Sogou Inc.
Q1 2020 Earnings Call Transcript

Published: 18 May 2020

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to Sogou's First Quarter 2020 Earnings Conference Call. [Operator Instructions]. 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 conference over to your host today, Jessie Zheng, Investor Relations Director of Sogou. Please go ahead.

[Jessie Zheng:]

Hello, everyone, and thank you for joining Sogou's First Quarter 2020 Earnings Conference Call. On the call, our CEO, Xiaochuan Wang; and our CFO, Joe Zhou, 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 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 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 until reliance on.Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of factors could cause actual results to differ materially from those contained in 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.

[Xiaochuan Wang:]

Thank you, Jessie. In the first quarter 2020, despite the setback in the macro environment and the online advertising industry in China amid COVID-19, Sogou continue to forge ahead with a 5% year-over-year increase in total revenues. Both our core search and Mobile Keyboard recorded new highs in the quarter, thanks to the search of users demand for reliable information and high efficiency during the pandemic. In particular, Sogou Search witnessed traffic increase at nearly 28% year-over-year, remaining China's second largest search engine, and our core search revenues continued to outperform in the industry.Meanwhile, Sogou Mobile Keyboard further expanded its DAUs by 9% year-over-year to 482 million, reinforcing its position as the third large Chinese mobile app in terms of DAUs, according to iResearch.Leveraging Mobile Keyboard, we continue to optimize recommendation service while also exploring new commercial opportunities for Mobile Keyboard with its user assets in the quarter. In addition, our Smart Hardware business maintained steady progress despite the pandemic. With the pandemic highlighting the importance of the Internet industry, would be opportunity to carry out all-around upgrades across our 4 businesses, leveraging our leading AI technologies in the first quarter, and at the same time, tap into new areas with high development potential. Specifically, we made further breakthroughs across our language-centric AI technology showed our core competitiveness in voice, computer vision, machine translation and Q&A and continue to empower our core search, Mobile Keyboard and Smart Hardware businesses in an effort to set a high threshold of technology advancement and product innovation in the industry.Taking our voice technology as an example, it has supported Mobile Keyboard's industry-leading voice recognition function and help Mobile Keyboard evolve into an AI communication assistant. In addition to that, it has also allowed our Smart Hardware to establish a number of technology barriers, which contributed to the solid growth of our smart recording products in both sales and gross margin in the quarter against the general down trend within the industry.Our Q&A technology is another good example, which has not only facilitated the upgrade of so-called search platform but also provided all of our technology integration to build up our AI health care platform that leverages search as a traffic gateway. Additionally, our exclusive Vocational Avatar and industry-leading simultaneous interpretation solution continued to strengthen the influence of our AI technologies and brands in the quarter, paving the way for more applications in certain sectors.Now let me walk you through each of our core businesses. Including Search, Mobile keyboard and Smart Hardware. In Search, we continue to push upgrades by integrating our intelligent Q&A capability moving beyond providing general information to offering valuable knowledge that best matches users search intent. In the first quarter, we focused on optimizing our knowledge graph to improve our overall search quality. As a result, for our high-quality encyclopedia content leveraging knowledge graph, the click-through rate increased over 30% year-over-year. Meanwhile, riding on our content and services that we have accumulated in health care search, we have been proactively developing AI health care during the pandemic.As a result, at peak health care search