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Sogou Inc. (NYSE:SOGO)
Q2 2019 Earnings Call
Aug 5, 2019, 7:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by, and welcome to Sogou's Second Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen only mode. After management's prepared remarks, there will be a Q&A session. Today's conference call is being recorded. [Operator Instructions] I now turn the call over to your host today, Jessie Zheng. Investor Relations Director of Sogou. Please go ahead.

Jessie Zheng -- Investor Relations Director

Hello, everyone, and thank you for joining Sogou's Second Quarter 2019 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 calls, Xiaochuan's prepared remarks will be in Xiaochuan voice using personalized speech synthesis and the 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 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 contained in any forward-looking statements.

For more information about 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 -- Sogou Board Member, Chief Executive Officer

Thank you, Jessie. And hello, everyone. We are pleased to report that in the second quarter we achieved steady growth across our core businesses with total revenues reaching USD304 million or over RMB2 billion. We also recorded solid profitability with non-GAAP net income of nearly USD38 million or RMB189 million. In fact, as of the end of June, Sogou maintained its position as China's second largest search engine. At the same time, our search revenues continues to grow faster than the industry average. In mobile keyboard, we recorded 450 million DAUs in the quarter, up 17% year-over-year, which reinforced its position as the third largest Chinese mobile app in terms of the DAU according to Research. With this expanded use of bases for both search and mobile keyboard, we have gradually built up our big data and recommendation service at a company level.

Revenues generated from this service have ramped up quickly and is on track to become our second growth engine. Additionally, with the support of our core AI capabilities, the smart hardware business has been progressing well with its ongoing upgrade and is delivering tangible results.

Now, let me walk you through each of our core businesses. In Search, we are committed to building a more efficient and knowledgeable search platform that provides high quality content, particularly in healthcare search and intelligence Q&A. In the second quarter, we further expanded the authoritative content offerings to better address user search intention and content need. This has resulted in a significant increase in the proportion of healthcare search clearly, as well as growth in the average number of clicks per user for healthcare search results.

Moreover, we stayed significantly ahead of our peers in both the fulfillment and accuracy rates of our call [Phonetic] direct answer results in the quarter. In addition, we further built up our content ecosystem with Sogou Health [Phonetic], our content application platform. During the quarter, we continued to broaden access to the authoritative healthcare and Q&A content of Sogou Ask, allowing us to provide high quality content at a consistent standard across all our platforms.

All this effort has effectively boosted our organic traffic growth on top of increasing high quality content, we have also been strengthening our service offerings in search. During the quarter, we started with the healthcare vertical and introduced initiatives to build a closed loop to better serve the demands of our users. Specifically, we recently received an Internet hospital license that secured the permission to develop online diagnosis and treatment services. Of note, our independently developed Mark 5 [Phonetic] technology, a core technology used news an online diagnosis and treatment was certified [Phonetic] by the Regional Healthcare platform in Shanghai and switched [Phonetic] in July 2019. Turning to mobile keyboard, thanks to a number of industry leading product innovation, Sogou mobile keyboard continues to grow its user base. By the end of June, average daily voice requests made by a Sogou mobile keyboard increases by 72% year-over-year with up to 680 million requests per day, thereby retaining its position as the largest voice app in China.

During the quarter, Sogou mobile keyboard launched the most advanced voice conversion technology, which gives the voice industry a strong testament to its leading-edge voice synthesis capability as well as its innovation strength. This technology allows users to convert their voices to a selection of nearly 20 characters, such as celebrities and animated characters, as well as dialect as we enable our users to communicate in more expressive and entertaining ways. Voice conversion has become one of the most popular entertainment functions on our mobile keyboard. While we're attracting more users to search at mobile keyboard, we're also building the big data and recommendation service to unlock is commercial value. And big data is based on our understanding of hundreds of millions of our users.

We have developed accuracy of user profiling and have continuously improved the algorithms to make progress with recommendations. This has led to a solid foundation for our recommendation service. Meanwhile, we have leveraged our own products matrix to provide our recommendation service for more users. In particular, we enhanced content and service distribution capabilities for mobile keyboard. [Indecipherable] During the quarter, we improved the user interface and content format to make its recommendation feature more intuitive and fast so that our users can receive and share content more conveniently. We're pleased the mobile keyboard is becoming an important driver for our recommendation service. In the second quarter, revenues generated from the big data and recommendation service tripled year-over-year. The service consists of new speech that leverage our various search related assets as a content recommendation using mobile keyboard, among other things, we expect the growth momentum to continue in the second half of 2019.

