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Sogou Inc. (SOGO)
Q3Â 2019 Earnings Call
Nov 4, 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 Third Quarter 2019 Earnings Conference Call. [Operator Instructions]
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 -- Director of Investor Relations
Hello, everyone, and thank you for joining Sogou's third quarter 2019 earnings conference call. On the call, are our CEO, Xiaochuan Wang; and our CFO, Joe Zhou will give an overview of the operations and financial results. In line with our practice on the previous earnings conference calls, Xiaochuan 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 the current plans, estimates and projections and therefore you should not place undue reliance on them. Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those containing any forward-looking statements. For more information about the potential risks and uncertainties, please refer to the Company's filings with the Securities and Exchange Commission.
With that, I will now turn the call over to our CEO, Xiaochuan Wang.
Xiaochuan Wang -- Chief Executive Officer
Thank you, Jessie and hello, everyone. Despite continued headwinds in the macro environment and the online advertising industry, we experienced healthy growth in the third quarter with steady top line increase and significant improvement on profitability. This was primarily driven by our constant efforts to drive organic traffic growth and unlock the monetization potential of our existing assets. In the quarter, our total revenue increased 17% year-over-year to over RMB2.2 billion. Excluding the impact of the one-time Douyin incident in the third quarter of 2018, when we suspended 10 days of online advertising business, on an apple to apple basis, total revenues increased 12% year-over-year in RMB.
In regards to our bottom line as we well manage traffic acquisition costs and continue to improve operational efficiency in the quarter. Our non-GAAP net income increased 47% year-over-year to RMB283 million. In third, Sogou maintained its position as China's second largest search engine, and our search revenue continued to grow faster than the industry average. In Mobile Keyboard, we recorded 464 million DAUs in the quarter up 14% year-over-year, reinforcing this position as the third largest Chinese mobile app in terms of DAUs. According to iResearch, with respect to our recommendation service that leverages our Mobile Keyboard. We are glad, these revenues ramp up quickly in the quarter. And this is on track to become our second growth engine following search. In addition, our Smart Hardware business returns to its growth trajectory in the quarter. Thanks to the launch of our new AI-enabled products.
Now let me walk you through each of our core businesses, including search, Mobile Keyboard and Smart Hardware. In search, healthcare vertical and intelligent Q&A remain our priorities as we are committed to building a high quality search platform. During the third quarter, we focused on enriching authoritative content, better than the most frequently searched healthcare queries, while expanding the coverage of healthcare encyclopedia content. These efforts resulted in better operating metrics across the board including a solid increase in the click-through rate of healthcare search result. We've also continued to stay ahead of peers in both the fulfillment and accuracy rate of our top direct answer results.
Meanwhile, our average improving content ecosystem effectively boosted organic traffic growth in the quarter. As a proof, average daily closure of the content page on Sogou Health are common aggregating platform increased significantly from the prior quarter. Turning to Mobile Keyboard. Thanks to a number of industry-leading product innovation. Sogou Mobile Keyboard further expanded its user base in the quarter. By the end of September, average daily voice requests made via Sogou Mobile Keyboard increased by 67% year-over-year with up to 830 million requests per day, retaining its position as the largest voice app in China.
Moreover, during the quarter, we launched an AI-assistance named, Smart Wanzai [Phonetic] within Mobile Keyboard which recommends the user and the rate of emoticons and expressions in chat. These innovative functions help evolve our Mobile Keyboard from a utility software to an AI-enabled communication assistance. Now recommended emoticons and expressions are used hundreds of million times per day on average. And the daily usage number is ramping quickly.
In the net debt, we will leverage Smart Wanzai to provide more targeted recommendations to address a variety of browsing uncertainties emerging in cap [Phonetic]. Driven by these initiatives in the third quarter revenue generated from our recommendation service that leverages Mobile Keyboard with a year-over-year increase of over 70%. On Smart Hardware, a AI hardware, a new team of products hit the market. Revenue generated from the Smart Hardware business was back on to a growth trajectory during the quarter. In particular, sales volume of AI-enabled smart recorder has got the best selling [Phonetic] on several mainstream e-commerce platform and gained broad attention among the industry.