queries tripled year-over-year and online health care consultation volume rose over sevenfold compared to the normal levels before the pandemic. Just a few examples of our initiatives in AI health care. Our AI-enabled symptom checker and intelligent Q&A robots have been able to save medical resources, especially in primary level health institutions, from handling massive and repetitive queries about the pandemic. In addition, we recently launched the world's first AI nutritionist jointly with China Nutrition Society, a nationwide nonprofit academic organization. Empowered by our knowledge computing and natural interaction technologies, the new service is able to provide personalized dietary guidance based on users' health conditions. Going forward, we will incorporate more cutting-edge AI technologies to transform our health care search to an accessible and reliable service platform for everyone.Turning to Mobile Keyboard. We are committed to developing it into an AI communication assistant. For one thing, we further enhanced its AI input functions to support users in a more efficient and thoughtful way. For example, to meet the input needs of different user groups, we launched an array of AI-enabled handwriting functions in the quarter, including autocomplete, smart association and hand-drawn emoticon. As a result, users for handwriting functions increased almost 30% year-over-year in the quarter. Meanwhile, we continue to upgrade Smart on-site and enable this to better assist the users in various chats.For example, we rolled out popular AI-enabled in multi consumption which can pop out all kinds of entertaining stickers and emojis on one place whenever users type, which significantly improved our user engagement and penetration. As of March, smart on-site has been used in 900 million times per week. And on a sequential basis, its per-person usage has increased 200%. Moreover, Mobile Keyboard continued to maintain its position as China's largest voice recognition app. As of the end of March, its average daily voice requests more than doubled from a year ago with a peak at 1.4 billion requests per day. In addition, as we continued to optimize our recommendation service that leverages mobile keyboard, we have also been expanding other use cases for mobile keyboard to better tap into the monetization potential of its user assets.On Smart Hardware, in the first quarter, we continued to upgrade AI offerings to further boost our product competitiveness and brand influence. Following the rollout of our industry-leading market recorder in 2019, we expanded our product metrics by launching an actual recorded category in this March for more complex use cases, such as conferences and training. It successfully captured the interest of users with a number of pioneering and distinctive functions such as transcription of the largest number of languages and dialects in the industry, mutual translation of the languages, industry's first AI-enabled noise reduction, auto identification of speakers, auto recognition of applause and laughter and so on. Driven by this new high-end category, our recording products continue to outperform the industry and peers in the quarter despite the dampening market during the pandemic, topping a few mainstream e-commerce platforms in sales and achieving gross margin expansion, going forward, we will carve out more AI hardware categories, particularly mainstream hardware, that will further position our product as AI assistants to users.Finally, as we move ahead, we will continue to gear up our AI and big data-driven business upgrades to create more value to our users, establishing a more robust business that presents greater potential.In Search, we expect to maintain steady development momentum in the quarter to come. While at the same time, we will strive to accelerate the growth of other businesses, expanding the contribution of Mobile Keyboard and Smart Hardware to our total revenues.Looking ahead, we expect the pandemic to continue to weigh in for serious time. However, as we steadily implement our strategy and with all our efforts in place, we believe we will return to healthy growth post the pandemic once the external market normalizes. Most importantly, our long-term growth prospects remain intact.With that, I will now turn the call to Joe to go through our financials. Joe, please go ahead.