Moving now to AI, in the second quarter we continued to implement our AI strategy of developing language- centric AI technologies. We geared up our effort to drive the innovation in technologies and applications and expand our leadership in voice and computer vision with many industry leading big growers[Phonetic]. For example, we launched the world's first Russian speaking AI news anchor named Lisa in partnership with ITAR-TASS, a news agency in Russia. We've also expanded the application scenario of our Sogou Vocational Avatar moving into the legal industry.

Jointly with the Beijing Internet court, we [Indecipherable] judge, the first of its kind in the world. With respect to AI smart hardware, we have leveraged our core AI capabilities to drive the ongoing upgrade of the three major product lines, children, translation and voice. As a result, our AI smart hardware business made significant progress in the second quarter. Let me provide just a few updates on the product. In May 2019, we launched Troy2[Phonetic], a new generation of children's smartwatch that integrates multiple AI enabled functions such as intelligent Q&A, simulation of parents bedtime storytelling and smart evaluation of children's spoken English level.

All of the functions are significantly improving our products' competitiveness. Also, our AI enabled Smart Recorder C1 has topped the best selling list of several mainstream e-commerce platforms since its launch in March. In addition, we have initiated R&D for high-end voice enabled hardware products that are empowered enhanced AI capabilities for more sophisticated use cases.

As new AI products hit the market, we expect our hardware business to return to profit[Phonetic] from the third quarter. In summary, it was a busy and productive quarter and now I will turn the call to Joe, who will walk you through our financials.

Jessie Zheng -- Investor Relations Director

Thank you, Xiaochuan. Hello, everyone. In the second quarter, our total revenues reached $304 million, which on a constant currency basis would have posted an 8% increase year-over-year. Notably, we saw a larger revenue contribution from the big data and the recommendation service as we continue to tap into its monetization potential. We also focused on improving operational efficiency and achieved a solid profitability in the second quarter. Although, we anticipate the external environment to remain challenging in the second half of 2019, we expect to experience positive momentum from our new growth drivers, including the big data and the recommendation service as well as smart hardware.

I'd like to also point out one other key portion of our announcement today. Highlighting our solid balance sheet and confidence in the Company's long term growth, our Board of Directors recently authorized our share repurchase program of up to USD50 million over the next 12 months. And please note that, we will fund our repurchases from our existing cash balance.

Now I'll walk you through our financials in greater detail. Please note that unless otherwise noted, all monetary amounts that I discuss are in US dollars. Also note 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 second quarter was $304 million. On a constant currency basis, total revenues in the second quarter would have been $324 million, an 8% increase year-over-year. Search and search-related revenues were $276 million on a constant currency basis. Search and search-related revenues would have booked a 9% increase year-over-year, the increase was primarily due to the growth in auction-based pay-for-click services; auction-based pay-for-click services accounted for 88% of search and search-related revenues compared to 85% in the corresponding period in 2018. The number of advertisers for our auction-based pay-for-click service was approximately 87,000, up 5% year-over-year. The average revenue per advertiser for auction-based pay-for-click services was $2,800, up 1% year-over-year.

Other revenues were $27 million, a 11% decrease year-over-year. The decrease was primarily due to lower sales of smart hardware products as a result of continued efforts to upgrade our smart hardware strategy. Based on new models launched and more in the pipeline, we expect hardware sales to return to growth in the third quarter of 2019.

Cost of revenues was $196 million, a 9% increase year-over-year. Traffic acquisition cost, our primary driver of cost of revenues was $146 million, a 8% increase year-over-year, representing 48% of total revenues compared to 45% in the corresponding period in 2018. The year-over-year increase was driven by price inflation, which has clearly moderated from a year ago.

As we continue to be selective with traffic acquisition and the benefit from increasing contribution from organic traffic, we expect traffic[Phonetic] growth to be well contained for the remaining quarters of 2019. Both GAAP and non-GAAP gross profit was $108 million compared to $122 million[Phonetic] in the corresponding period in the 2018. GAAP gross margin was 35% and the non-GAAP gross margin was 36% compared to 40% a year ago.

