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SOHU > SEC Filings for SOHU > Form 10-Q on 8-Nov-2012All Recent SEC Filings

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Form 10-Q for SOHU COM INC


8-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

As used in this report, references to "us," "we," "our," "our company," "our group," "Sohu" and "Sohu.com" are to Sohu.com Inc. and, except where the context requires otherwise, our wholly-owned and majority-owned subsidiaries and variable interest entities ("VIEs"), Sohu.com Limited, Sohu.com (Hong Kong) Limited ("Sohu Hong Kong"), All Honest International Limited, Sohu.com (Game) Limited ("Sohu Game"),Go2Map Inc., Sohu.com (Search) Limited, Sogou Inc., Sogou (BVI) Limited, Sogou Hong Kong Limited, Vast Creation Advertising Media Services Limited ("Vast Creation"), Fox Video Investment Holding Limited ("Video Investment"), Fox Video Limited ("Sohu Video"), Fox Video (HK) Limited ("Video HK"), Beijing Sohu New Era Information Technology Co., Ltd. ("Sohu Era"), Beijing Sohu Software Technology Co., Ltd. ("New Software"), Beijing Fire Fox Digital Technology Co., Ltd. ("Beijing Fire Fox", also known as Beijing Huohu Digital Technology Co., Ltd., or "Huohu"), Beijing Sohu Interactive Software Co., Ltd. ("Sohu Software"), Go2Map Software (Beijing) Co., Ltd. ("Go2Map Software"), Beijing Sogou Technology Development Co., Ltd. ("Sogou Technology"), Beijing Sogou Network Technology Co., Ltd ("Sogou Network"), Fox Information Technology (Tianjin) Limited ("Video Tianjin"), Beijing Sohu New Media Information Technology Co., Ltd. ("Sohu Media"), Beijing Focus Time Advertising Media Co., Ltd. ("Focus Time"), Beijing Sohu New Momentum Information Technology Co., Ltd. ("Sohu New Momentum"), Beijing Century High Tech Investment Co., Ltd. ("High Century"), Beijing Sohu Entertainment Culture Media Co., Ltd. ("Sohu Entertainment", formerly known as Beijing Hengda Yitong Internet Technology Development Co., Ltd., or "Hengda"), Beijing Sohu Internet Information Service Co., Ltd. ("Sohu Internet"), Beijing GoodFeel Information Technology Co., Ltd. ("GoodFeel"), Beijing Tu Xing Tian Xia Information Consultancy Co., Ltd. ("Tu Xing Tian Xia"), Beijing Sogou Information Service Co., Ltd. ("Sogou Information"), Beijing 21 East Culture Development Co., Ltd. ("21 East Beijing"), Beijing Sohu Donglin Advertising Co., Ltd.("Donglin"), Beijing Pilot New Era Advertising Co., Ltd. ("Pilot New Era"), Beijing Focus Yiju Network Information Technology Co., Ltd. ("Focus Yiju"), Beijing Yi He Jia Xun Information Technology Co., Ltd. ("Yi He Jia Xun"), Beijing 17173 Network Technology Co., Ltd. ("17173 Network"), Tianjin Jinhu Culture Development Co., Ltd. ("Tianjin Jinhu") and our independently-listed majority-owned subsidiary Changyou.com Limited ("Changyou", formerly known as TL Age Limited) as well as the following direct and indirect subsidiaries and VIEs of Changyou:
Changyou.com HK Limited ("Changyou HK", formerly known as TL Age Hong Kong Limited), Changyou.com Webgame (HK) Limited ("Changyou HK Webgame"), Changyou.com Gamepower (HK) Limited ("Changyou HK Gamepower"), ICE Entertainment (HK) Limited ("ICE HK"), Changyou.com (US) Inc. (formerly known as AmazGame Entertainment (US) Inc.), Changyou.com (UK) Company Limited ("Changyou UK"), ChangyouMy Sdn. Bhd ("Changyou Malaysia"), Changyou.com Korea Limited ("Changyou Korea"), Changyou.com India Private Limited ("Changyou India"), Changyou B?L???M H?ZMETLER? T?CARET L?M?TED ??RKET? ("Changyou Turkey"), Kylie Enterprises Limited, 7Road.com Limited ("7Road"), 7Road.com HK Limited ("7Road HK"), Beijing AmazGame Age Internet Technology Co., Ltd. ("AmazGame"), Beijing Changyou Gamespace Software Technology Co., Ltd. ("Gamespace"), ICE Information Technology (Shanghai) Co., Ltd. ("ICE Information"), Beijing Yang Fan Jing He Information Consulting Co., Ltd. ("Yang Fan Jing He"), Shanghai Jingmao Culture Communication Co., Ltd. ("Shanghai Jingmao"), Shanghai Hejin Data Consulting Co., Ltd. ("Shanghai Hejin"), Beijing Jingmao Film & Culture Communication Co., Ltd. ("Beijing Jingmao"), Beijing Gamease Age Digital Technology Co., Ltd. ("Gamease"), Beijing Guanyou Gamespace Digital Technology Co., Ltd. ("Guanyou Gamespace"), and Shanghai ICE Information Technology Co., Ltd.("Shanghai ICE"), Shenzhen 7Road Network Technologies Co., Ltd.("7Road Technology") , Shenzhen 7Road Technology Co., Ltd. ("Shenzhen 7Road"), and these references should be interpreted accordingly. Unless otherwise specified, references to "China" or "PRC" refer to the People's Republic of China and do not include the Hong Kong Special Administrative Region, the Macau Special Administrative Region or Taiwan. This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words "expect", "anticipate", "intend" ,"believe", or similar language. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our business and financial performance are subject to substantial risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information set forth under the heading "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission ("SEC") on February 28, 2012, as updated by Part II Item 1A of this report. Readers are cautioned not to place undue reliance on these forward-looking statements.