[Joe Zhou:]

Thank you, Xiaochuan. Hello, everyone. In the first quarter of 2020, our total revenues remained resilient in the challenging environment. On the profitability side, there was a definite impact from the COVID-19 as a result of the increase in traffic acquisition costs, which we had anticipated. Looking ahead, we foresee ongoing pressure on our overall results in the second quarter as the pandemic lingers.Last slide. In the second half of the year, we expect to drive further improvement quarter-by-quarter in both our top and bottom line performance and to eventually climb back to a healthy growth trajectory once the external market normalizes after the pandemic.Now I'll walk you through our first quarter financials in greater detail. Then I'll come to the guidance. Please note that unless otherwise noted, all monetary amounts that I discuss are in U.S. dollars. Also know that I will refer to some non-GAAP numbers, which exclude share-based compensation expenses. You can find a reconciliation of non-GAAP to GAAP measures in our earnings release.Total revenues in the first quarter were $257 million, a 2% increase year-over-year. On a constant currency basis, total revenues in the first quarter increased 5% year-over-year. Search and Search-related revenues were $238 million, a 1% increase year-over-year. On a constant currency basis, Search and Search-related revenues increased 5% year-over-year. The increase was primarily due to the growth in auction-based pay-for-click services which accounted for 91% of Search and Search-related revenues compared to 87% in the corresponding period in 2019.Other revenues were $20 million, a 6% increase year-over-year. The increase was primarily due to increased revenues from sales of Smart Hardware products. Cost of revenues was $270 million, an 18% increase year-over-year. Traffic acquisition costs, our primary driver of cost of revenues, was $181 million, a 27% increase year-over-year, representing 71% of total revenues compared to 57% in the corresponding period in 2019. The increase was driven by increased traffic acquisition as users confined to their homes spend more time online during the COVID-19 outbreak.Looking into the second quarter. As people are increasingly returning to work, and as we are proactively managing our traffic acquisition activity given the challenging environment, we expect traffic acquisition cost to gradually drop back to normal level with sequential decrease, both in absolute amount and as a percentage of total revenues. Gross profit and the non-GAAP gross profit were both $40 million, both a 41% decrease year-over-year. Both GAAP and non-GAAP gross margin was 16%, compared to 27% a year ago. The decrease primarily resulted from the growth of traffic acquisition costs outpacing that of revenues. Total operating expenses were $83 million, a 3% increase year-over-year. Research and development expenses were $47 million, a 15% increase year-over-year, representing 18% of total revenues compared to 16% in the corresponding period in 2019. The increase was primarily attributable to an increase in personnel-related expenses. Sales and marketing expenses were $29 million, a 2% decrease year-over-year, representing 11% of total revenues, largely flat with the corresponding period in 2019. G&A expenses were $7 million, a 29% decrease year-over-year, representing 3% of total revenues compared to 4% in the corresponding period in 2019. The decrease was primarily due to a decrease in expenses related to the company's noncore businesses. Operating loss was $42 million compared to a loss of $12 million in the corresponding period in 2019. Non-GAAP operating loss was $42 million compared to a loss of $11 million in the corresponding period in 2019. Other income net was $7.2 million compared to $8.7 million in the corresponding period in 2019. The decrease was primarily due to our charitable donations of $1.9 million associated with the COVID-19 outbreak.Income tax benefit was $1 million compared to income tax benefit of $0.2 million in the corresponding period in 2019. Net loss attributable to Sogou was $32 million compared to a net loss of $3.9 million in the corresponding period in 2019. Non-GAAP net loss attributable to Sogou was $31 million compared to a net loss of $2.7 million in the corresponding period in 2019. Both GAAP and non-GAAP basic and diluted loss per ADS was $0.08. As of March 31, 2020, we had cash and cash equivalents and short-term investments of $1.2 billion compared to $1.1 billion as of December 31, 2019. Net operating cash inflow for the first quarter of 2020 was $26 million. Capital expenditures for the first quarter were $3.8 million.And lastly, turning to our outlook. For the second quarter of 2020, we expect total revenues to be in the range of $260 million to $280 million, representing a decrease of 8% to 14% year-over-year or a decrease of 4% to 11% year-over-year in RMB terms. This near-term guidance takes into account the expected continued impact of the coronavirus outbreak and the resulting contraction of the Chinese economy, as well as other challenges in the macro environment and the online advertising industry.Last slide. On the bottom line, we expect our losses to narrow in the second quarter as we anticipate traffic acquisition costs will decrease sequentially. And we will continue to stringently manage our cost and expenses.Please note that for the second quarter 2020 guidance, we have presumed an exchange rate of CNY 7.07 to the dollar as compared with the actual exchange rate of approximately CNY 6.82 to the dollar for the second quarter of 2019. And CNY 6.98 to the dollar for the first quarter of 2020.That concludes our prepared remarks.

[Jessie Zheng:]

Thank you, Joe. Operator, we'd now like to open the call for questions.

[Operator:]

[Operator Instructions]. The first question today comes from Thomas Chong of Jefferies.