During the quarter, we have also partnered with leading recorder manufacturer such as Sony, AIGO and Newmine, jointly established an AI Innovation Alliance in which we open Sogou transcription service to the partner, the Alliance allows us to capture an increasing number of potential users or have the need to translate conversation. It also provides us an opportunity to test the water [Phonetic] for a service-based business model in the recorder market. In addition, we have devoted R&D efforts to high end AI-enabled recording products for more sophisticated use cases, which will further expand our AI product lines.
Moving onto AI. In the third quarter, we consolidated our language centric AI technologies to fully support innovation in the third Mobile Keyboard and Smart Hardware businesses. In terms of technology, we continue to upgrade our voice and Vocational Avatars technology. In particular, our general capability in voice recognition was significantly upgraded to enable a more natural way of speaking. As a result, our Chinese and English recognition capability in both distant and near field was significantly improved by over 20% in the third quarter.
We further reinforced total differentiation advantage and leading position in the sector. In terms of application let me share a few examples. First, by leveraging our voice technology, particularly the new generation of voice recognition model. Sogou Mobile keyboard improved the accuracy rate of mixed Chinese and English recognition by over 65%. This largely solved the technical issue that has been shaking the industry for a long time. Second, our pioneering personalized voice recognition technology enabled Mobile Keyboard to create a unique recognition model for each user, reducing the error rate by over 40% in the words and phrases frequently used by individuals.
Third, Sogou Vocational Avatars has developed into fourth generation and achieved a major upgrade to empower the virtual avatars with realistic -- real time human interaction. During the quarter, we further expanded its use bases into different sectors. We launched the world's first interactive AI customer service within our corporate service an online financing platform of Insurance.
Also I'd like to give an update on our partnership with WeChat. In October, we renewed our cooperation with WeChat. In the coming year, Sogou Search will continue to be the preferred search engine and WeChat for third-party search services to act as Internet content. Moreover, both WeChat and Sogou intend to the extent these partnerships year-to-year until 2023 as part of the overall framework agreement that Sogou and Tencent enter in September 2018.
Finally, let me share few thoughts on the rest of 2019. We expect that headwinds in the macro environment and the online advertising industry to continue, as well as the ongoing patent regulation in the Internet sector. While we anticipate short term softness, as the external challenges will impact our Q4 results and then linger into 2020, we have a solid strategy in place. In search, we will focus on building up our high quality search platform and driving organic traffic growth. At the same time, we are committed to delivering positive momentum in our new growth driver to accelerate the overall business expansion. We will gear up efforts to push forward the progress, the recommendation service leveraging Mobile Keyboard and accelerate Smart Hardware growth. We believe we are able to navigate the environment and continue to generate healthy growth and outperform the industry.
With that I will now turn the call to Joe to go through our financials.
Joe Zhou -- Chief Financial Officer
Thank you, Xiaochuan. Hello, everyone. In third quarter, our total revenues reached $315 million. As Xiaochuan mentioned, on an apple-to-apple basis, our total revenues increased 12% year-over-year in RMB terms. The increase was driven by the faster than the industry average growth of search revenue. The strong momentum of recommendation service as well as the back on track Smart Hardware revenue. Bottom-line wise non-GAAP net income grew by 46% year-over-year to $41 million. Margins improved across the Board. As we generated increasing contribution from organic traffic, which helped us well contain the traffic acquisition cost. And at the same time prudently manage the expenses and improved operational efficiency.
Now, I'll walk you through our third quarter financials in greater detail. Please know that unless otherwise noted. All monetary amounts that I discuss, are in US 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 third quarter were $315 million, a 14% increase year-over-year. Search and search-related revenues were $288 million, a 13% increase year-over-year. The increase was primarily due to growth in auction-based pay-for-click services. Auction-based pay-for-click services accounted for 89% of search and search-related revenues, compared to 83% in the corresponding period in 2018.