OVERVIEW

Sohu (NASDAQ: SOHU) is a leading Chinese online media, search, gaming, community and mobile service group. We operate one of the most comprehensive matrices of Chinese language Web properties, and we developed and operate one of the most popular massively multiplayer online games and two popular Web games in China. Substantially all of our operations are conducted through our indirect wholly-owned and majority-owned China-based subsidiaries and variable interest entities (collectively the "Sohu Group").

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Our businesses consist of the online advertising business, which consists of the brand advertising business as well as the search and others business, the online game business, the wireless business and the others business, among which online advertising and online games are our core businesses.

Factors and Trends Affecting our Business

The Internet and Internet-related markets in China continued to evolve rapidly during 2012. According to a semiannual report issued by the China Internet Network Information Center ("CNNIC"), the total number of Internet users in China had reached 538 million by the end of June 2012, an increase of 24.5 million from the end of 2011. The number of mobile Internet users in China had reached 388 million by the end of June 2012, an increase of 32.7 million from the end of 2011, and exceeding the 380 million desktop computer Internet users as of June 2012. Mobile Internet is becoming the top channel for Internet users to access Websites in China. We believe that this large and expanding user base will continue to provide significant opportunities for our company to expand our product offerings and to explore new revenue streams.

However, China's economy has been experiencing decelerating growth recently, with the result that many large advertisers were cautious regarding their spending on advertising in the face of this economy uncertainty. At the same time, we have been facing fierce competition arising from existing and new Internet companies, which have been seizing advertising market share. We have noted that this macro-economic environment and increased competition has had some adverse impact on our brand advertising business.

In China, online video is a popular Internet application, with over 350 million users as of June 30, 2012 according to the semiannual report issued by CNNIC. We expect that brand in the future will continue to allocate more advertising dollars to online video in order to exploit this growing market, but we are uncertain as to when such an increased allocation will occur, or how large it might be. The market prices of online video content are becoming relatively stable after a significant decline in prior months. During the third quarter of 2012, our strategic plan of building a dedicated sales team was well on track, and our video direct account sales team was in place. Also, we set up a video agency sales team during quarter. We are optimistic about the prospects of our online video business, and expect this business to resume on a growth track during the fourth quarter of 2012.

In the third quarter, our search and others business continued to grow, which was attributable to the growth of pay-for-click services, as well as online marketing services on Sogou Web Directory. We expect our search and others business will sustain healthy revenue growth through the remainder of 2012.

We continue to be pleased with, and optimistic regarding, the growth and profitability of our online games business. We believe that our strong performance in the third quarter reflects the resilience of the online games industry in China despite the weakening global macroeconomic environment and economic slowdown in China, and that it also reflects the ongoing strength of our online games content and our successful expansion into other fast-growing segments of the industry, such as web games.