[Thomas Chong:]

I have a question about the second half. Given the fact that our losses to be level in the Q1, in the second quarter, as traffic acquisition cost is trending down. How should we think about the second half advertising trends? As coronavirus is gradually fading out as well as our bottom line in terms of the profitability in the second half? That's my first question.And my second half question -- and my second question is about the loan advertising business, in particular, the smart hardware initiative. Can you talk about the long-term trend in terms of the profitability of this business? And how we should think about the timing in terms of improving the fundamentals in second half and 2021?

[Joe Zhou:]

Thanks. Okay. I'll take the first question regarding the second half. So due to the pandemic, currently, the visibility for the second half is not very high, but I can share with you some trends for the second half. So basically, for advertising revenue, it will improve quarter-over-quarter from Q2 to Q4. I and for our keyboard, we have been working hard to unlock its monetization value. So we will continue to do that. So together with the continuous expansion of user and [indiscernible] financial value of the mobile keyboard. So it's revenue contribution will continue to expand during the second half. And as it is organic traffic, so most of the incremental revenue will go into the hardware. And for Smart Hardware, the sales growth will accelerate in the second half, driven by solid sales momentum for new models of our existing products, say, Teemo watch and AI recorder and as well new products to be launched in the second half.So with the improvement on revenue side for the profitability post the pandemic, our profitability will return to a meaningful profit level. So basically, for search, with the search-related revenue grow quarter-over-quarter and tax will be trending down in the second half. So the profitability for the tech-related business will improve. And with the incremental revenue and profit from the Mobile Keyboard. And with the acceleration of sales and a healthy gross margin of the Smart Hardware business, we will see strong growth of gross profit from the Smart Hardware business in the second half.And last but not least, we will remain stringent on cost and expense control and continue to improve our operating efficiency. So with all that, profitability will improve quarter-over-quarter. And in the second half, it will climb back to a meaningful profit level.

[Xiaochuan Wang:]

So turning to your question on Smart Hardware. As you know, we are -- Smart Hardware is our long-term business strategy. We are trying to facilitate AI-driven product integrates -- to integrate more natural interaction technologies to create higher threshold for -- of technology barriers for competitors.So with that strategy, we have seen our sales and gross margin has been expanding for the past quarters. And if you look at the current market for smart hardware actually due to the COVID-19, actually, the industry has seen some downtrend that Sogou's AI Smart Hardware has booked a nice growth in the first quarter and will continue to record year-over-year growth of 30% in the second quarter, and we expect it to return to rapid growth in the second half of this year.And this year, we'll continue to leverage our strong AI technologies to further strengthen our product metrics and pipeline of 2 product lines, including Sogou AI and Teemo, For Sogou AI, it enhances our VPA positioning and make it personal intelligence with interaction hardware. And for Teemo, we will focus on children, education, and health. And we will invest in R&D and other necessary investments to facilitate the growth of Smart Hardware business and we expect loss will narrow down this year with accelerated revenue growth in the second half.

[Operator:]

The next question today comes from Elsie Cheng of Goldman Sachs.

[Elsie Cheng:]

My first question is on traffic monetization. We've got like 20%-plus traffic growth in the quarter with increased traffic in health care vertical and higher CPR in cycle PD side as well. So can management share a little bit more color on your thoughts in monetizing the traffic on our platform? How do you look at the near-term headwind from the macro side and long-term potential there? And the second question is on the input method user monetization. We've got quite a large user base has been growing healthily as well. Can you share some thoughts into the monetization outlook down the road?

[Xiaochuan Wang:]

In terms of search monetization, I think because of the distraction of the COVID-19, apparently, advertisers have scaled back their advertising budget. And for now, it looks like we have to take more time to negotiate with advertisers for their annual framework agreement and we expect advertising spend has a chance to normalize within this year if everything goes well.And for Sogou, on search, we are actually trying to upgrade our search products and services with smart Q&A capabilities and move beyond information, providing information to offering valuable knowledge. And we are focused on knowledge generation and then knowledge computing to bring more valuable added services to our users.For example, recently, we launched our AI nutrition list and empowered by our knowledge computing and natural interaction technologies, the new service is able to provide personalized dietary guidance based on user's health conditions. And this is some kind of value-added services to users that we can actually roll out to advertisers for monetization potential.