The number of advertisers for our auction-based pay-for-click service was approximately 92,000, up 13% year-over-year. The average revenue per advertiser for auction-based pay-for-click services was $2,800, up 7% year-over-year. Other revenues were $27 million, a 25% increase year-over-year. The increase was primarily due to increased revenues from sales of Smart Hardware. With the new models launched and the more in the pipeline, we expect hardware sales to keep the momentum for the rest of 2019.
Cost of revenues was $189 million, a 9% increase year-over-year. Traffic acquisition cost. Our primary driver of cost of revenues was $144 million, a 6% increase year-over-year, representing 46% of total revenues compared to 49% in the corresponding period in 2018. As we continue to benefit from the increasing contribution from organic traffic, we expect TAC growth to be well contained for the rest of 2019. Both GAAP and non-GAAP gross profit were $126 million, a 22% increase compared to the corresponding period in 2018. Both GAAP and non-GAAP gross margin increased to 40% compared to 37% a year ago.
The increase primarily resulted from our efforts to control traffic acquisition cost. Total operating expenses were $98 million, 10% decrease year-over-year. Research and development expenses were $50 million, relatively stable year-over-year, representing 16% of total revenues compared to 18% in the corresponding period in 2018. Sales and marketing expenses was $38 million, a 14% decrease year-over-year representing 12% of total revenues compared to 16% in the corresponding period in 2018.
The decrease was primarily attributable to a decrease in marketing and promotional spending. G&A expenses were $11 million, a 31% decrease year-over-year, representing 3% of total revenues compared to 6% in the corresponding period in 2018. The decrease was primarily due to a decrease in expenses related to non-core business.
Operating income was $27 million compared to an operating loss of $7 million in the corresponding period in 2018. Non-GAAP operating income was $32 million compared to non-GAAP operating loss of $3 million in the corresponding period in 2018. Other income net was $8 million compared to $24 million in the corresponding period in 2018. The decrease was primarily due to an $18 million gain from one of Sogou's equity investments recognized in the corresponding period in 2018. Income tax expense was $2 million compared to income tax benefit of $0.4 million in the corresponding period in 2018. Net income attributable to Sogou was $37 million,
a 53% increase year-over-year, compared to net income of $24 million in the corresponding period in 2018.
Non-GAAP net income attributable to Sogou was $41 million, a 46% increase year-over-year, compared to net income of $28 million in the corresponding period in 2018. Basic and diluted earnings per ADS were $0.09. Non-GAAP basic and diluted earnings per ADS were $0.10. As of September 30, 2019, we had cash and cash equivalents and short-term investments of $1.1 billion, compared with $1 billion as of December 31st, 2018. Net operating cash inflow for the third quarter was $20 million. Capital expenditures for the third quarter was $0.7 million.
And lastly, turning to our outlook. For the first quarter we expect total revenues to be in the range of $290 million to $310 million, representing a 3% decrease to 4% increase year-over-year. Well 0% to 7% increase year-over-year in RMB terms. The guidance takes into account the potential impact of the challenges in macro economy and online advertising industry as well as the ongoing tightening regulatory environment in the internet sector.
Please know that, for the first quarter 2019 guidance, we have assumed an exchange rate of RMB7.1 to $1, as compared with the actual exchange rate of approximately RMB6.91 to $1 for the first quarter of 2018 and RMB6.99 to $1 for the third quarter of 2019. That concludes our prepared remarks.
Jessie Zheng -- Director of Investor Relations
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 Thomas Chong with Jefferies.
Thomas Chong -- Jefferies -- Analyst
Evening and good morning, everyone. And thanks management for taking my questions. I have a question about the macro headwinds and competition, can management comment about which sectors are affected more by macro headwinds and which industries are affected more by competition on the short video side? And how should we think about the online advertising market in 2020? Thank you.
Xiaochuan Wang -- Chief Executive Officer
[Foreign Speech]
Jessie Zheng -- Director of Investor Relations
Okay. I would just sum up. There are some changes we see in Q4 so far, first, there are some recent regulations, start to impact online ad market, for example, the ongoing tightening regulation in fintech etc., more or less impact of sectors' ad spend. In terms of competition in the online ad market, we've seen our increasing competition for ad dollars for example advertisers in the gaming and e-commerce sectors tend to allocate more budget to the short video platforms in terms of the macro environment. We think it's a relatively stable as the online advertising market tends to slow down a bit, but it's something that is in materially adverse so to navigate this set of challenging environment, we have a solid strategy in place.