We believe, as discussed above, that there are significant opportunities to explore new revenue streams related to the mobile Internet market. Our wireless business faces a challenge in this regard, as we will need to catch up with our peer competitors with respect to penetration of new mobile applications and features.

Summary of Our Business

Online Advertising Business

Brand Advertising Business

Our brand advertising business offers various products and services (such as free of charge premier content including video content, interactive community, and other competitive Internet services) to our users, and provides advertising services to advertisers on our matrices of Chinese language Web properties consisting of:

sohu.com, a leading mass portal and online media destination;

focus.cn, a top real estate Website; and

17173.com, a leading game information portal. Since December 15, 2011, 17173.com has been owned and operated by our majority-owned subsidiary Changyou.com Limited ("Changyou").

Our brand advertising business offers advertisements on our Web properties to companies seeking to increase their brand awareness online.

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Search and Others Business

Our search and others business, provided by our search subsidiary Sogou Inc. ("Sogou"), primarily offers customers pay-for-click services, as well as online marketing services on Sogou Web Directory.

Online Game Business

Our online game business is conducted via Changyou, which is a leading online game developer and operator in China. Changyou engages in the development, operation and licensing of online games, including massively multiplayer online games ("MMOGs") and Web games. Changyou developed and operates Tian Long Ba Bu ("TLBB"), which is one of the most popular MMOGs in China. Changyou's majority-owned subsidiary 7Road.com Limited ("7Road") jointly operates DDTank and Wartune (also known as "Shen Qu"), which are two popular Web games in China, primarily through an extensive network of third-party game platforms in China and overseas.

For the third quarter of 2012, more than 71% of the revenues of our online game business were derived from TLBB. Changyou's online game revenues were $151.1 million, which represented 53% of our total revenues for the quarter. Net income contributed by Changyou for the quarter was $77.4 million, which represented 150% of our total net income. We depend on Changyou for a significant portion of our revenues, net income, and operating cash flow.

Wireless Business

Our wireless business offers mobile related services through different types of wireless products to mobile phone users. The mobile related services consist of the provision of content such as news, weather forecasts, chatting, entertainment information, mobile games, mobile phone ringtones, logo downloads and video content downloads. A majority of the content is purchased from third party content providers. The wireless products mainly consist of short messaging services ("SMS"), interactive voice response ("IVR"), mobile games and Ring Back Tone ("RBT").

Others Business

Our others business primarily includes sub-licensing of licensed video content to third parties, offering cinema advertisement slots to be shown in theaters before the screening of movies, and offering Internet value-added services ("IVAS") with respect to Web games developed by third-party developers under revenue sharing arrangements with third-party developers.

Business Restructuring

Initial Public Offering of Changyou

On April 7, 2009, Changyou completed its initial public offering on the NASDAQ Global Select Market, trading under the symbol "CYOU." After Changyou's offering, as we are Changyou's controlling shareholder, we continue to consolidate Changyou in our consolidated financial statements, but recognize noncontrolling interest reflecting shares held by shareholders other than us. For the third quarter of 2012, approximately 32% of the economic interest in Changyou was recognized as noncontrolling interest in our consolidated financial statements.

On August 6, 2012, Changyou declared a special one-time cash dividend of $1.90 per Class A or Class B ordinary share, or $3.80 per American depositary share ("ADS") and a total of $201 million. On September 21, 2012, Changyou paid out this special cash dividend, of which $136 million was paid to and received by Sohu.

We have entered into agreements with Changyou with respect to various interim and ongoing relationships between us, including a Master Transaction Agreement, a Revised Non-Competition Agreement, and an Amended and Restated Marketing Services Agreement. These agreements contain provisions which, among other things, relate to the transfer of assets and assumption of liabilities of the massively multiplayer online role-playing game ("MMORPG," which is a subset of the MMOG category) business, provide cross-indemnification between us and Changyou for liabilities arising from our respective businesses and mutually limit us and Changyou from competing in certain aspects of each other's businesses, and also include a number of ongoing commercial relationships.