The decrees primarily resulted from the growth of traffic acquisition costs outpacing that of revenues. Total operating expenses were $96 million, largely flat year-over-year. Research and development expenses were $51 million, a 10% decrease year-over-year, representing 17% of total revenues compared to 19% in the corresponding period in 2018. Sales and marketing expenses were $37 million, a 8% increase year-over-year, representing 12% of total revenues compared to 11% in the corresponding period in 2018. G&A expenses were $9 million, a 31% increase year-over-year, representing 3% of total revenues compared to 2% in the corresponding period in 2018. Operating income was $12 million compared to an operating income of $25 million in the corresponding period in 2018. Non-GAAP operating income was $18 million compared to a non-GAAP operating income of $30 million in the corresponding period in 2018. Other income net was $4 million compared to $3 million in the corresponding period in 2018.

Income tax benefit was $1 million compared to an income tax expense of $3 million in the corresponding period in 2018, the income tax benefit primarily resulted from a tax filing adjustment of income tax expense previously recognized. Net income attributable to Sogou was $21 million compared to net income of $33 million in the corresponding period in 2018. Non-GAAP net income attributable to Sogou was $28 million compared to net income of $38 million in the corresponding period in 2018. Basic and diluted earnings per ADS were $0.05. Non-GAAP basic and diluted earnings per ADS were $0.07.

As of June 30, 2019, we had cash and cash equivalents and short-term investments of $1.1 billion compared to $1 billion as of December 31, 2018. Net operating cash inflow for the second quarter was $56 million. Capital expenditures for the second quarter were $12 million.

And lastly turning to our outlook, for the third quarter we expect total revenues to be in the range of $304 million to $314 million, representing a 10% to 14% increase year-over-year or 11% to a 15% increase year-over-year in RMB terms.

Please note that for the third quarter 2019 guidance, we have assumed an exchange rate of RMB6.9 to the dollar as compared with the actual exchange rate of approximately RMB6.81 to the dollar for the third quarter of 2018 and RMB6.82 to the dollar for the second quarter of 2019.

That concludes our prepared remarks.

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

Questions and Answers:

Operator

Yes. Thank you. We will now begin the question-and-answer session. [Operator Instructions] And the first question comes from Elsie Cheng with Goldman Sachs.

Elsie Cheng -- Goldman Sachs -- Analyst

Thank you, management for taking my question. (Foreign Language) And I'll quickly translate my question. My first question is on the industry where the overall advertising industry growth remains challenged this year, we also observe some other Internet companies with big amount of user traffic are actively launching search features in the app as well. It is still very early stage right now. But I would like to hear management's thoughts on whether you think there is any changing dynamics in the competitive landscape in the search space? And how is Sogou strategically positioned to take on these challenges? And my second question is on the growth outlook of search business at Sogou. Is it fair for me to interpret your 3Q revenue guidance, which is a robust number of 11% to 15% in the RMB terms at the start of a normalized growth curve for the Company and coming out of the growth bottoms on the second quarter, as we just said.

And can management also provide more color on the short term or maybe long term growth drivers as well? Thank you.

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

(Foreign Language) Okay, so I'll take the first question. First, on online advertising, we believe that Toutiao's entry into the home ad sector has made the sector very, very competitive and actually has negatively impacted the search advertising. However, we believe that's it and we continue to grow our own traffic and the revenue. We believe our search revenue is going to maintain a steady growth and continue to grow faster than the industry average. And on the product front, our observation so far is that Toutiao's[Phonetic] search is intended to meet the user demand for consuming a variety of content. Remember, Toutiao is pretty much labeled as a content aggregator and very naturally its search will be serving the content that's having to match the user consumption appetite. So in contrast, at Sogou we do generic search and generic search is more about how can users find the right information, answer or develop an understanding of things. It's not a use case for consumption or consuming content. So for us, we are -- we will focus more on leveraging our AI technologies such as knowledge computing to enhance the search quality and raise the mind share of Sogou search among users so that we can be very differentiated from our competitors and continue to grow our market share.

(Foreign Language) In addition, you know, we have been focusing on developing our big data and the recommendations service, we've expanded user bases for both search and mobile keyboard. We have gradually built up our big data and recommendation service at the company level to add[Phonetic] to its commercial value. And we have seen a very solid momentum on that front. And second, we made very good progress with the business upgrading across our smart hardware categories, including children, translation and voice. So we believe these new growth drivers will continue to experience positive momentum and help Sogou grow its business for the longer term.