In general, we will focus on new growth drivers, including the recommendations to raise that leverages Mobile keyboard to attract a new advertising budget stream from clients by offering them a diversified set of ad formats. And in search, we will focus on increasing the mind share of Sogou Search among users by leveraging our a Q&A capabilities to provide knowledge base to search results. With that, we expect we will our whether this adverse conditions there as well.
Thomas Chong -- Jefferies -- Analyst
Thank you.
Operator
Thank you. And the next question comes from Miranda Zhuang with Bank of America.
Miranda Zhuang -- Bank of America Merrill Lynch -- Analyst
[Foreign Speech]
So just can management share with us more color about the progress of the recommendation services. So any useful metrics on three areas, for example, user metrics, operational metrics and revenue metrics. And also we noticed that the Company recently launched. Like for example, our AI assistant and meaning program platform in a Sogou keyboard. So would like to give us management to share with us your thinking about this area and any user feedback on this new services. And lastly, you just would like to note the company's expectation or target for the recommendation service in next year and in the mid to long-term. Thank you.
Xiaochuan Wang -- Chief Executive Officer
[Foreign Speech]
Okay. Let me first translator the first part. The recommendation service you mentioned, actually Mobile Keyboard is becoming an important driver for recommendation services, essentially we are trying to evolve Mobile Keyboard from a utility product toward service platform, Mobile Keyboard has 460 million DAUs increase of 14% year-over-year with approximately 60% market share, and we expect its user base to further grow. On the product front in Q3, there is some changes that we would like to highlight. As we mentioned, we launched an innovative feature called Smart Wanzai [Phonetic], it basically changes the user interaction format.
It's an AI-assistant that recommends emoticons and expressions in user chats. Smart Wanzai is intended to strengthen our new brand positioning. We are also testing an order for VPA-based service in Mobile Keyboard. For now, we are just recommending emoticons and expressions but as next step or we're trying to enhance its monetization capability as Sogou has long accelerating language processing and sending and it's often perceived as language expert. We will enrich and improve the AI services leveraging Smart Wanzai going forward.
Meanwhile, we will also try of other innovative functions in Mobile Keyboard such as smart recommendation to enhance AI capabilities and create AI differentiate -- differentiation. We've seen very positive feedback from users for Smart Wanzai. We noticed that the recommended emoticons and expressions are used hundreds of millions of times per day on average and the daily usage number is climbing very quickly.
In terms of revenue contribution from now it counts for roughly 5% of our total revenues. Going forward. We expect it to reach a more meaningful level over time, and fulfill the purpose of both serving user services and also create monetization opportunities.
Miranda Zhuang -- Bank of America Merrill Lynch -- Analyst
Thank you very much.
Operator
Thank you. And the next question comes from Elsie Cheng with Goldman Sachs.
Elsie Cheng -- Goldman Sachs -- Analyst
[Foreign Speech]
I'll now quickly translate the questions myself. My first question is to Xiaochuan. This year we have observed Sogou developed deployed its AI technology to many vertical solutions as well as smart hardware devices. I would like to ask, how would you strategically positioned for Sogou for the next two to three years. And can you share with us on long-term growth drivers of the Company. My second question is on capital allocation, your core business margin has been improving on the back of healthy organic traffic growth, and yet you also have another $1 billion cash on the balance sheet. And you plans to deploy that cash into any area of the business. Thank you.
Xiaochuan Wang -- Chief Executive Officer
[Foreign Speech]
Okay. Let me first sum up our strategic initiatives. Our strategy consists of three parts, search, Mobile Keyboard and smart hardware. We will steadily develop the search business and Mobile Keyboard is becoming an important driver for recommendation service. And we will and make strong efforts to accelerate smart hardware growth. In search, we will focus building our high quality search platform and especially we would like to leverage our Q&A capabilities to provide a knowledge base search in addition to information search to increase the mind share among our users.
