Sogou Inc.
Q2 2018 Earnings Call Transcript

Published: 31 Jul 2018

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to Sogou's Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. After management's prepared remarks, there will be a question-and-answer session. 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 call 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 second quarter of 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 current trends, estimates and the 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. With that, I will now turn the call over to our CEO, Xiaochuan Wang.

[Xiaochuan Wang:]

Thank you, Jessie. In the second quarter of 2018, we continued to steadily develop our twin growth engines

[Joe Zhou:]

Thank you, Xiaochuan. Hello, everyone. We achieved solid financial results in the second quarter of 2018. Our total revenues increased by 43% year-over-year to $301 million. Our non-GAAP net income was $38 million, representing a 58% year-over-year growth. Going forward, we will continue to boost the development and the synergies of our twin growth engines, Sogou Search and the Sogou Mobile Keyboard, and strategically strengthen our core AI capabilities in the R&D of smart hardware products. Now I'll walk through our financial results. 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 our reconciliation of non-GAAP to GAAP measures in our earnings release. As I noted earlier, total revenues in the second quarter was $301 million, a 43% increase year-over-year. On a constant current basis, if the exchange rate in the second quarter of 2018 had been the same as a year ago, total revenues in the second quarter would have been $281 million, a 33% increase year-over-year. Search and search-related revenues were $271 million, a 45% increase year-over-year. The increase was primarily due to strong growth in auction-based pay-for-click services, driven by improved monetization and continued traffic growth in mobile search. Auction-based pay-for-click services accounted for 85% of our total search and search-related revenues compared to 83% in the corresponding period in 2017. The number of advertisers for our auction-based pay-for-click services was approximately 83,000, an increase of 10% from the same period of 2017. The average revenue per advertiser for auction-based pay-for-click services was $2,760, an increase of 35% year-over-year. Other revenues were $31 million, a 27% 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 $180 million, a 70% increase year-over-year. Traffic acquisition cost, a primary driver of cost of revenues was $136 million, a 91% increase year-over-year, representing 45% of total revenues, compared to 34% 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, while balancing between cost and benefit. Gross profit was $122 million, a 15% increase year-over-year. Non-GAAP gross profit was $122 million, a 16% increase year-over-year. Both GAAP and non-GAAP gross margin were 40% compared with 50% a year-ago. The decrease primarily resulted from traffic acquisition cost outgrowing revenues. Total operating expenses were $97 million, a 21% increase year-over-year. Research and development expenses were $56 million, a 48% increase year-over-year, representing 19% of total revenues, compared to 18% in the corresponding period in 2017. The increase was primarily due to an increase in salary and benefits expenses, outsourced product development fees as well as share-based compensation expenses, reflecting our continued efforts to strengthen our AI capabilities. Sales and marketing expenses were $34 million, an 8% decrease year-over-year, representing 11% of total revenues, compared to 17% in the corresponding period in 2017. The decrease was primarily due to a decrease in marketing and promotional spending for our mobile products. G&A expenses were $7 million, a 27% increase year-over-year, representing 2% of total revenues, compared to 3% in the corresponding period in 2017. The increase was primarily due to an increase in share-based compensation expenses, and salary and benefit expenses. Operating income was $25 million, a 2% decrease year-over-year. Non-GAAP operating income was $30 million, a 14% increase year-over-year. Income tax expense was $3 million, compared to income tax expense of $2 million in the corresponding quarter of 2017. The effective tax rate was 8% compared to 8% in the corresponding quarter of 2017. Net income attributable to Sogou was $33 million, a 41% increase year-over-year. Non-GAAP net income attributable to Sogou was $38 million, a 58% increase year-over-year. Basic earnings per ADS were $0.09. Diluted earnings per ADS were $0.08. Non-GAAP basic and diluted earnings per ADS were $0.10 and $0.09 respectively. As of June 30, 2018, we had cash and cash equivalents and short-term investments of $1 billion, compared with $1.1 billion as of March 31. Net loans receivable was $13 million, representing the amounts receivable under small consumer loans extended through our recently launched internet finance platform. Net operating cash inflow for the second quarter of 2018 was $13 million. Capital expenditures for the second quarter of 2018 were $20 million. And finally, turning to guidance, for the third quarter of 2018, we expect total revenues to be in the range of $275 million to $285 million, representing a 7% to 11% increase year-over-year. The lower than anticipated guidance is primarily due to the one-time impact of the regulatory investigation, and the subsequent improvement of our advertising practices, the adjustment of our smart hardware strategy and the depreciation of the RMB. Please note that for the third quarter 2018 guidance, we have presumed an exchange rate of RMB 6.80 to the dollar, as compared with the actual exchange rate of approximately RMB 6.66 to the dollar for the third quarter of 2017, and RMB 6.38 to the dollar for the second quarter of 2018. That concludes our prepared remarks.