Joe Zhou -- Sogou Inc. -- Chief Financial Officer

This is Joe. I will take second question regarding the guidance of Q3. So for Q3, total revenues in RMB expected to increase by 11% to 15%. So take the middle end, that implies a 13% increase year-over-year in RMB terms. So I want to remind you that in Q3 2018, we did have a low base as we suspended 10 days of online ad business due to the Douyin incident. Though Apple[Phonetic] type of bases, if there was no Douyin incident, I think Q3 guidance, I mean, for the middle end would imply a 8% growth year-over-year in RMB terms. So basically, that means comparing to Q2 is also 8% growth year-over-year the growth in Q3 and continuing into the Q4 will be steadily at around 8%. Looking to next year, with the development of our big data and the recommendation service and the accelerated growth from smart hardware, we expect the revenue growth in 2020 will accelerate.

Elsie Cheng -- Goldman Sachs -- Analyst

Got it. Thank you. Thank you very much.

Operator

Thank you. And the next question comes from Alicia Yap with Citigroup.

Alicia Yap -- Citigroup -- Analyst

Hi, good evening. (Foreign Language) Thanks for taking my questions. I have a couple questions. Number one, is search. Could you elaborate a bit the increase in the traffic acquisition costs, which I think you mentioned, was due to the increase in pricing. So are you able to share with us what is the magnitude of the increase in pricing? And also how should we expect that to trend in the second half?

And if you have any early color into the 2020 on the CAC[Phonetic] costs. Second question is, how do you quantify the latest app demand outlook, especially on the medical customer you seems to be commenting, you are gaining some shares. So I wonder if you are able to quantify the percentage of the share gains from your peers? And also related to that healthcare, wonder if Sogou has plans to move the medical search queries into the structured data platform like your peers? Thank you.

Joe Zhou -- Sogou Inc. -- Chief Financial Officer

Okay. I'll take the first question regarding the tax increase. So as percentage to total revenue for Q2 in fact accounted for 48% of total revenues comparing to last year's 45%, so the increase is mainly due to the price inflation. So you know for 2018, unlike previous years, there is maybe a price inflation in 2018. So for the first half of 2019, the price inflation is about say 30% to 40%. But for the second half, the price inflation will slow down to 10% to 20%. So is our efforts to drive up the organic traffic and to be more selective on traffic acquisition. So in the second half, TAC as a percentage of total revenue will continue to increase [Phonetic] in Q3 and Q4. So overall, for whole year 2019, TAC as a percentage to total revenue will be increased just a little bit, say, 1 or 2 percentage points, I mean, as percentage to total revenue comparing to last year's 47% of total revenue.

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

(Foreign Language) In terms of ad demand outlook for the healthcare sector, we haven't seen a significant impact from our vertical peers. And in my thinking substance [Phonetic], the healthcare sector is very fragmented as compared to other sectors. So it's very difficult for vertical apps to just satisfy the older users' demands. Second, in terms of the structured data, we are doing the same thing as our competitors do. We are moving our search queries related to healthcare into a more structured platform so that we can increase the mind share of healthcare search among older users and improve our search quality.

Alicia Yap -- Citigroup -- Analyst

Thank you.

Operator

Thank you. And the next question comes from Xueru Zhang with 86Research.

Xueru Zhang -- 86Research -- Analyst

Good evening, management. Thank you for taking my questions. I have a quick question on the mobile keyboard. Can management help us understand better how recommendation works on the mobile keyboard and help Sogou to monetize through the features? And what is your long term revenue target regarding this business? Thank you.

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

(Foreign Language) In terms of the monetization potential for mobile keyboard, we are building actually the big data and recommendation service. So in big data actually we have very good understanding of our users from our various search assets, so that we can develop accurate user profiling and improve the algorithm to make targeted recommendations.

Also in mobile keyboard, we believe a lot of users they are trying to search with the mobile keyboard, whether it's general search or e-commerce search and so on. Mobile keyboard has also generated a lot of data so that we can improve our recommendation service.

In the future, mobile keyboard is going to be operated like a channel for us to push, there is information and various content and services. It will be more like a VTA kind of services that we can recommend various content and services to increasing number of users. And this is going to be a add -- a value-added service for our hundreds of millions of our mobile keyboard users.

(Foreign Language) The service, the recommendations service is not only going -- not trying to keep users reading the mobile keyboard, it's trying to leverage that user profiling to develop added services like New Seed, which is still accounts for a very low proportion of total revenue and also other services like Internet finance.

Xueru Zhang -- 86Research -- Analyst

That's very helpful. Thank you.

Operator

Thank you. And the next question comes from Alex Yao with JPMorgan.