Sogou Transactions

On October 22, 2010, Sogou sold 24.0 million, 14.4 million and 38.4 million, respectively, of its newly-issued Series A Preferred Shares to Alibaba Investment Limited ("Alibaba"), a private investment subsidiary of Alibaba Group Holding Limited, China Web Search (HK) Limited ("China Web"), an investment vehicle of Yunfeng Fund, LP, and Photon Group Limited ("Photon"), the investment fund of Sohu's Chairman and Chief Executive Officer Dr. Charles Zhang, for $15 million, $9 million, and $24 million, respectively.

On June 29, 2012, Sohu purchased the 24.0 million Sogou Series A Preferred Shares held by Alibaba for fixed cash consideration of $25.8 million. After the purchase of these shares, we held 73% of the combined total of Sogou's outstanding ordinary shares and Series A Preferred Shares. As we are Sogou's controlling shareholder, we continue to consolidate Sogou in our consolidated financial statements, but recognize noncontrolling interest reflecting shares held by shareholders other than us.

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17173 Transaction

On December 15, 2011, pursuant to an agreement entered into on November 29, 2011, we closed the sale to Changyou of certain assets associated with the business of 17173.com (the "17173 Business"), a leading game information portal in China, for fixed cash consideration of $162.5 million. In payment of part of the consideration, Changyou.com HK Limited delivered to Sohu.com Limited a promissory note in the amount of $16 million due on November 30, 2012. In connection with this transaction, we and Changyou revised the Non-Competition Agreement between us to provide our agreement not to compete with Changyou in the 17173 Business for a period of five years following the closing of Changyou's acquisition of the 17173 Business and to remove the prior prohibition on Changyou's competing with us in the 17173 Business. After the closing of the sale, we continued to consolidate the results of operations of the 17173 Business in our consolidated financial statements.

On November 29, 2011, we and Changyou entered into a services agreement and an online links and advertising agreement pursuant to which we agreed to provide links and advertising space and technical support to Changyou, including the provision and maintenance of user log-in, information management and virtual currency payment systems for the 17173 Business. The agreements provide for a term of 25 years for the virtual currency payment system services, and an initial term of three years for all the other relevant services and links and advertising space, with aggregate fees payable by Changyou to us of approximately $30 million. Under the agreements, Changyou may renew certain rights for a subsequent term of 22 years, and may obtain a perpetual software license in respect of the information management system and the user log-in system following the expiration of the three-year term, subject to Changyou's payment to us of additional fees of up to approximately $5 million in the aggregate.

7Road Transactions

On May 11, 2011, Changyou, through its VIE Gamease, acquired 68.258% of the equity interests of Shenzhen 7Road and began to consolidate Shenzhen 7Road's financial statements on June 1, 2011. Effective June 26, 2012, Shenzhen 7Road was reorganized into a Cayman Islands holding company structure where Changyou holds a direct ownership interest in 7Road through Changyou's subsidiary Changyou.com Webgame (HK) Limited, and Shenzhen 7Road is a VIE of 7Road. For purposes of clarity, as the reorganization did not result in any change in the ultimate beneficial ownership of Shenzhen 7Road's business, assets and results of operations, when we discuss 7Road and Shenzhen 7Road in this report, we treat the reorganization as if it had been effective upon Changyou's acquisition of 68.258% of the equity interests in Shenzhen 7Road.

On June 21, 2012, 7Road's Chief Executive Officer surrendered to 7Road, without consideration, ordinary shares of 7Road representing 5.1% of the outstanding ordinary shares of 7Road, in order to increase the number of ordinary shares available for issuance as equity incentives to employees, directors and consultants of 7Road without dilution of the other shareholders of 7Road. As a result, the noncontrolling interest decreased to 28.074% of 7Road and Changyou's interest in 7Road increased to 71.926%.

On September 26, 2012, 7Road submitted on a confidential basis to the SEC a draft registration statement for a possible initial public offering ("IPO") of ADSs representing ordinary shares of 7Road.

CRITICAL ACCOUNTING POLICIES AND MANAGEMENT ESTIMATES

Our discussion and analysis of our financial condition and results of operations relates to our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have identified below the accounting policies that reflect our more significant estimates and judgments, and those that we believe are the most critical to fully understanding and evaluating our consolidated financial statements.

Basis of Consolidation

The consolidated financial statements include the accounts of Sohu and its wholly-owned and majority-owned subsidiaries and variable interest entities ("VIEs"). All intercompany transactions are eliminated.