[Jessie Zheng:]

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

[Operator:]

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

[Thomas Chong:]

Hi, good evening. Thanks management for taking my questions. I have two questions. The first question is about our synergies with our Sogou Input, and when should we expect the monetization to kick off? Is it going to be the fourth quarter of 2019? And my second question is about our KPI for our hardware adjustment ARTUs [ph]. Is there any KPI that you can share about what our goal is in 2019? Thank you.

[Xiaochuan Wang:]

[Interpreted] Xiaochuan will take the first question. We maintained - on our Mobile Keyboard, we maintained the same strategy of better integrating mobile keyboard with search based on user intent and behavior while users are inputting words to offer search recommendations. We've been testing different functionalities and some of them had gone on live in the third quarter. And we expect meaningful contributions starting from the fourth quarter. On the hardware KPI, we expect sales volume to exceed 1 million units in 2019.

[Thomas Chong:]

Got it, thank you.

[Operator:]

Our next question comes from Bill Liu of Goldman Sachs. Please go ahead.

[Chong Liu:]

Thank you for taking my question. This is Bill on behalf of Piyush. I have two questions. First one is just a follow-up on the [Yin incident] [ph]. So in recent days, we realized that some more apps are being removed from App Store from third-party for tighter content control. I just wonder if there is any longer-term impact in terms of our cost structure. And so, how should we think about this, because probably your company needs to hire some extra staff to somehow conduct the censorship? The second question is in terms of operating expense, we noticed that our sales and marketing as percentage of revenue has started to drop. Going forward, what shall we think about the operating leverage from such cost item going forward? Thank you.

[Joe Zhou:]

Okay. I will take these two questions. So first, for [Dial-in] [ph], [Technical Difficulty], yes, okay, I will repeat. So first for [Dial-in] [ph], the key point to note is that the financial impact is one-time, which will all be reflected in Q3. The search-related advertising has completely recovered, and its revenue growth will return to normal in Q4. And before that incident, we had a stringent review mechanism that includes multiple steps. So once an ad is submitted to Sogou, the system will automatically filter keywords that are blacklisted. After the ad uploaded to Sogou's database, the system will do another round of auto inspection and we will perform manual inspection on sample basis. So after the incident, we have implemented a range of measures to prevent this from happening again. So we have established a dedicated team to monitor relevant new regulations and any changes of regulations as well as ensure timely implementation of such new regulations or changes accordingly. And we strengthened our auditing procedures by leverage AI to upgrade automated system and expand our manual inspection team to extend the scope of manual inspection. So next, for CapEx - for operating expenses, so with healthy revenue growth, we do expect the operating leverage will continue in 2019. So for 2018, roughly the operating leverage will contribute 6 to 7 percentage points on the operating margin. So next year, the contribution will be around, say, 3 to 4 percentage points.

[Chong Liu:]

Thank you.

[Operator:]

Our next question comes from Alex Yao of J.P. Morgan. Please go ahead.

[Alex Yao:]

Hi, good evening, management. Thank you for taking my question. I have two questions. Number one, can you guys comment on the competitive landscape in China's search engine market, especially in relation to the OEM traffic purchase? And then, number two, how do you guys think about evolvement of a keyword search, or more broadly speaking, search in the consumer market in China? Apparently, the search was originated from keywords based on the search. But some say that search either taking a new form and gradually becoming a behavior-based business, such as the feeds products figure out to the consumer demand and then feed the consumer with relevant content and advertising content. What's your view on the evolvement of search and are the implication to as budget allocation?