And in recommendation, in Mobile Keyboard, as I mentioned, we are testing the water for VPA-based to recommend based a series to enhance if monetization capability. I mean half year, we have integrated our products into two major product lines, Soguo AI and Timo [Phonetic] will increase R&D investment in more advanced AI products to catch leading market share. We expect to see a very good growth momentum in 2020. So due to all of the strategic initiatives, we expect that in the future we will ramp up out of our users, our revenues as well as our product competitiveness.
[Foreign Speech]
In addition to integrating AI capabilities to drive the growth of search and Mobile Keyboard, I especially for example is that the healthcare search and the service as a Mobile Keyboard, we are trying to build other forms of division beyond advertising. So turning to capital allocation we are leveraging our traffic to deepen our service offerings. In addition to search and mobile keyboard to generate new growth drivers. So capital will be allocated more to add back 12 new growth initiatives.
Elsie Cheng -- Goldman Sachs -- Analyst
Okay, thank you.
Operator
Thank you And the next question comes from Alex Yao with JPMorgan.
Alex Yao -- JPMorgan -- Analyst
[Foreign Speech]
So I have two questions. Number one is regarding the partnership and cooperation with the WeChat search. You guys mentioned in the prepared remarks that you just renewed a contract with WeChat such that you will continue to provide a general search within WeChat. Would you be able to share with us the latest thoughts on WeChat general search monetization. And then secondly, can you talk about your committed positioning in the AI based a smart hardware market. We understand then there are a lot of competitors that we've been a lot of similar products. What is your competitive advantage, and more importantly, how do we think about the monetization roadmaps for AI based hardware products in next couple of years. Thank you.
Xiaochuan Wang -- Chief Executive Officer
[Foreign Speech]
Okay. The, WeChat agreement is extension of our previous partnership. We are continuing the partnership on the same basis as before. Sogou continue to be the preferred third party search engine in WeChat access, Internet content, both, WeChat and Sogou intend to extend agreement year-to-year until 2023 as part of the overall framework Sogou entered the tender in 2018.
We are in discussion to expand our business collaboration for example in the future we may provide additional search such as image search and our business collaboration. Now focus is on the product front and we have -- we, it actually increases user activity on WeChat -- WeChat search platform. The exposure and the click-through rate of Sogou search result. And WeChat continues to increase, and the traffic generated is also on the rise. But as you know, we have been focusing on the product front, and there is no timeline for monetization yet.
[Foreign Speech]
So in terms of the smart hardware, I think we have very strong four language centric AI technologies. And we have excelled in voice, computer vision, translation and Q&A technologies, constantly drive product upgrades. We have leveraged our roadmap of natural interaction and knowledge computing and apply on these core competencies into our AI products to build above our competitive edge, innovation and enhance influence of Sogou AI technology. And one of our key product in 2019 is AI recorder and we because of the success of our AI technologies.
We have managed to partner with leading the quarter manufacturers to jointly establish of AI innovation alliance which allowed us to capture potential users and also test in order for service-based business model. And in terms of our application scenario, we have excellent use cases for our AI technologies, because we have search and Mobile Keyboard, one is the information output. The other is information input and by leveraging our AI capabilities, these can be gradually evolved from two -- from assistant AI assistant like service to hardware-oriented service that captures voice, image that kind of data.
A lot of people believe that speaker is the future of smart hardware, but actually we don't think so. Speaker is only a gateway, but the AI hardware, we are looking at as to create more mobility oriented services, so we believe in the future, under the umbrella of Sogou AI products, we will focus on smart voice interaction products, we want our AI products to gradually evolving virtual personal assistant.
Operator
Thank you. [Operator Instructions] And the next question comes from Alicia Yap with Citigroup.
Alicia Yap -- Citigroup -- Analyst
Hi, good evening, management. Thanks for taking my questions. I have a follow-up question regarding the macro comment that management make, so wanted to get a little bit more clarity, can you elaborate a bit on the challenging macro, when you compare in fourth quarter versus 3Q. Do you think that fourth quarter is actually getting worse than what you have seen in the third quarter.