[Xiaochuan Wang:]

With more knowledge embedded in our search results, it's actually going to attract an increasing number of advertisers and also if it is influential enough, we can actually charge users directly.Turning to the monetization of Mobile Keyboard. I think our strategy is always that we will further grow our user base and explore more use cases to accelerate the monetization progress. And in the past, we have rolled out recommendation series. We have steadily drive it forward with our optimized data capabilities that better supported -- better support targeted recommendation, and it's expected to maintain steady growth momentum and we are also tapping into the potential of more value-added services, such as e-commerce, shopping guides and emojis service to better connect customers and merchants. And we expect great growth room for Mobile Keyboard. Now Mobile Keyboard contributed to mid- to-high single digits of our total revenues. And we expect it to grow to a meaningful level within this year.

[Operator:]

The next question comes from Alex Yao of JPMorgan.

[Alex Yao:]

My first question is about the second quarter guidance. Can you break out the guidance for advertising revenue and non-ads revenue? Particularly for the ads revenue, is the weakness in the advertising revenue growth rate more reflective of the traffic weakness or demand weakness? If the issue is more on the demand side, can you help us understand where do you see the weakest demand at the moment? Is it more from the multinational companies or more from nonperformance of brands as budget? Any color would be helpful.

[Joe Zhou:]

Okay. I'll take the first question. So for Q2 guidance, in RMB term, our guidance indicates an 8% year-over-year decline on midpoint. So the decline was mainly due to the negative impact of the pandemic search-related revenues. For Smart Hardware, it will continue to have a strong year-over-year growth mainly driven by our AI recorder. So for the search-related revenue, the year-over-year decline is mainly due to the weak demand. So you know the pandemic hit all the sectors. So basically, for those rising sectors during the Q1, it started to normalize in Q2 as people are increasingly returning to work. So those advertisers, such as online gaming, including live streaming and online education, they scale back their ads budgets from the Q1 level. So in Q2, those sectors will report much slower growth in Q2 on a year-over-year basis.For the sectors that were seriously impacted by the pandemic in Q1, say those are offline service sectors, such as health care, merchant services the local life services have been recovering, but in a relatively slow pace. And still spend much less on a year-over-year basis so far.So for e-commerce, it's gradually recovering but not fully back to their normal levels on a year-over-year basis, especially for those online travel agencies. We include that into the e-commerce.So for OTA, it will take more time for their advertising comes back to normal level. So we think that for Q2, with the pressure on the revenue side, but tech were trending down, say, sequentially, it will decrease more than 10% -- between 10% to 20%. So we will narrow down our loss from to RMB 220 million in Q1 to basically around RMB 50 million loss in Q2.

[Alex Yao:]

Understood. So the second question is a follow-up on the traffic acquisition cost sides. Is the traffic acquisition payout occurring largely based on the number of search query generated within the third-party browsers? Meaning the more traffic query, the more you need to pay them regardless of your monetization level? Or if I were to generalize the trend, the TAC is more reflective of your traffic in terms of query growth with regard to the third-party browser operators and less a function of monetization or other elements. Is that the correct understanding?

[Joe Zhou:]

Yes. So the traffic increased roughly 20%. Due to the pandemic, say, people staying at home, and they have more time to go online, search for those information. So we pay to handset manufacturers for the default search engine on a by-query basis. So we'll pay them based on the number of queries, multiple played by fixed unit price. So due to the pandemic, advertiser downscaled their budgets. So -- but meanwhile, the price on traffic acquisition is fixed. So the economics on the acquired traffic online per unit basis decreased in Q1. So that's why we made RMB 220 million loss in Q1.So far, with pandemic get much better, the traffic has been trending down. So basically, by the end of Q2, it was basically back to a low level. So due to the trending down -- our average, I mean, for Q2, our average, the traffic will be, say, 10% to 20% lower than Q1. So accordingly, the tax will be 10% to 20% lower than Q1.