[Xiaochuan Wang:]

[Interpreted] So on the OEM traffic, we think that the competition for OEM traffic remains at an elevated level, [somehow renewed the] [ph] contract, but maintained the same scale of traffic acquisition as essentially in line with our expectation. And we believe that in the second half, we'll see a more balanced market with each competitor taking a certain share of OEM traffic. We will continue to campaign for traffic, while balancing between cost and the benefit in the market share. We aim to uplift the breakeven for OEM traffic and confident that our strong monetization definitely will keep us competitive. So we expect slower growth in OEM traffic than the market, but we still anticipate that we will get a certain percent of the OEM traffic. We feel that keywords-based search and the voice search are complementary, and they will exist together. For - I think for - in certain cases, when users ask questions, it's not just satisfying for them to get just simply what links. But in some cases, our keyword search is still very useful. So in terms of voice search technology, I would like to remind you for live streaming question-and-answer show in the first quarter. Actually leveraging our voice technology there are millions of users getting on a search platform to do voice-based Q&A.

[Operator:]

Our next question comes from Xueru Zhang of 86Research. Please go ahead.

[Xueru Zhang:]

Good evening, Xiaochuan Wang, Joe Zhou and Jessie. Thank you for taking my question. I do have a follow-up question on the traffic mix. So how the trends in traffic has been sweet among organic traffic, traffic from Tencent and traffic from the smartphone OEM? And I also have a question on your smart hardware business. Xiaochuan Wang mentioned during a conference that Sogou will release four new smart devices before year-end, so can management share more color on the new initiatives? Thank you.

[Joe Zhou:]

Okay. I'll take the first question and Xiaochuan will answer the smart hardware one. Okay, so for Q2, the traffic mix is that organic traffic, 25%; Tencent channel, 37%; and OEM channel, 38%. So with a lot of efforts putting on the Sogou information, we do expect organic traffic will ramp up during the first quarter and the year 2019. So by the end of 2018, we expect the contribution from organic channel will go up from current 25% to, say, 27%, 28%. And the Tencent channel basically will keep flat. And OEM channel due to the intensified competition, it will cap - in absolute traffic, it will cap the growth. But as a percentage of total traffic, its contribution will go down, say, 1 to 2 percentage points, say, from today's 38% to around 36% by the end of this year.

[Xiaochuan Wang:]

[Interpreted] Also in the - on the question on smart hardware, in the first half, we've successfully launched the two translation devices leveraging our industry-leading translation technologies. We already have a number of new AI-enabled products in the pipeline that we plan to launch before the end of the year, but we're not disclosing the specific product at this stage. You can be sure that it will incorporate some of our core AI technology that Sogou is known for including voice and Q&A, in addition to translation. We believe these products leveraging our AI capabilities will help us build a product differentiation and competitiveness, and it also offers us flexibility to cater for higher gross margin products or low price to market to gain market share. And one thing I want to add is that these products are more consumer-orientated, and it's more closely connected with our core AI capabilities, measured interaction and the knowledge computing.

[Xueru Zhang:]

Thanks for the detailed answer.

[Operator:]

Our next question comes from Alicia Yap of Citigroup. Please go ahead.

[Alicia Yap:]

Hi, good evening, management. Thanks for taking my questions. I have a follow-up questions regarding the 10-day suspension's impact with 3Q guidance. So can you elaborate a little bit on the impact? It seems like the 3Q guidance are suggesting more serious impact than the 10-day suspension. So wanted to know how much of that coming from exactly the 10 days impact and how much of that is actually coming from the ongoing cleanup on the monitoring of those ad services. So any detailed elaborations would be helpful.

[Joe Zhou:]