Alex Yao -- JPMorgan -- Analyst

Hi, good evening, management. Thank you for taking my question. I have two questions and for one, Joe, you talked about the advertising growth outlook in 2020 will be better than 2019. Can you walk us through what is the underlying assumption behind this statement? For example, are you seeing the macro impact on advertiser sentiment or budget allocation is it diminishing or are you seeing the pricing pressure from Douyin releasing inventory is going down? Or are you seeing traffic contribution, meaningful traffic contribution from the keyboard software?

And then second question is the recent Toutiao's search engine launch? I think you guys already talked about, that you really see the impact on operation. My question is, how do you see the next two to four quarters? Are you seeing possibility the Nielsen[Phonetic] will increasingly make more search for Toutiao platform gradually from content sourcing to service sourcing? Should we expect increasing competition pressure from new entrants to search engine marketing? Thank you.

Joe Zhou -- Sogou Inc. -- Chief Financial Officer

Okay. For 2020 outlook for search revenue, we expect it will be quite stable in 2020. So the acceleration is coming from number one, with the development of our recommendation service, we expect the revenue from that will continue to ramp up in 2020. And the second, with new products launched this year and more in the pipeline we expect smart hardware sales will accelerate in 2020.

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

(Foreign Language) So in terms of your question for Toutiao to expand from content search to general search. We believe that Toutiao, it depends on how users recognize Toutiao as whether it's a generic search engine or its content consuming platform. I think so far, I've mentioned that Toutiao is pretty much labeled an accountant aggregator.

Having said that, we will keep an eye on how things are going to develop going forward.

Operator

Okay. Thank you. And the next question comes from Natalie Wu with CICC.

Unidentified Participant

Hi. Thanks management for taking my question. This is Juku [Phonetic] representing Natalie. So we notice that the recommendation experienced a strong growth in the second quarter. So what do you think are like major drivers behind it and what do you think are your like major competitive advantage compared to the industry peers? And what is your like strategy and expectation for this kind of the -- for this business going forward? (Foreign Language)

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

As compared to our peers, I think we have a competitive advantage in providing the recommendation service because we have a massive user base. We are actually the number four largest Internet company in terms of user base, only after VAT[Phonetic]. And second, we have very good user profiling capability because we understand our users from search and mobile keyboard. That's where our strength is.

(Foreign Language) In terms of revenue contribution, I think it's a bit too early to tell because this recommendation series is not only about, you know, online advertising, it's more about other services, including seed and financial services, which we expect a higher ARPU from these, you know, innovative services, leveraging big data capabilities of the recommendation service.

Operator

Next question comes from Thomas Chong with Jefferies.

Thomas Chong -- Jefferies -- Analyst

Hi, thanks management for taking my questions. I'm not sure if my questions have been answered in previous questions. I just want to get an update about our cooperation with Tencent in terms of the monetization of general search. And my second question is about our hardware initiatives, can management give us some color about the profit profile over the long run, if there's any? Thank you.

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

(Foreign Language) In terms of our cooperation with Tencent, I think it's progressing well as planned, whether it's WeChat search, our collaboration with QQ Mobile browser. We have extended, you know, relevant agreements and we believe there is a chance that we can expand our cooperation going forward. (Foreign Language) In terms of how -- on our most recent product, AI Smart Recorder, C1, is a strong testament to our AI technology capability. It's a very good use of our natural interaction and knowledge computing strategy, for example, it has wonderful sound picking capability with very high accuracy.

And in the future, we're going to leverage our advantages in search and mobile keyboard search, which means you are actually outputting -- which means output and mobile keyboards, which means input. So in the future, we are going to develop other categories of products that can leverage this output/input capabilities and those categories -- those products are intended for a much more mainstream market.

Thomas Chong -- Jefferies -- Analyst

Thank you.

Operator

Thank you. And that is the end of the question session. I would like to return the floor to management for any closing comments.

Jessie Zheng -- Investor Relations Director

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

[Operator Instructions]

Duration: 50 minutes

Call participants:

Jessie Zheng -- Investor Relations Director

Xiaochuan Wang -- Sogou Board Member, Chief Executive Officer

Elsie Cheng -- Goldman Sachs -- Analyst

Joe Zhou -- Sogou Inc. -- Chief Financial Officer

Alicia Yap -- Citigroup -- Analyst

Xueru Zhang -- 86Research -- Analyst

Alex Yao -- JPMorgan -- Analyst

Unidentified Participant

Thomas Chong -- Jefferies -- Analyst

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