always -- actually was scheduled. We actually -- because we planned to have IPO sometime in the future. So many years ago, we decided that we're going to IPO. So now it's a decision that we just made. It's on a very good trajectory, yes.

Yes. So I mean, it's great. I'm just -- I think we're looking for something -- yes, I think we're looking for like 39%, 45% for next quarter year-over-year. Can we just kind of dissect that into how much we're seeing on the traffic side, how much we're seeing on this for the ARPU side? And what is really driving a lot of that acceleration relative to second quarter or the first quarter?

For Q3, the year-over-year growth is driven by continued ramp-up of mobile traffic and monetization. It's also due to an easy comparison as Q3 last year to now be a trough over in the incident and that we have now fully recovered from that.

Yes, from my point of view, I just see that a constant improvement of search quality so that we actually eat into our competitor's market share with a larger traffic because we have better search results with answer -- question-and-answer, with translation, with -- and also via also the WeChat content, a lot of things. It's really constant improvement and the traffic growth that contributed to the growth. And in the future, the -- yes, in the future, a large user base of the mobile keyboard and also the information, user profile information, that will help us to expand into more -- besides this traditional search business, we're going to get into -- as one of the previous questions, our initiatives to get into the information feed, news feed and other knowledge-based applications.

The next question comes from the line of Jialong Shi from Nomura Capital.

I've got [indiscernible] Management. I have 2 questions for Xiaochuan. First of all, congratulations on kicking off the IPO process. It's a long journey for Sogou, but really glad you're finally there. And my first question is about the cooperation with Tencent. So I just wonder, in addition to your existing cooperations with WeChat and with Tencent QQ Browser, should we expect to see any other broadened or deepened cooperations with WeChat or Tencent going forward? And my second question is about the search advertising market. We're now more than halfway through 2017. So I just wonder, how do you think of the growth, how do you think of the overall search advertising market will be growing for this year and then next year? And also, what will be the likely drivers for the advertising, for the search advertising market?

So in terms of our cooperation with Tencent, we have been closely working with Tencent on both product and technology cooperation. Last quarter, Sogou Baike, one of the largest online encyclopedias in China, has started to provide exclusive content for WeChat -- in-app WeChat search. And our Q&A capability have also provided technical support for Tencent Cloud Xiaowei. Due to the IPO, we're restricted from providing any guidance on our future cooperations with Tencent.

The next question comes from the line of Tian Hou from T.H. Capital.

I have two questions. One is about the search. Tencent as a single entity is the biggest shareholder of Sogou. And now Xiaochuan mentioned the traffic contribution from Tencent actually less than before. And so I wonder, going forward in Sogou's development, particularly in AI development, what kind of role will Tencent play? What kind of resources and data and other things can Sogou draw upon from your biggest shareholder? That's number one. Number two is about the post-IPO Sohu report. Is Sohu going to continue to consolidate Sogou's book? That's the questions.

40%, you said 40%, right? The traffic of Tencent related...

Less than 40%.

Yes, less than 40%, going back right? Yes. [Foreign Language]

Yes, we -- I've got your -- we've got your question, yes. [Foreign Language]

Consolidate, Sohu will consolidate.

So maybe I should translate to everyone.

Yes. So in the past, Tencent has contributed a lot to Sogou in terms of traffic growth. But in terms of AI, I want -- we want to emphasize that Sogou has built its AI capabilities on its own and focused on natural language understanding. And this capabilities have built upon our existing products like search and mobile keyboard. And also, we lay a solid foundation for any future products we plan to use. And for -- so for our cooperation with Tencent in AI, our -- some of our core capabilities like Q&A has already supported Tencent's properties such as Tencent Cloud Xiaowei. And as long as their users start to use our services, in turn, we can get a huge amount of valuable data from Tencent.

The second question?

And on the second question, Sohu will continue to consolidate Sogou's financials.

Thank you. I would like to hand the conference back to the management as there are no further questions. Please go ahead, sir.

Okay. Thank you all for joining us and goodbye.