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We have adopted the guidance of accounting for VIEs, which requires VIEs to be consolidated by the primary beneficiary of the entity. Our management made evaluations of the relationships between us and its VIEs and the economic benefit flow of contractual arrangements with the VIEs. In connection with such evaluation, management also took into account the fact that, as a result of such contractual arrangements, the Sohu Group controls the shareholders' voting interests in the VIEs. As a result of such evaluation, management concluded that the Sohu Group is the primary beneficiary of its VIEs. As a result, we consolidate all of its VIEs in its consolidated financial statements.

For majority-owned subsidiaries and VIEs, noncontrolling interest is recognized to reflect the portion of their equity which is not attributable, directly or indirectly, to the controlling shareholder.

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. The recognition of revenues involves certain management judgments. The amount and timing of our revenues could be materially different for any period if management made different judgments or utilized different estimates.

Online Advertising Revenues

Online advertising revenues include revenues from brand advertising services as well as search and others services.

For a barter transaction involving online advertising services, we recognize revenue and expense at fair value only if the fair value of the advertising services surrendered /received in the transaction is determinable. For our advertising-for-advertising barter transactions, the fair value of the advertising surrendered /received is not determinable, so no revenue from advertising-for-advertising barter transactions is recognized.

Before September 1, 2012, our online advertising revenues were subject to PRC business tax ("Business Tax"). Our online advertising revenues were recognized after deducting agent rebates and applicable Business Tax and related surcharges. Business Tax is imposed primarily on revenues from the provision of taxable services and is calculated by multiplying the applicable tax rate by gross revenue.

Effective September 1, 2012, the PRC Ministry of Finance and the State Administration of Taxation launched a Business Tax to Value Added Tax Transformation Pilot Program (the "Pilot Program") for certain industries in eight regions, including Beijing and Tianjin. Value Added Tax ("VAT") payable on goods sold or taxable labor services provided by a general VAT taxpayer for a taxable period is the net balance of the output VAT for the period after crediting the input VAT for the period. Hence, the amount of VAT payable does not result directly from output VAT generated from goods sold or taxable labor services provided. With the adoption of Pilot Program, our online advertising revenues are subject to VAT. Our online advertising revenues are now recognized after deducting agent rebates and net of VAT and related surcharges.

Brand Advertising Revenues

Business Model

Currently the brand advertising business has two main types of pricing models, consisting of the Fixed Price Model and the Cost Per Impression ("CPM") pricing model. We apply the Fixed Price Model for a majority of our brand advertising revenues. Under the Fixed Price Model, a contract is signed to establish a fixed price for the advertising services to be provided. Under the CPM pricing model, the total contract amount for the advertising services is not fixed. Instead, a fixed price for each qualifying display is stated. Advertisers using the CPM pricing model pay us based on the number of qualifying displays of their advertisements appear on our Websites, and we recognize as revenue the fees charged to advertisers each time their advertisements are displayed on the Websites, on the condition that each display meets certain selected criteria imposed by advertisers. We provide advertisement placements to our advertisers on our different Website channels and in different formats, which can include, among other things, banners, links, logos, buttons, rich media, pre-roll and post-roll video screens, pause video screens and content integration, as specified in the contracts with the advertisers.

Revenue recognition and basis of revenue presentation

For brand advertising revenue recognition, prior to entering into contracts, we make a credit assessment of the customer to assess the collectability of the contract. For those contracts for which the collectability is determined to be reasonably assured, we recognize revenue when all revenue recognition criteria are met. For those contracts for which the collectability is determined not to be reasonably assured, we recognize revenue only when the cash was received and all other revenue recognition criteria are met.

In accordance with ASU No.2009 -13, which we adopted commencing January 1, 2011, we treat advertising contracts with multiple deliverable elements as separate units of accounting for revenue recognition purposes and to recognize revenue on a periodic basis during the contract when each deliverable service is provided. Since the contract price is for all deliverables, we allocate the arrangement consideration to all deliverables at the inception of the arrangement on the basis of their relative selling prices. Since the number of advertising contracts that covered more than one quarter and the revenues from advertising contracts that covered more than one quarter were immaterial compared to the total advertising contracts, the impact of adoption of ASU 2009-13 to us is immaterial.

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We recognize gross revenue for the amount of fees we receive from our advertisers. Determining whether revenue should be reported gross or net is . . .

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