Okay, I will take this question. So first, let me give you more details on Q2 revenue. That was such a very good basis for you to understanding Q3 revenue guidance. So for Q2, excluding 10 percentage points exchange rate impact total revenues in RMB increased by 33% year-over-year. Among that search-related revenues grew 35% year-over-year and the hardware revenues grew 19% year-over-year. For search-related revenue, the increase of 35% year-over-year were driven by, first, mid-single-digit growth in search traffic and 23% improvement on monetization. So for other revenues, it grew by 19%. The modest growth was primarily due to slower-than-expected Teemo sales as we already started to transition to hardware products that are better connected with AI capabilities. So that's for Q2. For Q3, excluding 2 percentage points exchange rate impact, if we use the midrange of our guidance that implies total revenues in RMB terms to grow 11% year-over-year. So among that, search-related revenues were increased by mid-teens and other revenues were decreased 25% to 30%. So for search-related revenues to grow by mid-teens year-over-year, that's driven by, first single-digit growth in traffic and about 10% improvement on monetization. So, comparing to 23% year-over-year growth on the monetization improvement in Q2, the speed slowdown in Q3 due to the 10-day suspension as a result of the Yin [ph] incident. So other revenues are expected to decrease by 25% to 30% costs toward the end of Q2. We started to accelerate the adjustment of our smart hardware strategy by transitioning to products that are better connected with AI capabilities. Therefore, we are phasing out hardware products that are now AI-enabled such as certain legacy models of the Teemo Smart Watch. Although, this will have active impact on the second half, it will increase the competitiveness and better develop our smart hardware business next year and in the long-term. So for the Yin [ph] impact, I think the key point to note is that this is one of financial impacts than the revenue already recovered. So in Q4, the revenue growth - I mean, the year-over-year revenue growth will go back to normal.

[Alicia Yap:]

Okay. Thank you.

[Operator:]

Our next question comes from Natalie Wu of CICC. Please go ahead.

[Natalie Wu:]

Hi, good evening, Xiaochuan, Joe Zhou and Jessie. Thanks for taking my question. And I have two questions here. First one is regarding the OEM channel. Just curious, what do you think of your RPM trend going forwards? Do you think that your RPM could grow faster than traffic acquisition cost in the foreseeable maybe one or two years? And in terms of the advertiser industry, which industry is playing the largest part in terms of the RPM hike? And also, just curious if someday, let's say, the CPM for OEM channel rises to a level beyond your RPM, net of rebate, will you stop purchasing traffic from that channel? This is my first part of the question. And second question is regarding the input method - the Sogou input method monetization. Just curious how will you balance the monetization effect and user experience for the IME monetization? Thank you.

[Joe Zhou:]

Okay. I will take the first question and Mr. Xiaochuan will answer the input method one. So for OEM channel, so first of all for the RPM trend, considering the intensity of our competition, so our first strategy is that we call it the twin engine - twin growth engine strategy. So the most important thing is to drive up the monetization of our input method. And after that, we will try our best to improve the RPM for our traditional search business. So for this year, if we look at Q2, the RPM improved 23% comparing to a year ago. So in 2019, I think it will slow down a little bit, while continuing to improve. So the key thing is not only the improvement on RPM, but also on the - how much is the price inflation next year. So basically, we think next year, the OEM channel - the competition for OEM channel should be remaining at an intensified level, yeah. So if next year the price inflation be very high and far exceeds our RPM, we will make loss on such traffic acquisition. If that's true, our principle is that we try to aggressively acquire traffic, but we need to balance the cost-benefit. I mean, we need to consider bottom line impact. We can make loss, but we don't want to make a huge loss on that. So for ad industry, so basically the top 5 industry are still, say, number one, healthcare; number two, e-commerce; number three, gaming; and the number four, merchant services; and number five, business services. So among these top 5 industries, e-commerce and healthcare grew faster than the average. Okay. That's my part.

[Xiaochuan Wang:]

[Interpreted] So on Mobile Keyboard, our Mobile Keyboard has a market share of over 50% on smartphones and is still rising. So first, we will continue to focus on user experience and the product innovation to increase user retention as well as to have other partners to recognize our branding and the product quality. We have been very prudent in the monetization of our mobile keyboard. We have been for a long time testing different use cases and functionalities without damaging the user experience. And for the users who are pretty sensitive to advertisement, we offer them an option to opt out. But it turns out that very few users would choose to opt out. On the other hand, Sogou Mobile Keyboard has strong big data capabilities, which have not been unlocked. Our Mobile Keyboard captures over 90 billion Chinese characters every day. And that allows us to capture our users' language data and the user behavior and intent across use cases, which help us to increase the accuracy of user profiling. And, this has benefited the development of Internet finance business.

[Natalie Wu:]

That's very helpful.

[Operator:]

[Operator Instructions] 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 is now concluded. Thank you for attending today's presentation. You may now disconnect.