[Operator:]

The next question today comes from Natalie Wu of CICC.

[Natalie Wu:]

My question is more regarding the traffic acquisition costs as well. So Joe, you've mentioned that 20% growth is coming from traffic growth in the first quarter. So that -- does that mean that the other like, 5% to 7%, is coming from the price hike? So just wondering, can we assume a similar price hike growth coming into the second half of this year?

[Joe Zhou:]

For other sectors -- so basically, other sectors, we see traffic growth. Yes, yes. So we see the traffic increase for all the channels, organic and Tencent and also acquired traffic. So for the acquired traffic. So the total traffic increase, apart from the increased traffic volume, they are also, say, 5% to 10% price hike.

[Natalie Wu:]

Yes. So for the second half of this year, should we assume a similar pace of this kind of the year-on-year growth of the price hike?

[Joe Zhou:]

Yes. Yes. The price fixed at the beginning of this year, so it will be the same price going through the year.

[Natalie Wu:]

Got it. Also, can I get an update of the -- of your traffic distribution between the organic and the acquired traffic? And also, how much traffic contributions from which channel currently? Did you see any improvement after the format upgrade earlier this year?

[Joe Zhou:]

Yes. Okay. So let's start with the last quarter. So in Q4 '19, the traffic contribution, 30% from organic and a 35%, Tencent and another 35% from acquired traffic. So in Q1, due to the pandemic, so we see the substantial increase in traffic, especially for those traffic from acquired traffic channel. So this quarter, organic -- other -- for other channel, you look at the absolute volume, the traffic are increased comparing to last quarter. But with more traffic increased from acquired traffic channel, so the contribution changed to 25% organic, 36% from Tencent and 39% from acquired channel.So after the pandemic, the traffic acquisition will go down. So if we look at the end of this year, so basically, it will back to normal, say, 30% organic, 35% from Tencent and 35% from traffic acquisition. So when I say we try to drive up our organic traffic and unlock the value of such traffic will mean traffic more than search traffic. So for Mobile Keyboard, we may unlock its value, we'll create more scenario to monetize, not necessarily search or use feed. So for those kind of traffic, we cannot translate it into the search volume. So when I say by the end, the composition will be 30% from organic. We don't include such traffic other than search. And as Xiaochuan mentioned, we will try to charge users for those value-added services. So for that kind of revenue -- traffic, we can now translate that into organic traffic.

[Natalie Wu:]

Got it. So we think the 35% traffic coming from Tencent channel, is the traffic contribution from WeChat still minimal?

[Joe Zhou:]

Yes, still minimum. Whilst the majority of the traffic is coming from Q2 mobile browser.

[Operator:]

[Operator Instructions]. The next question today comes from Alicia Yap of Citigroup.

[Alicia Yap:]

Wanted to see if management can share with us what's your view on how the Chinese users are searching whether the information discovery behavior will change over time. So will searching through browser environment still important gateway? And how is the status of Sogou Mini program progress and any tractions there? And then just kind of follow-up on the TAC part. So the pricing increase is associated in the beginning of the year, right? So with the pandemic, is there any chance that we can renegotiate the pricing to go lower for the second half?

[Xiaochuan Wang:]

From the users behavior for search, I think for general search, it's always browser- or app-concentrated rather than app, which is basically the same thing. And for vertical -- for some of the vertical search happens within the vertical ecosystems systems that some large platforms build such as WeChat or Toutiao. So regarding your second question on traffic acquisition cost, I think it's already at a plateau within the industry, and we are making proactive negotiations with the OEM manufacturers to see if there is some opportunity to move the price.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Jessie Zheng for any closing remarks.

[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:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.