And then also online gaming is that mainly, your comment is related to the competition from the short video and the gaming is not necessarily seeing the tightening regulation. Right. And then lastly on the healthcare vertical, if management can share a bit of color in terms of what is the healthcare growth. The vertical growth in the third quarter on your search revenue and the revenue contribution from this vertical and what is your expectation into the fourth quarter? Thank you.
Joe Zhou -- Chief Financial Officer
Okay. So if you're comparing Q4 versus Q3, paper played for the macro, where we do see increasing impact from macro economy slowdown and budget. So as I mentioned, such as e-commerce and the franchise. So for example, typically in Q4 is our peak season for e-commerce, by way see a different trend this year in Q4 and for the increasing competition on our budget. Such as the increasing competition from short video regarding gaming and e-commerce. For healthcare, it's still one of above the top five largest sector for our search business.
Alicia Yap -- Citigroup -- Analyst
Can I get a bit follow up. So, how fast is the healthcare growth and have you guys been taking some shares from your major peers?
Xiaochuan Wang -- Chief Executive Officer
[Foreign Speech]
In terms of the healthcare, I just want to add that we are trying to tap the opportunities of service-oriented business model in addition to advertising business model. There is an opportunity to connect to -- hubs to hospitals and doctors. So, we are going beyond advertising.
Alicia Yap -- Citigroup -- Analyst
I see. Actually, can I follow up in terms of healthcare, are we seeing growth and we are taking market share from our peers?
Xiaochuan Wang -- Chief Executive Officer
[Foreign Speech]
Joe Zhou -- Chief Financial Officer
Yeah, for healthcare advertising, basically now with our overall growth, so we don't see significant market share increase in healthcare this quarter.
Alicia Yap -- Citigroup -- Analyst
Okay, thank you.
Operator
Thank you. And the next question comes from Natalie Wu with CICC.
Natalie Wu -- CICC -- Analyst
Hi. Thanks for taking my question. I have two to ask. Just, regarding the other sizes, in terms of verticals, year-to-date basis for your to five vertical advertisers which one leads the growth and which one checks the most of your search business by the largest. And among those verticals, which -- weaker than you expected, which ones do you think that can be more describe to us technical and what you are is no related with structural. And second one is regarding the traffic acquisition costs, I just wonder if there is any different chance you've witnessed in the industry level lately.
[Foreign Speech]
Joe Zhou -- Chief Financial Officer
Okay. So first of all, our top sectors, there are still e-commerce, healthcare, gaming, merchant services and the business services. Apart from that education is among the faster-growing sector in our search advertising. And if you're comparing Q4 versus Q3, there is seasonality cost. There was summer vacation in Q3. So after that, say for travel, education and training and gaming, they have a sequential decrease in Q4. So for TAC, first of all for Q3, because we drive up our organic traffic. So if you look at TAC as percentage to total revenue, the ratio has been trending down in the first three quarters of 2019.
So going forward, it's how our strategy to drive up the organic traffic and to push forward recommendation services. So you know, for recommendation service for monetization it's tax rate. So if you look into Q4 2019. And the next year TAC as percentage to total revenue will continue to trending down.
Natalie Wu -- CICC -- Analyst
Got it. Thank you.
Operator
Thank you. And at this time, I would like to return the floor to management for any closing comments.
Jessie Zheng -- Director of Investor Relations
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 Closing Remarks]
Duration: 58 minutes
Call participants:
Jessie Zheng -- Director of Investor Relations
Xiaochuan Wang -- Chief Executive Officer
Joe Zhou -- Chief Financial Officer
Thomas Chong -- Jefferies -- Analyst
Miranda Zhuang -- Bank of America Merrill Lynch -- Analyst
Elsie Cheng -- Goldman Sachs -- Analyst
Alex Yao -- JPMorgan -- Analyst
Alicia Yap -- Citigroup -- Analyst
Natalie Wu -- CICC -- Analyst
